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Will Banks Have to Boost Capital Because of New Lease Standard?

FASB officials are worried that federal banking regulators may be preparing to tell some banks to hold larger capital reserves once the new lease accounting standard goes into effect. Officials from the accounting board are concerned that bank regulators may see the changes adopted in the new lease standard as requiring them to increase the indebtedness reported by bank borrowers that make extensive use of leasing and cause reappraisals of the borrowers that tag them as being more risky. The reassessment may mean banks will have to add to their capital bases.

FASB officials are worried that federal banking regulators may be preparing to tell some banks to hold larger capital reserves once the new lease accounting standard goes into effect.

Publicly traded companies will not have to adopt the standard until 2019, and privately held businesses have until 2020, but in the most recent meeting between FASB representatives and banking agencies’ accounting policymakers, the accounting board’s delegation grew concerned about how bank regulators may see the changes adopted in Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). Some FASB members fear that regulators may increase the indebtedness reported by bank borrowers that make extensive use of leasing and reappraise the borrowers as higher risks. The result may be a demand that the bank lenders set aside larger capital reserves to protect themselves from default if the borrowers start missing loan payments.

In the view of FASB Vice Chairman James Kroeker, the regulators would be wrong to make such a move.

“I was personally disappointed. I explained very clearly that there is no change to the economics one bit,” Kroeker said during a September 13, 2016, Baltimore conference sponsored by the Equipment Leasing and Finance Association, as he described the recent discussion between the FASB and regulators. “Don’t view our standard as the basis to say, ‘Well, suddenly the capital regime needs to be changed.'”

Kroeker’s statement was a response to a question from a conference attendee who said his recent meetings with officials from the Office of the Comptroller of the Currency (OCC) and the Federal Reserve have led him to conclude that higher capital demands are coming.

“We are going in places where no man has gone before,” the unidentified attendee said. The regulators want to call the lease contracts a class of debt, which will inevitably make borrowers look more indebted and riskier. “[The regulators] don’t understand the nuances that we might understand because we attend all of your [FASB] meetings.”

“Don’t use our standards to say suddenly the regime has changed,” Kroeker said. “Don’t opportunistically pin something to our standard. This is the right change. We explained why this is the right change.”

The Fed and the OCC declined to comment.

The publication of ASU No. 2016-02 completed an assignment the SEC handed the FASB in 2005 in Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements With Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers. The report advised the FASB to, among other things, reexamine the accounting for lease contracts because so many companies were using them to avoid reporting exposures to significant liabilities.

The report was one of the SEC’s many responses to the 2001 bankruptcy of Enron and the numerous major-company accounting scandals that were unmasked following Enron’s collapse. The scandals compelled Congress to enact the Sarbanes-Oxley Act of 2002 , and lawmakers and regulators, because Enron had so blatantly misused off-balance-sheet accounting to hide its true level of debt, became determined to have the SEC and FASB conduct a broader review of U.S. GAAP to look for standards that companies could use to mask their indebtedness. Lease accounting, because it is so important for financial reporting in many industries where leasing real estate and heavy machinery is a significant part of business, was singled out as a standard that required change.

For most of the nearly 11 years that the FASB worked on the new lease standard, accounting board representatives took pains to say it was not their goal to write a standard that changed the economics for lessors and lessees. Instead the board sought to issue a standard that provided the capital markets with better information about borrowers’ balance sheets.

For their part, federal banking agencies tie their regulations to U.S. GAAP, and if audited financial statements show a higher level of debt among bank borrowers, examiners may see a need to pressure banks to hold more capital in reserve. Given that the lease standard will not be in effect for more than two years, it is not likely that bank examiners have been using it to push banks to immediately boost their capital reserves.

But Kroeker seemed concerned that if capital demands are issued in two to three years, and banks curtail lending to clients who were once considered to have clean balance sheets, that the FASB will be blamed.

Joseph Carcello, a professor of accounting at the University of Tennessee, said there were merits to the arguments from both the banking regulators and the FASB.

“The whole point of holding capital is as a buffer against risk,” Carcello said. “Has risk increased because of a change in this particular accounting rule? I think it would be hard to argue that risk has increased… So if risk hasn’t increased, then it’s not immediately obvious to me why there should be a reflexive reaction” by banking supervisors.

For their part, the bank regulators may see themselves as having little choice. The banking agencies have been heavily criticized in the recent past for missing the warning signs about the savings and loan crisis of the late 1980s and the collapse of the housing market in 2007-2008. In each case, bank failures spiked and taxpayers absorbed the losses. If the new lease accounting sheds light on bank borrowers with heavy debt loads, the regulators may fear the onset of a new collapse.

“[The] FASB is right,” Jeff Mahoney, general counsel of the Council of Institutional Investors, said in an email response to a question. “[The] Fed links its capital requirements to GAAP, in part, to avoid the wrath of those it regulates for changes to those requirements, i.e. ‘blame the FASB, not us.'”

For in-depth analysis of the FASB’s standard for lease accounting, please see Catalyst: U.S. GAAP — Leases, also on Checkpoint.

Additional analysis of the guidance in the lease standard can be found in Accounting and Auditing Update Service [AAUS No. 2016-15] and the SEC Accounting and Reporting Update Service [SARU No. 2016-13] (March 2016): Special Report: Accounting for Leases—An Explanation and Analysis of Accounting Standards Update No. 2016-02.

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