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Comments to FASB on Lease Accounting – My Recommendations November 7, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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Like every vote, every comment counts.

This past August, the U.S.-based Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued the ”Exposure Draft on Leases” which details how the two accounting boards think lease accounting should work.   The Boards will accept comments on the new standard until December 15, 2010 with comments to FASB being shared with IASB, and vice versa.  The two Boards plan to jointly issue the final standard by the end of June 2011.

The thrust of the new accounting is to put  all lease obligations (with some minor exceptions) on company balance sheets (along with an off-setting “right of use asset”).   Most knowledgeable observers agree that leases, which today represent some of the largest obligations of companies, need to be on balance sheets … if balance sheets are to be  meaningful.  Comments to FASB that oppose the fundamental principle of putting leases on balance sheets are likely to be considered uninformed.

As they say, though,” the devil is in the details”.  Leases are sufficiently complex that accounting for them requires a lot of detailed, sometimes devilish, rules, and there are details of the proposed  accounting that merit comment .   In fact, the Exposure Draft lists nineteen questions that the accounting boards are interested in hearing comments on.

As I’ve noted in a previous post, though … while there are many effects of the new accounting that may be seen as undesirable, either because they cause a large administrative burden or negatively affect P&L statements in ways that don’t seem intuitive,  this, itself,  is not a legitimate reason to comment to FASB.  Only comments that respect existing accounting principles and suggest a better way to account for  leases are likely to be seriously considered.   There is no use in making comments that are uninformed.  Said another way: “No belly aching”.

The new accounting affects companies on both sides of a lease transaction, and no matter what your perspective … tenant, landlord … equipment lessee, equipment lessor …  outsourcer, contract manufacturer … there is probably a lot to not like in the new accounting.  You’ll want to review the Exposure Draft carefully to see if your company has any idiosyncratic situations that would be affected by the new accounting in ways not intended by the accounting boards. Those special situations might merit comment and might prompt FASB and IASB to modify the proposed standard to avoid unintended consequences.

There are, though, controversial elements of the new accounting that will affect everyone applying the new standard, and these merit comment from you.   From a corporate-real-estate perspective, I believe two elements of the accounting rise to the top of concerns.  Here they are:

Concern #1:  Longest possible lease length more likely than not to occur

The accounting detailed in the Exposure Draft requires tenants to evaluate the likelihood of their exercising options-to-renew (and also, presumably, options-to-expand).  A company would then place onto its balance sheet the future obligations related to the “longest possible lease length more likely than not to occur.”  If you’re likely to renew a lease with an option to renew, you would include the obligations during that extension period in the amount that goes onto the balance sheet.

Most tenants will not like this element of the new accounting … that is including obligations related to the extension period … because it will increase the amount that goes on the balance sheet.   Companies, in general, will want to minimize that amount because the higher the amount of liabilities shown on a company’s balance sheet, the riskier will the company look to investors.  

The proposed treatment for leases differs markedly from how “capital leases” (or “finance leases”) are accounted for today.  Presently, capital leases go onto balance sheets but only in an amount equal to the company’s contractual obligation (albeit, including renewal periods where exercise of a bargain-renewal-option is reasonably assured.) 

Reportedly, the accounting boards want obligations related to extension periods on balance sheets because they fear that tenants would otherwise be able to hide obligations by writing short leases with multiple renewal periods.  The truth is, though, such “structuring around” the lease accounting is easier said than done.  The economic motivations of lessors would, in fact, prevent this from happening.  Lessors are usually not indifferent to having a long lease versus a short lease renewable at the tenant’s option.  If this is the Board’s concern, it seems unfounded.

It seems to me that lease obligations that go onto the balance sheet should be only those amounts for which a company is contractually obligated, plus those related to bargain-renewal-options.   That is, after all, all that they owe.   If a bargain-renewal-option does not exist, then obligations related to extension periods should not go on the balance sheet.

Issue #2:  Effective Date.  

The Exposure Draft calls for a tenant to “apply this guidance in its annual financial statements for periods beginning on or after” the Effective Date.  If, for example, the Effective Date were January 1, 2012, then a company’s first annual report after that date would have to comply … whether that report was issued on January 2nd or December 31st of 2012. 

For now, the Boards have left the Effective Date blank, but they have their task cut out for them in filling in that blank.

Debate about when should be the Effective Date will be lively.  On one side will be those who want balance sheets to be made meaningful ASAP; on the other side will be those who are worried about how long it will take companies to comply with the new standard.

Most companies do not presently collect all the information and assumptions related to leases that they will need in order to comply with the new standard.  In fact, many companies do not even have an inventory of leases that they could vouch as being accurate enough to be the basis for the amounts that will go on their balance sheets.  Companies have quite a bit of work before them to be ready to comply.

Moreover, IT applications don’t even exist yet to easily collect the required lease data and assumptions, to manipulate that data, and to export it to financial accounting systems.   Software suppliers are unlikely to put significant resources into developing such applications until the standard is finalized, and it could take them a year or longer before their new applications are ready for market.

Making matters even worse, the standard calls for companies to use a “simplified retrospective approach” to transition to the new standard.  To do this, companies will have to have data stretching back two to three years prior to the Effective Date for existing leases.  They’ll also need data on leases that have expired within the two or three years prior to the Effective Date.

The “simplified retrospective approach” is a compromise offered to the two sides of the aforementioned debate.   Those wanting the most meaningful balance sheets ASAP would prefer a “fully retrospective approach”.  That would have required companies to go all the way back to the inception of every existing lease and recreate what the accounting would have been over the years if the new standard had been in place.  The Boards deemed the cost of that approach to not be worth the benefits.  Those worried about the cost and difficulty of compliance would have liked existing leases to be grandfathered and for the standard to only apply to new leases.  This would be a “prospective approach”.  The Boards rejected this as not treating all leases the same and as an approach that would take many years before existing leases expired and all leases would be accounted for under the new standard.

The middle ground that is proposed, the “simplified retrospective approach”, calls for leases to be treated as if they are new leases at the time the new standard is applied.  The rub, though, is that the new standard has to be applied at the “date of initial application” which is the “beginning of the first comparative period presented in the first financial statements in which the entity applies this guidance.”   Most companies present in their annual financial statements, for comparison purposes, financial statements for the two prior years.  This means most companies will have to begin applying the new standard three years prior to the date they first issue financial statements using the new standard.  It’s three years because they need to apply the standard to the year that is the subject of the financial statements plus the two prior years.

That means, if the Effective Date were January 1, 2012 and if a company issued annual financial statements for the year ending, say, March 31, 2012, then the company would have had to apply the new standard way back on April 1, 2009.  That was over a year ago.  What company still has all the data around that it will need to go back and apply the standard at such an early date?  You can see the problem.

It would be unreasonable to require companies to apply the standard to a date prior to the issuance of the standard.  So, if the standard is issued on June 30, 2011, then the Effective Date shouldn’t be until June 30, 2014.  And since companies deserve to have a little bit of runway before they need to start the accounting, my recommendation is a date of December 31, 2014, in which case the standard would have to be applied no earlier than January 1, 2012.

This Effective Date is going to be hotly debated.  My suggestion means that some companies will not issue statements using the new accounting until they issue statements for fiscal years ending December 31, 2015.  Those won’t actually be issued until early 2016.  Some may think this is way too long to wait for balance sheets to become meaningful.

Your Comment Counts

It’s like voting.   Every comment counts.  Don’t miss the deadline:  December 15.  FASB and IASB are awaiting your comments.  Mobilize your company to prepare and send one, NOW!

There are other sources of recommendations for comments you might check out.   A group of members of Corenet Global have prepared a good document to guide you.  If you are a Corenet member you can access it from the homepage of Corenet’s Strategy and Portfolio Planning Community here.

See my other posts on lease accounting here.

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Comments»

1. Michael Bell - November 8, 2010

Bob, your postings and papers on the new lease accting are very informative.

I have two questions:

1. What is the tax effect of these new standards? Wont the incremental amortization cost of leases be deductable for tax purposes. If so, wont this vastly reduce federal and state tax revenues, and enhance after tax income?

2. Today if you own a real estate asset outright (no debt) you typically depreciate straight line over 40 years. The new FASB standard would have you depreciate and amortize over the length of the lease plus all likely option periods. Doesn’t create a significant advantage to outright, non leveraged ownership of real estate assets?

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3. Janine - November 8, 2010

Bob–what is a “bargain-renewal-option”? Is this defined in FASB proposed language? I’ve never encountered such a phrase in commercial leasing–

4. Steven Minick - November 8, 2010

Michael

There will be no changes to the current tax treatment of leases. As a result, many companies will have to retain their current system for tax purposes and develop and implement a new process for book. This will just create additional timing differences to track.

The own vs. lease question will become somewhat more difficult for some companies. However, in the end, I believe most prudent companies will continue with their philosophy of owning or leasing property based on what is best for the business.

Janine –
Bargain renewal options are generally options to extend the lease at a favorable rate (generally below market at the time of the extension). The literature is biased towards including renewals of this type as the economics tend to compel a company to renew and consequently having the renewal period included in determinations of capital or operating or the lease term.


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