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Review of Lease Accounting Proposal Begins

November 22, 2013

The FASB and IASB have started redeliberations on their lease accounting proposals by sorting through the hundreds of comment letters and reports from scores of meetings with businesses and investors. The boards plan to review the fundamental parts of the proposals and consider allowing small-ticket leased items to be exempt from the draft standards.

The FASB and IASB on November 20, 2013, made their first attempt at sifting through the hundreds of comment letters and reams of feedback from investors and companies on their converged lease accounting proposals.

The exercise revealed much of what the standard-setters already knew: Businesses think the changes will be expensive to implement, and analysts are divided about the value of the information the proposed changes will give them.

The FASB and IASB, which met via videoconference, did not make any decisions about the project. Instead, members of their research staffs went over the feedback and outlined the next steps for drafting accounting standards to require companies to recognize lease liabilities on their balance sheets.

“What we have got here is so much divergent opinions about cost, complexity and consequences,” IASB member Jan Engstrom said. “So I think it’s almost impossible to understand really where we are.”

The boards plan to start redeliberations by focusing on the accounting plan they outlined for lessees and lessors in May in the FASB’s Proposed Accounting Standards Update (ASU) No. 2013-270 Leases (Topic 842), and the IASB’s Exposure Draft (ED) No. 2013-5, Leases.

The boards also expect to review potential modifications, such as scoping out small-ticket items to see if that alleviates businesses’ concerns about the proposals’ cost and complexity.

The mostly converged draft standards are an attempt to address criticism that the obligation for businesses to make lease payments on things like office space, airplanes, and essential equipment can make up a significant part of a company’s liabilities and should be as transparent as possible.

Under the FASB and IASB’s model, businesses would have to recognize things like leased storefronts and trucks as assets and the contractual payments for them as liabilities.

The boards’ proposals contrast with current practice, which only requires balance-sheet recognition if the lease obligation is akin to a financing arrangement, such as a rent-to-own contract for a building or a vehicle. Under U.S. GAAP and IFRS, few leases appear on company balance sheets because of the so-called “bright line” in accounting standards that gives companies leeway to structure most lease obligations to look like rentals.

Almost every company, auditor, and analyst that has offered feedback on the proposals agrees with the premise behind the changes, but the vast majority disagree with the methods the FASB and IASB chose.

Many companies and auditors told the boards that the proposals are too complex to implement and lack conceptual merit. Investors, whom the boards cite as a main reason for pursuing the project, are also divided on whether the proposals will help or hinder them.

Much of the criticism centers on the boards’ treatment of different types of lease arrangements.

The previous versions of the proposals issued in 2010 required all lease contracts to be treated like financing arrangements, but most companies balked. The FASB and IASB responded by agreeing that not all leases were the same.

Under the 2013 proposals, an asset with most of its life left after the contract would be recorded in a manner that’s similar to a rental expense, with even payments over time. A leased asset where most of the life is used up would be accounted for as a financing transaction. The threshold is “more than insignificant” consumption, meaning that if much of the usable life of the asset remains after the lease term, the lease would be recorded similarly to a rental expense.

For simplicity’s sake, the boards decided that almost all leases of office buildings or storefronts would receive the even, or straight-line, expense-recognition treatment, while almost all leases of equipment would receive financing treatment, with interest and amortization calculated with the rental expense. Because interest is calculated on a declining balance over time, the cost to rent a piece of equipment will look more expensive at the beginning of the lease term. The decision pleased real estate companies but has continued to rankle heavy equipment lessors.

Most of the audit firms, businesses, and investors who gave feedback to the FASB and IASB agreed that the current accounting model is broken, but there’s no consensus about the best way to fix it, IASB staffer Patrina Buchanan said.

Among investors, credit analysts are more inclined to favor the proposal over equity analysts.

FASB member Harold Schroeder, a former portfolio manager, said he wanted to see a more detailed breakdown on the feedback from investors and analysts. Much of the outreach to investors was conducted in private meetings, and Schroeder said he wanted to see if there differences in the views of analysts from investment companies versus those from brokerage firms or differences between analysts from firms that are heavy short-sellers and those with more traditional investment strategies.

Several FASB and IASB members said they wanted to proceed carefully on evaluating the potential costs of the new standards. Many businesses have told the standard-setters that the new accounting would be costly for them to apply, but few have given details.

“I’ve observed over time, too, that for proposals you dislike, to have an estimate of the costs be higher,” FASB member Thomas Linsmeier said.

While most of the feedback focused on the proposed accounting model for lessees, the boards received significant resistance about the model they developed for lessors. Most of the comment letters said the current accounting for lessors works, and some FASB and IASB members said they agreed with this assessment.

“I came to the lessor side thinking symmetry was sort of a requirement, if you will, and sort of feeling bad if we couldn’t get there with symmetry,” FASB member Daryl Buck said. “I’ve completely changed that now, and… I would go even further and say I’m not even sure symmetry is desirable.”