The following article is reprinted from Compliance Week, published 1 December 2015.
By Gary Kabureck
Neither the International Accounting Standards Board nor the Financial Accounting Standards Board are strangers to making improvements to financial reporting that in the development phase, meet some resistance; but once issued become accepted practice, leading many to question what all the fuss was about.
A topical example is the forthcoming lease accounting Standard—the result of 10 years of joint work by the Standard-setters. The two boards are fully aligned on the central issue of requiring virtually all lessee obligations to be reported as balance sheet liabilities.
The boards consulted extensively throughout the lifecycle of the project, and an exceptional amount of valuable feedback was received throughout this journey. The validity of many expressed concerns was acknowledged, and we made numerous modifications to address complexity, operationality, and cost to comply. We will be issuing a very well-developed Standard.
Unfortunately, we cannot please everyone. Indeed, the Securities and Exchange Commission predicted as much in 2005, when in a report to Congress it said:
The fact that lease structuring based on the accounting guidance has become so prevalent will likely mean that there will be strong resistance to significant changes to the leasing guidance, both from preparers who have become accustomed to designing leases that achieve various reporting goals, and from other parties that assist those preparers.
IASB and FASB are change agents who make important improvements to financial reporting. Sometimes these changes are controversial and meet resistance. This is because we often challenge an established status quo, which can lead to an entrenched and motivated opposition deploying all available tools and arguments. When undertaking a controversial project, we often hear about the potential for broad-based credit and debt defaults, likely material adverse economic effects for critical industries, the end of valuable products and programmes as we know them, and the risk of significant job losses. This is typically accompanied by legislative lobbying and involvement.
You may have noticed I did not use the word “lease” in this list of alleged dire consequences caused by new accounting. Instead I was thinking about earlier, equally controversial, Standards that consolidated financial services subsidiaries, commenced expensing stock options, and required full accrual of retiree benefits. I could go on.
Those projects each experienced the same emotional and motivated arguments not to proceed, accompanied by articulate prognostications of dire consequences. As a former chief accounting officer of a Fortune 500 company myself, my job was to understand these arguments. But on every occasion, the world did not end. We adapted to the new accounting requirements.
And 25 years later companies still have captive financing subsidiaries; retiree medical benefit programmes did not cease to exist in 1993 when accrual accounting was introduced. In the decade since the expensing of stock options began, Silicon Valley is doing just fine.
In this article, I will counter some of the concerns raised about the changes to lease accounting and explain why I believe they are overblown and unlikely to occur on any consequential scale. For most companies, the new requirements will operationally be little more than adopting another mandatory accounting change that provides enhanced transparency about what already exists. Where material, I expect lessee disclosures will note that the recognized amounts are consistent with prior footnote disclosures, that cash payments remain unaffected, and that there will be no consequential changes in strategy, since operational implications are few.
Leasing provides a long menu of valuable benefits: the ability to pay for and use only the portion of an asset’s life the lessee requires; predictable payments; use of assets without legal ownership; an alternative source of financing; ongoing asset refreshes as technology changes; and complimentary services by lessors such as maintenance; favorable taxation, and simplified asset disposals. These operational benefits have nothing to do with accounting, and they will continue to exist because they are valuable. Reporting leases on a balance sheet does not take that value away.
Quite the contrary, it is highly certain that a company’s credit providers have always known about material operating lease commitments. This was confirmed repeatedly throughout the project. The boards held meetings with all sectors of the financial services industry, including financiers as well as financial information providers such as credit rating agencies and research analysts.
All major credit rating agencies, for decades, have routinely adjusted entity financial statements to capitalise operating leases. Assuming a company has forthrightly prepared today’s required lease disclosures, then its credit rating will most likely be unaffected by the accounting change. One major rating agency (Moody’s Investors Service) recently reported that once the new leasing requirements become effective, not only are no downgrades expected, conversely, they expect some upgrades.
We also learned the same is true for lending and other credit arrangements provided by banks and other financial intermediaries when evaluating a company’s credit capacity—operating leases are fully considered. The bottom line: all levels of the credit extension process include operating lease obligations when evaluating a company’s capacity to pay its bills. Consequently, it is just not plausible the effects of operating leases are largely ignored when they are off-balance sheet and a crisis when they are on, as some critics suggest.
Some are concerned that the new lease Standard will change companies. Yes, it is correct to say that a company’s balance sheet for a lease intensive company will look different—but has the company itself really changed?
Let’s look at it by thinking of a company as represented by a circle and inside is 100 percent of a company’s essence, including all recognised assets and liabilities, all off-balance sheet arrangements, and all intangibles. When the new lease accounting becomes effective, the circumference (and therefore the circle) remains unchanged—because all that has happened is heretofore unrecognised lease arrangements that have shifted their inside position and have become attached to the balance sheet.
Consequently, to answer the question: Yes, a company is still the same company whether or not its lease commitments are on or off its balance sheet.
Sophisticated users of financial information routinely separate the effects of changing accounting principles from the financial statement effects of a company’s performance. Doing so is critical for proper analysis. Many mandatory accounting changes have come along over the years. It is commonplace for debt and similar agreements to have clauses that measure financial compliance with “frozen GAAP”—a concept that holds material new accounting requirements in abeyance until the debt agreement is due for renegotiation. The objective couldn’t be clearer: isolate the effect of accounting changes from changes in business performance.
Neither the IASB or FASB is requiring lease obligations to be reported in or as “debt” in the balance sheet, and there is some flexibility in labeling the obligation. Common credit measures such as EBITDA, net debt, and interest coverage are not defined by either board, and we learned these are often custom-defined terms at the company level.
Much of the discussion of the new lease requirements has been about the adverse effects on various debt ratios. What is rarely mentioned is that many non-GAAP credit measures, such as EBITDA and operating cash flow, will actually improve—primarily for IASB reporting entities. This is because current rating agency methodology tends to overstate lease obligations, so the enhanced analyses the new Standard enables should broadly improve credit metrics. Many lease-intensive companies already provide, without seemingly ill effects, non-GAAP information by pro forma capitalising their lease obligations.
My business experience tells me that the effect of mandatory accounting changes is largely transitional and has minimal impact on business fundamentals. So in various ways the world adopts, adjusts, and moves on. I expect the world will do just fine!
Gary Kabureck is a member of the International Accounting Standards Board. The views expressed in this article are his alone and do not necessarily represent the views of the IASB or IASB members individually.