Boards Struggle on Single Method to Account for All Leases

Try as they might, accounting standard setters haven't yet figured out a single method to account for all leases, so they're rethinking whether they should create different approaches for different kinds of leases, even though they briefly considered and dismissed that idea just a year ago.

Companies that are anticipating a new accounting standard to bring all leases on to corporate balance sheets are anxious to see what they decide. “This is a huge issue,” says John Hepp, a partner at Grant Thornton. “There's a lot of interest in this. My phone is ringing.”

The Financial Accounting Standards Board and the International Accounting Standards Board remain committed to finalizing a standard to require companies to put leased assets on the balance sheet. The boards haven't wavered on that objective, despite continued appeals from those who oppose the idea. On May 22, 60 members of Congress signed a letter urging FASB to abandon the idea. The members of Congress raised concerns about grossing up corporate balance sheets with liabilities during an already fragile economic recovery. They want FASB to further study and field test the idea before implementing it. 

At a recent joint meeting, the boards emphasized that their outreach with preparers and users of financial statements still suggests the idea of bringing leased assets and liabilities on to corporate balance sheets is valid and well supported. Hepp says he doesn't hear objection to putting leased assets on the balance sheet, but companies are very concerned about the pattern by which the expense would be recognized on the income statement. That's where the boards are stumped.

FASB and IASB are wrestling with how to reconcile accounting theory with economic reality. According to accounting theory, liabilities on the corporate balance sheet should be recognized through the income statement based on the time value of money, factoring in things like interest cost and depreciation, says Julie Valpey, a partner with accounting firm BDO USA. That leads to an accelerated recognition of the   expense through the income statement, similar to the way capital leases are recognized today when a company acquires a leased asset in an arrangement that is much like the purchase of an asset through financing.

The boards aren't hearing much pushback to that idea for handling the leasing of long-lived assets that will remain on the books for several years. But companies are objecting to that treatment for short-term leases on short-lived assets where accelerated recognition of the expense doesn't match the economics of a straight-line cash flow to pay down the lease obligation, like many of today's operating leases.

The boards have long struggled with how to do away with today's bright-line distinction between operating leases and capital leases—which encourages entities to structure lease contracts to achieve a particular accounting treatment and instead recognize all leases under a single model. Given persistent problems with how to recognize the expense, FASB and IASB conceded recently it may be impossible to develop a single model that fits all leases. But they don't have a firm plan in place for how to define a difference between leases or prescribe how they might qualify for different accounting.

The boards have already tentatively decided they will scope out the shortest of short-term leases, and allow companies to simply straight-line the expense on the income statement. Now they are debating whether to allow more straight-line expense recognition than they originally envisioned, because they can't figure out another method that better matches accounting theory. The boards have developed and test driven ideas for recognizing the liability based by amortizing the interest rate or based on the consumption of the underlying asset. After communicating with users and preparers of financial statements, they have largely dismissed those ideas as too complicated, too costly, and too difficult to audit.

LETTER FROM CONGRESS

Below is Congress' letter to the Financial Accounting Standards Board regarding lease accounting:

Accurate and transparent financial reporting is the cornerstone of global capital markets. We believe that a formal and open cost-benefit analysis should be an integral part of the financial reporting standard setting process.

Nonetheless, we are very concerned with the unintended economic consequences of the Financial Accounting Standards Board (FASB) and International Accounting Standards Boards' (IASB) joint lease accounting proposal (File Reference: No. 1850-100, Leases (Topic 840)) and subsequent updates to this exposure draft. According to a recent study released by Chang & Adams Consulting, the current lease proposal would negatively impact job creation, the health of the U.S. commercial real estate sector, loan covenant agreements, and liabilities of U.S. publicly traded companies.

The report analyzes the current lease proposal under a best case scenario estimated its economic impacts as: (1) increasing liabilities for public companies by $1.5 trillion; (2) increasing costs to U.S. public companies by $10.2 billion annually; (3) potentially leading to job losses of over 190,000; (4) reducing U.S. household earnings by $7.8 billion annually; and (5) lowering U.S. GDP by $27.5 billion each year.

The results of the Chang & Adams study, along with others, indicate the need for FASB and IASB to fully analyze the economic ramifications of lease accounting rule changes. Real estate is the cornerstone of our economy; however, the commercial real estate market continues to be negatively impacted by high unemployment levels, low consumer confidence, falling property values, and a contraction in lending. A further disruption of this market will have serious negative consequences.

Furthermore, we believe it is imperative that FASB and IASB undertake and publish an all-inclusive economic impact study before any final action is taken on the lease accounting proposal. The study should examine all potential economic consequences for businesses that own, invest, and rent commercial real estate. This should include, but not be limited to possible effects, such as higher rents, further reduced property values due to shortened lease terms, administrative costs and problems resulting from obscured financial reporting, which were not calculated under the Chang & Adams study. Additionally, the potential increase on borrowing costs for all commercial real estate participants as well as the financial and regulatory impact on lending institutions must be fully examined. Finally, field testing should be undertaken to identify any further potential economic consequences before the proposal is finalized, as well as in the pre and post implementation phases of the final standard.

Thoroughly vetted and sound accounting standards are needed to create certainty in the marketplace for investors and businesses alike. A comprehensive examination of the costs and benefits should be a part of that process.

Source: U.S. Congress.

Some board members are torn over what they see as a choice between two imperfect options:—imposing a single model that doesn't adequately reflect all leases, or developing different models that will be difficult to define without the kind of bright lines that lead to transaction structuring. “I appreciate the desire for simplicity, but I think it would be a mistake if we try to cram all leases into one model,” said FASB member Daryl Buck. “I don't think it would appropriately reflect the economics of all transactions. I would go with a two-model approach, and as far as where to draw the line, do it in principles. Try not to be too prescriptive and too detailed.”

FASB and IASB instructed their staff members to develop a new proposal that would provide for a way to distinguish between leases that should be recognized as long-term liabilities and those that might reasonably qualify for a straight-line treatment of expense. Rich Stuart, a partner with McGladrey & Pullen, says many board members seem open to various ideas on what criteria to focus on to draw distinctions between leases.

The boards could agree to consider tests in current accounting rules, but without precise, numerical thresholds that will automatically drop a line between categories of leases, he says. They also could focus on developing criteria that will point to the transfer of risks and rewards associated with leased assets. Some board members also suggest the standard draw a distinction between leases for property vs. equipment. “If they come back with two models, they need some kind of classification test for determining which model you're in,” says Stuart.

The boards have set a fourth-quarter target to issue a revised exposure draft of the lease proposal and an early 2013 target for issuing a final standard, which would fit the timeline for finalizing key standards as part of the effort to converge U.S. and international accounting rules.

Sydney Garmong, a partner with Crowe Horwath, says the task before the board is not an easy one. “Even board members have said it's going to be a challenge to come up with one model that makes everyone happy,” she says. “Someone is going to be disappointed.”

Valpey says the boards should expect plenty of mixed feedback on virtually anything they decide. “Depending on what they end up with, they could see the same number of comments and complaints about the methods. Preparers are going to have issues with the new models they are proposing. It's not going to be a simple exercise.”