FASB Votes to Revamp Lease Accounting

But new rules won't be ready until 2009.

The Financial Accounting Standards Board voted unanimously on Wednesday to put lease accounting on its formal agenda, setting the wheels in motion to rework the rule that allows companies to keep certain leases off their balance sheets. The board agreed to work jointly on the project with the International Accounting Standards Board, which passed a similar vote earlier in the day.

But don’t expect change to come any time soon. It’s likely that the updated rule will be issued three years from now, said FASB Chairman Robert Herz. The timeline for amending FAS 13, Accounting for Leases, is as follows: In 2006, the FASB and IASB staffs will meet to develop issues to be considered; in 2007, the two boards will deliberate the issues and request public comment; in 2008, a discussion paper summarizing the preliminary views of both boards will be published; and sometime in 2009, an amended FAS 13 will be issued.

The protracted timeline, which was set by the FASB staff, raised eyebrows of a few board members before the vote. FASB member Donald Young warned that reworking lease accounting rules was a crucial for U.S. investors and regulators and that the board should be prepared to “decouple” the project from the IASB if joint standard-setting blocked progress. Although they didn’t mention decoupling, all six remaining members expressed interest in making the process efficient and speedy—but not until the issues were properly vetted.

Written in 1976, FAS 13 defines all leases as either capital leases or operating leases. When a company is financing an asset purchase via a capital lease, it records the asset and lease payments on the balance sheet. In contrast, a rental contract—an operating lease—requires neither the asset nor the payment obligation to be recorded on the balance sheet.

The Securities and Exchange Commission and many investors don’t like lease accounting. In a June 2005 report on off-balance-sheet activity commissioned by Congress as part of the Sarbanes-Oxley Act of 2002, SEC staff argued that lease-accounting standards should be rewritten. The commission’s staff estimated that the standards allow publicly traded companies to keep an undiscounted $1.25 trillion in future cash obligations off their balance sheets.

The off-balance-sheet treatment that results from such “structuring,” it says, has turned leasing into “an industry unto itself” over the past 30 years. “Transparency and the degree to which accounting and disclosure standards achieve their goals can be greatly diminished by the use of structuring, even when that structuring appears to comply with the standards,” the report notes.

Herz, a critic of existing lease accounting, told CFO three years ago, “that lease-accounting rules provide the ability to make sure no leases go on the balance sheet.”

At Wednesday’s meeting, FASB member Leslie Seidman noted that the vote to place lease accounting on the agenda “has been a long time coming,” adding that reworking FAS 13 ranks second behind pension accounting as one of FASB’s top priorities. Before casting his vote, George Batavick, another board member, noted that the rules-based accounting system give companies the ability to structure leases to avoid booking them on balance sheets, and that “is not good” for financial statements.

The scope of the project was also debated by FASB members. Batavick said he wants to keep the project scope as narrow as possible, and concentrate efforts on where the most improvement could be gained. For example, he does not want FASB to get “bogged down” with small leases that represent relatively minor financial transactions. He would rather focus on “where the big dollars are.”

That’s a similar view to the Equipment Leasing Association, a trade group, whose leadership has been vocal on lease accounting. ELA would like to see small leases exempt from the rules because, in most cases, the transactions represent an operating expense rather than true financing, they claim.

Herz was unsure whether a bright-line standard exempting smaller leases would be part of the working group’s proposal that’s due out the end of this year. He posited that one possibility was a rule that made an exception for one-year leases. But, he warned, such a bright-line standard could lead to more accounting games in which companies structure annual, renewable leases to move the transaction off the balance sheets.

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