The Path of Lease Resistance

Many CFOs agree that companies should put leases on the balance sheet. But the 'how' has them up in arms.
David KatzMarch 1, 2014

The latest chapter in the long-running saga on lease accounting began in January, when the Financial Accounting Standards Board started to mull the proposals in its May 2013 exposure draft, Leases (Topic 842). If approved, the new rules could add hundreds of billions of dollars to the liabilities on corporate balance sheets. Finance executives have been vocal in their criticisms, and no one is sure what will happen next.

The story proper begins more than a decade ago, in the dark recesses of off-balance-sheet financial arrangements, where regulators found Enron and other scandal-plagued companies hiding billions of dollars of debt. In its quarterly filing of November 19, 2001, for example, Enron reported debt on its balance sheet of about $13 billion. Yet the crumbling energy company told its bankers on that very same day that its debt was about $38 billion. Why the staggering discrepancy? Enron explained that the missing $25 billion was either off-balance-sheet debt or reported on the balance sheet as something other than debt.

1403_LeaseAccounting_p36bWhile Enron kept about $14 billion of debt off its balance sheet through the use of special-purpose entities — deals that attracted a great deal of attention at the time — the Securities and Exchange Commission took a wider-bore approach in its investigation of off-balance-sheet arrangements. In a 2005 report to Congress mandated by the Sarbanes-Oxley Act, the SEC made recommendations for improving accounting in a number of areas—among them leasing.

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Then as now, the problem with leases concerned the companies leasing the land or equipment (the lessees) much more than the financial services companies (the lessors) that lease it to them. In its report, the SEC cited “$1.25 trillion in non-cancelable future cash obligations committed under operating leases that are not recognized on issuer balance sheets, but are instead disclosed in the notes to the financial statements.” All that under-reported off-balance-sheet debt could provide ample opportunities for companies so disposed to cook the books, misrepresenting their true financial conditions, the reasoning went.

At the core of the problem has been an “all or nothing” approach to lease accounting. That is, economically similar arrangements can get different accounting if they score a tad differently on a strictly drawn bright-line test. There may be, for instance, almost no real difference between two leases committing companies to pay 89% and 90%, respectively, of the leased assets’ values. Yet that 1% difference can mean that one lease must be placed on the balance sheet and that the other could be kept off.

As a result, many companies engineered their lease accounting to stay on the good side of the bright line. What’s more, those companies “have been aided in these endeavors by a large number of attorneys, lenders, investment banks, accountants, insurers, industry advocates, and other advisers,” the SEC reported in 2005. “Indeed, lease structuring to meet various accounting, and other goals, has become an industry unto itself in the last 30 years.”

The system distinguished, as it does today, only between operating leases (in which the lessee basically rents the land or equipment from the lessor) and capital leases (in which the lessee essentially agrees to buy the asset with financing help from the lessor). Operating leases were left off the balance sheet, capital leases were put on. Simple as that.

In reality, however, leases can’t be classified so simply. They range from pure rentals to lease-to-buy contracts to mortgage arrangements, and the accounting needed to be changed to reflect those nuances, according to the SEC. The commission recommended that FASB launch a leases project to change the system.

Incomplete Consensus
Fast-forward seven years, through a half decade of deliberations, two exposure drafts, and hundreds of comment letters, and FASB and its overseas counterpart, the International Accounting Standards Board, are in a position to vote on a final new lease accounting standard this month.

With some exceptions, the boards have built a consensus among a diverse group of constituencies — corporate lessees, financial lessors, investors, CFOs, and auditors among them — that the standard should require that corporations report all manner of leases of longer than 12 months on their balance sheets. Yet although the boards have put forth a plan, no consensus yet exists on how, exactly, that should be done.

Indeed, many constituents still contend that the lease-accounting requirements under current generally accepted accounting principles aren’t broken and hence don’t need to be fixed. For their part, individual investors rarely drill down deep enough into their portfolios to care about lease accounting. And since analysts and institutional investors can easily tease out lease-derived debt from existing corporate financial statements, why is it necessary to change the way leases are reported?

FASB’s answer to that has been that it’s the large investors themselves who have asked that the assets and liabilities of operating leases be placed on the balance sheets of financial statements. Yet even shareholders don’t agree with the board’s notion of how that should be done. FASB’s own Investor Advisory Committee, in fact, rejected the board’s most recent exposure draft on lease accounting, on the grounds that it was overly complex.

The IAC hasn’t been alone in making that criticism. Many if not most of the more than 600 comment letters that FASB received in response to its most recent proposal, including abundant correspondence from CFOs, controllers, and senior accounting executives, aired versions of the same objection: The boards have made financial statements more complicated by dividing lease accounting into two new categories.

Two Types
Under FASB’s plan, instead of classifying their leasing arrangements in the current manner as either capital or operating, companies would begin their accounting by separating their leases according to the type of asset they’re leasing: Type A leases (equipment, including anything from aircraft to office copiers) or Type B leases (real estate, including land and buildings). The two types of leases would be accounted for on the balance sheet in different ways.

Lessees would treat the liabilities on their Type A leases as “front loaded.” Much in the way that they account for capital leases today, Type A lessees would assume they have already bought the asset, estimate its amortized costs over the length of the lease, and allot those costs in line with the depreciation of the asset’s value over time. Type A lessees would thus record more expense in the early years of the lease than they would later on.

By contrast, lessees would account for their Type B payments in roughly equal amounts over time. They would recognize the total lease cost on a straight-line basis over the lease term — like recording the same rent expense for office space each month, for instance.

By presenting lessees with this new classification system, FASB triggered an uproar, particularly among financial-statement preparers who feel that two types of lease are one too many. Senior finance executives at Koch Industries, Time Warner Cable, Altria, Dell, and other big companies have come out in favor of a system that draws no such distinction.

In a September 11, 2013, comment letter, William F. Osbourn Jr., the chief accounting officer and controller of Time Warner Cable, wrote that “the widely criticized shortcomings of the current lease accounting model, which have focused primarily on the need to bring operating leases ‘on-balance sheet,’ can be better addressed using a single and consistent model for all leases.”

Like many finance executives who favor a single model, Osbourn prefers the Type A approach, which he said is “similar to today’s capital lease accounting model” and as such “is already well understood by financial statement users and preparers.” Moreover, “financial systems for recording such leases are well-established,” he added.

The “accounting for the asset and liability sides of Type B leases will be far more complex to administer than for Type A leases,” warned Osbourn. “This will also lead to increased costs in order to build and maintain the new Type B lease accounting systems.”

Price Tag in the Billions
Not surprisingly, the possible compliance costs involved in changing the accounting for all the leases used by Corporate America create the most anxiety among many senior finance executives. The lack of clarity on what the final standard will be, much less on the kinds of software and systems that could be required, hasn’t prevented some from putting the compliance price tag in the billions of dollars.

Without a doubt, the costs would be many and varied. “To implement the new requirements, preparers will incur significant costs to develop new systems, modify existing systems and develop new processes and controls,” wrote Gregg L. Nelson, vice president for accounting policy and financial reporting at IBM, in a comment letter.

Further, the proposal’s “complexity and the significant judgments inherent in the model” could trigger hefty ongoing compliance costs, said Nelson. The subjectivity of terms like “significant” and “substantially” in FASB’s exposure draft could make it hard — and more costly — for lessees to confirm results each reporting period.

Another source of judgment that will weigh heavily on lessees’ minds and pockets: a proposed requirement to periodically reassess the terms of the lease. Such reassessment could be trickier, and a lot more expensive, in the case of leases that call for such ongoing adjustments as the need to align payments with the Consumer Price Index every quarter, according to IBM’s Nelson.

An even more pressing cost concern, for big lessees like Toys“R”Us, will be the need to account for high volumes of leases of low-value equipment. The toy retailer, which has more than 1,700 stores, has a lease portfolio containing “thousands of operating leases, including a majority of our retail locations and a myriad of equipment worldwide,” F. Clay Creasey Jr., the company’s CFO, wrote in a comment letter.

The company is worried that the standard will cause it to account for cheaply leased equipment in the same way as it does for high-rent stores. “The sheer volume of our leases will be exceedingly unmanageable without significant changes in our current internal processes, accounting and lease administration systems and human capital,” said Creasey.

1403_LeaseAccounting_p40aTo avoid such a heavy cost for what he feels is a limited benefit, the boards should treat different kinds of leases differently, said the CFO. Investors “are far more concerned with obligations arising from our long-term leases of real estate assets” than with “obligations arising from those leases that do not have overall significance to our business.”

For example, Toys“R”Us estimates that real estate assets account for over 95% of its total lease expense, but only about 20% of the total number of its leased assets. The remaining 80% of its portfolio, consisting of “non-core assets, such as leases for equipment that are used to support our operations,” accounts for less than 5% of the company’s lease expense, Creasey noted.

As a result of that discrepancy, Toys“R”Us wants FASB to allow lessees to keep the non-core assets and liabilities off the balance sheet, as operating leases currently are. Under the proposal, however, companies would only be able to keep leases with terms of less than a year off-balance-sheet. Creasey contends that this break should be extended to such things as leased laptop computers, “even though lease terms generally exceed 12 months.”

Breaking the Logjam
Facing such strong opposition to their exposure draft, the boards met on January 23 to start deliberations on a possible way forward through the apparent logjam. Based on their reading of the comment letters and meetings with financial-statement users, FASB and IASB staffers came to the decision that the boards should revisit where the line between Type A and Type B lessee accounting should be drawn — and, for that matter, whether there should be a line.

At the meeting, the boards began consideration of three different approaches to lease accounting developed by the staff. One would be a single model, in which lessees would account for all leases as they would for Type A leases. The second approach would basically retain the Type A–Type B model. The third approach would return to the current GAAP distinction between capital and operating leases, albeit now including all leases on the balance sheet. Lessees would account for most capital leases as Type A leases and for most operating leases as Type B leases.

As complicated as deciding among those choices sounds, the two boards are actually much closer to putting out a final standard than they’ve ever been. Although it’s anybody’s guess which of the three approaches they’ll choose, and whether they will approve a final rule at their March meeting, the boards are likely to move quickly now on producing a standard that will put all leases on the balance sheet.

David M. Katz is a Deputy Editor at CFO.

Cracking Covenants
Putting all leases on the balance sheet could jar bank covenants.

Whatever changes accounting standards-setters may make to the most recent lease-accounting proposal, one thing is nearly certain: the assets and liabilities of what are now operating leases will henceforth be recorded on corporate balance sheets. That, in turn, could make a borrower look much more leveraged than previously.

The changes could also worsen the financial ratios that govern a loan’s covenants, to the point where a borrower is in violation of its agreement with the bank. Key ratios such as earnings before interest, taxes, depreciation, and amortization; debt to equity; and return on assets are bound to come out a whole lot differently for many companies.

Especially affected by a new system would be companies that retain the right to use equipment or real estate via operating leases. The assets and liabilities of such leases, which are tantamount to rentals, aren’t currently reported on corporate balance sheets.

Oddly, the changes are likely to be favorable for many corporations when it comes to EBITDA. That’s because a large amount of what’s currently operating expense on lessee income statements would be reported on balance sheets as debt and amortization. “If we required minimum EBITDA of $25 million … the customer’s financial performance could deteriorate[,] yet it could meet the covenant,” Roger May, president and board chairman of CBI Equipment Finance, a subsidiary of Commerce Bank, wrote to FASB chairman Russell Golden in September 2013.

Precisely because of the appearance of all that debt, however, bankers could be looking at a raft of borrowers with much gloomier debt-to-equity ratios. Thus, “even though the customer’s financial performance has remained the same,” its higher leverage ratio under the proposed lease accounting standard could violate its debt covenant with the bank, wrote May. That would require the borrower to obtain a waiver for breaking the covenant and to redocument the loan request; both actions would involve fees.

The current situation in lease accounting is difficult for CFOs, because without final guidance from FASB and the IASB, it’s hard to know how to approach bankers. “What we are suggesting to our client base is, ‘Don’t start doing the accounting yet, because it might very well change. But start talking to your lenders and the people who hold your covenants, because you might be able to reach some accommodation with them,’” says Richard Stuart, a partner in the national accounting standards group at McGladrey.

One possibility is for finance chiefs to try to persuade their lenders to allow current lease accounting to apply to their covenants, even if new standards are needed to satisfy generally accepted accounting principles, he says. But that would come at a price: “You still have the cost of having to keep up another set of books,” Stuart notes. — D.M.K.