When a corporation leases a building, is the adjoining parking lot automatically included? Or should the lot be accounted for separately? Does it make economic sense to count the lot as a separate asset from the building, since in a typical suburban office complex one generally doesn’t exist without the other?
Such questions are getting tougher and tougher to answer for CFOs and other executives who account for lease expenses that their companies incur – especially when you consider that the parties in the debate can’t even agree on such a basic element as the definition of an “asset.” In the example above, for instance, is the parking lot an asset owned by the lessee, or is it simply a piece of rented property?
The confusion stems from a lease accounting proposal jointly agreed upon by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in June that requires lease expenses to be recorded on corporate balance sheets. The boards decided that lessees should distinguish between equipment and property leases, and that the distinction should be based on whether the lessee acquires and/or uses up more than an “insignificant” portion of the underlying asset. Along with other criteria, if a lessee buys or consumes more than that amount, it would have to account for its cost on a property-lease basis; if less, than the arrangement would be deemed an equipment lease.
FASB and IASB further came to an agreement on having property leases accounted for using a straight-line approach (in which a single lease expense is recognized over the life of a lease) and equipment leases accounted for in a front-loaded manner (in which larger interest charges occur at the beginning of a lease than at the end).
Ralph Petta, chief operating officer at the Equipment Leasing and Finance Association (ELFA), notes that the boards’ decision to make the equipment lease expense recognition front-loaded creates a lot of problems. “It makes the accounting more complex than it needs to be,” he says. Since equipment leases have not previously been front-loaded, lessees would have to do a whole lot more calculating of asset values if the plan goes through.
While ELFA supports having leases recorded on lessees’ balance sheets and incorporating two types of leases for property and equipment, the association’s leaders find fault with the way the boards are addressing those issues now.
Critics of the proposal like Rod Hurd, CFO of Bridgeway Capital Advisors and chair of ELFA’s financial committee, don’t think the standard setters’ plan correctly addresses most lessees’ accounting needs.
For one thing, he notes the “economics” of the FASB/IASB proposal don’t jibe with general accounting principles. In a front-loaded lease on a balance sheet, as in the case of an equipment lease, the asset appears to be worth less than its present economic value, notes Hurd.
FASB and IASB’s front-loaded approach for equipment leases considers all equipment leases as purchases, perhaps reasoning that, in many cases, short-term lessees resemble owners more than renters. ELFA and others, however, say that the concept doesn’t match reality.
They note that the boards’ lessee accounting model disregards the nature of the lease contract, focusing too much on equating the lease to the underlying asset. The asset is often out of the control of the lessee, so they say accounting for the value and price of an asset exclusively as an owned asset isn’t appropriate in certain situations. In short, they want the focus back on the actual contract and away from the underlying asset.
Accounting for equipment leases more on the basis of the contract is also more in line with existing commercial real estate and income tax laws, Hurd says. The standard-setters’ proposal would be at odds with those laws.
“From the preparer point of view and the user point of view, this is a critical issue,” Hurd adds. Getting the right lease accounting standard in place for companies has significant implications for a lessee’s ability to raise capital, he notes, since rating agencies pay particular attention to lease-cost models. And bank underwriters often take a close look at how well a prospective borrower’s lease accounting matches the facts.
The stakes in the leasing debate are indeed getting higher. ELFA said earlier this month it would consider withdrawing support for the FASB/IASB leasing proposal because of its disagreement with the accounting boards’ solutions for lease accounting. Although ELFA agrees with the plan’s distinction between equipment and property lease accounting, the association thinks the devil’s in the details. For example, it opposes front-loading for equipment leases and the characterization of all equipment leases as purchases.
If the trade group, which represents more than 550 companies, pulls its support from the proposal, it would mark a huge blow to the leasing project, which started as an attempt to more accurately portray leases in financial statements. The equipment finance sector now totals $628 billion, according to ELFA.
“We just decided we would tell them as forthright as we could the fact we are very serious about considering not supporting the project,” says Petta. They favor a new proposal, not a revised exposure draft of the current proposal.
An indication of the chaotic divergence of views among various participation is that the Investors Technical Advisory Committee (ITAC), an investor group established by FASB itself, can’t even agree on what they like or dislike about the proposal.
If no consensus is established soon, the issuance of a revised exposure draft that the standard-setting boards are hoping to publish in the fourth quarter of 2012 could be delayed, participants say.
For their part, FASB and IASB are aware of the overall dissatisfaction among CFOs and finance executives with their proposal, particularly when it comes to lessee lease accounting. Daryl Buck, member of FASB, noted at an ELFA conference last week that they are listening to industry feedback, having already altered previous lease accounting efforts in response to comments.
Still, Buck stands by FASB’s overall approach. “Not all leases are the same. Therefore, I am personally in support of a two-model approach.”
Making everyone content will be a challenge, though. Part of the problem in finding a workable solution over lease accounting, according to Prabhakar Kalavacherla, member of the International Accounting Standards Board, is that different lobbyists are working for just their slice of the lease accounting proposal and are not thinking about what concessions can be made for a workable solution to the issues confronting all lessees. “We need to think much more broadly on this aspect about lobbying only for your solution,” he said at the conference.
ELFA’s Petta is still optimistic, however. Until FASB and IASB actually vote on the project (since most decisions until now have been tentative) the boards have time to “get it right and issue an exposure draft that makes sense,” he says.