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Lease accounting is FASB’s next hot potato
by Bruce Meyerson
Associate Press

The overlords of accounting are a brave, tireless bunch. Still mending from tough battles to reform the way companies report on stock options and pension obligations, the rule makers are now gearing up to tackle the thorny question of accounting for leased equipment and property.

Hum‑drum as it may sound, lease accounting is not a topic to be taken lightly. And as with options and pensions, it’s a scrap worth fighting for–hundreds of billions of dollars in future lease payments companies are not required to report as a liability on their balance sheets.

A decision by the Financial Accounting Standards Board (FASB) to force those assets and debts onto the balance sheet would affect many popular metrics used to assess companies. It also might sway corporate decisions about how best to finance their operations, which could in turn mean a big blow to those who lease out equipment, vehicles and other assets, an industry that generates well over $200 billion in revenue a year.

No surprise, then, that there’s strong opposition to change coming from several corners.

Companies with hefty leasing obligations–particularly in proportion to the debts and liabilities that do appear on their balance sheets–include: Walgreen Co. with $15.2 billion, CVS Corp. with $11.1 billion and FedEx Corp. with $10.5 billion, according to calculations by Credit Suisse Group.

That those calculations are possible forms the basis of the chief argument against accounting reform: Every company is already required to detail its future lease obligations with a special footnote in the annual report, while the actual rent payments during any given quarter are deducted in the income statement for that period.

William Bosco, a member of the accounting committee for the Equipment Leasing Association, also argues that reform would put the FASB’s rules out of step with the way the Internal Revenue Service, bankruptcy law and the uniform commercial code treat leases. More importantly, he said, what’s really lacking is any projection of a company’s future cash needs after current leases expire.

Notably, and confusingly, the footnote actually may not reflect every lease. Some, perhaps less than a 10th of the dollar value of all leases according to Bear Steans & Co., are reflected as liabilities on the balance sheet under the present rules.

Generally speaking, those deals where a company can buy the equipment or property at the end of the contract are viewed as just another type of loan, and so the assets and obligations are tallied into the appropriate columns on the balance sheet. But if the contract meets four criteria that more closely describe a temporary, rental‑type arrangement, it can be treated as an operating lease and recorded in the footnote instead.

While it’s true that footnote information can and is used by analysts and professional investors in their calculations of a company’s financial health, corporations try very hard to structure leases to keep them off the balance sheet so they appear to be less indebted. And when accounting rules become the basis for companies’ business decisions rather than merely reflecting them, that’s a sure sign change is needed.

Such was the case with employee stock options, which became a very popular form of compensation in part because companies weren’t required to treat them as an expense in their profit reports.

An estimate of options expense was disclosed in a footnote, so the information wasn’t exactly hidden from the investing public. Still, there was no bottom‑line consequence, which meant companies could hand out options with the reckless abandon of a bottomless printing press. Now that FASB has changed the rules, options grants are shrinking.

There’s also a question about the usefulness of leasing footnotes since it’s not good enough to simply add up all the future payments listed there. Instead, the future payments need to be “discounted” to remove the interest portion because money owed years down the road isn’t an

immediate burden like a debt due tomorrow. That requires assumptions about the number of years over which the debts need be repaid, as well as what interest rate the company is paying.

Credit Suisse accounting analyst David Zion points out that the mathematical cartwheels and guesswork needed to interpret the footnotes have given rise to a popular rule of thumb: Many professionals simply multiply a company’s annual rental costs by eight.

Applying that shortcut to the entire Standard & Poor’s 500, Zion found that off‑balance‑sheet lease obligations would total $720 billion for those companies. That’s almost twice as much as the $396 billion estimate Zion gets by calculating the present value of the future lease payments those companies list in their footnotes.

Either way, the assets represented by those big numbers are hardly peripheral to the daily operations at these companies. Walgreen, for example, owns less than a fifth of its drug store locations and leases the rest. FedEx’s leases cover airplanes, land and facilities central to its business.

The balance sheet is supposed to provide a quick report card on a company’s financial strengths and weaknesses. Without including all these lease obligations, many companies come away with higher marks than they deserve.

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