ANTHONY H. CATANACH JR. is an associate professor in the School of Business at Villanova University, as well as the Cary M. Maguire Fellow at the American College Center for Ethics in Financial Services. His professional experience includes five years as an audit manager with KPMG and six years in the financial services industry. Dr. Catanach has received numerous awards for his publication, teaching, and curriculum innovation efforts. He has authored numerous articles on a variety of accounting, finance, and management issues, as well as several business education texts..
Emily Chasan wrote in The CFO Journal that a “Lease Accounting Breakthrough Could Come in June.” Since this issue has been debated for several decades, it is about time.
Chasan reports that “board members … still believe investors want to see lease obligations on corporate balance sheets to get a clearer picture of corporate liabilities.” Like duh!! Of course they do, because any reasonable person would readily admit that all lease obligations should be recognized. They are liabilities—and even intro accounting students know that liabilities go on the balance sheet.
That being said, two California congressmen (who are actually CPAs) unbelievably oppose putting these debts on the balance sheet because of the “disastrous consequences” that presumably would ensue for American businesses. Didn’t we hear these same “the sky is falling” arguments for pension obligation and stock option accounting as well? Nevertheless, these two accountant-legislators either missed an accounting theory class along the way, or worry more about re-election than financial reporting transparency.
Back to the new lease proposals…a big point of contention at both the FASB and the IASB is how to amortize costs. One approach would use a present value approach, and the alternative would straight-line the costs. While we prefer the first as conceptually superior, the other method is also acceptable because it at least forces corporate America to recognize these debts in the financial statements instead of pretending that they do not exist. The second more simplistic approach also avoids yet another opportunity for managers to play with the numbers via discount rate and other present value assumptions.
Let’s restate the fundamental problem with present-day lease accounting. Issued in November 1976, Statement No. 13 still governs the accounting for lessees in the US. The statement invents two classes of leases: capital and operating. In a capital lease, the firm records an asset and an obligation for the leased property equal to the present value of the future cash flows specified in the lease agreement (not to exceed its fair value). Going forward, companies must report depreciation for the capitalized asset, as well as interest expense and principal payments for the lease obligation. In contrast, for operating leases, an entity completely ignores its property rights and obligations; the only thing it does is book rent expense.
Accounting for most operating lessees is ridiculous, absurd, contorted, distorted, and illogical. By allowing business enterprises to ignore the reality of some leases, and not to report the economic effects on the financial statements, the FASB and the IASB have been accessories to the accounting games played by corporate managers for decades.
Earlier this year we illustrated the magnitude of the problem by recasting the financial statements of CVS to disclose the effects of lease capitalization. (We also have illustrated the effects of lease capitalization on Groupon and Zynga.) We employed the following adjustment process:
- Find the lease cash payments.
- Choose an appropriate rate of interest.
- Compute the leased assets and the lease obligations as the present value of the future cash payments.
- Estimate the life of the leased assets and their current age. With these assumptions, calculate depreciation expense and accumulated depreciation.
- Estimate the interest expense.
- Estimate the change in income taxes and deferred income taxes.
- With these adjustments, prepare the adjusted income statement and the adjusted balance sheet.
We carried out these steps for CVS Caremark using its annual report for 2011 and obtained the following results (dollar amounts in millions of dollars). Previously we showed the adjusted statement effects with the present value method of amortization. We now include a column that depicts the results if CVS had used the straight-line method.
| Adjusted | Adjusted | ||
| Reported | PV Depr. | S-L Depr. | |
| Net income |
3,461 |
2,932 |
3,022 |
|
|
|
|
|
| Current Assets |
18,594 |
18,954 |
18,954 |
| Long-term Assets |
45,949 |
54,746 |
54,746 |
| Total Assets |
64,543 |
73,700 |
73,700 |
|
|
|||
| Current Debts |
11,956 |
14,002 |
14,002 |
| Long-term debts |
14,536 |
27,755 |
27,203 |
| Stockholders’ Equity |
38,051 |
31,943 |
32,495 |
What is at stake is whether the FASB (and the IASB) will fend off political and managerial pressures and promulgate rules that will give us useful lease accounting numbers. Note the large increase in long-term assets and the even higher increases in long-term debts. In addition, both of the adjustment methods generate less net income than the originally reported amount. And yes, these revised numbers better approximate economic reality than the GAAP numbers reported, which are just wrong. As we have suggested so many times, GAAP compliance does not guarantee transparency and financial statement quality. Current lease accounting is an excellent example.
The Equipment Leasing and Financing Foundation and the Chamber of Commerce have commissioned “research” reports that also claim the “sky will fall” if we capitalize leases. This is nuts. As we demonstrated in our criticisms of these reports, users believe that lease obligations are real liabilities, and they need to be recognized by the business entity.
One could argue that the capitalization of operating leases is unnecessary because outsiders like us can use FASB disclosures to adjust the statements if they wish. The fallacy of this argument is that we have to employ a number of assumptions when preparing this adjustment, thereby creating estimation errors. Corporate preparation and dissemination of the proper numbers reduces such errors.
We hear a lot about principles-based accounting, but principles-based accounting still requires principles-based regulators (and intestinal fortitude). If the FASB and the IASB cannot use their own definitions of liability to comprehend the fact that lease obligations are indeed liabilities, then financial reporting is in trouble. The FASB needs to act, and it needs to act now. And the IASB should do the same. Would this be reverse condorsement?
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.
J. EDWARD KETZ is an associate professor of accounting in the Smeal College of Business at Pennsylvania State University. He has a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D., all from Virginia Tech. Professor Ketz has been a member of the Penn State faculty since 1981. He also has taught at the University of Connecticut and the University of Maryland. Professor Ketz has authored and edited 17 books including Hidden Financial Risk (Wiley, 2003) which examines the corporate culture and the institutional setting that engendered recent accounting scandals. Dr. Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today. He also has appeared as an accounting commentator on CNN, National Public Radio, and Bloomberg Radio.
The goal w/ operating leases, I thought, was to give the BS a chance to live up to its name.
At the Financial Accounting Standards Research Initiative (FASRI) blog, I introduce Approach Y as the breakthrough that everyone’s been hoping for.
How to Avoid Lease Booking Under the New Dual Model of 2012
Scenario 5 (Airplane Leases of 5-Years Each)
Depending on how the new 2012 Dual Model deals with booking versus non-booking of forecasted transaction lease renewals, it might be possible to avoid part or all booking of a lease for a new airplane and most any other asset. For example, instead of a 40-year lease on an airplane, Southwest Airlines can negotiate a lease for five years with an option to renew in a separate contract that might be free or might have a premium price. Assume that after the 5-year lease expires there is no penalty fee if Southwest simply decides not to renew. If the lease renewal cash flows for subsequent years of the economic life of this aircraft are not booked, this is not the same as booking the full amount of a 40-year economic life of that aircraft to Southwest Airlines.
Why would a lessor agree to such a deal?
There are various possible reasons. The lessor might place a serious price that Southwest Airlines must pay initially (in year 0) for the option to renew in five years. The lessor might devise a diminishing rental schedule with very high monthly rental prices for the first 5-year lease and substantial rent savings with subsequent lease renewals. Or the lessor may lease 40 such aircraft to Southwest Airlines knowing that there’s a very high probability that almost all of then will be renewed.
What will Southwest Airlines book for the lease(s) in Scenario 5?
It’s not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will only have to book the first five-year lease initially (the present value of monthly rents for five years) and will not have to book possible renewals until the renewals are contracted.
However, there is wiggle wording in the dual model proposal that opens the door to required booking forecasted transactions of renewal if there is very high subjective probability that the leases will be renewed. Sadly, this wiggle wording encounters all sorts of problems of uncertainty regarding forecasted renewals and forecasted renewal rental amounts (that are not verifiable at time zero if there is no contract for a rental renewal. The whole thing is beginning to look like a mess in terms of overcoming the OBSF problem.
Scenario 4 (Airplane Leases of 1-Year Each)
Scenario 4 is the same as Scenario 5 except that instead of a 5-year lease on an airplane Southwest Airlines negotiated a 1-year lease for that aircraft. In this case Southwest would not have to book the aircraft lease unless required to book it plus forecasted transactions of future renewals. This might be a relatively expensive lease with 12 months of very high rents, although the rents might be reduced if the lessor can instead sell option contracts to Southwest Airlines to renew the leases. In that case the monthly rentals might be lower, but Southwest would have to buy the lease renewal options.
What will Southwest Airlines book for the lease(s) in Scenario 4?
It’s not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will only have to book nothing for the Scenario 4 annual leases over the many years of use of this airplane by Southwest Airlines.
However, there is wiggle wording in the dual model proposal that opens the door to required booking forecasted transactions of renewal if there is very high subjective probability that the leases will be renewed. Sadly, this wiggle wording encounters all sorts of problems of uncertainty regarding forecasted renewals and forecasted renewal rental amounts (that are not verifiable at time zero if there is no contract for a rental renewal. The whole thing is beginning to look like a mess in terms of overcoming the OBSF problem.
Scenario 3 (Airport Gate Leases of 5-Years Each)
Scenario 3 is similar to Scenario 5 except that in Scenario 3 the lease is for Gate 12 at the Manchester, NH airport rather than an airplane. There are differences between airport gate leases and airplane leases. For example, if the lease terms are five years each, Southwest has a small number of possible forecasted transactions for lease renewals say between 4-8 such renewals. In the case of a gate renewal there are in theory an infinite number of such renewals. Also in the case of an airport gate the lessor probably pays the maintenance costs. In the case of a leased airplane the lessee most likely pays the maintenance costs (that usually increase with the age of the aircraft).
What will Southwest Airlines book for the lease(s) in Scenario 3?
It’s not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will book the each 5-year lease only when a contract is signed for that lease. Booking forecasted transactions for lease renewals is two uncertain since there may be an infinite number of such renewals.
Scenario 2 (Airport Gate Leases of 1-Year Each)
Scenario 2 is similar to Scenario 4 except that in Scenario 3 the lease is for Gate 12 at the Manchester, NH airport rather than an airplane. There are differences between airport gate leases and airplane leases. For example, if the lease terms are one year each, Southwest has a small number of possible forecasted transactions for lease renewals say between 1-39 such renewals. In the case of a gate renewal there are in theory an infinite number of such renewals. Also in the case of an airport gate the lessor probably pays the maintenance costs. In the case of a leased airplane the lessee most likely pays the maintenance costs (that usually increase with the age of the aircraft).
What will Southwest Airlines book for the lease(s) in Scenario 2?
It’s not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will book the each 1-year lease only when a contract is signed for that lease. Booking forecasted transactions for lease renewals is two uncertain since there may be an infinite number of such renewals.
Scenario 1 (Forecasted Transaction of the Purchase of One Million Gallons of Jet Fuel)
Southwest has a forecasted transaction for purchasing one million gallons of jet fuel in 12 months. This is called the forecasted transaction “hedged item.”
Southwest purchases a call option for $200,000 that locks in the strike price at $3.12 per gallon for each gallon purchased up to one million gallons.
What will Southwest Airlines book for the hedged item and hedging contract in Scenario 1?
Southwest will does not book forecasted transactions or long-term purchase contracts under current GAAP rules. Hence there will be no booking of the forecasted purchase of one million gallons, the amount (notional) of which can be changed at any time in those 12 months.
Under FAS 133 rules Southwest Airlines must book the hedging contract (in this case an option) at $200,000 initially and then adjust the fair value of that option at least every 90 days or less. This is a common type of cash flow hedging contract used by Southwest Airlines and it qualifies for hedge accounting treatment under FAS 133 such that changes in the value of the option contract are booked to AOCI rather than current earnings. If the forecasted transaction is changed say to something like 500,000 gallons, the option contract must still be carried at fair value but hedge accounting is no longer allowed on the full 1-million gallon notional.
Possibly the Conceptual Framework Must Be Expanded
I don’t anticipate that forecasted transaction purchases of jet fuel will ever be booked as described in Scenario 1. However, the forecasted transaction lease renewals in Scenarios 2-4 could possibly force us to rewrite the Conceptual Framework since the Conceptual Framework is built around contractual obligations rather than forecasted transactions.
An the Conceptual Framework would have to deal with such issues as a finite number of lease renewals (e.g., for an airplane) versus an infinite number of lease reneals (e.g., for an airline gate).
I’m just glad it’s not my job to rewrite the Conceptual Framework.
The goal w/ operating leases, I thought, was to give the BS a chance to live up to its name.