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Off the Books – Kogod Now
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Kogod Now / Cover Story  / Off the Books
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Off the Books

Words: 2,944, Read Time: 11 minutes –

Off the Books

Company debt can seem like a shell game: now you see it – now you don’t. While financial disclosures can capture headlines and interest, a legal and common practice may go unnoticed. For years, companies have stashed debt related to their equipment and property leases off their balance sheets. Accounting standards allow this, both in the United States and abroad, so long as certain disclosures are made in the footnotes to the financial statements.

These leases can amount to enormous obligations. Companies may soon have to add those liabilities onto their balance sheets, which could be a huge change in their debt-to-equity ratios. An impending rule change will mean a substantial shift—for better or worse—in how balance sheets look, say a trio of American University professors.

This means a there could be a potential pitfall in securing bank loans and attracting investors that results in a heavier bottom line.

CHANGE COMING

Operating leases, such as a commercial warehouse rental, require regular payments but don’t include any ownership stake. Traditionally, these leases have not been considered debt so they were kept off firms’ balance sheets. Alternately, capital leases involve lease payments that effectively result in ownership and currently are on the balance sheet.

“THE LEASE ACCOUNTING GAME IS CONSIDERED ONE OF THE LARGEST HOLES IN GAAP, SO LARGE YOU CAN DRIVE A TRUCK THROUGH IT.”
PROFESSOR GOPAL KRISHNAN

The size of an asset or how important it is to the company’s operations aren’t factors considered in the accounting standards. So it can be surprising when a person finds out what is and isn’t recognized. Sir David Tweedie, former chairman of the International Accounting Standards Board (IASB), said, “One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.”

As early as next year, the Financial Accounting Standards Board (FASB) and its international counterpart IASB may issue changes to generally accepted accounting principles (GAAP) that require companies to dump the two lease types into the same accounting bucket for the first time. Critics say it could exponentially increase how much debt companies officially recognize, and that increase could change the perception of its financial health.

“The lease accounting game is considered one of the largest holes in GAAP; so large you can drive a truck through it,” says Gopal Krishnan, chair of the accounting department, who studied the effect of lease accounting on banks’ debt covenants and audit fees. “It’s a contentious issue,” he said.

The Securities and Exchange Commission (SEC) in 2005 estimated that companies had $1.25 trillion in off-balance-sheet (and non-cancelable) leases—about 31 times more than the companies had in recognized capital leases. After the fall of Enron, the SEC ordered the FASB to look into all off-balance-sheet issues including leases.

The FASB issued two exposure drafts, called for industry comment, and has courted controversy ever since. Here’s the thrust of the problem: nobody seems to agree on what the best model for lease accounting should be, and the discussions on the rule proposals have become a witches’ brew of economic alarmism and regulatory red tape. Industry leaders wrote hundreds of comment letters to the FASB after its initial exposure draft. Its implementation has been pushed back several times and now stands estimated at 2018. Regulators seem to want one thing, accountants another, and industry groups are splintered on the finer points. Even locking down the need to distinguish between a capital lease versus an operating lease (FASB is debating Type A and Type B leases) is in flux.

The rule is sure to impact all companies to some degree because experts estimate equipment leasing represents a $725 billion industry. But some stand to lose more than others. Airline companies, restaurants, “big-box” retailers, and trucking companies rely heavily on operating leases. Critics warn that unintended side effects from the rule could cripple companies and hamstring undercapitalized banks.

The US Chamber of Commerce estimates the proposed rule would add roughly $1.5 trillion back onto corporate balance sheets: in a “best case scenario,” it would “destroy approximately 190,000 US jobs” because of increased borrowing costs and lost value from commercial real estate, among other unintended consequences. It is debt without being called debt.

“I think it will be a very big deal for some companies,” said Kimberly Cornaggia, associate professor of finance, who is currently studying how bank and publicly traded bond debt covenants may be affected by lease accounting rules. Her recent research on the issue suggests companies may face a seismic shift in their balance sheets if regulators have their way.

“I believe economically long-term, non-cancellable leases are essentially long-term debt. Recognizing these commitments on the balance sheet could trigger technical default for firms with binding debt covenants,” she said.

In a 2013 study, Cornaggia found that if operating leases were put back on the books, companies would face a 15 percent to 29 percent increase in debt-to-capital ratios. She said that average off-balance-sheet lease financing increased 745 percent as a proportion of total debt from 1980 to 2007. Capital leases fell by half during that same period.

Cornaggia uses Walgreens as an example of a company that appears very conservatively financed, but it does not appear that way when its leased assets are recognized. According to Walgreens’ 2007 annual report, the company owned about 20 percent of its storefronts and leased the rest. In 2007, Walgreens had a 10.6 percent return-on- capital estimate. After recognizing leased assets, its return-on-capital estimate dropped to 7.5 percent, Cornaggia wrote.

Return on capital is a key metric for investors, and such a drop could be a huge red flag for potential or existing shareholders in Walgreens.

Regulators still have much work to do to finalize a rule. Standard-setters have yet to agree on how companies can expense their operating leases once they come back on the books, as well as how to treat small-ticket items.

Current accounting rules designed to protect investors have resulted in arbitrary thresholds on when the leases can go off the books. For example, if the length of the lease term is more than 75 percent of the asset’s expected economic life, the lease does not have to be recognized—or, if the minimum lease payments end up equaling more than 90 percent of the leased asset’s fair value. Those thresholds, in turn, have only resulted in companies eking out lease terms to come in just under those ceilings.

“A cottage industry [of consultants] has cropped up around on how to structure lease contracts in order to comply with standards for off-balance-sheet accounting treatment,” Cornaggia said.

DEBT COVENANTS MAY FALTER

When the FASB began its foray into lease accounting, fraud was one of the major forces behind the rule change.

In her study, Cornaggia found high levels of excessive leasing among companies investigated by federal authorities for accounting fraud. This finding may be explained, she said, if one considers that firms which are intentionally distorting financial statements could simply be using all available means—including taking advantage of off-balance-sheet accounting treatment—to do so.

“Fraud can’t explain the vast amount of leasing that we’ve seen,” she said. “There is some benefit to having it be [off the balance sheet] rather than capitalized, at least from the perception of management.”

However, fraud may not be the biggest concern after all, and there are legitimate benefits from off- balance-sheet leases. The first benefit, Cornaggia said, is tax-related; companies with low marginal tax rates can pass the tax benefits to a lessor—who can in turn lease the equipment at a lower cost. Another benefit is operating flexibility, especially if leased equipment can become technologically obsolete quickly.

The second is that companies need to keep leases off the books to satisfy banking debt covenants, formal loan contracts that protect banks from borrowers that go into bankruptcy.

“Once this stuff comes on the balance sheets, some firms will be in breach of covenants. There is no way around it,” said Cornaggia.

Therein is the rub. If companies are forced to recognize leases as liabilities, changing the complexion of the balance sheet and upping their debt, banks may require higher interest payments from affected companies. Banks always have a choice to forbear if it serves them. Yet, this is only an accounting change; there is no real impact on the underlying risk of the firm, and the bank likely knows this. By comparison, changing reporting standards from Celsius to Fahrenheit does not make a room warmer, but it could complicate contracts that are based on a maximum of 30 degrees.

Critics say the rule change would inflate leverage ratios, raise fixed asset ratios, and morph current earnings before interest, tax, and depreciation.

Dennis Nixon, president of International Bancshares Corporation, wrote last year to the FASB that “most existing covenants will need to be changed as a result of the new standard,” which may “result in a de facto increase in the regulatory capital requirements of financial institutions.” Banks have already seen their capital reserve requirements increase in recent years, mostly due to anxiety from the 2007 economic downturn.

Many banks use debt covenants of five years or more, which means many would have to renegotiate terms if FASB’s rule changes the landscape. Bankruptcy law does not consider off-balance-sheet leases as debt, which could further muddy the issue for many banks and companies.

“Right now the tax, legal, and accounting legs are all aligned. This proposal would break that alignment,” said Bill Bosco, lease consultant and former chairman of the Equipment Leasing and Finance Association. Bosco, a member of the FASB-IASB lease accounting working group, said renegotiated debt covenants would at a minimum impose higher fees, heftier costs, and greater compliance burdens on companies. “It gives banks an excuse to ‘call the loans’ and increase their fees,” Bosco said.

Fortunately, some banks have foreseen this potential accounting apocalypse. According to Professor Peter Demerjian at the University of Washington, debt covenants have relied less heavily on the balance sheet to determine risk and debt. He wrote that, in 1996, covenants based on the balance sheet were used in about four of every five private debt contracts. A decade later, he found that number had fallen to about one of every three private debt contracts.

Additionally, many current debt covenants have evolved to include grandfather clauses that specify any changes to accounting rules would apply only to new covenants.

If debt covenants fail, that could also mean higher audit fees. In his research, Krishnan found that audit fees for firms with at least one debt covenant violation were 15 percent higher than firms without violations, and those fees remained higher several years after the initial violation.

Krishnan disagreed that requiring companies to recognize operating leases on the balance sheet would be the end of the world and said auditors already take them into account. “People have known about [operating leases being off-balance-sheet] for 20 years,” Krishnan said. “All that is being done [under FASB’s proposal] is moving leases from the footnotes to the body of the statement.”

The FASB seems to be swayed by these arguments. On June 18, the board agreed that the balance sheet or footnotes should identify lease liabilities separately, by type, which means they might not be lumped in with other debt after all. The IASB has agreed as well, although immediately, it would only recognize one type of lease. So, as with any regulation, the devil will be in the details of the final rule.

THE ELEPHANT IN THE ROOM

Some say the rule proposal is much ado about nothing because shareholders and equity analysts already account for off-balance-sheet leases. “Investment advisors and shareholders have talked about this for a long time,” Krishnan said.

Leased assets may be the elephant in the room. According to published research, some equity analysts have “fatigue” and don’t have the time or know-how to compute and analyze the leased assets discussed in a company’s footnotes.

Furthermore, another problem may be smaller, less sophisticated investors. Susan Krische, associate accounting professor, said individual investors are typically considered less savvy than equity and credit analysts when it comes to reading financial statements.

“I think this is a very, very large issue for individual investors because they won’t necessarily recognize the additional debt and the additional risk,” she said. “What may not be a big issue for analysts could be a huge one for individual investors. The combined effect on leverage and credit risk can potentially be quite dramatic [for any investors who are not trained to make the relevant adjustments].”

Information on the structure and terms of operating leases is required in the footnotes of the financial statements. That allows companies to disclose, but not officially recognize, the leases commitments. Technically, companies are providing information to investors, but it’s harder to figure out the true cost of the debt during a period of time.

“Managers think that somehow the footnote information is discounted or overlooked, which means they will try their best to move stuff away from the statements to the footnotes,” Krishnan said. “In practice, it requires a cost on users because you have to read the footnotes and under- stand the implications of them. It requires a lot of accounting knowledge.”

Equity analysts have known about operating leases for a long time and are trained to search them for them, so to the analysts off-balance-sheet leases are not a red flag, Krische said. Rather, analysts look for large discrepancies within an industry, such as one airline company leasing 40 percent of its fleet off the books versus another airline company leasing 5 percent off the books, then adjusting the balance sheets to capture the differences in lease liabilities.

In a 2013 research study, Krische found that lease structuring does not raise the same concerns for analysts as do other earnings management activities. However, companies that provide supplemental reconciliations to recognize operating leases and adjust debt-to-earnings ratios can help ease analyst fears about management’s credibility, Krische said.

Auditors that review company books don’t seem too worried by operating leases, either. In a 2011 study, Krishnan found that auditors already account for operating leases (and charge for them) when they review company books. The study found, auditors also take into account all off-balance-sheet leases when issuing going-concern decisions, which are used to determine if a company has enough resources to remain solvent.

When all is said and done, the rule changes will help clarify financial statements for individual investors, analysts, and auditors, Cornaggia said. “If you are looking at anything that needs some measure of debt, and you ignore this, those measures are distorted,” she said. KN mark


Academic papers that gave rise to the cover story:

“How do Auditors Perceive Recognized vs. Disclosed Lease and Pension Obligations? Evidence from Fees and Going-Concern Opinions,” Gopal V. Krishnan and Partha Sengupta, was published in the International Journal of Auditing in 2011.

“Bringing leased assets onto the balance sheet,” Kimberly J. Cornaggia, Laurel A. Franzen, and Timothy T. Simin, was published in the Journal of Corporate Finance in 2013.

“Management Credibility and Investment Risk: An Experimental Investigation of Lease Accounting Alternatives,” Susan D. Krische, Paula R. Sanders, Steven D. Smith, was published in Behavioral Research in Accounting in 2014.

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