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:
- At the end of the term, does ownership automatically transfer to the purported lessee?
- Is the term equal to or greater than 75 percent of the property’s economic life?
- Is there a “bargain” purchase option?
- Does the present value of the rents exceed 90 percent of the fair market value of the property at the outset of the lease?
If the answer to any of these questions is yes, lessee records on its balance sheet property, plant or equipment (PPE) as an asset and the obligation to pay “rent” to the lessor as a liability. With respect to the lessee, this outcome is known as a “capital lease.”
Also if the answer to any of the questions is yes, the lessor books a receivable (like a loan) and a “residual” for the estimated value of the PPE at the end of the lease. With respect to the lessor, this is known as a “direct finance lease.”
If the answer to each of questions from the lessee’s perspective is no, the lessee merely has periodic rent (i.e., the average annual rent) as an expense on its income statement. This is known as an “operating lease.”
If the answer to each of the questions from the lessor’s perspective is no, the lessor merely books PPE as an asset on its balance sheet that it depreciates straight-line over the economic useful life of the asset (which is likely longer than the tax recovery period for depreciation purposes). This too is known as an “operating lease.”
In practice, IASB’s test is similar to FASB’s. The international standard-setter adds a fifth element: Are the leased assets of such a specialized nature that only the lessee can use them without major modifications? That is a relatively rare situation.
A. Asymmetry Invites Abuse
Under current rules, a lease can be structured such that it does not result in either the lessor or the lessee depreciating PPE. The potential for asymmetry invites trouble. Rather than discarding the current rules, the boards should motivate the parties to have the PPE on one of their books. If both parties publish financial statements, the lease document should have to stipulate which party will depreciate the PPE in its financial statements. (This assumes the agreed treatment corresponds to the applicable lease accounting tests. Parties may not just arbitrarily agree that one of them depreciates the PPE.)
If the parties are unable to agree in the lease document, they should each have to include detail about the lease in the footnotes to their financial statements. Such detail would encourage their auditors, their investors, the securities regulators and tax authorities to scrutinize the transaction.
B. The Same Discount Rate Is Not Required
The 90 percent present value test has a certain appeal as a financial metric. However, with care the parties can avoid using the same discount rate. If the lessee knows the discount rate used by the lessor in the lease pricing, the lessee is supposed to use that discount rate. If the lessee does not know that rate, it is supposed to use its own marginal cost of funds.
This motivates the lessor to use a low discount rate so the present value of the rents exceeds 90 percent, but not to tell the lessee its rate. The lessee can then argue that its cost of funds is high, so the present value of the rents is less than 90 percent.
One way to avoid this problem would be for the standards boards to publish discount rates for various-duration leases for lessees with various credit standings. Parties to a lease could avoid using the boards’ discount rate if they agreed in writing to use a mutual discount rate.
This approach to discount rates may understate the after-tax benefit the lease provides to the lessor, if the lessor is entitled to tax benefits that enhance its return. For instance, a lessor of a solar project in the United States entitled can be entitled to a 30 percent investment tax credit, plus accelerated depreciation. Therefore, the cash rent it charges the lessee may be quite low. The published discount rate would not capture that. That tax nuance would be traded for consistency and simplicity.
C. Residual Value Insurance
If the lessor is unable to justify a discount rate that results in a present value of rent in excess of 90 percent, it can resort to residual value insurance. Residual value insurance is insurance that the lessor purchases; the insurer pays the lessor if, at lease expiry, the value of the property is below an agreed amount. A claim under residual value insurance is rare. First, it is difficult to meet the deductible; second, the lessor does not want to make a claim for one asset or even a class of assets and then see its deductibles go up for future leases.
The current lease-accounting rules should be amended to eliminate potential payments from residual value insurance from the lessor’s 90 percent present value test.
D. An Outdated Bargain Purchase Option Test
The bargain purchase option is a sensible test, but it needs to be updated to reflect today’s financial structuring.
1. First Loss Guarantees.
First, the bargain purchase option test does not consider what obligations the lessee has if it does not exercise its purchase option. Specifically, lessees have been able to characterize as operating leases those transactions in which, if the lessee does not exercise its fixed-price purchase option, the asset is sold and the lessee is responsible to pay the lessor to the extent the sales price is less than an agreed threshold. The amount is capped, so the obligation does not trip the 90 percent present value test. Often the threshold is the same as the fixed purchase option price.
For instance, a lease could have a three-year term and a purchase option for $100. If the lessee does not exercise that purchase option, the asset would be sold and the lessee would be obligated to make the lessor whole for the difference between the actual sale price and its fixed price purchase option price (but subject to a cap on the lessee’s liability). For example, the lessee could be obligated to pay the lessor up to 80 percent of the fixed purchase option price. So if the asset sells for $93, the lessee pays $7 to the lessor. If the asset sells for $19, the lessee pays only $80. In other words, the asset must be worth 81 percent less than expected for the lessor to bear any residual risk.
In fairness to the current standard, that potential $80 payment is included in the 90 percent present value test; therefore, the present value of the rents before the purchase option date can only be $9.90 for the lessee to still pass the 90 percent present value test. Nonetheless, the bargain purchase option test should also have to account for that downside obligation. One way to do this would be for the accounting standards to be amended to provide a modest ceiling on how much of a residual guarantee a lessee may provide and characterize a lease as an operating lease to it.
2. Fixed Price Early Buyout Options
An early buyout option (EBO) is a common structuring technique. If the lessee does not exercise the EBO, the lease merely continues. However, the scheduled rents often escalate. The bargain purchase option test does not consider the effect of those post-EBO rents on the lessee’s decision to exercise the purchase option.
One way to address this weakness would be to add another prong for EBOs: The EBO price must exceed the sum of the present value, discounted to the EBO date, of (i) the “avoided” post-EBO rents and (ii) likely economic residual value at lease end. The discount rate could be the same discount rate described above.
3. Return Conditions
A lease may have an end-of-term purchase option that if not exercised requires the lessee to return the equipment cleaned, oiled and with updated software and packed in its original box. If the lessee forgets to keep the original box (and who keeps those boxes?), it may well decide to exercise the purchase option to avoid the cost of noncompliance with the lease.
Further, a lease may provide that the lessee is obligated to return the equipment at its expense to a location in the United States selected by the lessor. That could be the bottom of the Grand Canyon.
The return condition concern could be addressed by providing that if a lease is to be an “operating lease” for the lessee, the return conditions must be “reasonable” and cannot be reasonably expected to exceed a given percentage of the cumulative rents.