Taking the “Ease” Out of “Lease”?

By doing away with operating leases, new accounting rules could bring billions of dollars back onto balance sheets.

Accounting-standards setters are under fire, again. The new leasing standard, proposed jointly by the Financial Accounting Standards Board and the International Accounting Standards Board, has been characterized as naïve, lacking value, and in need of serious reevaluation. The outcry comes not from a handful of opponents but from companies on both sides of common lease contracts — those that rent office space, copiers, or airplanes and those that own the assets.

At the center of the maelstrom is the “right-to-use” asset concept, the accounting mechanism that places leased assets and liabilities on the balance sheets of lessees, as if they owned the assets. That would essentially eliminate operating leases. Credit Suisse estimates that, within the S&P 500 alone, the volume of assets returning to balance sheets could surpass $550 billion.

At those levels, asset ratios could be thrown out of whack, potentially sending debt covenants — if not adjusted — into default, says Ross Prindle, a managing director with Duff & Phelps, while also requiring banks to increase their regulatory capital and wreaking havoc on compensation plans tied to the asset measures.

In addition, the proposed standard (called Topic 840 by FASB) requires lessors to recognize assets and liabilities in a new way. A lessor must recognize an asset as representing its right to receive lease payments and, when appropriate, record a liability as representing the contractual right of others to use their equipment or real estate.

Then, based on how much residual value the lessor estimates it will retain at the end of the lease, it must also use one of two accounting approaches laid out in the draft: either the performance obligation or the derecognition model.

If the rules seem complicated, that’s because they are, says D.J. Gannon, a deputy managing partner with Deloitte. However, he says the proposed changes are well intentioned: rulemakers want to curb abusive leasing practices by companies that structure around the 90% ownership test that currently determines whether a contract is an operating lease and can therefore be removed from their balance sheets.

Be that as it may, in the year-plus since FASB issued its first discussion paper on the topic, more than 300 comment letters have been submitted, most indicating that stakeholders are not convinced that the intended benefits will be worth the additional cost and effort.

The comment period is open until December 15, and two days later FASB and the IASB will hold the first of four new “outreach” meetings to get a better handle on what worries constituents. The boards plan to release a final rule during the first half of 2011.

The current leasing market and possible effects of the proposed rules (FASB Topic 840)

Lessor Has More

What’s interesting is that most critics are less concerned about the concept of capitalizing all leases than with how FASB and the IASB propose to treat the leases after bringing them back on balance sheets.

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