The Financial Accounting Standards Board (FASB) has begun reviewing its guidance on one of the most complex areas of off-balance sheet reporting, accounting for leases, Chairman Robert Herz told Forbes. The Securities and Exchange Commission (SEC) had requested that FASB review off-balance sheet arrangements, special purpose entities and related issues in a staff report issued in June 2005. The most prominent topics for review were pension disclosure and accounting for leases.
Having issued its Exposure Draft to Improve Accounting of Pensions and other Postretirement Benefits, FASB is now considering moving lease obligations from the current footnote disclosure to the balance sheet. But the sheer number of rules and regulations that relate to leases – hundreds, according to Business Week – offers experts plenty of opportunities to keep disclosure off the books and presents FASB with an enormous challenge.
Companies are currently required to record future lease obligations in a footnote, but actual rent payments are deducted in quarterly income statements. Approximately 10 percent of leases are already disclosed on the balance sheet as liabilities because the company can purchase the equipment at the end of the lease, and therefore the lease is treated as a loan, or because lease payments add up to 90 percent of the value of the leased property.
Robert Herz says, according to Business Week, that “cookie-cutter templates” have been created to design leases so that they don’t add up to more than 89 percent of the value of the property. And to add to the complexity, the AP says, if the contract describes a more temporary rental-type arrangement, it can be treated as an operating lease and recorded in the footnote.
Leasing footnotes do not reveal the interest portion of future payments and require the analyst or investor to make assumptions about the number of years over which the debt needs to be paid, the AP says, as well as the interest rate the company will be paying. David Zion, an analyst from Credit Suisse told the AP that many professionals interpret the footnotes by multiplying a company’s annual rental costs by eight.
Thomas J. Linsmeier, recently named a member of the FASB, said that the current rule for accounting for leases needed to be changed because it sets such specific criteria. “It is a poster child for bright-line tests,” he said, according to the New York Times.
The SEC requested the review it said in a press release because “the current accounting for leases takes an “all or nothing” approach to recognizing leases on the balance sheet. This results in a clustering of lease arrangements such that their terms approach, but do not cross, “the bright lines” in the accounting guidance that would require a liability to be recognized. As a consequence, arrangements with similar economic outcomes are accounted for very differently.”
Finding a way to define a lease for accounting purposes presents additional problems. Some accountants argue that since the lessor does not own the property and cannot sell it, the property should not be viewed as an asset, Business Week says. Others say that the promise to pay a rent is equal to any other liability.
Of 200 companies reviewed by SEC staffers in 2005, 77 percent had off-balance-sheet operating leases, totaling about $1.25 trillion, the Wall Street Journal reported.
Among the companies with the biggest lease obligations are Walgreen Co. with $15.2 billion, CVS Corp with $11.1 billion and Fedex Corp. with $10.5 billion, the AP reports. Walgreens owns less that one-fifth of its store locations and leases the rest. Fedex leases airplanes, land and facilities.
Robert Herz, in an editorial response in Forbes to Harvey Pitt, former SEC chairman, acknowledged that FASB’s current projects, including the review of lease accounting, could generate controversy. But he says that the complexity and volume of standards impedes transparency, and that the FASB is working jointly with the IASB to develop more principles based standards.
“Complexity has impeded the overall usefulness of financial statements and added to the costs of preparing and auditing financial statements – particularly for small and private enterprises – and it is also viewed as a contributory factor to the unacceptably high number of restatements,” Herz writes in Forbes.
Herz does not expect the new rules to be completed before 2008 or 2009, Business Week says.