The Board issued a Discussion Paper “Leases: Preliminary Views” in March. In this document the FASB finally begins to follow the definitions specified in its own conceptual framework. Recall that assets are “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events” and liabilities are “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” As leases grant lessees probable future economic benefits and generate probable future sacrifices, lessees have assets and liabilities they need to account for.
Let us remind ourselves of how important this topic is by examining the case of CVS Caremark. Like most retailers, this corporation leases many of its stores throughout the country. The lease structures utilized by CVS Caremark allow it to categorize most of its leases as operating leases and thereby not disclose a significant amount of its liabilities.
While this accounting is permitted under current FASB and IASB rules, it supplies not-so-little white lies to investors and creditors. It is time for corporate America (and the rest of the world) to tell the truth about leased assets and lease obligations. It would be a way of practicing ethics instead of just preaching about them.
Employing the data disclosed in its last 10-K (2008), I recast the numbers as if the entity employed capital lease accounting. Performing these adjustments generates the following results for CVS Caremark (all numbers in millions of dollars).
The leased assets are included in the assets of the business enterprise, so long-term assets and total assets increase by $9.269 billion. This amount is clearly a significant amount of property rights not to include on the balance sheet.
The current liabilities increase by $1.645 billion and the long-term liabilities by $13.804 billion. That’s a lot of debt to conceal from shareholders, creditors, and the general public.
The stockholders’ equity has gone down because depreciation costs and interest expense replace rental charges. For this firm and this period, the cumulative depreciation and interest would have exceeded rental fees.
In terms of some common ratios, the changes are also significant. The current ratio for reported numbers is 1.21 and for adjusted numbers 1.09. The ratio debt-to-capital is 43% for reported numbers, but jumps to 60% for adjusted numbers. Long-term-debt-to-capital is 21% for reported numbers, but almost doubles to 38% for adjusted numbers.
However you slice it, these are some huge assets and liabilities playing hide-and-seek with the investment community.
I am happy to report that the FASB and the IASB are leaning toward requiring business entities to report these assets and liabilities. I am not so happy with the discussions pertaining to options, lease terms, contingencies, and guaranteed and unguaranteed residual values. The FASB and the IASB should forget all of the minutiae dealing with implicit interest rates versus incremental borrowing rates, residual values, and contingencies. As they construct a new standard for lessee accounting, the FASB and the IASB need to forget all of the garbage in FAS 13 and IAS 17.
Let the standard be simple: measure the capitalized asset at its fair value and measure the lease obligation at its present value. There is no need for the other trivia; let the auditors sort out the details. And let plaintiffs’ attorneys monitor the auditors.
This approach would prove simple and rational. Companies would then supply relevant and reliable financial information. And it really would be principles-based.2009 SmartPros Ltd. All Rights Reserved. Editorial and opinion content does not represent the opinions or beliefs of The Pennsylvania State University or SmartPros Ltd.