FASB's Latest Lease Accounting Proposal Draws Criticism

Reviews are in for the Financial Accounting Standards Board's latest proposal to revise the rules for lease accounting and there are a lot of thumbs pointing at the ground. 

Critics of the proposal are pelting the Financial Accounting Standards Board with criticism and demanding that it start over. The vast majority of comment letters so far tell FASB its proposed method of classifying and measuring leases to get them on the balance sheet is too complicated and doesn't reflect the economic realities of leasing.

Many letters, including one from Financial Executives International, question whether the cost and complexity associated with the proposal provide an equivalent improvement to financial reporting. “We believe that field testing of the proposal should be conducted to ensure that the costs and operationality of the revised principles can be realistically determined,” wrote Marie Hollein, president of FEI.

Other suggestions are even more radical. FASB's own Investor Advisory Council told FASB in a meeting recently that it should scrap the entire plan to bring leases on the balance sheet because the exercise has proven too difficult. Instead, the panel, led by analyst Gary Buesser, a director at Lazard Asset Management, said FASB should retain the current accounting model, but enhance disclosures.

FASB's method of classifying leases as “Type A” and “Type B” leases creates a distinction that is just not that important to analysts, Buesser said. Under FASB's model, Type A leases are those where a company essentially consumes an asset over the lease term, such as factory equipment or vehicles. With a Type B lease, the company returns an asset at the end of a lease term that still has plenty of useful life, such as an office building or other real estate. “We don't believe measurement should be different because you have different lease terms or you're leasing different types of assets,” Buesser told FASB.

Surprised somewhat by the investor panel's reaction, FASB members peppered the IAC with questions: You don't care if some leased assets are on the balance sheet and others are not? You aren't interested in at least having the minimum contractual liability on the books? You don't believe the flexibility provided in shorter-term leases should be recognized? You want to maintain current GAAP?

David Trainer, IAC member and CEO of New Constructs, agrees that the latest lease accounting proposal is overly complex. “The problem with the [proposed] model is you've got complexities and assumptions and accounting constructs that muddle the economics,” he said during the meeting. Analysts will have extra work to do to unwind the calculations and build models of their own that they will find more relevant, he said.

“We believe that field testing of the proposal should be conducted to ensure that the costs and operationality of the revised principles can be realistically determined.”

—Marie Hollein,

President,

FEI

The IAC panel mapped out some disclosure requirements that, if added to current accounting requirements, would give analysts what they need to understand and measure the implications of a company's lease obligations.

Jonathan Nus, a senior director at Standard & Poor's, said FASB should require a tabular disclosure of the range of possible cash outflows for all leases, short-term and long-term, taking into account management's expectations about lease options. “That table would in a sense provide valuation uncertainty around leases,” he said. FASB also should require disclosures on historical minimum and variable cash rent payments, average and median lease terms, incremental borrowing rate, inflation rate assumptions, and sensitivity analyses, Nus said.

Your Move, FASB

An unsold Russ Golden, chairman of FASB, offered no promises either way. “We get substantial criticism when we require forward-looking disclosures,” he told IAC members. “We would have to do a substantial amount of research” to determine if such disclosures would provide a viable solution.

IAC itself was not unanimous with its recommendation. IAC member Dane Mott, an independent research analyst after his departure from J.P. Morgan, chimed in with his own view. “Operating leases are forward contracts, or financial derivatives,” he said. While a capital lease is the financed purchase of an asset, he sees an operating lease as the purchase of a right to use someone else's asset. “That's a forward contract,” he said. “That's where I would draw the line.”

LEASE COMMENTS

Below are some comments FASB received on the lease accounting proposal.

For preparers, the proposals raise important questions with regard to assessing the costs of the standard. The reporting environment in the United States is very demanding and requires the development of high quality, repeatable and sustainable processes and controls. The environment also requires a thorough and transparent approach for related disclosures that enables investors to fully understand the nature and effect of the required changes. When one considers the tens of thousands of lease contracts this will apply to at each reporting company and the fact that the unit of accounting is at the individual contract level, meeting all of these expectations will cause companies to incur very significant compliance costs for internal and external technical accounting resources, information systems, controls and audit-related support. These costs are likely to be proportionately greater for leases of low value items, which comprise the largest volume, but not the largest monetary value, of lease contracts. The need to compensate for lack of investor consensus on the recognition and measurement conclusions through additional disclosures will be another source of added costs. We also note that the choice of accounting models will have significant implications on costs of transition to the new standard. How those costs are factored in to the analysis should be an important consideration in the boards' discussions.

—Marie Hollein, President, CEO, FEI

The distortions among reporting by public companies resulting from the wide disparity in discount rates used to compute present value will be enormous, in my opinion. Public companies will go to outlandish lengths to attempt to mitigate the impact of this proposal, in my opinion. I see that non-public entities and not-for-profits would be allowed to use risk free rates of return. Why a distinction from public companies?

—Dennis Moore, SVP & CFO, J & J Snack Foods Corp.

We are supportive of the overall objectives that the ASU will provide financial statement users greater transparency into a company's lease obligation. Additionally, Johnson & Johnson would like to commend the Boards for including positive changes from the original proposal, particularly around the simplification in the calculation inputs. The items below will be more practical and operational for companies to adopt and implement this change.

The exclusion of variable lease payments that are usage or performance based.

The modification to include only renewal terms that have significant incentive to renew.

The exclusion of term option penalties in a manner that is consistent with the accounting for option to extend or terminate a lease. For example, if there is penalty not to renew, but the renewal period was not considered in the initial measurement, then the penalty

should have the same accounting treatment.

—Stephen Cosgrove, VP, Corp. Controller, Johnson & Johnson

Source: FASB.

Still, critics of the proposal far outnumber its supporters. Ed Trott, a former member of FASB, says the board's current proposal will not improve financial reporting. In addition to the complexity, he's concerned that ambiguity around terms like “significant” and “substantially all” will lead to differences in interpretation. “I don't think they will issue a standard based on either of these exposure drafts,” he says. “I expect they will say we're going to leave the current accounting in place and expand it in the form of detailed information about leases.”

Another wildcard in the equation, says Trott, is the view of FASB's newest member, Jim Kroeker, former chief accountant at the Securities and Exchange Commission, who filled the vacancy created by Leslie Seidman's departure and Golden's promotion to chairman. Seidman was one of only four board members who supported the exposure draft when it was published. Three board members dissented, and Kroeker hasn't weighed in publicly since assuming his seat, but he was on staff at the SEC when it issued its off-balance-sheet accounting study calling for leases to be brought on the balance sheet, Trott notes. “I just don't know where his passion is on this,” he says.

John Hepp, a partner with Grant Thornton, says FASB is hitting a wall with the concept of building the standard around a “right-of-use” asset. “It's now been vetted three times, in a discussion paper and two exposure drafts, and it's time to re-examine it,” he says. “The most important test of any accounting model is does it provide relevant information? Is the information useful? If the answer is no, then you've got the wrong model.”

Julie Valpey, a partner at BDO USA, doesn't believe the board will scrap the entire proposal. “I would be very surprised if we didn't end up with leases on the balance sheet,” she says. She hears a great deal of support for going back to the original idea of the first exposure draft of having a single model for all leases. “It would not only reduce complexity but also reduce judgment of which accounting is appropriate for which leases,” she says.

Chad Soarez, a partner with PwC, says feedback from overseas is not much more supportive. “I wouldn't characterize this as a U.S. concern only,” he says.

Companies should speak up with their views, but should do so thoughtfully, says John McGaw, a partner with KPMG, and Rich Stuart, a partner with McGladrey. “What's particularly useful is when companies provide depth on specifics,” says McGaw. “If you send a letter that just says we don't like this; it's too expensive—that's not enough information for the board to act on.” Stuart says it's late in the game for companies to provide comments, “but it's a worthwhile effort.”

At EY, partner Betty Davis is encouraging companies to hang in there and continue to follow the debate. “I think there's a little bit of lease fatigue,” she says. “But leasing affects everyone so we have to continue to follow the project and comment.” The boards are hosting five roundtables globally through early October.