FASB meets with Small Business Advisory Committee

This morning the FASB met with the Small Business Advisory Committee. The meeting is continuing as I write this, but discussion on leases was near the beginning of the agenda, and that's what I'm concerned with.

A FASB staff member gave a bit of an update of the outreach they've been doing since the February meeting, when the FASB and IASB considered some options for expense recognition on leases in the new standard. They've been meeting both with companies that would apply the standard ("preparers") and analysts ("users"). They've found that among users, there is near unanimity in agreement on the balance sheet approach planned for the new standard (i.e., capitalizing essentially all leases). There is, however, considerable diversity on the income statement side, selecting from among the options that the board is considering.

The presentation at this meeting included three alternatives to the current capital/finance lease model, rather than the two discussed at the February meeting. In addition to February's interest-based amortization and underlying asset approaches (see my prior summary of these), they showed an "Approach D," which is straight-line rent expense, like current operating lease accounting. It wasn't clear how the balance sheet balances would be amortized in such a situation: Would the asset and liability be shown undiscounted, and then amortized straight-line, or would they be shown as the present value of remaining rents (either based on cash rents or the straight-line equivalent), or something else?

In general, the committee expressed strong support for level expense recognition, considering that capital lease accounting provides unhelpful information in their environment. Some still want to make the case for it being off the balance sheet ("If I can't sublet, do I really have an asset, since I can't transfer it?") I don't see any likelihood of that prevailing.

Some expressed support for handling real estate differently from equipment, making the argument that real estate leasing is more about reducing risk (knowing what your rent will be into the future) while equipment has more of a financing approach (I can't afford to buy it up front; though often an equipment lease is related to wanting the equipment for a limited time, wanting quicker upgrades, etc.). This was in support of level expense recognition for real estate even if equipment used the standard financing model.

A FASB board member, however, said he didn't like the idea of basing the accounting on the type of underlying asset. He wondered if they could define characteristics that justified the different treatment. One that he mentioned is that in a real estate lease, the asset is expected to have little or no reduction in value (a land lease particularly exemplifying this concept).

Another committee member suggested that if the present value of the rents is less than "about" half the value of the underlying asset, operating lease accounting should be acceptable. But he didn't have a good answer for how to draw the line between leases that would and wouldn't qualify. A major issue driving the revision of lease accounting is that similar leases (those just barely on opposite sides of the capital vs. operating dividing line) are accounted for very differently.

A banker commented that many leases are written to game the accounting rules, and she fully expects the same thing to happen under the new rules. A particular area of potential vulnerability that several people saw is the issue of substitutability--according to the current draft, a lease requires a specific asset to be named, and if the asset can be freely substituted (so that it's the output of the asset, rather than the asset itself, that the lessee is controlling), it's a service contract rather than a lease. It was suggested that lessors may start writing leases so that all kinds of equipment are officially subject to substitution. Whether "substance over form" principles will protect against that is unclear.