WSJ Article: Leases Suffer Identity Crisis

Yesterday's Wall Street Journal (May 22) had a sizable article produced by CFO Journal, titled "Leases Suffer Identity Crisis," reviewing the controversy over expense recognition in the new lease accounting standard. Most of what's discussed there we've already seen, though a few items are worthy of note:

• They expect the revised exposure draft to be released in "mid-2013"
• IASB Chairman Hans Hoogervorst is quoted as saying that leases “are somewhere in between a purchase and a service, so our traditional answers in accounting don’t give a simple way to do this. ... The only clear signal we have from investors is to get them on the balance sheet and to keep it as simple as possible.”

The article quotes both a preparer and an accountant as considering many of the proposals overly complex ("over-engineered") and not useful.

The Journal often doesn't make CFO Journal articles available on the web (see, for instance, the article noted in this post), but at least for now, it's available without a subscription.

Tomorrow's meeting will discuss expense recognition. I intend to listen live, and will report once it's complete.

Outreach results on expense recognition

At their February meeting, as previously reported, the FASB & IASB were split regarding the proper approach to expense recognition for leases under the new standard. They directed the staffs to do outreach, meeting with a total of nearly 200 preparers (companies and organizations that prepare financial statements), users (banks and analysts that use financial statements for investing and lending decisions), lessors, and auditors.

That work is now complete, and the boards will review the results at a meeting next Thursday, May 24. The summary is available online. Highlights:

Approaches:
The staff presented four options for reporting expenses:
Approach A: Identical to current capital/finance lease accounting: Interest expense calculated on the remaining liability balance, with depreciation expense recognized usually straight line.
Approach B:  Interest expense as in Approach A. Officially the remaining asset would be the present value of the remaining benefits, with depreciation the difference between the remaining asset at the beginning and end of the period. If remaining benefits are considered to be equal throughout the life of the lease, and rent payments are also equal, depreciation plus interest in any given period would be equal to the rent (and equal over the life of the lease). This was described as "interest-based amortization" at the February meeting.
Approach C:  Interest expense as in Approach A. Depreciation is based on considering the estimated consumption of the underlying asset over the lease term. For a real estate lease whose property is expected to be worth as much or more at the end of the lease, depreciation would equal principal repayment, and the total expense would give a result similar to operating lease accounting. For an equipment lease whose property is completely used up during the lease, the result would be the same as Approach A. A lease in between would get a proportionate result. This was described as the "underlying asset approach" at the February meeting.
Approach D: This was not discussed at the February meeting. A single lease expense item would be reported, equal to the straight-line rent. It is not clear how the asset and liability would be calculated for balance sheet purposes (I believe liability would be the same as for other approaches, but I've seen no indication of how the journal entries would work for it or for the asset amortization).

Users:
Nearly all users reported that they attempt to capitalize lessees' operating leases currently to get a better picture of a company's financial situation. However, they had a variety of methods of doing so, on both the balance sheet and the income statement sides. There's no way to provide matching results for everyone.

Most users thought a single model for all leases would be best, though they recognize that people lease for different reasons. Most preferred either Approach A or Approach D.

Preparers:
Most thought Approaches A & D would be least costly and difficult to apply. Some thought that C would be prohibitively costly; some retail lessees reported having over 15,000 leases that are regularly renegotiated, which they considered would make reassessing the consumption pattern impracticable. Preferences were often influenced by the type of leasing a preparer did: retail lessees tended to prefer D while oil & gas lessees preferred A. Some argued, though, that D would call into question recognizing the leases on the balance sheet.

Lessors:
There was no agreement on whether symmetry between lessee and lessor accounting was critical, though it was noted that a lack of symmetry could make sublease accounting "anomalous." Lessors said they would not always be able to provide information to lessees regarding valuations (residual values, etc.), because that is sometimes confidential for competitive reasons. While they find the receivable and residual model proposed for lessors to be appropriate for assets that are leased just once or twice, they find it less appropriate for longer-lived assets that are leased multiple times to different lessees, and would prefer current operating lease accounting for such transactions.

Auditors:
Some have questioned whether Approach C in particular is auditable. Auditors believe it is, but that it would be the most costly approach to audit (and for preparers to implement). They also question how to test and account for impairments under B and D because of the unusual method of calculating the net asset.

We'll see if the boards can reach a consensus at next week's meeting. It's not outside the realm of possibility that they'll punt the issue, offering more than one alternative in the revised exposure draft and asking for responses, making the final decision during redeliberation.

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.

No lease accounting discussion this month

At the February meeting, the FASB & IASB directed the staffs to conduct outreach on the alternative expense recognition possibilities considered. The plan at the time was for results of the outreach to be discussed at the boards' combined meeting in April. The agenda for April has now been released, and leases are not on the list. So yet another month of delay for finalizing the revised exposure draft...

Into the second half of 2012

The FASB recently updated their project timeline for the new lease accounting standard, and they've now officially pushed back the date for release of the revised exposure draft (RED) to the second half of 2012. This is at least a 9-month delay from the original plan: last July they expected to finish the redeliberations in September 2011 with the RED to come shortly thereafter. But, of course, the whole project has been a story of delays; it's mind-boggling to think that when they announced the project in 2006, they expected to be finished in 2008.

Yet another delay

As previously mentioned, the last substantive issue the boards are discussing is the expense profile of lessee leases. Capital lease accounting under FAS 13/IAS 17 results in more expense in the early months/years of the lease than at the end, because interest expense is accrued on the remaining obligation, which declines over the life of the lease, while depreciation expense is usually equal through the lease's life. Operating leases, on the other hand, show level rent expense throughout their life (even if the rent increases).

There has been a great deal of pushback from lessees about applying this expense profile to all leases. They argue that front-loading the expense doesn't reflect actual usage and costs; it also means a mismatch with likely benefits, since income tends to rise over time. If managers are reviewed based on profitability, front-loaded expenses may skew the view of how well or poorly they're actually doing.

At the FASB/IASB meeting Feb. 27-29, the boards considered two alternatives to current capital lease accounting, each of which would reduce or eliminate the front-loading of expenses. The alternatives are:

• Interest-based amortization: Depreciation would be based on the "present value of remaining economic benefits." As a practical matter, unless there's a reason to think the benefits provided by the asset will dramatically change in value during the lease, the depreciation recognized will be equal to the reduction in the obligation balance if the rent is equal over the life of the lease. If rents are unequal, the depreciation will be equal to what the reduction in obligation would be if the rents were leveled.
  
  The expectation is that if this method is chosen, it would not apply to all leases. More or less all leases that currently are considered capital would be accounted for the same way as they are now, to keep their accounting more consistent with purchase accounting.
  
  
• Underlying asset approach: Depreciation would be based on a combination of the portion of the underlying asset expected to be consumed during the lease term plus unwinding the discount on the expected residual value. The effect is that for a real estate lease, where the expected future value is the same as or more than the current value, depreciation would be the same as for interest-based amortization, and the expense profile would be flat. For an asset expected to be fully consumed by the end of the lease term (zero residual), the expense profile would be the same as current capital lease accounting. A residual value in between would give a proportionally interim result.

Each approach has advantages and disadvantages, both practically and conceptually. Interest-based amortization is simpler in most cases, but is different from typical amortization of PPE (property, plant, & equipment). The underlying asset approach in some ways seems more conceptually correct, but is dependent on determining the expected consumption of the asset at the end of the lease term, which many lessees will have no simple way to determine, and there is concern that trying to determine it will be 1) an expense that serves no other purpose, and 2) a subjective exercise that is difficult to audit.

The boards split in their positions. Some board members want to maintain capital lease accounting for all leases, but a majority of the FASB favors interest-based amortization, while a majority of the IASB favors the underlying asset approach. However, the overall conclusion was that more "outreach" is needed, discussing the options with both statement preparers and users; the underlying asset approach in particular is a very new concept which has received little review. Therefore, the boards are going to take two months to meet with interested parties, and plan to continue discussions in April with the results of their outreach.

Given that once this is settled, the boards need to decide if there is any impact on lessor accounting, and then they need to talk about final details such as the comment period and interim disclosures, it looks like we're not going to get a revised exposure draft before June.

IASB/EFRAG meeting
The IASB met March 9 with EFRAG, the European Financial Reporting Advisory Group, to discuss several current IASB projects. EFRAG wants to keep the current distinction between capital and operating leases, with just minor improvements to determining when leases ought to be considered financing transactions and therefore capitalized. That seems unlikely.

Schedule for wrapping up the redeliberations

The IASB has posted on its web site the agenda papers for next week's combined IASB/FASB board meeting, which will include discussion of lease accounting. One of the agenda papers details the schedule from here out:

February boards meeting: last substantive discussions
March boards meeting: "sweep issues" such as comment period and any interim disclosures
Following: Second Exposure Draft is drafted. They don't say anything more than "later in 2012" for when it will be released, though the IASB Work Plan page indicates Q2 2012 (the equivalent FASB Project Updates page says the same thing).