Peeling away financial reporting issues one layer at a time

Reason #2 to Dump on the IASB/FASB Leasing Proposal

In my previous post, I let 'er rip at the IASB/FASB "preliminary views" on measuring lease contract assets and liabilities. A close second on my list of investor-unfriendliness contained in their joint lease accounting Discussion Paper is the proposal that lease options (e.g., renewal, purchase, cancellation, etc.) and all other separately identifiable components of a contract should be balled up into one big ole asset and a corresponding liability. 

My unsubstantiated suspicion is that the leasing industry served this one up to the boards in exchange for lowering their resistance to the elimination of operating lease accounting.  It seems plausible, because, as I'm about to illustrate, that if we fail to require separate measurement for all of the material components of a lease contract, we will end up right back where we started. In other words, off-balance sheet lease accounting will continue to plague us.

Here's the example:

  • The fair value of an airplane is $100; economic depreciation is expected to be $10 per year. Airline A enters into a one-year lease contract with Lessor B for $12, paid in advance. The lessee has an option to buy the airplane for $90.01 at the end of the one-year lease term.

  • Separate and apart from its lease with Lessor B, Airline A purchases an option from a third party, Lessor C, to enter into another $12, one-year lease, commencing one year from now. The leased asset under this 'option to lease' would be a one-year-old airplane, with an option to buy for $80.01 at the end of the one-year lease term.

  • And so on, and so forth. Airline A also enters into similar option contracts for subsequent years with new, or perhaps the same, lessors.

In accordance with the DP and the FASB's preliminary views, Airline A will conclude that the probability of exercising the purchase option is less than 50%. Therefore, Airline A will not add any portion of the expected future cash flows related to the option to the measurement of the rights acquired under the lease, or to the corresponding liability. Also, the numerous 'options to lease' do not meet the definition of a derivative per FAS 133 or IAS 39 (physical delivery of the leased asset will be required), so they won't be recognized until exercised.

Bottom line: $12 lease expense, no asset, no liability. Even though operating lease accounting will supposedly gone away, Airline A essentially achieves operating lease accounting in Year 1, and for subsequent years as well.

Is there a cost to constructing this crazy web of leases and options? You betcha, but I don't expect that would deter Mr. Schmo CEO from incurring that cost to get the accounting he 'needs.' Moreover, the result under the IASB's preliminary views would be even sweeter. (Are you surprised?) Let's say that the lease crosses over two accounting periods. The IASB approach would recognize $55 (=$10 + $90.01/2) of expense in the first fiscal year. This creates a $45 earnings bank that can be used in the second year. If Schmo CEO doesn't 'need' more earnings and the purchase option is in the money, then he will go ahead and exercise; otherwise he will let the option expire and withdraw $45 of earnings from the bank.

The Stated Rationale for Rejecting a Components Approach, and Why They're Wrong

Here's the boards' reasons—and my reasons for why theirs are bad reasons:

  • A components approach may be difficult to apply.

Funny, but that hasn't stopped the boards from promulgating anti-abuse provisions before. I'm thinking about the FAS 133 requirement to bifurcate embedded derivatives. I'm also thinking about FIN 46(R) a complex an anti-abuse standard in its entirety. The point of my airline example is that, without some sort of components approach, the leasing industry is going to have a field day offering new and 'innovative' financial products designed solely to minimize the effect of lease capitalization on the balance sheets of lessees; and it's why I think all of this may be their idea.

  • Components are often interrelated. For example, recognizing a liability in respect of a residual value guarantee may not provide useful information to users if the lessee is likely to exercise a purchase option.

That's like saying that the fair value of an option doesn't provide useful information if the probability of its exercise is low! It certainly has not deterred the boards from requiring fair value measurement for all options within the scope of FAS 133 or IAS 39, regardless of their probability of being exercised.

Having said that, however, any sensible and principles-based standard should provide that insignificant lease components need not be separately measured, and perhaps combined with the most basic rights and obligations associated with the lease contract.

  • All components would have to be measured on the same basis, like fair value, in order to result in comparability and to curb abuse.

Amen. If you will be so kind as to read my previous post, I may be able to convince you that a principles-based approach to lease accounting would perforce require measurement of all rights and obligations at their replacement costs.

  • The fair value [or replacement cost] of some components may be difficult to measure, because there is no market for them, and they are not normally priced separate from the lease contract.

Right again, but generating random numbers that are misleadingly labeled 'historic costs' is not at all a substitute for a good faith effort to measure a real financial attribute of an asset/liability.

But, I do understand the cost/benefit tradeoff, and would retain operating lease accounting for small, non-public companies. The IASB has done a good thing by creating a simpler version of their standards for use by smaller companies. If there is one area in which the FASB should follow the IASB's lead, it is in providing more accomodations to small companies, and leasing is an excellent place to start. But, while they are at it, they should also relax the requirements in FAS 133 for bifurcation of derivatives from certain host contracts, ease up on business combinations, goodwill impairment testing and FIN 48 (deferred taxes).

If you think I'm being paranoid about potental abuses of a new lease accounting standard that is not principles-based, then think about this:  if it took me 10 minutes to cook up my little example, then who knows what other schemes currently lurk in the minds of the 'financial engineers,' who actually get paid to think up new ways to steal from shareholders?

1 Comment

  1. Reply John Hepp April 20, 2009

    I think that you have identified the key issue: components. The contract is the wrong unit of account. This will lead to accounting for contract elements within a lease contract differently from similar elements outside a lease (e.g. guarantees, options, and embedded financial instruments).
    The accounting for option periods as part of the lease term reflects anti-abuse provisions from the current model that were designed to prevent circumvention of the 90% rule and the 75% rule in FASB 13. It is largely irrelevant in a capitalization model and leads to the irrational result of recognizing a liability for an option. A better model would be to recognize options as assets (but not obligations) if valuable (e.g. bargain purchase, real estate) or ignored if inconsequential (e.g. options to renew at market value).
    Try generating some journal entries and numbers for bargain purchase options or for a lease of real estate with a purchase option and the mismatch should become readily apparent. For example, the FASB model will overstate liabilities and amortization in the initial lease period and understate the asset and amortization in the option period.

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