Peeling away financial reporting issues one layer at a time

Lease Accounting: Replacement Cost is the Only Hope for a Principles-Based Solution

A couple of weeks ago, the FASB and IASB jointly published a discussion paper (DP) entitled Leases: Preliminary Views. I take no pleasure in saying that SFAS 13 is the oldest worst accounting standard currently living and breathing; and the DP is a wet blanket on my hopes that it (along with its politically tweaked clone, IAS 17) would ever be replaced with a principles-based standard.

SFAS 13 was issued almost 35 years ago, irreparably broken right out of the box. For decades, it has been Exhibit A for critics of bright line rules, while IAS 17 has been similarly excoriated from the outset for its fuzzy rules. There has been no better example than these two standards of the proposition that rules without principles cannot result in high quality financial reporting—unless you're a big fan of off-balance sheet financing and earnings management. The rules are so bad, that a flurry of articles and textbook chapters appeared almost immediately after SFAS 13 was issued to guide users in their restatements of 'operating lease' accounting.

Financial reporting lived with SFAS 13 for 20 years until some quasi authority, the G4+1 group of standard setters, finally published a discussion paper advocating the capitalization of all leases. Duh.  Ten more years had to pass for the FASB and IASB to commence its joint project on lease accounting. It has taken almost another three years for these accounting whizzes to come out with this watery "preliminary views" document.

Why so long? First, issuers are in no hurry to give up the chicken salad they ordered, and were served on a silver platter in FAS 13; and second, as we are finally coming to recognize, investors have not pushed hard enough on their own for the changes in accounting they are entitled to. If there is any good that might come out of the mark-to-market debate following the financial meltdown, it is the realization that investors can't count on any other 'stakeholder' group to help them unless they themselves become a much stronger voice.

The Good News First

By far, the best thing to come out of the PV document is the proposal to treat all leases as giving rise to an asset (termed the "right to use the leased item" in the PV), and a liability for the obligation to pay rentals. In other words, 'operating lease accounting' and the gift of off-balance sheet accounting that went with it, may finally be out the window! Unfortunately, the rest of the PV follows a long-practiced FASB gambit of doing just enough, and no more, to cross the project off the list — and to keep those pesky investors at bay for another 15 – 30 years.

Now for the bad news. Actually, there's lots of it, but I don't have time to write a book. So, in this post I'm just going to focus on the one issue that relates to some of my previous posts on 'fair value' versus 'replacement cost' measurements.

Let's Pretend These Numbers Actually Mean Something

To illustrate the point I want to make, let's take a relatively straightforward variation of a plain vanilla 8-year lease on retail store space: the lease term is divided into an initial 5-year period with an option to renew after 3 years at an inflation-adjusted price. Monthly rents contain a fixed component plus a variable component depending on store sales.

The FASB and IASB have slightly different preferences at this point, but let's start with the IASB's only because it's easier to explain: they propose that initial measurement take place as follows:

Estimate the expected lease term, and the expected (i.e., probability weighted) cash payments to be made by the lessee; and discount the expected cash payments at the lessee's incremental borrowing rate.

That's rules-based accounting for you. The DP does not state what the objective of this calculation is, because there isn't one, other than to come up with some number, any number, which they think enough people will say that 'it looks about right.' Stated plainly, the calculation results produces a hash—a number that can only be described by the chicken salad recipe used to cook it up.

There actually is a better way to measure a lease based on discounted cash flows, but it only applies in very restrictive circumstances. Let's set aside the choice of discount rate for the moment, which is a big problem in and of itself, and focus on measuring the numerators, if you will, of the terms in an expected net present value calculation. Finance 101 would say that there should be one term for each possible year (i.e., the maximum lease term), and the amounts for each year should be their expected cash flows.

Too see why that's the only rational approach to present value, think about how you would calculate the present value of an annuity for the rest of your life. Choice 'a' is to calculate your life expectancy (say, 80 years) and to discount the cash payments you would receive only up to the year in which you attain the age of 80. Choice 'b' would be to discount the expected cash flows for each year you could possibly live, where the expected cash flow is the contractual amount multiplied by the probability you should live so long. Choice 'b' is obviously the correct one, and should also be the approach for measuring the present value of a lease obligation of an uncertain term.

For some reason I fail to grasp, the flawed choice 'a' is essentially what the IASB is advocating. The DP describes some other, even more obtuse approaches they purportedly considered, but Choice 'b' is not even given lip service; probably because they knew of no way to put it back in the bag once they let it out. In this, and other aspects, the DP's reasoning is disingenuous at best, but more likely, intentionally deceptive.

Now, let's talk about the discount rate. Using the lessee's incremental borrowing rate for a fixed term lease could make sense, because the result of the calculation would yield the 'settlement amount': i.e., the amount that should discharge the liability in a single payment at the inception of the lease. But, in the presence of the renewal option, or any other type of option, the incremental borrowing rate is just a number pulled out of the air; kind of like adding red food coloring to artificially flavored jell-o. Where the FASB and IASB differ is only with respect to the shade of red: in place of expected cash flows, the FASB would use "most likely" cash flows. Big Hairy Deal. Nothing about either calculation method will produce historic cost, fair value, replacement cost, settlement amount, or any other attribute of assets and liabilities. Neither calculation will result in a "fair presentation" or a "true and fair presentation," or any other paliative weasel phrase the boards want to associate with the financial reporting solutions they are pushing.

A Principles-Based Approach to Lease Accounting

There are two basic principles of lease accounting that should guide the project. First, I agree with the FASB that lease contracts give rise to assets and liabilities; operating leases should be history. Second, and this is the payoff from reading this overly long post, the only relevant measurement attribute of rights and obligations arising from lease contracts is replacement cost. In fact, if you believe that non-transferable rights should be recognized as assets, I can think of no better example to show why replacement cost is preferable to fair value as a comprehensive basis of measurement.

Both boards take the position that contractual rights meet the conceptual definition of an 'asset,' including non-transferable contractual rights. But, if you are contractually prohibited from selling something, the only logical answer to the fair value question is 'zero'! Imagine the fair value balance sheet of an airline that finances its entire fleet of planes with non-transferable leases. It's not just ugly, it's of absolutely no use investors.

However, the replacement cost of a leased asset, regardless of transferability, can be substantial. And, unlike the FASB or IASB's improvised approaches to measurement, any rules that the boards would deign to impose with regard to how one should go about estimating replacement cost can be based on sound principles.

For stating that operating lease accounting should go away, I give the boards a 10. But for the rest of their preliminary views, even though I haven't told you about everything that bothers me, I give them a big fat zero. When I ponder the measurement rules they are proposing, I can't help thinking of the game we used to play as little tykes: "Let's Pretend."

2 Comments

  1. Reply Eddie Thomas April 10, 2009

    I’m sure you’ve explained this before, but what do you do with depreciation if assets are valued at replacement cost? My understanding of depreciation is not that it approximates fair value but that it embodies the principle of matching expenses to revenues. Would an upward adjustment in the value of a capital lease (due to an increase in replacement value, under your suggestion) lead to an adjustment in depreciation taken?
    Historic cost, for all of its deficiencies when it comes to the balance sheet, is fairly intuitive for the income statement. I paid certain costs, received certain revenues, and count the difference as profit. Fair market valuations, via exit prices or replacement costs, seem counter to this intuition, although admittedly it is much worse with exit prices. (Using exit prices to value inventory would seem to make every sale a zero profit action. Income would then be only the change in value of a firm’s assets from one point in time to another.)

  2. Reply Blair Stover June 10, 2009

    I really enjoyed the read – keep them coming.

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