Peeling away financial reporting issues one layer at a time

Taking the Measure of Lease Expense (Part 1 of 2)

The best thing to come out of the lease accounting project is that, except in very limited circumstances, 'operating lease' accounting will be jettisoned. At the inception of a lease contract, lessees will have to recognize a liability to make future lease payments and a corresponding asset for a right of use (ROU) of the leased asset during the lease term.

I do wish I had more positives to report, but such is not the case. For the past ten years, the boards have been beset at every turn by financial statement issuers; mostly to grind down recognition of lease obligations to some crudely calculated and arbitrary amount they might grudgingly accept. I have had much to say about this in earlier posts, here and here.

The latest lobbying efforts have been focused on stamping out income statement variability derived from the subsequent measurement of the ROU asset and the lease obligation. I imagine that most of my readers are familiar with how capital lease accounting, as set forth in current GAAP and IFRS, results in higher(lower) lease expense in earlier(later) periods, but kindly bear with me as I demonstrate this phenomena via the rudimentary example, below. You should take a little time to examine it if only because a close variation will serve to make my main points.

Example 1

  • Paul the pumpkin farmer trucks a portion of his harvest each year to the nearest city, where he rents a vacant lot and sells pumpkins to residents on Halloween.
  • Today, exactly one year before the next Halloween, Paul signed a lease contract with Larry the landowner. The contract conveys to Paul the right to use Larry's land for one day each year in exchange for rent of $1,086 per year.
  • The appropriate rate of interest is 10%.

Under existing U.S. GAAP and IFRS (assuming capital lease accounting), the following amounts would be reported over the life of the lease contract:

Companies who enjoyed the cosmetic benefits of operating lease accounting, including reporting level amounts of lease expense, objected to the boards continuation of this pattern of lease expense in the 2010 lease accounting exposure draft. Among other things, they observed that land does not depreciate; therefore, they argued, the pattern of expense recognition corresponding to purchasing a depreciable the asset and financing that purchase with debt doesn't always make sense.

The Latest Capitulation

Evidently, the boards were either persuaded by some version of this argument, or given the absence of a reasoned explanation from the boards, they just caved in response to the incessant pressure. A recent press release announced that they recently agreed to permit level recognition of lease expense under the following circumstances:

  • In a lease of property (land, building or both) – the lease term is for a major part of the economic life of the underlying asset, or the present value of fixed lease payments accounts for "substantially" (whatever that means) all of the fair value of the underlying asset.
  • Leases of assets other than property – the lease term is an insignificant portion of the economic life of the underlying asset, or the present value of the fixed lease payments is "insignificant" (see "substantially," supra) relative to the fair value of the asset.

After reading the press release, I retrieved the minutes of the meeting in which the boards came to this consensus in search of their reasoning, or some indications of what transpired during their 3.5 hour discussion. The "minutes" were totally unhelpful: only one page of narrative, and giving no indication as to how the boards were persuaded to essentially permit a choice of methods for measuring periodic lease expense. The only hint came from the press release wherein FASB chair Leslie Seidman was quoted: "…we decided that leases that convey a relatively small percentage of the life or value of the leased asset should be recognized evenly over the lease term."

Since the board now (correctly) views a lease as conveying the contractual right to use an asset for a period of time, as opposed to conveying the asset itself, the logic of Ms. Seidman's comment totally escapes me. Accounting for the ROU should render irrelevant any information about the economic life of the asset after lease expires — which I will more formally illustrate with another simple example.

Towards a Principles-Based Approach to Lease Accounting: Example 2

To demonstrate how lease expense attribution should be approached by the boards, I'm going to tweak the first example somewhat (my tweaks are in italics):

  • Paul the pumpkin farmer trucks a portion of his harvest each year to the city where he rents a vacant lot, and sells pumpkins to residents on Halloween.
  • Today, exactly one year before the next Halloween, Paul signed three forward contracts with Larry the landowner. The first(second)[third] of these forward contracts will provide Paul with the right to use Larry's land for one day exactly one(two)[three] years from today in exchange $1,086 per contract at time of delivery.
  • Today, Larry could rent his land for the day for $900.
  • The appropriate rate of interest for all three contracts is 10%.

The journal entries below are the result of accounting for these forward contracts at 'hypothetical' fair value – i.e., assuming constant interest rates and spot rate of the underlying. (Note that even though there are three forward contracts, there is only one underlying, which is the rental today for one day.) Also, consistent with the presentation of a capital lease, I have grossed up the presentation of the forward contracts on the balance sheet such that their asset and liability legs are presented separately.

Below are the amounts related to the forward contracts that would be reported over the three years. Note that with the exception of captions, they are the same as the first example.

At this point, I hope you are now asking yourself, "what happens to lease expense when the underlying asset depreciates?" I'm saving that for the next post, which I hope to spring on you in a day or so. In the meantime, here is what I see are the logical implications of my analysis to this point:

  • A plain vanilla lease is, in economic substance, a series of forward contracts. My example is somewhat stylized, but continuous "delivery" does not alter the fundamental economics.
  • It is not a coincidence that the pattern of lease expense corresponds exactly to what would have been obtained by applying current US GAAP or IFRS under capital lease treatment. One the other hand, it would be purely coincidental for the economics to yield a level lease expense pattern.
  • The "underlying" to a lease contract is not the asset itself, but the right to use the asset. This is consistent with the boards' right of use approach.
  • Since the leased asset did not depreciate, its depreciation is not the factor that determines the pattern of lease expense. Instead, the decline in the economic value of the right to use the leased asset is one of the two drivers of lease expense. (The timing of the lease payments and its effect on the interest component is the other factor.)
  • To account for a lease as a forward contract, I had to have the spot price for the underlying. For a non-depreciating asset only one spot price is needed. For a depreciating asset, multiple spot prices are needed (and I will show how this affects the results in my next post).

* * * * * *

Critics of my conceptualization of a lease as a series of forward contracts will point to numerous obvious implementation problems. In response, I would point out that the boards have spent the last 10 years and counting discussing implementation problems of their rules-based solution; and many loose ends still remain before a revised exposure draft can be issued. Unlike the boards, at least I have economic principles for dealing with implementation issues as I begin to consider them.

If the boards would practice what the IASB preaches – that substance trumps legal form – then leases should be treated as forward contracts. But, that's not what I want to be the main take-away from this post; which is that the boards' criteria for permitting level lease expense attribution are, if Ms. Seidman's statement in the press release is an indication, purely arbitrary and have no basis in economic logic.

I wonder whether I will laugh or cry as I read the basis for conclusions in the final standard.


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