Except for the naive or disingenuous, everyone involved in financial reporting knows about the huge problems created by the lease accounting industry. Failing to confront them only allows further deterioration of the integrity of managers, auditors, standard-setters, and regulators.
To put a scale on these problems, the Securities and Exchange Commission estimated in 2005 that $1.25 trillion of lease liabilities were omitted from public company financial statements. Everybody should wonder how much larger that number is now, and what the Financial Accounting Standards Board has done to eliminate this disastrous yet obvious shortcoming.
Our guess on the first point is that it’s much larger, with multiple trillions. Our observation on the second is that the board has worked really hard but has been constrained and slowed by trying to converge with the International Accounting Standards Board. But there’s a lot more behind its lack of headway.
Even if the boards had progressed at a faster clip, the results would fall well short of the disruptive change that is desperately needed to eradicate the collusive industry that systematically creates bogus financial statements. Here’s why.
THE PALEOLITHIC APPROACH
Through 65-plus years of efforts to eliminate lease-based off-balance-sheet financing, standard-setters have unsuccessfully applied the same ineffective approach over and over again.
Four different boards have known that the problem originates in management’s proclivity to camouflage credit purchases of assets as simple leases. The Committee on Accounting Procedure attempted to rein in abuses with ARB 38 in 1949. The Accounting Principles Board tried with Opinions 5, 7 and 29. FASB started with SFAS 13 in 1976 and has published many other standards since. The IASB’s joint effort with FASB produced a now two-year-old exposure draft that still doesn’t overcome the real problem.
Specifically, all four boards have adopted the doomed strategy of developing criteria to distinguish legitimate convenient rental agreements from stealthy asset acquisitions.
CRITERIA OR GUIDELINES?
This criteria-based strategy never has worked because it presumes that this three-step process takes place:
1. The lessee negotiates a lease.
2. The lessee applies the criteria to classify it as operating or capital.
3. The lessee accounts for it accordingly.
The real process actually unfolds with these different three steps:
1. The lessee sets out to avoid reporting a liability from an asset purchase.
2. The lessee studies the criteria to devise a way around them.
3. The lessee retains a lessor to concoct terms that produce an operating lease.
In effect, lessees and lessors, and the former’s auditors, use the criteria as guidelines to defeat their purpose.
A DEADLY CYCLE
Standard-setters have followed this cycle for nearly seven decades:
1. The board issues criteria.
2. Lessees/lessors find loopholes.
3. The board and lessees/lessors repeat Steps 1 and 2.
With every iteration, both standards and leases have grown more complex.
One obvious result is tarnished and untrustworthy financial statements.
Another outcome is inflated asset acquisition costs for lessees who enter into complicated and unsound agreements just to qualify for OBSF. Ironically, these managers waste gross amounts of shareholders’ money trying to deceive them.
Surely, this two-kinds-of-leases approach imposes costs on individual firms and the capital markets while enriching an industry that facilitates deception.
We find the exposure draft to be a jungle of dense provisions intended to anticipate all possible variations. That’s not good.
The good news is that it would require lessees to recognize liabilities for all leases.
More bad news: As a nod to practical considerations, this requirement wouldn’t apply to leases that last 12 months or less.
However, this exception creates a porous materiality filter that would, say, encourage a retail chain’s management to collude with lessors to create thousands of 12-month leases to avoid recognizing liabilities. (This dodge wouldn’t work if materiality were to be based on the lessee’s lease portfolio taken as a whole.)
Other bad news is the draft’s pretzel-like procedures for assigning numbers to lessors’ and lessees’ assets, liabilities, revenues, and expenses. It appears to us that the boards are placating preparers’ inclinations to report non-volatile income.
As difficult as it would be, the best solution would be to begin anew with the intent to totally disrupt the industry that thrives on off-balance-sheet financing, specifically the combined actions of lessors and auditors to indulge lessees’ inclination to lie with leases. FASB can achieve that disruption by first tossing out the criteria-based approach and then implementing uncompromised standards for all leases based on these six fundamental principles:
- First, all lessees acquire intangible assets in the form of limited rights to use lessors’ tangible property.
- Second, lessees have liabilities for every economically plausible future cash outflow. (More on this point later.)
- Third, lessees have no lease expense but incur income effects for debt-related financing costs and changes (up or down) in their intangible assets’ values.
- Fourth, lessors have revenue at lease inception from selling intangible rights to lessees with offsetting costs for the leased properties’ diminished value (if any).
- Fifth, lessors have no lease revenue but earn financing income on their lease receivables.
- Sixth, lessors also incur income effects from changes in the value of their residual rights in the property.
The disruption will be made complete by also applying these principles retroactively to all existing leases. The result will be no new cases of OBSF while recognizing currently unreported liabilities worth trillions of dollars in the United States alone.
The ultimate outcome will be the end of the conspiracy that enables lessees’ tomfoolery. Lacking the ability to create off-balance-sheet financing, managers will be compelled to lease assets only when it makes economic sense.
We speculate that the leasing industry will contract significantly when all avenues for using OBSF are closed. Frankly, we won’t mourn the displacement of bogus lessors who unscrupulously prospered by abetting others’ bad behavior.
Further, financial statements will be more trustworthy and more useful. Lessee’s debt levels will be readily known and users will not waste time and money guesstimating real amounts of debt, assets, income and cash flows. In short, capital markets will be more efficient.
Lessees will not face significantly higher compliance costs because they won’t have as many leases, and their lease-or-buy models will provide the accounting measures for their legitimate agreements.
They will also come out ahead since they will no longer pay excessive amounts to duplicitous lessors. In addition, their capital costs will decline because their newly informative statements will diminish uncertainty and risk.
NOT NEW IDEAS
Some may think we’re advocating radical ideas. Well, we are, but they’re not ours.
In fact, they were unveiled years ago in two reports involving FASB, several other national standard-setters, and the International Accounting Standards Committee.
The first was Accounting for Leases: A New Approach, written by Warren McGregor and published by FASB in 1996. The second was Leases: Implementation of a New Approach, compiled by Hans Nailor and Andrew Lenhard and published by the board in 2000.
We embraced these concepts then and they’re still praiseworthy. Somehow, though, FASB and the IASB got cold feet, and the leasing industry flourished.
These reports predate the enacment of Sarbanes-Oxley in 2002, which gave FASB independent funding to replace donations from OBSF-loving preparers. However, this power boost was nullified only 50 days later when the Norwalk Agreement committed the board to collaborating with the IASB, which did (and still does) depend on U.S. corporate managers’ generosity. This arrangement compromised the U.S. standard-setter’s ability to create disruptive reform.
However, the Norwalk Agreement is now moribund and the board is no longer compelled to agree with the IASB. The dissipation of these political pressures has positioned FASB to actually disrupt the lease industry and break the pernicious accounting standard-setting cycle like never before.
SAME OL’ SAME OL’?
To get more pragmatic, we’re convinced that the vertigo-inducing complexities in today’s lease agreements are rooted in misbegotten conspiracies to defeat accounting standards.
Thus, we’re certain that some bull-headed lessees’ initial response to mandatory liability recognition will be collusion with lessors to game the system to reduce their reported liabilities by striking sly deals with minimal agreed-upon rental payments. This behavior can be discouraged by requiring capitalization of all plausible future payments, including not only explicit contractual payments but also those that are contingent, optional and implied by such things as past practices, current strategies and common sense.
Importantly, FASB, the SEC, the American Institute of CPAs, the Institute of Management Accountants, the IASB, and others should sponsor an intense educational campaign to convince slow learners that OBSF’s advantages are illusory and detrimental.
To summarize, this straightforward “capitalize everything” solution will destroy the market for leases that don’t offer genuine convenience or another sound economic result.
This outcome will help eliminate the unethical behaviors aimed at fabricating false and misleading financial reports.
There’s no question that everyone involved in these transactions is neck-deep in the muck. That includes egregious lessees as well as their vulture-like lessors who bilk them with higher rents to achieve cosmetic advantages that only fool themselves. We also censure auditors who conspire with clients to produce OBSF and then render clean opinions on their statements.
Bottom line: The only losers after this disruption will be those who thought they were getting away with manipulation and misrepresentation. Not one tear should be shed for them.
Are we dreaming wild dreams? Of course. That’s our special responsibility. Our overriding objective is to point out who has failed to perform as they should. We want our words to make a great many people feel exposed and uncomfortable, and we hope we’ve done that.
It’s now up to FASB to get rid of this destructive blight on the integrity of all financial reporting. AT
Paul B. W. Miller is an emeritus 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 or Accounting Today. Reach them at firstname.lastname@example.org.
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