In the previous issue, we republished a column from 2008 to help readers who might be confused or even baffled by the massive paradigm shift contained in the recent lease accounting exposure draft issued jointly by the Financial Accounting Standards Board and the International Accounting Standards Board. When implemented, the proposal would capitalize all leases, finally closing down a 35-year-old loophole that has proven to be insanely popular with managers for achieving off-balance-sheet financing. The prior column described why this change is for the best.

In this one, we are reprinting a follow-up column from the same year in which we responded to criticisms from an individual accountant who basically denied that any problems exist with operating lease accounting, to the point that he didn't even acknowledge that it provided a way for management to deliberately mislead financial statement users. (Because he was upset by our replies to his arguments, we've edited this version to change his name, but not his thoughts.)

We received an e-mail about our off-balance-sheet financing column (Feb. 11, 2008) from Joe Smith, a divisional chief financial officer for a large company, a former Andersen auditor, and an erstwhile accounting instructor. We don't mind getting under readers' skin if it jars them loose from complacency. In this case, it appears we did the former but not the latter. We think others would learn from seeing his challenges (in italics, edited for prolixity) and our replies.

"Generally I find your articles thought-provoking and enlightening and generally espouse a different point of view than how we working accountants think about things. But I do get tired of one of your continuing themes that we are somehow dishonest in what we do... ."

Despite Joe's innuendo, we both actually go to work every day, where we are obliged to look objectively at financial reporting, seeking ways to make it better. What we find is that users aren't well-served and that most preparers (like Smith) don't seem to care.

For verification, the CFA Institute's 2005 monograph, A Comprehensive Business Reporting Model (downloadable free at www.cfapubs.org) provides this noteworthy comment on the status quo: "We believe that investors will be best served if revisions to the financial reporting model involve fundamental reforms, rather than superficial, cosmetic changes. Consequently, we will work with purpose and determination to assist standard-setters to address the underlying problems of an antiquated accounting model" (page 2). So, maybe it makes sense to start thinking differently.

With regard to Smith's suggestion that we imply that he and others are "dishonest," he is correct, but he probably doesn't fully comprehend where we're coming from. What we have concluded is that their behavior is dysfunctional because they do not, indeed cannot, serve the capital markets' needs through minimal compliance with politically compromised and obsolete accounting principles. As accounting experts (whether preparers or auditors), they have the responsibility to know better than to publish misleading and incomplete financial statements, even if they comply with GAAP. And if they fail to meet this responsibility, they are dishonest in holding themselves out as competent and trustworthy.

If they don't see the flaws in GAAP, they are not competent. But if they do see the flaws and still don't provide the best information, then they are not to be trusted. Either way, they are dysfunctional because they are hurting the markets, their clients, and their shareholders.

"Although I am sympathetic to your high-level assertion that OBSF is a bad thing, I disagree with your characterization of operating leases for rent as OBSF ... . The whole point of differentiation between operating and capital leases is to get at the issue of whether or not the lease is essentially a purchase and financing transaction versus renting an asset for a period of time. In the case of [Abercrombie & Fitch], they almost certainly rent their space and have no residual ownership in the building, and booking the transaction as if they really do "own" the building is even more misleading than booking it as they do."

Contrary to Smith, operating leases definitely are off-balance-sheet financing. Further, the whole point of good lease accounting is not to identify what's a purchase and what isn't. All leases produce assets in the form of lessees' rights to use lessors' property. It makes no difference whether a lease covers 0.1 percent, 74.9 percent, 75.1 percent, or 100 percent of the property's predicted life, the lessee has an asset (in the right to use the property) as well as a liability for any future payments. It isn't just our opinion: FASB of the 1980s said so, FASB of the 1990s joined with other standard-setters in espousing this view, and, with the Securities and Exchange Commission's urging, the present FASB [joined by the IASB in 2010] is reforming lease accounting along these lines.

Sure, Abercrombie & Fitch doesn't own a building, but it does have a valuable asset. The most (only?) useful economic facts about assets and liabilities are their current fair values. Reporting other numbers (especially zero) is misleading.

"There is nothing really wrong ... in how you computed the 'phantom debt' and 'phantom asset' that you purport should be on the books, but please tell me how this is more enlightening than how A&F is doing their accounting. They clearly disclose the future lease payments and the terms of the lease, so as an astute reader of the [financial statement], I clearly know what kind of future liability they have and I am not even a little bit confused nor do I feel they are 'hiding' something."

The only thing phantasmic about assets and debt from operating leases is their present invisibility on balance sheets. As for the cliché that disclosure is good enough, why not leave losses and expenses off the income statement and put them in the footnotes? Perhaps Smith doesn't feel confused, but he is. The CFA report describes current lease accounting and then says: "Reporting methods that omit or fail to reflect the economic essence of events and transactions as they occur do not achieve the purpose of financial reporting" (page 5).

Obviously, A&F management isn't successfully hiding anything from diligent analysts, but their disingenuous attempt to do so is readily apparent. They, and Smith, need to realize that the capital markets do not reward them for making information harder to retrieve and trust. Just the opposite is true.

"Another logic flaw in your argument is that if A&F really did buy these buildings, that the transactions would somehow be the same as how you would account for these leases. However, instead of depreciating the building over the lease term, you would instead depreciate it over something more like 40 years."

As for Smith's inference about what we would do, he isn't even close. If the property were purchased, we would record it at full fair value and then mark it to market at every reporting date, taking the change in value to income. We repudiate traditional depreciation as unreliable because it is based on assumptions and predictions about hypothetical future events, instead of observations of real current events.

"Most companies try hard to create a larger EBITDA number because analysts somehow think this is more relevant than net income. You are proposing a new, artificial way for them to increase this number."

This comment reveals that Smith would use standards to restrict bad behavior, not to provide useful information. He doesn't understand that producing illusory positive results only scars management's reputation and creates discounted stock prices.

As for our providing "artificial" ways to increase reported EBITDA, we disclaim responsibility for fabrications by duplicitous managers that get blessed by cooperative auditors. They are responsible for any untruths they report. Standards don't faze hard-core liars who want to lie, but they will lose when full and transparent financial reporting is the norm.

ANOTHER THOUGHT

We confess to disappointment, even despondency, that dysfunctional ignorance of the economic power inherent in useful information is so profound in Smith in particular and so widespread among others. His letter displays attitudes that simply must be replaced by the conviction that truth-telling is both feasible and rewarding.

Managers' dogged pursuit of complete and useful statements will bring far greater financial returns and personal satisfaction than today's hide-and-seek games. Truth-telling is not a difficult concept or practice, once you get used to trusting markets to do what's right for both them and you, instead of vainly hoping that you can mislead them into doing what's wrong for them and somehow right for you.

So, there you have it. A new standard could change the rules but, alas, it will probably not change the minds of accountants like Smith who just don't see the difference between telling the truth and merely following the rules without stopping to ask whether the resulting financial statements tell the truth. We often wonder what it will take to bring about this gestalt-level change in thinking. Perhaps a new standard based on the FASB/IASB exposure draft will help move accounting practice in that direction, but it is not without its own flaws. We'll describe a couple of those shortcomings in our next column.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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