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Lease-Accounting Rules: Tinker, Don’t Trash

The changes proposed by FASB and IASB address a limited set of weaknesses in the existing rules that merely need some tightening, not a complete overhaul.

The current proposal to overhaul lease-accounting rules is off base, because for most lease transactions, the existing rules work well.

The Financial Accounting Standards Board and International Accounting Standards Board should not throw away decades of experience and force lessors to spend millions of dollars updating their accounting systems to address a limited set of weaknesses in the rules. Users and preparers of financial statements would be better served if the current rules were merely tightened to address the areas that make them vulnerable to manipulation.

I. The Good: The Simplicity of the Existing Rules
The existing lease-accounting rules are fundamentally sound and are imbued with a simple elegance. However, in certain respects they are subject to easy manipulation that can result in questionable outcomes. The reforms suggested below would significantly address the concerns identified by the Securities and Exchange Commission in its 2005 report on off-balance-sheet arrangements.

Further, the current rules provide information that is useful in preparing tax returns and analyzing the consequences of a bankruptcy. For instance, it is likely that for tax purposes the lessor is the owner of an operating lease and the lessee is entitled to a rental deduction. Also, in a bankruptcy analysis, it is unlikely that the lessee would be able to recharacterize an operating lease as a secured loan that could result in the creditor being paid pennies on the dollar.

II. The Bad: Exposure Drafts
The second exposure draft, like the first one in 2010, attempts to divine the real economics of each lease: the lessor would book an “asset” for the value of the property it held and a liability for its obligation to provide the property to the lessee. In contrast, the lessee would book an asset for the value of its leasehold, and a liability for its obligation to pay future rents. The accounting profession, securities analysts and issuers of financial statements all were unhappy with this approach.

At a high level, the second exposure draft differs from the first in three ways: (1) leases of twelve months or less are excluded and continue to be accounted for under the existing rules for operating leases; (2) in calculating the assets and liabilities arising from a lease, a renewal option is included only if there is an economic incentive for the lessee to exercise them; and (3) a different amortization calculation is applied to real estate leases than is applied to equipment leases. Despite these improvements, it is likely that issuers and users of financial statements will find the new exposure draft’s complexity justifiable, given the improvement in the quality of information conveyed by the new approach.

III. The Ugly: Opportunity for Manipulation
The simplicity of the current rules exposes them to manipulation. An understanding of the current rules is necessary to appreciate their vulnerabilities. FASB currently has a four-part test:

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