SEC Report Calls for Overhaul of Lease Accounting But change may be five years off

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1 Financial Watch SEC Report Calls for Overhaul of Lease Accounting But change may be five years off On June 15, 2005, the Securities and Exchange Commission (SEC) issued its long-awaited and much-anticipated report on off balance sheet arrangements. Entitled Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers, the report identifies and describes well known and often-criticized off balance sheet transactions. At over one hundred pages in length, the report provides a broad, yet crisp, overview of off balance sheet arrangements with commentary on the transparency of financial reporting for such arrangements and recommendations for improvements in financial reporting and accounting standards. The SEC report calls for a global overhaul of lease accounting. While it supports the new approach (the asset and liability model advanced by a group of international standard setters) on its conceptual merit, the SEC staff The SEC s acknowledgement that achieving consistent application to the different leasing transactions will involve significant time and resources means that the desired overhaul will likely take five or more years to complete. 12 August 2005

2 deliver a report to the President and committees of the U.S. House of Representatives and Senate addressing the extent of off balance sheet transactions and whether GAAP results in financial statements that reflect the economics of such transactions in a transparent manner. The SEC was directed to quantify the amount of off-balance sheet transactions, and to address the extent to which special purpose entities (SPEs) are used, whether new accounting standards resulted in consolidation of SPEs based on risks and rewards and to make recommendations to enhance the transparency and quality of reporting of off balance sheet transactions. The mandate for the report was a direct response to corporate accounting abuses. The study by the SEC staff details the nature and extent of off balance sheet arrangements such as leasing, securitization, retirement benefits, derivatives, equity method accounting and SPEs. It provides a general description of each area of practice, an explanation of the accounting standards applicable to each area and an estimate of the extent to which each type of arrangement is used. The quantitative analysis is based on a sample of 200 compaacknowledge that achieving consistent application to the different types of leasing transactions will involve significant time and resources of those involved in the standard-setting process. This acknowledgement means that the desired overhaul will likely take five or more years to complete. The impact of the SEC report, therefore, may be limited in the short run. The report does not contain any surprises, accounting bombshells or statements that would have the immediate effect of re-interpreting GAAP. The SEC staff presents its views of the shortcomings of most of the accounting standards that address off balance sheet accounting and directs the Financial Accounting Standards Board (FASB) to add lease and pension accounting to its agenda. Perhaps the most significant near term effects of the report are that the SEC staff sets a new tone for practices and behavior by businesses and their advisors surrounding off balance sheet transactions and calls for improved communication in financial reporting. Background and Methodology The Sarbanes-Oxley Act of 2002 mandated the SEC to 14 August 2005

3 The report does not contain any surprises, accounting bombshells or statements that would have the immediate effect of re-interpreting GAAP. nies including the 100 largest SEC registrants ranked by market capitalization and 100 other registrants selected at random. The report reviews the impact of certain changes in accounting standards on financial reporting and the use of SPEs including FASB Interpretation No. 46 (FIN 46R), Consolidation of Variable Interest Entities, as issued and revised in December 2003, and FASB Interpretation No. 45 (FIN 45), Guarantor s Accounting and Disclosure Requirements for Guarantees, issued in November The SEC identified several goals to improve financial reporting and increase transparency. These recommendations are part of a broad-based approach that emphasizes actions that go beyond simply making improvements to existing accounting standards or disclosure requirements. The report discourages transactions and transaction structures motivated primarily by accounting and reporting concerns, rather than economics and recommends: Expanded use by the FASB of objectives-based standards, which would have the desirable effect of reducing complexity in accounting standards. Improvement in the consistency and relevance of disclosures that supplement the basic financial statements. Improvements in the communication focus in financial reporting. Lease Accounting Criticized Leasing and securitization are identified as practices where similar economic transactions can be accounted for on or off balance sheet by paying careful attention to rules-based accounting standards. Leasing, in particular, is held out as a prime example of all-or-nothing, rules-based standard with bright-line tests that can be easily structured around to achieve a desired accounting result. The report gives an overview of lease accounting under SFAS No. 13, Accounting for Leases, explaining the determination of whether an August

4 Leasing, in particular, is held out as a prime example of allor-nothing, rules-based standard with bright-line tests that can be easily structured around to achieve a desired accounting result. arrangement should be classified as an operating lease or capital lease by a lessee and sales-type or direct financing lease by a lessor. The SEC staff notes that classification is straightforward in most instances, but can be challenging given the specific provisions in a lease, such as contingent or variable payment requirements, optional term extensions, and other clauses that affect evaluation under one or more of the four classification tests in paragraph 7 of SFAS 13. The report credits the extensive disclosure requirements for leases for providing meaningful and useful information on the nature, timing and amount of cash inflows and outflows and rights and obligations associated with leases. The extent of use of leasing in the U.S. economy is not insignificant. Using the 200 company sample base and extrapolating to the entire population of active U.S. registrants, the report estimates that the total undiscounted cash flows associated with operating leases approaches $1.25 trillion. The report uses a discount factor of 67 percent for ten years of annual lease payments, allowing one to conclude that the present value of operating lease obligations is $837 billion. This number compares to $5.3 trillion of non-financial corporate business debt outstanding in the first quarter of 2005 (statistics published by the Federal Reserve Bank). It is generally well accepted that conventional real estate occupancy leases comprise the vast majority of operating leases. The report cites ELA s data observing that $208 billion, or 31 percent of the $668 billion of equipment assets acquired for use by businesses in 2003 was financed through leases. The report makes no attempt to quantify the amount of leasing activity that is accounting motivated. As an example though, the ELA s 2003 and 2004 annual industry surveys show that synthetic lease volume comprises less than 2 percent of total leased equipment. While not exactly new news, the report is highly critical of the all-or-nothing approach of SFAS 13 the fact that a company leasing property will either recognize the entire leased asset on its books and a liability, or it will recognize no asset or liability. It states that SFAS 13 is an improvement over the model that existed prior to its issuance in 1976 in that it intended to record an asset and liability on the books of the party with most of the risks and rewards of ownership and for whom performance under a contractual obligation is deemed satisfied at inception. At the same time, the SEC staff points out that, consistent with previous pointed criticisms widely reported in the press, many of today s issues with lease accounting are a direct result of SFAS 13 itself, which led practitioners to structure around the rules, using the weaknesses of the accounting standard to their advantage. The report notes that structuring of leases has become an industry unto itself with assistance from attorneys, lenders, investment bankers, accountants, insurers, industry advocates, and other advisors. Since the report offers no estimate of the extent of the problem, it may create a false impression that structuring largely explains off balance sheet financing. Securitization Practices Criticized Similar to leasing, the report criticizes securitization of financial assets for accounting-motivated structuring and for accounting standards that allow that to happen. Unlike leasing with its all-or-nothing approach to recording assets and liabilities, SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, allows companies to recognize a sale of a portion of assets even when the seller maintains significant continuing involvement and credit risk because of the financial components nature of the standard. In addition, SFAS 140 provides a unique exemption from consolidation for qualifying SPEs (QSPEs). New disclosure requirements have provided more meaningful information on these arrangements, especially on the nature and extent of continuing involvement. While securitization uses a control model as opposed to the risks and rewards model of leasing, the accounting framework has not eliminated structuring or the need for ongoing refinements in accounting standards. The FASB is in the process of amending SFAS 140 to ensure that QSPEs are not used for more than they were originally intended under the standard. 16 August 2005

5 Leasing Targeted for Accounting Change Leasing, along with pension accounting, are the two off balance sheet arrangements targeted by the SEC for changes in accounting standards. The SEC staff suggests that FASB add these two topics to its agenda and that the projects would be most effective if conducted jointly with the International Accounting Standards Board (IASB). The report supports continued consideration of the conceptual framework for a new standard for lease accounting presented in a discussion paper issued in December 1999 by the G4+1, a group comprised of accounting standard setting bodies from Australia, Canada, New Zealand, the United Kingdom and the United States along with the predecessor to the IASB, the International Accounting Standards Committee. The new approach supports recognizing assets and liabilities associated with leased assets on an entity s balance sheet using a measurement of contractual cash inflows and outflows. The SEC staff admits that it will be challenging to develop an approach on lease accounting that treats the many different types of leasing transactions in a conceptually consistent manner. Even with agreement on a conceptual framework between the IASB and the FASB, the SEC acknowledges that a project on lease accounting will generate significant controversy. For these reasons, the report concludes that a leasing project will take a significant amount of time and a substantial amount of FASB staff resources. Given the added task of managing a timetable in a joint project with the IASB, many observers believe that a new standard on lease accounting will easily take five years or more to complete. Call for Changes in Business Practices An overriding theme of the report and SEC communications over the past year has been inducing broad changes in corporate behavior and improvements in the quality August

6 While perceived problems with lease accounting may or may not warrant throwing the baby out with the bath water, ELA believes that the broad based concerns warrant research and revision. of disclosure and transparency around off balance sheet transactions. The report admonishes corporations and their advisors for structuring around the rules, noting that the outgrowth of FIN 46R was restructuring to avoid consolidation. The SEC admits that without a cultural shift among companies and their advisors, this behavior will continue regardless of future changes in accounting. The lack of surprise in the SEC findings is due in good part to the Commission s stepped-up enforcement and criticism of industry practice. Following Enron, intensive scrutiny of off balance sheet arrangements was tracked and reported by the media. In addition, FASB deliberations and implementation of FIN 46R educated many investors. In December 2004, Scott Taub, Deputy Chief Accountant of the SEC, delivered a well-publicized speech to the AICPA in which he made pointed comments about structured finance practices. He stated in part that, the promulgation of an accounting standard is itself often a catalyst for the development of new transactions, and recognized that standard setters have fallen victim to a vicious cycle when they, sometimes responded to structuring efforts by refining and expanding the standards. His bottom line is that whether these arrangements achieve their accounting goals or not, employing them is not in the best interests of investors, does not promote transparency, and is evidence of the fact that the focus on compliance undermines quality financing reporting. This theme has been wending its way through industry, and behavior has changed in some quarters as companies and their public accountants openly discuss the economic merits of a financial transaction. This shift is an all-important part of the behavioral change that the SEC believes is necessary. It has been a convenient time for industry to accept such a change cash flows and earnings are strong, companies are paying down debt and capital spending is light all factors that create less pressure for managing the balance sheet and earnings. The call for change clearly intends to avoid a repeat of accounting scandals and the resulting loss of investor confidence. Companies will need to respond by institutionalizing best practices within the context of business requirements and prudent cost-benefit parameters. However, preparers remain concerned about overzealous regulation and its potentially chilling effect on the normal course of business. They also believe that continued improvement in enforcement actions will help surface and resolve improper accounting for certain arrangements that might otherwise go undetected. ELA Supports Accounting Changes The focus on shortcomings of SFAS 13 is not new, but the SEC report may finally cause lease accounting to be added to the agenda of the FASB. While SFAS 13 was considered a significant improvement upon adoption nearly 30 years ago, its complexity and shortcomings have drawn disdain from the current generation of standard setters. ELA has long supported adding accounting for leases to the FASB agenda and it has actively participated in the IASB s research project on accounting for leases by providing ongoing commentary. While perceived problems with lease accounting may or may not warrant throwing the baby out with the bath water, ELA believes that the broad based concerns warrant research and revision. The ELA seeks an improved environment where disruptions to the market arise from economic not accounting issues. In the meantime, the use of off balance sheet arrangements will continue primarily because of the economic value and access to capital that the structures provide. There appear to be no significant changes in lease accounting in the short run, but disclosures are likely to become more useful and meaningful. Five to ten years from now, we may finally witness a long-anticipated change in lease accounting. The report can be found on the SEC s website at ELT thanks Mindy Berman, Senior Managing Director, 42 North Structured Finance, Inc., for this month s column. The author wishes to acknowledge the contributions of Lynn Rogers, Wachovia Corporation, and Rodney Hurd, Montgomery Street Financial LLC to this article. 18 August 2005