Peeling away financial reporting issues one layer at a time

From Where I Sit, Where Investors Should Stand on the New Lease Accounting

It’s hard to pick which of the major accounting standards convergence projects has given investors the shortest shrift.  But leases is notable for one thing: the FASB’s handpicked Investor Advisory Committee (IAC) panned the FASB’s proposals, and then were completely ignored.  This one case should be all anyone really needs to know  about the legitimacy of the FASB’s so-called “due process”.

But, how bad is the new standard (ASC 842), really?  I’m going to try to answer that question from a number of perspectives.

Is it Good Accounting?

The best outcome from the lease accounting project is that lessees will report some arbitrary number purporting to represent some small portion  the economic “right of use” (ROU) arising from a lease, and a related liability for the obligation to make lease payments.  In other words, off-balance sheet financing via leasing arrangements has been diminished to an extent.

But, I wish I could say that the rest of the new standard amounts to anything more than a stray dog’s breakfast, for earnings management is still alive and doing very well.  Here are just two examples:

Hide the interest expense — The last major tweak before finalization is so ad hoc that it took the FASB years just to come up with a name for it.  In a nutshell, issuers objected to the current capital lease accounting method because: (1) it reports higher amounts of expense in the early years of a lease (with smaller amounts in later years) relative to the operating lease method; and (2) it characterizes a portion of the cost as interest expense from having booked lease obligations.

So, for arrangements that management judges to meet the IASB’s current clear-as-mud definition of an operating lease (imagine playing tennis without lines on the court), lease expense will be presented along with amortization of the ROU asset on one line of the income statement.  But, in order to get a level expense each period, amortization of the ROU asset will simply be a PLUG.

Hide the contingent lease payments — Lots of judgment will be required to determine how much of contingent lease payments should be capitalized.  Areas ripe for manipulation include residual value guarantees, options, contingent rent, determining the non-lease components of an arrangement, and timing changes in estimates. In other words, pretty much everything except for a vanilla lease is up for grabs.

If the FASB has demonstrated anything during its 43-year existence it is that there are many philosophies of accounting standard setting.  Originally, it was thought, the FASB would publish a a reasonably complete statement of its guiding principles and concepts, and that subsequent standards should rigorously hew to them. The desired result was to produce “good accounting” (my term).  Perhaps the greatest understatement in the history of my blogging life is for me to tell you that this is not what actually happened.

So-called “principles-based” or “objectives-based” accounting have at best either been given lip service or taken in vain. Trial and error would be a more apt description — i.e., an iterative search for new rules to the same old game so a sufficient number of stakeholders might still agree to play along without making too big a fuss.  Perhaps there is no better example of this than the new revenue recognition standard. The final lease accounting standard does require lease capitalization at some contrived amount, but it retains an issuer’s ability to smooth earnings in all sorts of ways, and to conflate operating costs with interest expense.

But, failure to produce “good accounting”  alone does not make the lease accounting standard distinctive.  Read on.

What Will be the Economic Effects?

From where I sit, there are three drivers of the economic costs and benefits from this half-baked leasing standard: financial statement presentation, implementation costs, and effects on managerial decision making.

Financial statements — Let’s consider the kinds of companies whose financial statements will be affected the most profoundly — i.e., companies currently with lots of off-balance sheet leases relative to their on-balance sheet assets.  For these companies, their debt ratios will go through the roof.

Serves them right, I say! But, will anybody be surprised?  I should think not.

Surely lessors/debt holders demand enough information from lessees/borrowers to evaluate total leverage when setting prices for their leases/loans; and just as surely, lessors and debt holders have built the off-balance sheet effects of lease accounting into their contracts.  Perhaps, some fine tuning will be required, but everybody saw some version of this standard coming for a long time — so things can’t get too bad.

As for equity investors, every analyst knows how to do a reasonably accurate pro forma capitalization of operating leases from note disclosures. How far off can the actual effect of capitalization be from consensus estimates?

Yet, for the last 13 years (!!) as a new leasing standard was being contemplated, there were all those predictions that the economy would sag from the weight of all of the new liabilities on balance sheets. The Chicken Littles were probably a coalition of issuers and their advisors, who feared that their intellectual capital, consisting in the main of arcane tricks to avoid lease capitalization, would become worthless.

But if you are still fearful of standards driven balance sheet inflation, recall the aftermath of SFAS 87 and 106, which put trillions of dollars in liabilities for post-employment benefits on balance sheets. Did the sky fall?  Nope.

Implementation Costs — Unquestionably, the new leasing standard will impose significant costs on financial statement issuers that go well beyond re-training of their accounting staffs.  However, the investor community stands to gain because the capitalization exercise will only have to be done once (by the issuer), instead of by anyone who would care to produce a reasonably thorough analysis a particular company that has a significant level of operating leases.

And from where I sit as an educator, perhaps we can finally be able to stop teaching hundreds of thousands of business students each year about how to deal with the esoterica of operating lease disclosures.  We might instead teach something that actually matters.

Managerial Decision Making — “Good accounting” would mean that financial statements would more fully reflect the economics of leasing.  Consequently, the decision to lease an asset would be made based on economics alone.  Unfortunately, it is difficult to state with any degree of certainty how the change from one half-baked standard to another will affect decision making.  Perhaps, there will be a tendency to lease assets less frequently, and to purchase them instead. Or perhaps it will go the other way.

But if pressed, I’ll put my money on greater dysfunction.  The new standard will do even more to encourage leasing for accounting’s sake.   Granted, there will be less flexibility in the new rules to engage in off-balance sheet financing, but there will be much greater flexibility to manipulate lease expense.  As I stated earlier, I really don’t think that the loss of off-balance sheet financing is going to be that big of a deal.  But, management gets their bonus by hitting income numbers. It will always be thus, and leasing will, more than ever, give management a better chance to hit their bonus target.

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The current leasing standard, SFAS No. 13, is now 40 years old, about the same age as the FASB itself.  Some would say that SFAS No. 13 was obsolete when issued, but at the time its supporters said that it at least was making some progress towards “good accounting.”  But in the end, all SFAS No. 13 did was to further entrench an industry of already questionable societal value whose “service” was to help issuers game the accounting rules.  The lesson for the FASB, which it is bound to disregard, is that half measures can be disastrous.

It will probably be another 40 years before lease accounting is seriously considered once again. I imagine that for most of us, our debit and credit days will be over by then.  In the meantime, investors will have to cope with a new leasing standard that lowers the earnings goal posts even further.

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New additions to the bookstore:

InvestementValuationInvestment Valuation: Tools and Techniques for Determining the Value of Any Asset

This is my go to book on investment valuation.  I use the M&A chapter in my M&A accounting course, and it has helped me on numerous occasions in my litigation support practice.

real-optionsReal Options: A Practitioner’s Guide

Apropos to lease accounting, the case study on how Airbus prices its airplane leases is worth the price of the book just by itself.  I consider the topic of “real options” to be on the frontiers of finance — and business strategy.  After reading this book, you’ll never think about capital budgeting decisions in the same way.

3 Comments

  1. Reply Jeffrey Mealey July 6, 2016

    Tom, help me out could you? The actual owner of the leased asset could theoretically accelerate the depreciation of the asset while the lessee is also amortizing the ROU of the same asset?

    • Reply Tom Selling July 7, 2016

      Hi, Jeffrey:

      The financial reporting by the lessor and the lessee is not symmetric. Therefore, what you write is theoretically possible. But accelerated depreciation is rarely used for financial reporting purposes.

      For tax reporting (note that I am not an expert on this), lessors and lessees both generally apply operating lease accounting.

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