I Love Leases to Pieces

Implications: Grant Thornton has gotten out in front of a very old issue, changes in lease accounting, which is now subject to a review by the Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB). This project has been in the works for a long time, with the first meeting for February 2007.

"The current lease standards need to be changed to give investors greater transparency in the reporting of financial information," said Grant Thornton LLP CEO, Edward Nusbaum, when asked "should lease accounting rules be revised to give investors more transparency." Though there maybe opposition, GT shows that 63% of senior controllers and CFOs agreed that "lease accounting rules need to be revised to give investors more transparency."

In the Grant Thornton presentation, however, people claim to speak for investor needs and desires, with no investor actually cited. The only implication is that for reasons of their own, some accountants want the rules changed, without an analyst in view.

Analysis:

Grant Thornton claims to speak for financial statement users in calling for changes in lease disclosures. They quote an in-house of controllers and CFOs claiming to speak for investors. For any understanding it is necessary to review the logic of the current system, and what might be done without doing violence to accounting practice.

It strikes me as exceedingly odd that they would quote corporate financial personnel while claiming to speak for the user. I suspect that no one involved has the slightest knowledge or interest in how operating lease information is used or why.

As has been mentioned in elsewhere, S&P and other fixed income analysts routinely calculate a NPV for future lease payments and an associated interest expense. The leverage and coverage ratios derived are in turn used for benchmarking, to show relative debt and general fixed charge capacity for the firms.

The FASB and the APB both rejected universal lease capitalization. Current thinking is as follows:

The rights and obligations related to unperformed portions of executory contracts are not recognized as assets and liabilities in financial statements under generally accepted accounting principles as presently understood. APB No. 5 par.

Stated another way, capitalizing these leases violates assertions of both existence or occurrence and rights and obligations.

The SEC doesn’t care much for the bright-line issue, but has enough respect for the time and effort related to the rules not to want to change them. If the rules are changed, both sides will adjust to get the results they desire.

The funniest thing about this whole debate is Grant Thornton’s argument:

"What's wrong with the current accounting rules? Well, imagine an airline that has no planes, or a hotel chain with no hotels on their balance sheet."

As a financial analyst, nothing would make me happier than to see a company with no assets except cash and maybe receivables. Assets have risk, capitalizing lease payment does not an asset make, except notionally because there is no change in ownership.

Well, the accounting profession is trying to speak for analysts, but never mentions any specifically who want to see these notional assets on the balance sheet. Further, the profession has not said a word about the impact of these assets on a company’s cost structure. The APB left the door open for reconsideration, but no coherent argument has been made for doing so. If it does happen, the market will find a work-around.