The Spirit of Accounting

It surely is no surprise, least of all to the Financial Accounting Standards Board, that its exposure draft on lease accounting has not been warmly received.

For starters, the draft barely made it out the door with a 4-3 tally, including Chair Leslie Seidman's affirmative vote just before her second term ended. We also think that the dissenters' comments put forth substantive objections that will be difficult to overcome. Further, it isn't assured that the three who voted aye are strongly committed. Another setback came in September, when the board's own Investor Advisory Committee didn't endorse the draft. Of course, lessees and lessors have whined about compliance costs and it's no surprise that the Equipment Leasing & Finance Association has sobbed that forcing lessees to be more truthful would cut off their access to funding.

On the other hand, the draft really does try to get more useful information about assets and liabilities into financial statements. However, we don't think it's strong enough, because it doesn't cleanly address the No. 1 priority issue that asks whether off-balance-sheet financing has any legitimacy in financial reporting.



From the get-go, the OBSF idea is oxymoronic. Financing involves obtaining assets by creating debt or issuing stock. When that fact is paired with the axiom that balance sheets should help users assess future cash flows by usefully describing assets, liabilities and equity, it follows that OBSF makes no sense.

We know it doesn't happen by accident, either, because managers knowingly and willfully configure transactions to get it done. Let's all start calling it what it is: fraudulent reporting. There - we've proclaimed what everyone else knows but hasn't said.

That's why we don't think much of the footnote disclosure compromise that opponents are touting as an alternative. All it would do is openly declare that financial statements are inadequate, misleading and untrustworthy. It also would show that our profession doesn't have sufficient integrity, will or political power to wipe it out.

Beyond that condemnation, the wished-for disclosure compromise exacerbates market inefficiency by forcing users to perform redundant individual analyses with incomplete data, instead of just having management do it once with complete information. Besides, FASB has repeatedly and rightfully established that disclosure is a poor substitute for recognition.

All this leads us to our main point: Any lease accounting standard should permanently eliminate OBSF.



In short, what's at stake in this debate is the full credibility of the financial reporting community's efforts to serve capital markets.

Why? The Securities and Exchange Commission released a staff report on OBSF in 2005 that revealed that U.S. public company lessees had future cash outflow obligations under operating leases amounting to $1.2 trillion, with a T. To us, it's unthinkable that this huge population of assets and liabilities is first of all not reported; worse still is that an omission of this magnitude has been tolerated and otherwise left unchallenged as if it doesn't matter.

Think about it: If users know that managers, auditors and regulators have caused and stood by while unreported assets and liabilities piled up to that extent, how can they trust anything in financial statements? In the same vein, how can accounting professionals pretend that this disaster doesn't reflect poorly on their individual character?



Another overlooked point is that it wasn't Congress' intent to have the SEC merely publish a report. They wanted results.

Their whole idea was to prod the profession to action. FASB has had some success dealing with OBSF produced by special purpose entities. However, it hasn't been able to fix the leasing debacle since the SEC report was released, not to mention the four decades that have passed since the severely flawed SFAS 13 was issued. In light of the exposure draft's compromises and its political vulnerability, it just isn't strong enough to eradicate OBSF accomplished through leases.

Thus, all accountants should be profoundly aware that their indifference negates all their claims that GAAP protects the public against financial reporting fraud.



All that makes us believe that the draft proposes only a small step when a giant leap is desperately needed. Specifically, we think FASB needs to fully confront the elephant in the room that is the undeniable reality that any form of OBSF is intolerable.

If the board were to frame its central issue as "telling the truth versus not telling the truth," it would be compelled to take the first position and eliminate OBSF. However, we think that the issue was diluted down to become "asset/liability recognition some of the time versus non-recognition some of the time." As a result, the draft allows respondents to ignore the truth issue and just quibble about implementation details and whine that lessees won't get financing. That's highly unfortunate.

We assert that the best starting point would be resolutely establishing the inarguable premise that truth will be provided only if all lease-related assets and liabilities are reported on all lessees' balance sheets. We would offer no exceptions other than materiality, and that judgment would be justified only by considering all the lessee's leases as a collective portfolio, instead of testing each individual lease. After all, a portfolio of individually immaterial leases can easily create material assets and liabilities, just like portfolios of individually immaterial trade receivables and payables aggregate to be material assets and liabilities.

We anticipate two significant positive economic consequences from this premise. One would be the extinction of complex leases that serve no purpose other than creating OBSF. The other would be more efficient capital markets that have access to more credible financial reports.



Contrary to those who believe that complicated leases require complex accounting rules, we assert the opposite observation that complex rules have encouraged lessees to produce complicated leases.

It's our position that 99.9 percent of the complexity in today's leases comes from lessees' efforts to evade the SFAS 13 criteria for capitalization. We also think that the proliferation of lease terms that add to uncertainty, such as contingent rentals, service agreements, renewal options, and the like, seldom provide lessees with sufficient real economic benefits to justify their existence. Rather, we contend that they're fabricated to confound the SFAS 13 analysis by blurring the lease's character to keep it from looking like acquiring an asset with debt.

If FASB were to issue a general proclamation that its goal is to eliminate OBSF by requiring all leases to be reported on balance sheets, it would blunt the typical flimsy arguments that defend lessees' real intent to deceive.

Therefore, we think a straightforward standard that would capitalize every lease will compel managers to enter into one only if doing so makes good business sense.



Before discussing market efficiency, we want to explain another seldom-mentioned impact of using leases to hide debt that destroys shareholder value. Specifically, lessees (aided by co-conspiring lessors) have focused so intently on concealing liabilities that they've overlooked the fact that OBSF delivers massive hits to their reported operating cash flows. Ironically, it's very clear that stock prices are more affected by cash flow numbers than debt/equity ratios.

Here's the deal: If real capital leases are misclassified as operating, their periodic rent payments reduce reported cash flow from operations. On the other hand, if they were treated as capital leases, those outlays would be reported as loan repayments in the financing section. The result would be higher reported amounts of both operating cash flows and EBITDA.

We know anecdotally that many financial analysts fully understand this ludicrous byproduct of using OBSF and they're not amused by it.



We're firmly convinced that common sense shows that capitalizing all material leases will significantly increase market efficiency.

Specifically, greater efficiency will ensue because investors and creditors will have more confidence in the reported numbers and will no longer have to guess the amount of hidden lease liabilities. Their analyses concerning leased assets will also be markedly improved because current standards don't require management to disclose their approximate values. Together with improved cash flow information, this reform will boost financial statement credibility and decrease the markets' uncertainty.

Because uncertainty is the parent of risk, investors and creditors will perceive less of it, and thus be satisfied with a lower rate of return that is the mirror image of reporting companies' cost of capital. The ultimate result will be more efficiently priced securities, with higher market values to boot.



More useful balance sheets and cash flow statements are even more crucial for private companies, since their investors and creditors are vastly more dependent on financial statement information for estimating firm values because there are no established public market values for their shares.

Please, don't even think about arguing that these companies should be excluded from a new lease standard!



As we described in October's column, FASB is now far more free to seek reform without having to bend to the self-serving wishes of constituents who used to contribute funds for its budget.

The lease project would be a great place to exercise that freedom and move toward an uncompromised solution.

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 or Accounting Today. reach them at paulandpaul@qfr.biz.