Accounting and Auditing

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Accounting and Auditing

The Long Road to a New Standard for Lease Accounting

Topic(s): GAAP, IASB, FASB, Financial Management, Financial Reporting, Disclosure

by Nicola M. White

Summary: Real estate companies and many others are worried about the FASB and IASB

proposal that calls for companies to front-load their leasing expenses. But the boards are determined to push ahead with a standard that they hope satisfies investor demands for better information on lease commitments. The final standard may not be ready until late 2012, and before it's out, the companies whose balance sheets will undergo the biggest changes are likely to fight its main provisions.

Former IASB Chairman Sir David Tweedie made no secret about his frustration with businesses keeping potentially large liabilities away from the eyes of investors.

“One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet,” the onetime partner with KPMG's U.K. affiliate said in an April 2008 speech to the Empire Club of Canada. It was a statement Sir David repeated often during his tenure in reference to the long-standing practice that keeps lease expenses off company balance sheets.

But Sir David may soon get his wish. The FASB and IASB are well on their way to requiring businesses to state their lease expenses on their balance sheets, a move proponents say will give investors better insight about a company’s debts.

This is big news because almost every business engages in some sort of lease contract, whether it’s for a fleet of trucks or a few photocopiers. A 2005 SEC study estimates that more than $1.25 trillion would be shifted onto company balance sheets if lessees had to record the amounts they owe for the goods.

But the years-long journey to get to a workable accounting solution has not been smooth. Because of all the discord in drafting a proposal, the FASB and IASB have agreed to give the

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public one more shot to vet the plan before they write a final standard. During this second round of comments—expected to open up in late March or early April—the boards expect to hear plenty, not only from accountants and auditors but also from equipment lessors and real estate industry insiders.

The number one complaint: The current proposal changes the expense recognition pattern on the income statement to make a business look like it purchased the storefront or factory equipment. This shifts the pattern from straight-line expensing to a method that front loads lease payments, as if the customer were purchasing the asset and recognizing interest. This makes businesses look like they’re using up cash, when in reality they’re most likely making even payments month by month, critics say.

IASB member Patrick Finnegan even acknowledged that this is a problem.

“By far and away, that’s an issue we’re going to have to look at square in the face,” Finnegan said at a Standard & Poor’s conference in New York in November.

The real estate industry is especially anxious about the front-loading. The market remains fragile from the mortgage meltdown of 2008, and it may be further hurt by changes that could discourage tenants from signing long-term leases. The lack of long-term revenue commitments could make it difficult for landlords to borrow from risk-averse banks. “There are a lot of people in the industry who think if they could fix the P&L pattern or get back to straight line, they can deal with all the balance sheet issues,” said Mindy Berman, managing director with Jones Lang LaSalle, a real estate firm.

Financial Executives International in a November 23 comment letter to the FASB and IASB said its members agreed with the outcome of putting leases on balance sheets but had “significant” concerns about the boards’ “right-of-use” accounting approach, which could misstate profits and losses.

“Specifically, we believe that the Boards’ current conclusions obfuscate, rather than clarify, the effect of leasing transactions on future cash flows. We believe that this will render the financial statements less useful to investors,” FEI wrote.

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Long history

Lease accounting has perplexed standard-setters for decades. The chief complaint: A business that leases its factory equipment or its office space looks like it has less debt than a business that takes out a loan to buy them even if the payments are the same. The discrepancy forces investors to determine the true financial health of a company.

The FASB first tackled the issue in the 1970s when it established the idea of a capital lease. The basic thinking was that if you leased something but had most the risks and rewards of ownership, you should acknowledge that obligation in your financial statement. If not, you’d treat it as an operating expense that you pay as you go, much like a rental arrangement. Because of the bright lines surrounding the rules, sophisticated preparers were able to apply them in a way that made sure few leases were capitalized, said former FASB Chairman Dennis Beresford, now an accounting professors at the University of Georgia.

The rules have been tweaked over the years so more businesses, especially those that ended up purchasing the leased asset at the end of the contract, put their leases on their balance sheets. Some information is also disclosed in financial statement footnotes but many critics thought it wasn’t enough.

“I think most of the analysts that read those financial statements feel in substance those are assets and liabilities that should be added to financial statements,” Beresford said. “The same thing is true of a lot of industrial companies that have long-term leases for very substantive types of property and equipment that ought to be considered the same as owned assets.”

When Terry Warfield, a University of Wisconsin accounting professor was on the FASB's Financial Accounting Standards Advisory Council in 2006, investors repeatedly raised lease accounting as an area where they wanted more clarity. Although he said he understood businesses’ concerns about change, the proposal treats leasing like borrowing or securing a mortgage, which better reflects the economic transaction.

“Yes, it’s different from what we’re doing now, but that doesn’t mean what we’re doing now is the right thing,” Warfield said.

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The FASB in 2006 announced that it would add to its agenda a project to address lease accounting problems. During his term as IASB chairman, Sir David also made it clear that he wanted to overhaul lease accounting. But several bigger projects got in the way, as did the fallout from the global financial crisis.

In 2009, the FASB and IASB released discussion documents and followed them in August 2010 with formal exposure drafts, proposed Accounting Standards Update (ASU) No. 1850-100, Leases (Topic 450), for the FASB and Exposure Draft (ED) No. 2010-9, Leases for the IASB.

Immediately, businesses found flaws in the proposals. The exposure drafts called for a single accounting method to measure leases, which critics said didn’t properly reflect the realities of a business that repeatedly rented the same piece of equipment or real estate with no reasonable expectation of buying it later on. The boards backed down in April and agreed to two models. But coming up with accounting methods that shed light on company expenses for two different scenarios was too complex, so the boards in May went back to the original plan.

The complaints led the standard-setters to agree to issue a revised proposal for a second round of comments—and potential redeliberation.

That release is expected by either the end of March or early April, and the boards are expected to meet at least once beforehand, which could mean a few more tweaks before the draft goes out.

Lessor accounting

Figuring out the decades-old question of how best to highlight lease debt expenses for lessees was supposed to have been the main goal of the project. But the FASB raised concerns about symmetry between lessee accounting and accounting for landlords and equipment lessors.

Now the aspect of the project that was originally considered an afterthought has also proven to be tricky.

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The Equipment Leasing and Finance Association has criticized the boards for failing to distinguish between a lease contract where a retailer continues to rent a cash register or storefront versus a contract where the lessee eventually owns it.

The issues for real estate businesses are even muddier. In many instances, a tenant at a shopping mall or in an office building has no chance of ever purchasing the space.

The proposals “overlook the fact that the majority of real estate leases are just about using space so there’s not a possibility to own,” Berman of Jones Lang LaSalle said.

The boards in October offered relief to some landlords, however, by tentatively deciding to exclude investment property businesses from the new standards. Although the boards have yet to clarify what an investment property business is, debate at the joint meeting indicated that it could include owners of multi-tenant shopping malls or office towers that consider their spaces to be investment assets.

Some members of the boards were unhappy.

“You could drive a truck through this exception and essentially undermine not just two years, but six, seven—how many years?” IASB member Finnegan said at the time. Is front-loading such a big deal?

Standard-setters have to strike a balance between reforming a problem that investors have complained about for years and not burdening businesses with new accounting rules. But critics of the current lease accounting rules, which they say offer investors and creditors little clear-cut information about a company’s real obligations, say tweaking the rules to appease businesses won’t help the overall goal of the project.

“I think they’re trying to be too sensitive to the politics,” said Pennsylvania State University accounting professor J. Edward Ketz. “They just need to make a decision and tell some folks that don’t like it to take their grief elsewhere.”

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