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 of.” 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 1 (see “On The Hook,” below). 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.”

That’s because to find the present value of an operating lease, a financial-statement user must estimate the discount rate, as well as the payment stream for the period beyond five years. (The labor involved is evident in the fact that the SEC itself did not attempt to discount the $1.25 trillion amount in its study.) Moreover, calculating the exact principal and interest for each payment is often complicated by the presentation of costs such as property taxes and maintenance as a lump sum.

“If companies themselves actually do the present-value calculation, it’s going to be much more accurate and consistently applied,” says Mulford, “than if every user does seat-of-the-pants calculations to figure out what should be on the balance sheet.”

What Now?

Lease accounting has already been under pressure in various ways — a recent clarification from the SEC’s chief accountant on how to account for certain aspects of property rental led more than 150 retailers and restaurant chains to restate results, while Fin 46 forced many companies to unwind synthetic leases and required companies such as Dell to consolidate vendor-financing arms that themselves issue leases.

But the SEC wants to go further. Its report cites studies by the IASB suggesting lease accounting be based on contractual cash inflows and outflows. Under this method, both the lessor and lessee would report their economic interest in the leased assets, as well as assets and liabilities related to the lease payments. “Leases that are at present characterized as operating leases,” notes an IASB summary, “would give rise to assets and liabilities — but only to the extent of the rights and obligations that are conveyed by the lease.” This and similar approaches, the SEC report noted, “remain worthy of consideration.”

Fleming says the ELA is amenable to change, though it encourages an accounting treatment that is “workable and reflects reality.” But, he notes, “you can’t treat something on your balance sheet as an asset if you don’t own it.”

Yet Mulford thinks that’s probably exactly what will happen. “A lease on the balance sheet will not represent ownership, but the economic reality of commitment. It won’t say you own a [rented] storefront, but that you control it for a certain time, and that it is both an asset and an obligation.”

Both sides of any debate already agree on one thing: lease accounting may change, but leasing won’t go away. “There are benefits to having use of an asset without owning it,” says Geert Kraak, vice president of finance for Dutch Rabobank Group financing subsidiary De Lage Landen. “If you look at how much is financed by leasing companies in the United States and worldwide, that is not just going to disappear. There is a definite need for leasing.”

“The value proposition we offer is less and less dependent on the off-balance-sheet treatment of the leases,” says Kraak. “It is more about value added in terms of asset management, risk management, and the availability of point-of-sale financing.”

“Accounting treatment was the driving factor for leasing until now,” says Dan Sholem, an equipment finance-and-lease adviser. “The SEC’s [suggestions] are going to move the emphasis toward the operational benefits of leasing.”

Tim Reason is a senior editor at CFO.

Watch Those Terms

The Securities and Exchange Commission’s argument against operating leases is that the accounting often doesn’t reflect the true economics of the transaction. But others argue that overzealous pursuit of a favorable accounting treatment actually can cause economic damage.

“There is often too much emphasis on the off-balance—sheet treatment,” says Dan Sholem, an equipment finance—and-lease adviser. He warns that lack of focus on a company’s operational needs can ultimately force it to pay more for leasing an asset than for purchasing it outright. “A lot of times, companies will, at the end of a lease, get stuck with things they wish they’d bought,” he says.

Under FAS 13, a lease does not qualify as an operating lease if the company can purchase the asset at a price that is substantially lower than the expected fair value at the end of the lease term. Nor does it qualify if the present value of the lease payments equals or exceeds 90 percent of the asset’s fair value. A lease structured to avoid these triggers could cost a company far more than the original cost of the asset if the company later discovers that it needs to buy the asset or extend the lease, says Sholem.

Moreover, he says, the tendency of companies to package multiple big-ticket items into a single lease has complicated subsequent mergers and private-equity buyouts. “If there’s $50 million of machine tools spread over five facilities and you’re buying four facilities, you may have to pay more to buy out equipment you don’t need,” he notes.

And while finance departments often drive the lease-versus-buy decision, that’s not always the case. In equipment-intensive industries, finance executives can sometimes be caught unaware of lease obligations because line managers preferred signing a lease to requesting approval for a large capital expenditure.

Charles W. Mulford, an accounting professor at the Georgia Institute of Technology, also suspects the accounting treatment may drive poor economic decisions. In theory, he says, the benefit of an operational lease is that the lessor can take advantage of economies of scale and the tax benefits of ownership, and pass some of the financial benefit along to a lessee with fewer financial resources. “That does happen,” he says. “But I suspect there are also examples where the inherent cost of funds in an operating lease is higher than a company’s actual cost of capital.” —T.R.

Bright Lines

Lease rules are easily skirted, says the SEC.

The current accounting standard for leases (FAS 13) defines a lease as a capital lease/asset sale if one of the following holds true:

(1) The lease transfers ownership to the lessee using the asset by the end of the lease term.

(2) The lease contains an option whereby the issuer can purchase the leased property at a significant discount to the expected fair value of the leased property at the end of the lease term.

(3) The term of the lease is equal to or greater than 75 percent of the estimated economic life of the leased property.

(4) The present value of the minimum lease payments to be made by the issuer is equal to or greater than 90 percent of the fair value of the leased property.

Sources: SEC, FASB