FASB lease action significant

Defense Market Report
By James Smith
July 21, 2006

There is an old adage taught in every business school curriculum: read company annual reports from the back.

I am not suggesting that anyone change their old habits. But recent actions by the US Financial Accounting Standards Board (FASB) may be food for thought.

FASB said on July 19 that it had place on its agenda a reconsideration of accounting for leases.

FASB said: “The goal of that project is to insure that investors and other users of financial statements are provided useful, transparent, and complete information about leasing transactions in the financial statements. The decision to add a leasing project, which will be conducted jointly with the International Accounting Standards Board (IASB), reflects the board’s concern that the current accounting in this area does not clearly portray the resources and obligations arising from lease transactions.”

In a nutshell, a quick glance at a company’s balance sheet does not tell the whole story.

Companies routinely acquire equipment on operating leases. By using operating leases – an off-balance sheet type of financing – a company can maintain a low debt-to-equity ratio, especially if by capitalizing these leases would compromise negative debt covenants.

By using operating leases, rather than the outright purchase of equipment, a company can report only rental expense, with the asset kept off-balance sheet.

Off-balance sheet financing is also used in accounting for joint ventures and research-and-development costs, among other arrangements.

Conversely, loans, other forms of debt and equity appear on the balance sheet.

FASB noted that leases are an integral part of doing business. The current US leasing standard FAS 13 (Accounting for Leases) was established in 1976. FASB added: “While that standard represented a significant improvement at the time, lease arrangements have evolved considerably over the past 30 years and the standards are outdated. Today, leasing arrangements can vary from simple rentals of equipment to complex, tax-motivated arrangements involving real estate and other types of assets. Moreover, the current accounting standards in this area are complex and rules-based, which makes it possible to structure transactions to achieve desired accounting outcomes."

FASB expects to have a discussion paper on a new lease accounting standard by 2008 and a final standard some time in 2009.

The project represents a first step that could potentially require companies to recognise leases on corporate balance sheets instead of in financial statement footnotes.

FASB is expected to call for capitalising operating leases, a move which would result in huge increases to a company’s debt-to-equity ratios, often seen as an indication of a company's financial leverage.

The recent Enron scandal brought the inappropriate use of off-balance sheet financing to public scrutiny.

If FASB decides to issue revised guidance calling for caitalizing or expensing leases -- as is expected -- many investors will look at potential investment opportunities with a different perspective.

For more Defense Market Report with James Smith - click here

Disclaimer
James Smith is an independent columnist for this web site. James Smith may hold long or short positions in any of the stocks mentioned in this article and those positions can change at any moment. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp, InvestorIdeas is not affiliated or compensated by the companies mentioned in this article. James Smith is a freelance writer. Nothing in the articles should be construed as an offer or solicitation or recommendation to buy or sell any specific products or securities. Past performance does not guarantee future results.