The matter of serious contemplation of significant changes to lease accounting rules arose in 2010, with the IASB (International Accounting Standards Board) and FASB (Financial Accounting Standards Board) proposing lease accounting changes, with an impact on lessee.
Background
The IASB and FASB had, as intent, the objective of having lessees show on their balance sheets greater amounts of lease assets and liabilities than presently exist. This would occur via capitalization of operating lease payments, adding significant leverage to balance sheets. While the objective was transparency, the proposed changes have been criticized for a slew of potential unintended consequences. For example, the effects of capitalizing previously off-balance sheet transactions on company leverage ratios will create the real possibility of an impact on debt covenant compliance for many without any true change in the company?s ability to make good on its obligations.
Further changes affecting lessees were criticized for their stringency, creating more rigorous stressing of company balance sheets than those required in credit rating analysis by the rating agencies. For example, historical behavior would be used to dictate balance sheet treatment, thus turning the potential decision of a lessee to structure post-primary term payments into current liability reflected on its balance sheet. Additionally, a use of the longest possible lease term that was ?more likely than not? occurring, a forecast of ?most likely? lease renewals, contingent rental payments, residual value guarantees, and purchase options, and rental escalations would all be lumped into a capitalization formula to be applied.
An onerous compliance burden was included in the proposal and would include complex calculations for booking immaterial lease transactions requiring additional subjective judgment. Additionally, periodic adjustments during a lease term were proposed based on lease payment estimates expected to adjust in each reporting period based on an anticipated end term decision of the lessee.
Equipment Finance Industry Response
The IASB and FASB had received significant opposition to the draft proposal, including the preliminary June 2011 timetable set forth by the two Boards for the adoption of a new standard. Subsequent meetings were set, to deliberate on the issues involved and also a new timeline for the project.
The Equipment Leasing and Finance Association (ELFA), a trade association that represents more than 600 financial services companies and manufacturers in the more than $500 billion U.S. equipment finance sector, has released on its popular website www.elfaonline.com material covering these proposed changes to the area of lease accounting and financial reporting, including the impact on the leasing and finance industry.
By mid-January 2011, ELFA had received over 700 comment letters from members and others concerned with the proposed changes to lease accounting rules. Many responses were critical of the lease term and variable lease payment provisions in the proposal, pointing out that they would be too costly and complex to apply and would not provide the most relevant financial information. Some responses questioned whether requiring lessees to recognize liabilities, and lessors to recognize assets that include payments that could be avoided would meet the definitions of assets and liabilities under the conceptual framework
Some Progress Has Been Made
The result of the January 2011 meeting was a change to the proposed model for lease accounting as initially set forth by the boards, with a tentative agreement to revise proposed definitions of lease terms and treatment of variable lease payments. The boards remained committed to the position that all leases be recognized on balance sheets, but were open to re-deliberation and reconsideration of an income and expense recognition pattern, the definition of lease, and a lessor accounting model.
By February 2011, resulting from the many comments in letters, the FASB and IASB decided to change the definition of a lease term. Other issues were still deliberated.
Without final agreement on all issues, leasing standards were still being delayed in April 2011; the June 2011 target date for implementation was pushed back to allow for more feedback, for example. By May 2011 Financial Watch was reporting the efforts of the boards to change standards, the progress that had been made, and what was still being debated and considered.
At the end of May 2011, the FASB and IASB reversed prior tentative decisions in the lease accounting project, tentatively deciding on lessee P&L parameters, and changing its stance on a retrospective accounting methodology. The new method would utilize an incremental borrowing rate to calculate adjustments when lease term assumptions changed. At that time, short-term leases were not made exempt from capitalization and a lessor accounting method was still undecided.
A Very Active ELFA
By July 2011, in response to the May 2011 position of the Boards, ELFA (together with numerous other interested organizations and parties) expressed concern that failure to consider public comment and inconsistent decision making was reflective of a ?weakening of due process? and the board virtually ignoring the substance and merits of the matters being considered. The ELFA then requested an economic impact study, full field testing, and re-exposure of the lease accounting proposal in an effort to create a standard that would meet the marketplace tests and fulfill stakeholder needs.
Month after month, the ELFA continued to press the boards. By October 2011, the boards had made major changes to the lease project, in response to the issues raised by the ELFA comment letters and those of other interested parties. Most negative issues were reconsidered with a favorable result including less burdensome proposed changes that would lessen the financial and compliance impact.
Still, several major issues were still outstanding. Three of the major issues not adopted were straight line lessee P&L cost, the retention of sales type lease accounting, and the retention of leveraged lease accounting.
In November 2011 a Project Update was released, and also a statement that a new draft on accounting for leases was set for issuance in March or April 2012 with a 120 day comment period.
A study of the economic impact of the proposed changes to lease accounting standards was released in December 2011. This comprehensive document assessed strengths and weaknesses of the proposed changes and the impact on the economy and equity in U.S. companies, with a potential reduction of $96 billion in reduced equity. It also found that there would be an estimated $2 trillion added to balance sheets of US corporations and a reduction of pre-tax income. The study found that there could be significant but unintended consequences resulting from the proposed changes including a clear change in lessor-lessee dynamics. It was portended that a front-loading of leasing costs would take about five years or so to reverse direction and, in general, the new accounting model would have a long-term negative impact on the equity reported by companies on their balance sheets.
So Where Does This Leave Us?
In March 2012 the IASB and FASB were differing on how to approach certain operating expenses and leases. By April 2012 lessee accounting approaches were still being considered by the two boards. At the end of May 2012 the boards had dropped two of four possible approaches and alternatives to lessee/lessor accounting, as being too complex.
Last week saw a compromise between the IASB and FASB that may suggest movement toward an approach that would be less burdensome on equipment finance companies. The two accounting standards boards agreed that lease accounting rules would include two types of leases: one to be treated like financing and the other to be treated as straight-line expense.
It is possible that a final version of the rules could be available sometime next year and perhaps go into effect as early as 2016. Still at issue is coming to agreement as to how to determine which treatment a lease should get. This is not yet clear, but the fact that the boards recognized that all leases were not created equal is very encouraging.
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