Peeling away financial reporting issues one layer at a time

Taking the Measure of Lease Expense – Part 2 of 2

This post could turn out to be a little dry. So, to whet your curiosity, I’ll start with the payoff:

First, contrary to the conclusions of the FASB and IASB, level periodic lease expense does not reflect the unerlying economics of leasing. 

Second, even though current capital lease accounting rules would ‘frontload’ lease expense, the amount of the frontloading is less than the amount that best reflects the underlying economics of leasing.

I provided a partial demonstration of the first point in my first post on this topic, in which the asset being leased was non-depreciating. In this post, I’ll show that lease expense is even more frontloaded when, as is generally the case, the leased asset is depreciating.

To briefly review, I have tried to establish a principle that the basic kernel of a lease contract – the right to use (ROU) an asset in the future – is economically equivalent to a series of forward contracts. This may be difficult for some to accept, so maybe these observations will help:

  • It is true that some forward contracts require or permit net settlement, whereas a lease generally requires delivery of a ROU in exchange for cash.
  • In principle, however, the manner of settlement should not affect the accounting.  This is because the basic nature of the risks and rewards are the same, regardless of how the contract is settled.
  • To explain further, in a cash settled contract, variability of outcomes is manifested by a variable amount of cash exchanging hands at settlement. In a physically settled contract, however, the cash exchanged upon delivery of a good or service is fixed, but the value of the delivered item is variable.
  • To see this, think about the difference between a cash settled contract to purchase jet fuel, and a physically settled contract.  If you don’t see any substantial economic difference between the cash-settled and physically-settled versions, then you can read on without first taking two aspirin.

A Simple Example

This is a continuation of my story of Paul the pumpkin farmer:

  • Recall that 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.
  • It has just occurred to Paul that he only uses a truck one day a year, so why not rent instead of own? Accordingly, Paul signed three forward contracts (or call it one lease – I don’t care) with Ted the truck owner. The first(second)[third] of these forward contracts will provide Paul with the right to use Ted’s truck for one day exactly one(two)[three] years from today in exchange for $1,086 per contract at the time Paul is given the keys to Ted’s truck.
  • When the first delivery date occurs, Ted’s truck will be one year old.
  • The spot (rental) rate today for a one-year old truck is $1,000 per day; for a two-year old truck, $900; and for a three-year old truck, $800.
  • The appropriate rate of interest for all three contracts is 10%.

At this point, you may want to go back and review Example 2 from my earlier post. The shared elements of that example, and this new one are as follows:

  • The “underlying” of each forward contract is the spot rental rate at the delivery date. The three contracted rental rates (or delivery prices in forward contract terminology) sum to the same $2700.
  • The relationship between the forward price (F) and the spot price (S) of the asset to be delivered in the future is defined by the formula F=S(1+r)n. In a finance textbook, you will find that this is the simplest forward contract pricing model available, and is applied to analyzing a forward contract on a share of stock that pays no dividends. I use this pricing model here solely for simplicity and without loss of generality.
  • If each contract had been negotiated separately, the delivery prices (F) would have been $990, $1089 and $1,189.  To make the three contracts look more like a conventional lease, I ‘annuitized’ them to $1,086 per contract.
  • Economically, there would be uncertainty with respect to future settlement values.  For the purposes of my journal entries, however, I assumed constant spot prices and interest rates.  If any among you want to propose that leases be accounted for at fair value on each balance sheet date, I would be in favor of that! But, I made these assumptions to be consistent with the FASB and IASB approach; I want to present my points as straightforwardly as possible.

Basically, the only difference in this new example is that the ROUs conveyed are for a depreciating asset. Therefore, instead of one spot rate at the inception of the lease, there are three – to reflect the fact that each forward contract has a different asset that is being delivered.

Hopefully, that’s all you need to know to derive these journal entries:

Note that in each of the examples I have provided over these two posts produce the same amount of lease expense over the three years.  However, compare the total expenses in this example to the previous examples: lease expense is even more frontloaded.  The reason is because the asset being leased depreciates.

In summary, I have provided these analyses to demonstrate that the FASB and IASB are way off base in permitting level recognition of lease expense for any asset.  Moreover, the boards should note that the amount of frontloading that the current capital lease accounting rules require is kinder to lessees’ income statements than is justified. Ironically, the correct answer is even more extreme than the answer that issuers have been objecting to.

Going forward, I would say that the boards have three choices for basic lease accounting:

  1. Analogy to a buy-borrow transaction — this is consistent with historic cost accounting (not preferable, but acceptable).
  2. Analogy to a series of forward contracts — this is consistent with the underlying economics of leasing (preferable, because it is principles-based).
  3. Make something up.

My money is on #3.

 

 

 

 

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