Hidden in plain sight: leasing may soon have to be justified on economic terms alone

CFO: Magazine for Senior Financial Executives,  August, 2005  by Tim Reason

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THE SECURITIES AND EXCHANGE COMMISSION doesn't like lease accounting, and it's not going to take it any more. In a June report on off-balance-sheet activity commissioned by Congress as part of the Sarbanes-Oxley Act of 2002, SEC staff" argued that lease-accounting standards should be rewritten, estimating that they allow publicly traded companies to keep $1.25 trillion (undiscounted) in future cash obligations off their balance sheets.

Released more than eight months late, the report is a testament to the difficulty that even SEC staffers have in gauging the full extent of debt and other obligations that companies can legally keep off their balance sheets.

SEC staffers, who also pushed for changes to pension-plan accounting and for the fair-value reporting of all financial instruments, were sharply critical of the way lease-accounting standards are applied. Currently, the report complains, companies can easily make a financed purchase look instead like a rental contract by"taking advantage of the bright-line nature" of the standards.

The off-balance-sheet treatment that results from such "structuring," it says, has turned leasing into "an industry unto itself" over the past 30 years. "Transparency and the degree to which accounting and disclosure standards achieve their goals can be greatly diminished by the use of structuring, even when that structuring appears to comply with the standards," the report notes. "Leasing is a prime example of this."

Financial Accounting Standards Board chairman Robert Herz, a critic of existing lease accounting, proclaimed his support for the SEC's suggestions in an official FASB release the same day. "My personal view," Herz told CFO two years ago, "is that lease-accounting rules provide the ability to make sure no leases go on the balance sheet. Yet you have the asset and an obligation to pay money that you can't get out off If companies don't want to capitalize the assets on their balance sheets, he declared, "then something is wrong."

Written in 1976, Fin 13 defines all leases as either capital leases or operating leases. When a company is essentially financing an asset purchase--a capital lease--it records the asset and lease payments on the balance sheet. By contrast, a rental contract--an operating lease--requires neither the asset nor the payment obligation be recorded on the balance sheet.

FLYING WITHOUT WINGS Over the years, that off-balance-sheet treatment has made operating-lease treatment increasingly popular, even for large, essential assets. "Balance-sheet management" appears second on a list of 10 leasing benefits posted to the Website of the Equipment Leasing Association (ELA). The SEC report estimates that only about 22 percent of public companies use capital leases, while 63 percent use operating leases. Yet even more telling are the estimated total cash flows related to noncancelable operating leases, which outweigh the cash flows related to capital leases by more than 25 to I (see chart, left). As International Accounting Standards Board (IASB) chairman David Tweedie famously observed during Senate testimony after the Enron scandal: "A balance sheet that presents an airline without any aircraft is clearly not a faithful representation of economic reality."

Tweedie's comment is significant: FASB is likely to work closely with the IASB--which has already done several studies on the subject--in developing any new lease-accounting standard.

WHY NOW? Yet not everyone agrees that lease accounting is as serious a problem as the SEC suggests. ELA president Michael Fleming notes that the 30-year-old standard has long taken a backseat to more-pressing issues. "No investors are standing up and saying they have been misled because of lease accounting," he says.

Indeed, under an SEC rule adopted in 2003, companies must disclose all contractual obligations--including both types of leases--in a table in the Management's Discussion and Analysis (MD&A) section of the financial statements.

Dennis Hernreich, CFO and COO at Casual Male Retail Group Inc., says lease accounting is "very transparent" and that changes are unnecessary. "To me, there's more than adequate disclosure in the footnotes," he says. Operating leases are, of course, common in the retail industry, where they generally reflect the sort of rental contracts standards setters had in mind. Casual Male's total (undiscounted) future obligation for operating leases of $150 million is disclosed in a table of contractual obligations. (By contrast, Casual Male records $124 million in long-term debt obligations, which appears both in the table and on the balance sheet). Still, if FASB changes the accounting, he says, "we'd have a lot more assets and a lot more liability." But he insists "that really wouldn't be a problem"

Critics of the current accounting acknowledge that off-balance-sheet leases are far less pernicious than the depredations that prompted the SEC report in the first place. But they argue that even sophisticated users don't get all the information they need from the MD&A table, which lays out undiscounted payments for each of the coming five years and lumps the rest of the lease amount into a "thereafter" category. Charles W. Mulford, an accounting professor at the Georgia Institute of Technology, says even commercial lenders with whom he consults "routinely come up with overly conservative estimates of operating leases."