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Lease Accounting- Separating Myth From Reality Op/Ed

The Accounting Cycle

August 2006 I take today's title from a white paper written by William Bosco, a member of the financial accounting committee for Equipment Leasing Association (ELA). His subtitle is, "Are the Lease Accounting Rules as Bad as They Say?" Well, Bill, they are -- at least for the users of financial statements, which after all is the intended audience. In this column, I shall explain why your white paper defends that which is ridiculous, absurd, contorted, and illogical.

In the white paper (PDF), Bosco begins by claiming, "True equipment leases are executory contracts under commercial law (rooted in common law). Such contracts do not constitute a sale or create a security interest."

But who cares? The purpose of financial accounting is to provide information to users about a particular business enterprise. I suggest Bosco would benefit from reading the Financial Accounting Standards Board's Concepts Statement No. 1 that deals with the objectives of financial reporting. He should also read APB Statement No. 4, which enunciates the principle of substance over form. In essence, the accounting profession has long recognized that the legal form of a transaction sometimes obscures the information that the investment community needs. In those cases, the accounting should reflect the economic substance of the transaction instead of the legal form.

Bosco then defends the operating lease treatment with an appeal to the tax code. He states, "Income tax law treats a true lessor as the owner of the property and affords the lessor the same tax benefits as a user." Again, Bosco supports form over substance. The income tax code has as its goals things such as revenue generation for the government and various social objectives; however, the IRS could care less if its rules inform investors or creditors. The tax code cannot be relied upon when deciding accounting policy issues.

After this preliminary analysis, Bosco enumerates six problems with lease accounting, which he terms myths, and then clarifies the investigation with what he terms "reality." His first myth is, "Lease accounting restatements are evidence that the lease accounting rules are faulty." I agree with Bosco that this was actually a compliance issue. Still, I remain curious why he lists this proposition as a problem with lease accounting, for I do not know even one person who calls for a change in lease accounting because of these restatements. This first myth turns out to be a straw man that attempts to present weak arguments that nobody is making.

The second so-called myth is "Leases are engineered to avoid capitalization." Incredibly, Bosco says it isn't so and that an ELA survey proves it. I laugh at this idiotic statement. Technical partners at each of the large auditing firms help managers design leases to avoid capitalization; the accounting firms even advertise their expertise to engineer financial reporting results. The ELA study is clearly self-serving and Bosco should come up for fresh air if we are to consider anything he utters. Really!

Third, "Current lease accounting rules do not recognize material assets and liabilities arising from operating leases." Now we get to the heart of the matter, as current rules allow lessees to ignore their property rights and, more importantly to the managers, the obligations that arise from the transaction. Bosco asserts that it is not an asset because "the lessee clearly has no control of the asset to sell it, modify it or lease it to someone else." He conveniently forgets that the lessee controls the use of the property over the life of the lease. It is these property rights that comprise an economic asset. Worse, he omits any discussion about the financial obligations of the corporation, which is the central issue of this debate. I assume he neglects this point because he cannot refute it.

Next Bosco mentions as a myth: "The operating lease/finance lease distinction [are] based on bright line tests that are arbitrary." He defends these bright lines on the basis of "ensuring consistency." I guess that may be true, but the rules are still arbitrary. Moreover, they serve as targets to avoid. Many CPAs have reported the engineering of leases so that the present value of the minimum lease payments comes to 89.99 percent of the asset's fair value. The gaming by managers is a stiff price to pay to attempt to achieve consistency.

"Lease accounting rules are too complex," constitutes Bosco's fifth myth. He counters that, "Lease transactions often are complex." This response seems a non sequitur, even if true. The driving force behind accounting is to cut through the morass of details and account for the substance of the transaction. Even if the transaction is complex, a lease confers property rights to the lessee and a concomitant obligation. If the accounting profession wants to inform the financial statement users, then we must recognize these items no matter what the intricacy of the transaction.

As an aside, notice that Bosco never contemplates the fact that the complexity of lease accounting rules is the vehicle by which CEOs and CFOs engineer the financial statements so that they can disclose whatever they want. I assume he did this on purpose.

The sixth myth is, "Capitalization of operating leases by preparers clearly would give better information." Bosco merely claims that this isn't so. As he provides no evidence, I'll simply reply that quite a few academic studies support the notion that market participants act as if capitalized assets are indeed assets and the capitalization of future minimum lease payments is truly a liability. It is inappropriate for Bosco to dismiss these research papers by saying it isn't so. Until he supplies a serious argument, we shall accept this literature's finding and recognize that capitalization of future cash flows does generate information to the investment community.

Bosco closes with the advice that if lease accounting is seriously flowed, the FASB should remedy the situation with more and better disclosures. Good disclosures, however, never redeem poor accounting. The treatment requires radical surgery, and FASB should admit its errors by repealing the crap we call lease accounting and start recognizing the property rights and the financial obligations of lessees.

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries.