A wave of change on financial issues is fast approaching for public companies. New financial reform regulations and changes to major accounting rules that have been in place since 1976, as well as the expected transition to International Financial Reporting Standards, are just a few of the challenges ahead. One new rule in the accounting pipeline that is sure to cause commotion would require companies to place the expense of operating leases on their balance sheets. This change, say experts, has the potential to upset debt ratios and make it harder for companies to secure loans among other things. “It’s not anything that’s necessarily going to change whether a company is healthy or not healthy, it’s not going to change cash flow, it’s not going to materially change the income statement, but it changes the balance sheet which changes a lot of leverage covenants,” said Bob Pearlman, partner in the accounting firm BDO, who provides tax, financial advisory and consulting services to a wide range of publicly traded companies. • July 21, 2010 President Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The permanent exemption for non accelerated files from the internal control audit requirements of SOX included in the Dodd-Frank bill became effective. • August 17, 2010 FASB issues an Exposure Draft addressing accounting for leases. • September 15, 2010 The SEC adopts amendments to its rules and forms to conform them to the Dodd-Frank Wall Street Reform and Consumer Protection Act. • December 15, 2010 FASB is accepting public comment on the proposed standard for leases through this date. • January 21, 2010 FASB is accepting input from stakeholders about the time and effort that will be involved in adapting to several anticipated new accounting and reporting standards and when those standards should be effective through this date. FASB plans to make several targeted improvements to U.S. GAAP over the next year. Financial Accounting Standard 13, or FAS 13, originally set the standard for accounting for leases back in 1976. This standard required capital leases (leases in which there is an excellent chance that the company will wish to acquire full ownership of the product at the end of the lease agreement) to show up on a company’s balance sheet. Operating leases, those that have features more attributable to a rental rather than a purchase such as renting a copy machine for example, did not have to be reflected in the balance sheet. “Under FAS 13 (now ASC 840) operating leases did not go on the balance sheet as an asset or a liability you would just take that monthly lease payment and hit an expense account called equipment rental, for example, and it would impact the income statement but not be recorded as a liability on the balance sheet,” said Pearlman. Under the proposed changes, more than $1 trillion in operating leases would be shifted onto the books, according to estimates from the Securities and Exchange Commission. Possible complications This could weigh down balance sheets with liabilities and make companies look a lot more leveraged than they previously seemed. “From the lease accounting perspective it could be problematic. A company’s credit institution may have certain loan covenants that are driven on balance sheet metrics, therefore a company may not be in compliance with their covenants just due to an accounting standard change,” said Todd Batchelor, assurance senior manager for Moss Adams. “So the bankers and users of those financial statements are also going to have to realign their thinking around what a certain covenant may be or what may be an important metric.” Some, like USC’s Leventhal School of Accounting professor William Holder, believe these proposed changes are a step in the right direction towards making a company’s balance sheets more accurately reflect financial reality. “It’s going to do a lot to improve representational faithfulness, how circumstances are presented on paper,” he said. These proposed changes could be finalized by the Financial Accounting Standards Board and the International Accounting Standards Board by the second quarter of 2011. Getting a break Amid a sea of reform, another change taking effect cuts some public companies a big break. The Dodd-Frank financial reform package includes a provision easing the audit requirements that were put in place under Sarbanes-Oxley, for smaller, publicly traded companies. This measure affects at least a dozen public companies in the San Fernando Valley that qualify as “non-accelerated filers” with less than $75 million in market capitalization. In the wake of public accounting scandals such as Enron in the early 2000s, Sarbanes-Oxley was intended to reduce risk of accounting mistakes or fraud. Under the legislation, all public companies are required to design, implement and test a system of internal controls that is adequate to reduce or eliminate the potential for fraud. In addition to the company testing and making its assertion, an outside auditing firm also has to provide a second opinion. The new provision permanently exempts these smaller companies from the external auditing requirements, which represent an expense that can range anywhere from the tens of thousands to the hundreds of thousands of dollars. “Smaller public companies are the ones that can least afford to spend the money it takes to comply with those rules and to have outside auditors opine on their systems of internal controls,” Pearlman said. “And that’s why over the last several years you’ve been seeing many smaller public companies go private, because as a private company they wouldn’t have to even bother with it. And so this is really a huge weight off the shoulders of the smaller public company.” Going global The road to a uniform international set of accounting standards could be rocky, and public companies should also start bracing for what could be a difficult convergence of a principle based system and a rules based one, according to some accountants. “Historically U.S. accounting has been very rules-based which means that you’ve got a book that’s about a foot thick and every possible thing you can possibly think of has a rule, and it really obviates the need for a significant amount of judgment,” said Pearlman. “In a principles-based environment, which is more of what IFRS is, the book is a lot smaller, which means that there are general rules and guidelines but it also means that there’s a lot more room for judgment and interpretation.” Converging the rules will improve comparability between companies in the U.S. with those abroad, and help the investing community look at companies on an equal plane. Today this is not the case. Two companies with the exact same business and financial performance may not be accurately compared if one is abiding by the U.S. Generally Accepted Accounting Principles and the other is guided by other standards. For example, certain revenue recognition rules under GAAP may cause a U.S. company to defer revenues for several periods, making it seem that its exact counterpart in Europe has higher revenues and is a better financial investment than it really is. “We’re a worldwide marketplace these days, more companies are operating internationally and reporting on various stock exchanges on an international basis that being able to compare financial statements on a consistent basis is very important,” said Batchelor. Case for IFRS The idea of IFRS has such compelling value and benefit that there’s little doubt in some experts’ minds that it will become a reality. “The desirability of a single set of accounting standards is like an irresistible force, so attractive in concept that it will come to pass, but it doesn’t mean it’s Nirvana,” said professor Holder. The Securities and Exchange Commission is expected to decide next year on whether to approve incorporating IFRS into the U.S. financial reporting system. Certain companies may be required to report on IFRS basis by 2015. However companies should start thinking about it sooner than later. “For larger public companies there’s a requirement to report three years of income statements in your balance sheets so you really have to think about that from a 2012 perspective. So it’s closer in time than what people think,” said Batchelor. “In my view that’s the most important thing that public companies need to be looking at from a financial accounting standards point of view,” Pearlman added.
