Tuesday, January 11, 2011

"It's not a done deal."

That was the statement of Larry Smith, FASB board member, at last Thursday's (Jan. 6) afternoon roundtable discussion on the proposed new lease accounting standard. He was responding to one participant's comment that people in the leasing industry he's talked to thought there was no point in submitting a comment letter or otherwise participating in the boards' outreach activities, because they thought the standard was "a done deal" and the process was just for show. Smith was emphatic in denying that. New FASB Chairman Leslie Seidman concurred, adding, "I've already decided that I will change my position on one or two matters," and suggesting that she may make further changes based on additional review of the comment letters and discussion with interested parties.

The count of comment letters is now up to 746 (including letters received after the deadline, which are still being posted to the FASB website). I can't possibly read them all (I need to do my real job), but members of the FASB and IASB staff are. I spoke to one of the FASB staff who is personally reading every single comment letter on lease accounting, and commented that the letters are substantive (and lengthy); they're impressed by the thoughtful responses presented. I'm sure it'll be a few more weeks before they have compiled a summary for the boards, and the boards can begin redeliberations.

I attended the Thursday afternoon roundtable as an invited participant. Other participants included representatives of KPMG and Ernst & Young, lessors Xerox and International Lease Finance (one of the largest aviation lessors in the world), the CFA Institute (financial analyst, and thus a user of financial statements), Toys R Us, Transocean (the world's largest drilling rig operator, unfortunately now infamous as the driller of the BP well that blew up last year), and consultants to the leasing industry. Also present were all five members of the FASB board, as well as two IASB members and several staff members from both boards.

We had four planned topics of discussion: the definition of a lease, the lessor accounting model, the lease term, and variable lease payments (i.e., contingent rents). Most of the discussion of the definition of a lease centered on the distinction from service contracts. It was noted that the line is sometimes fuzzy even today, but because operating leases and service contracts are accounted for relatively similarly, differentiating them isn't a significant issue. With capitalization of leases, the difference becomes much more significant. Transocean is concerned that they may be seen as lessors, which they haven't been up to now, for contracts which include use of a drilling rig, but provide full crew and other services. Airlines similarly may lease aircraft with crew & maintenance included (a "wet lease") or just the aircraft alone ("dry lease"). Aviation lessees and lessors are concerned that fully capitalizing a wet lease will reduce comparability. No consensus was reached about how or whether to divide services and leases.

We also briefly discussed whether the scope exclusion for "in-substance purchases" should be maintained, with some feeling it was a leftover in the proposal: it was set up when the boards were planning to provide only a performance obligation approach to lessor accounting, and lessors wanted a way to recognize up-front profit if they were effectively selling an asset. With the inclusion of the derecognition model, there seems to be less reason to have a separate methodology for in-substance purchases.

For the lessor accounting model, some prefer performance obligation, some prefer derecognition, and some see a place for both. But a number of participants essentially felt, "If it ain't broke, don't fix it." They don't see significant problems with current lessor accounting, and suggested essentially keeping it in place, with removal of FAS 13's "bright lines" differentiating capital and operating leases (i.e., using IAS 17 terminology of "the lease term is for the major part of the economic life" and "the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset"). The boards seemed to be willing to seriously consider that. Some participants noted that it was important to make this a long-term rather than interim decision (i.e., don't just tweak it until they can revisit it in a few years; if a change is required, do it now).

We spent long enough on these topics that our discussion leader (the FASB staff project manager for leases) decided to combine the issues of the lease term and variable payments, feeling they were in many respects similar. I agreed; in both cases, the boards are calling for capitalization of amounts that don't meet their own definition of a liability. We discussed the operational difficulty of making and updating the estimates for portfolios of thousands of leases. One FASB board member brought up a suggestion, apparently received in another venue, of doing the estimates on a whole portfolio basis rather than lease by lease. Roundtable participants felt that would not be workable, since in many cases there is wide variation in types of leases or characteristics of leases (real estate leases in particular are rarely cookie-cutter). The accountants also felt that such estimates would not be auditable.

The financial analyst expressed interest in an "expected value" approach, but other participants were extremely negative about booking, for instance, fractional lease terms (like a 7.2 year lease for a 5-year lease with several yearly renewal options). I argued that there is a qualitative difference between a 15-year lease and a 1-year lease with 14 yearly renewal options, since the lessee has the flexibility to walk away with no penalty. The current proposal makes those look identical if the renewals are judged "more likely than not," which penalizes the lessee and understates the lessor's risk of nonrenewal (and a nonrenewal would inevitably result in a substantial hit to the lessor's income statement, meaning potential for substantial earnings volatility). Options aren't "structuring;" they provide choices.

For contingent rents, a best estimate was seen as more tolerable than the current "reasonable number of estimates" (what's a reasonable number? does the norm vary from country to country?), though still all the participants in the room other than the analyst were opposed to capitalizing most contingent rents as well as the "more likely than not" threshold for including renewal options in the lease term. People were also opposed to using forward rates to estimate contingent rents that are based on an index or rate, considering it needlessly complex (do you use a different estimated rate for each monthly payment out five years or more?).

The three hours went quickly. Larry Smith of the FASB commented at the end, "We will take time." While the boards' goal has been to complete the project by June 2011, he said that has always been subject to the extent and nature of comment letters and other outreach responses, and they will extend the schedule if needed to properly respond. Their goal is a "comprehensive, converged, improved, and able to be implemented standard."

I definitely felt the board members were listening with open minds. It remains to be seen how they will balance the various perceived needs, and the varying purposes of leasing. One of the fundamental issues they're dealing with is that sometimes leasing is equivalent to purchasing an asset (a computer lease is perhaps the best example, given the short economic life of a computer), while at other times it's closer to provision of a service (a copier lease with low fixed charges and a per-page price). A methodology that provides comparability to one form doesn't work well for the other. But there are so many gradations between that it's hard to define a principle, any more than a bright line, that differentiates them.

Many people are concerned that whatever change the boards make will mess up their current business operations. Yet doing nothing means that true liabilities of a company are largely hidden (as the financial analyst put it, "Disclosure is not enough"). I don't think the boards will back down from requiring lessees to capitalize virtually all leases. But the rest of the standard is certainly in question, and the deliberations this spring are likely to be lengthy and contentious. Stay tuned!

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