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The SEC's OBS Report: Leases

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Posted by: Jack Ciesielski	6/21/2005 5:47 AM
Today's nuggets served up from the SEC's off-balance sheet financings report: leases. There are two kinds of leases in the world; most people think they're operating leases or capital leases. True enough, but it might be easier to think of two kinds of leases as visible assets or buried expenses. A lease is capitalized if its terms meet one of the following four criteria in Statement No. 13 (issued in 1976): The lease transfers ownership to the issuer (i.e., the lessee) using the asset by the end of the lease term; or The lease contains an option whereby the issuer can purchase the leased property at a price sufficiently lower than the expected fair value of the leased property at the end of the lease term; or The term of the lease is equal to or greater than 75% of the estimated economic life of the leased property; or The present value of the minimum lease payments to be made by the issuer is equal to or greater than 90% of the fair value of the leased property. Fail all four tests, and the lessee records the lease payments as rental expense - an "operating lease" treatment. No asset recognized, no debt recorded, no messy depreciation. And you can actually get some lenders or equity investors to believe that there's plenty "margin of safety" for additional borrowing. Sweet. As the SEC report puts it, this classification of leases through a series of bright-line tests is an "all or nothing" exercise, and it leads to all manner of structured transactions: for example, is there any economic difference in a lease that "commits an issuer to payments equaling 89% of an asset's fair value vs. 90% of an asset's fair value?" And the structuring of transactions has been aided and abetted by an army of "attorneys, lenders, investment banks, accountants, insurers, industry advocates, and other advisers." Which means that there are plenty of parties that would be affected by any changes to lease accounting - and naturally, would resist any changes. The SEC found that in its sample of 200 issuers, the gross cash flows for future commitments under non-cancelable operating leases totaled about $206 billion; extrapolating to the population of active U.S. issuers for the same type of leases puts the total to about $1.25 trillion. Remember - those are gross cash flows, not their present value, which would be the amount of debt kept off of the collective balance sheets. The study's authors acknowledged that they did not attempt to determine the appropriate discount rates for estimating the present value of the cash flows; in fact, one could only make assumptions in the absence of detailed knowledge of underlying leases. To put things into a more reasonable perspective, they did note that if the cash flow commitments were discounted as equal payments at 8% over five years, their present value would be $1 trillion; over ten years, "only" $837.5 billion. The SEC recommendation: the FASB should consider adding a lease accounting project to its agenda, possibly with a "focus on contractual cash inflows and outflows in determining the amount of assets and liabilities," adding that the project might be most effective if it was executed jointly with the IASB. The recommendation also acknowledged that any revisions to lease accounting principles would generate "a signficant amount of controversy." Given the broad array of vested interests in lease accounting (this is not just a Silicon Valley issue; leases are everywhere), that may be the understatement of the year.

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