Critics Call Lease Accounting Proposal Overly Complex

The latest proposal to overhaul lease accounting fulfills the original objective of bringing leases on to corporate balance sheets, but not everyone is singing its praises.

The plan, proposed by the Financial Accounting Standards Board last month, faces an uphill battle to reach agreement on how to recognize lease costs in financial statements. Even the seven members of FASB aren't in agreement over it. Three members attached “alternative views” to the proposal, and even those dissenting views are not in concert with one another.

It's a “deceptive consensus” that plagues the journey to a new lease accounting rule, says John Hepp, a partner with Grant Thornton. “Everyone agrees leases should be on the balance sheet,” he say. “But when we get to the details about how they should be recognized and measured, that consensus goes away. That's what's reflected in this new exposure draft.”

Indeed, the new proposal represents a mixture of ideas on how leases should be categorized, how they should be measured, how they should be recognized by lessees compared with lessors, and how the expense should be recognized in the income statement.

The current lease accounting rule allows for two different kinds of operating leases: capital leases, which are treated like the financed purchase of an asset, and operating leases, which are treated like rental agreements that do not appear on the balance sheet. The difference between leases is distinguished by a series of bright-line tests that focus on who carries the bulk of the risk and reward associated with the leased asset.

When FASB issued its first proposal on lease accounting in 2010, the board wanted to treat all leases the same—like today's capital leases—but it eventually was persuaded to agree that there are economic differences in leases that should be reflected in financial statements. The model FASB considered at that time required companies to establish values for things like contingent rents and renewal terms that were not explicit at the outset of a lease agreement. It also required companies to front-load the interest cost associated with all leases, even short-term agreements that looked more like straight-line rentals.

“The initial concerns over the 2010 proposal were around complexity and uncertainty,” says Julie Valpey, a partner with BDO USA. “With the new proposal, they've addressed to a certain extent some of the uncertainty, but the biggest issue is complexity. That's going to be the biggest complaint for this exposure draft overall.”

Except for leases of less than 12 months that may remain off the balance sheet, the current proposal establishes two categories of leases based on the expected consumption of the economic life of the leased asset, says Myles Corson, a partner with Ernst & Young. “Type A” leases would be those where a company expects to consume more than an insignificant portion of the economic benefits of the asset. FASB envisions this would include equipment leases more than real estate leases. “Type B” leases would more often involve property or buildings, where a company is gaining access to use the asset but not necessarily consuming its useful life.

“With the new proposal, they've addressed to a certain extent some of the uncertainty, but the biggest issue is complexity. That's going to be the biggest complaint for this exposure draft overall.”

—Julie Valpey,

Partner,

BDO USA

For Type A leases, companies would be required to perform present value calculations and show interest and amortization separately. For Type B leases, companies would be able to recognize a single lease cost on a straight-line basis. “Judgment will be one of the big discussion points that comes up with this,” Corson says. “How do you define the classifications?”

That represents the most significant change in the current proposal from the first proposal in 2010, says Richard Stuart, a partner with McGladrey. “The accounting for Type A leases is the type of accounting that was put forth for all leases in the exposure draft three years ago, where you had an interest component on the liability and amortization on the asset,” he says. FASB heard a great deal of pushback that a straight-line recognition made sense for some types of leases. “This proposal attempts to address that,” he says.

Shahab Moreh, a partner and head of real estate services at accounting firm WeiserMazars, says the real estate sector is not enthusiastic about the proposal. “The reaction largely has been that this is very complicated—overly complicated,” he says. “There's going to be a tremendous cost to companies to keep track of this, calculate this, and put it on the balance sheet.”

LESSEE PROVISIONS

Below is an excerpt from FASB's lease proposal regarding the main provisions relating to the lessee model.

The core principle of the proposed requirements is that an organization should recognize assets and liabilities arising from a lease. This represents an improvement over existing leases standards, which do not require lease assets and lease liabilities to be recognized by many lessees. In accordance with that principle, a lessee would recognize assets and liabilities for leases with a maximum possible term of more than 12 months. A lessee would recognize a liability to make lease payments and a right-of-use asset representing its right to use the leased asset for the lease term.

The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee

would depend primarily on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset. For practical purposes, this assessment would often depend on the nature of the underlying asset. For most leases of assets other than property (for example, equipment, aircraft, cars, trucks), a lessee would do the following:

Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments

Recognize and present the interest on the lease liability separately from the amortization of the right-of-use asset.

For most leases of property (for example, land and/or a building or a part of a building), a lessee would

do the following:

Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments

Recognize a single lease cost, combining the interest on the lease liability with the amortization of the right-

of-use asset, on a straight-line basis.

The Boards also proposed disclosures that should enable investors and other users of financial statements to understand the amount, timing, and uncertainty of cash flows arising from leases. The Boards made changes to the proposals since the 2010 Exposure Draft in response to feedback from stakeholders that should reduce the cost and complexity of the proposed guidance. Examples of decisions the Boards made during redeliberations that should reduce cost and complexity include:

Short-term leases: The Boards tentatively decided that a preparer can elect not to apply the proposals to short-term leases (leases with a maximum lease term of 12 months or less).

Variable lease payments (for example, payments based on a percentage of sales from leased retail space): The Boards tentatively decided that variable lease payments not based on an index or rate (for example, lease payments based on percentage of sales) should not be included in the liability.

Lease renewals/optional periods: The Boards tentatively decided to raise the threshold for including optional periods in the liability.

Non-public organizations (FASB only): The Board tentatively decided that private companies and non-public not-for-profit organizations can elect to use a risk-free rate to discount the lease liability, and they are not required to disclose a roll-forward of the lease liability.

Source: FASB.

The equipment sector is even less enthusiastic. Ralph Petta, chief operating officer for the Equipment Leasing & Finance Association, says the biggest issue he sees with the proposal is the different treatment for real estate leases and equipment leases without a clear conceptual basis for making the distinction. “We favor capitalization,” he says. “We don't oppose bringing leases on the balance sheet. But the way they're doing it now does not make sense.” ELFA believes the present tests around risks and rewards are well understood and make sense, but the new ideas put forth in the proposal are more like carve-outs or exceptions to satisfy different constituent groups or an objective to converge U.S. standards with international rules.

Nick Difazio, a partner with Deloitte & Touche, says he sees large global companies with significant lease activity gearing up to eventually adopt a new standard, even if the final standard is not yet determined. “They are beginning to come up with a strategy for how to gather the information they will need,” he says. “It could be in different languages or in different systems, so they are looking for ways to centralize and standardize.” He also sees companies that are upgrading or changing their real estate reporting systems thinking about the new standard, looking to assure their new systems will accommodate whatever requirements the new standard will put into place.

If FASB were to adopt its current proposal, companies would face significant new data requirements, says Difazio. “Depending on the complexity of the lease, there could be 80 to 90 data elements per lease” that must be captured and somehow managed to comply with the present proposal, he says. “Companies in general won't have all the data they would need to do these calculations, so an effort is going to have to be undertaken to get organized.”

Mike Gullette, vice president of accounting and financial management for the American Bankers Association, says the implications of the proposal are huge. “This is for every company in America that ever leases anything,” he says. “The scope of this is pretty large. It can't get much larger.”

FASB is accepting comments on the proposal through mid-September.