Imagine a map. Imagine yourself folding the map.
Now imagine an economist who, seeing the crease, complains about the canyon you just dug in the middle of someone’s corn field.
The actual headline read “Shocking New Accounting Rules.” Published in The Economist (8/19/2010), which really should know better, it explains that IASB (the International Accounting Standards Board) and FASB (America’s Financial Accounting Standards Board) are re-thinking the rules for booking operating leases, treating them much more like capital leases.
The logic: When you sign an operating lease, you still have an obligation to make all payments. In exchange you have the right to use the equipment. The obligation is indistinguishable from debt; meanwhile, the right to use the equipment (the principle benefit of ownership) would be booked as an asset.
As the article says, “That will make a lot of firms look wobblier: a survey by PricewaterhouseCoopers, an accounting firm, found that it would add about 58% to the average company’s interest-bearing debt.”
That’s a lot of debt.
Except that actually, it isn’t: The day after implementing this accounting change (if it is implemented) every company in the world will be in exactly the same financial condition it was before the accounting change.
Exactly the same.
If PWC’s survey is correct, the change would result in a 58% increase in how much interest-bearing debt an average company reports on its balance sheet — very different from increasing its financial obligations. The amount of money entering and leaving the company would not change one cent (except, of course, for the cost of restating the books).
For some executives this would be an annoying but unimportant distraction. They want an accurate picture of their company’s health, and base decisions on how they affect it. These “Accurate Count Executives” (ACEs) decide whether to obtain equipment through purchase, a capital lease, an operating lease, or simple rent depending on how long they expect to need the equipment, a comparison of debt financing costs to other uses for available capital, and the tax consequences of depreciation.
Other business executives care less about having an accurate picture than about making their company’s stock more attractive on the open market. These “Balance Sheet exaggerators” (BSers) base their buy/lease/rent decisions on which will make the company’s financial statements look better (which includes taking into account what ends up in the statements themselves and what can be legally relegated to the footnotes).
The difference between ACEs and BSers is easy to spot. Take, for example, a position on your team that opens up a couple of months before the end of the fiscal year. An ACE will ask whether the company will make a profit on the position or not. If it will, the ACE will tell you to fill it as quickly as you can … so long, of course, as you fill it with an outstanding candidate.
ACEs see no reason to delay an increase in profits.
A BSer, on the other hand, will give you very different instructions: Hold off filling the position until the next fiscal year, and then fill it with the least expensive candidate competent to do the work.
Don’t blame the BSers. They’re doing what they’re paid to do. They almost always receive part of their compensation as “at risk pay” (aka their annual or quarterly bonus). It’s a chunk of cash that depends in large part on the company’s financial performance –how good the balance sheet and profit-and-loss statement look at the end of the year.
If you only receive your bonus when the balance sheet and profit-and-loss statement look good, you’ll do your part to make them look good.
Emphasis on the word “look.”
Here’s the irony: Staff-level employees who have no compensation at risk have no incentive to skew the financial statements to make them look better. It’s quite the opposite.
They know exaggerated profits will be spent on executive bonuses and dividends for shareholders. It won’t go to bigger raises — pay levels are, after all, pegged to the labor marketplace, not available cash — so all in all they’d prefer an accurate count to taking on debt the company can hide but can’t afford.
Basing decisions on an accurate picture increases their employer’s sustainability and their job security. They know it, know when company executives are pretending otherwise, and generally know it’s because bonuses depend on the pretense.
Don’t believe me? Ask your employees which they’d rather work for — a BSer or an ACE.
I think you know the answer.
Bob, Even worse than the ACE vs BS folks is the huge fog these types of rules create within the organization and the industry.
I spent an “interesting” 7 years as the Audit Committee chair of a public company. What absolutely confounded me was the absence of consistent, rules based accounting processes. Any three good public accountants could come up with at least five treatments of nearly any transaction. To a has been engineer this really makes your head hurt. Similar to the fuzz that will be created with the changes for accounting for leases I recall a situation where the rules (lore would be a more appropriate label)for accounting for the leasehold improvements in property was changed. It blew holes in the numbers of chain stores and others opening many new premises each year. Did the cash flow or any other operational factor change? Not a bit. Did the reported results change? for some enormously and even worse, many restatements were required.’
Idiotic, dumb, wasteful, wattless work . . .
John Blair
Well put! I read the article over the weekend and nowhere, from what I can recall, did The Economist give the impression that nothing will change from a “financial condition” point of view. How do we change a BSer into an ACE, that’s the Million Dollar Question.
So folding the map differently would actually create a canyon in someones back yard in this case. The aphorism, “You get what you measure” would seem to be the core of your article. Change the measure and the management of the BSer at least will change, and I sincerely doubt any large organization is all ACEs.
Also, are you sure there would not be secondary considerations, such as tax laws or automated stock trading algorithms that would cause such an accounting change to have other effects on the health of a company? Even an ACE may have to reconsider if a sudden dip in stock price were to open the company up to a hostile take-over.
No tax consequences: FASB and IASB have no authority to change tax reporting.
Stock price? It’s possible: If the change reveals weaknesses that had previously been concealed, that could happen.