FASB, IASB Begin Rethinking Leases

The accounting standard setters take another step toward amending lease accounting, though a new standard remains at least two years away.

The U.S. and international standard-setters are making slow but steady progress toward revising how public companies account for leases. Earlier this week, the Financial Accounting Standards Board and the International Accounting Standards Board told their staffers to limit their initial work to only the leasing arrangements covered in the existing standards.

CFOs anxious to find out how the final amended standard could affect their balance sheets will have to wait a bit longer: FASB and IASB’s latest directive to their staff was simply a process decision that may keep them on track to meet their 2008 deadline for releasing a discussion paper. They don’t expect to release a joint, revised standard until 2009.

Because of its potential impact on corporate financial statements, lease accounting is potentially the most explosive issue on the agenda of accounting standard setters, and one that could have an enormous impact on retailers, airlines, and railroad companies. Under FAS 13, leases are defined as either capital leases or operating leases. The Securities and Exchange Commission and investors have criticized the ambiguity surrounding which agreements fall into which category. Companies do not have to record the assets or the payment obligation for their rental contracts — operating leases — on the balance sheet. The new lease accounting standard will likely change that understanding and require companies to capitalize more assets on their balance sheets. The result could be a certain percentage of companies whose financial standing will look less profitable and more highly leveraged, says Charles Mulford, an accounting professor who oversees the Financial Analysis Lab at Georgia Institute of Technology.

“It could have negative implications for some large capital investment companies,” says Kenneth Bentsen, president of the Equipment Leasing and Finance Association. “Their debt-to-equity ratios could change radically overnight.” Bentsen’s trade association is paying close attention now in the hopes of having some sort of influence on the standard-setters. Last month, ELFA and five international leasing associations sent FASB and IASB a letter to make sure they address several aspects of lease accounting, such as how to deal with short-term leases, what types of agreements would be material, and how to create one standard that would apply to both lessees and lessors. “We don’t want a situation where you come out with an absolute type of standard that’s broadly defined and then you have to back your way into defining it in practice with a lot of amendments,” Bentsen says. “It’s better to have certainty and answer questions up front.”

To be sure, FASB and IASB are taking a cautious approach. At a meeting in London on Tuesday, the staffers said they worried that starting off the project by immediately trying to address the trickier leasing questions, such as how companies should account for intangible assets, would take too long. As it is, the public won’t get a formal taste for the standard-setters’ leanings until next year.

Still, the boards were reluctant to let the staff procrastinate on tackling tough questions. But in the interest of staying on track and focusing on one area at a time, the majority of board members agreed to take a two-phase approach. They will first concentrate on the areas currently addressed in FAS 13 and IASB’s companion standard. These include property, plants, and equipment but not intangible assets, such as service contracts.

If they had taken another starting point, the standard-setters would have spent “a significant amount of time trying to redefine what a lease is, develop a model, and then find that the model does not seem to improve financial reporting,” said FASB member Ed Trott, who will retire from the board in June.

FASB member Donald Young opposed letting the staff base its work on the “flawed” existing standard. “I think 13 is just a waste of time,” he said. “I don’t know how we can build on that. I’m really uncomfortable taking that route.”

In 2005, the Securities and Exchange Commission decided the lease accounting rules should be rewritten after estimating that they allowed publicly traded companies to keep $1.25 trillion of future cash obligations off their balance sheets. One year later and 30 years after FASB first issued FAS 13, the board put lease accounting on its formal agenda.

Observers agree that whatever the final standard will look like, it will require companies that have lease agreements to pull more of their liabilities out of the footnotes and account for them on their balance sheets. Since companies would also carry more assets on their balance sheets, profitability measures, such as return on assets, would fall. At the same time, explains Mulford, corporate income statements would likely reflect an increase in interest expense, decreasing net income. By contrast, EBITDA (earnings before interest, depreciation, taxes, and amortization), which does not reflect interest, would be higher.

The threat of change has had little impact on leasing activity. ELFA reported a 53.7 percent increase in volume last month compared to February’s business. March’s new business volume grew by 18.2 percent compared to March 2006.

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