Lessor Due Process: GAAP in a Political Environment

In establishing financial accounting standards, the Financial Accounting Standards Board (“FASB“) relies on two basic premises: (1) The FASB should be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession, and, (2) it should operate in full view of the public through a “due process” system that gives interested persons ample opportunity to make their views known.  Passage of a new FASB Standards Statement requires the support of four of the seven members of the FASB Board.  What is GAAP?  It is composed of a mixture of over 2,000 documents that have developed over the last 70 years.  It includes such items as FASB Standards, Interpretations, and Staff Positions; APB Opinions; and AICPA Research Bulletins in addition to the 51 previously issued Accounting Research Bulletins issued by the Committee on Accounting Procedure between 1939 and 1959 and the 31 Opinions issued by the Accounting Principles Board from 1959 to 1973.  Since replacing the APB, the FASB has issued over 160 standards, 48 interpretations, and nearly 100 staff positions. 

Industry user groups are possibly the most powerful force influencing the development of GAAP.  User groups consist of those most interested in or affected by accounting rules.  Like lobbyists in our state and national capitals, Industry user groups play a significant role.  GAAP is as much a product of political action as it is of careful logic or empirical findings.  Lessors should make known how they want particular economic events accounted for, or reported.  The most effective way to influence GAAP is to participate in the formulation of these rules or to try to influence or persuade the formulator of them.  Should there be politics in establishing GAAP for financial accounting and reporting?  WHY NOT?  We have politics at home; at the office: and at church, temple and mosque.  Politics are everywhere.  GAAP is part of the real world, and it cannot escape politics and political pressure.

As an example, in the wake of the credit crisis, banking industry pressure resulted in the suspension of fair value accounting, based on concerns that use of fair value accounting, which calls for recording significant losses on poorly performing loans and investments could scare investors and depositors and lead to a “run on the bank.”  Whether political pressure will have an effect on Lessor accounting is up to the Lessor community.   There is no question the Leasing Industry has stirred up significant debate and reconsideration.  In short, the numbers have consequences and considering the economic consequences of many accounting rules, special interest groups should vocalize their reactions to proposed rules.  The FASB should pay attention to its constituencies while basing GAAP on sound research and a conceptual framework that has its foundation in economic reality.  Accounting standards have economic consequences on the wealth position of both issuers and users of financial information, and on the decision-making behavior of the capital markets.[1]  

A corporate executive once made the following remark to the FASB about a proposed rule:  “In all my years in the financial arena, I have never seen such an absolutely ridiculous proposal…. For God’s sake, use common sense just this once.”[2]

Classification and Treatment of Leases: A Categorical Imperative[1]?

“The basic needs of humans are simple: to get enough food, to find shelter, and to keep debt off the balance sheet.”  … from Richard Green, Forbes, November 24, 1980.

Luca Pacioli wrote the first accounting text in 1494, and many more have been written since then to explain the “how’s´ of accounting and reporting: how to value assets, how to audit financial statements, how to comply with the tax laws, how to evaluate corporate performance, and with the coming re-release of the FASB-IASB Lease Accounting Exposure Draft, expected in the first half of 2012, “how to” to account for leases.

A balance sheet’s left-hand side displays assets recognized by accounting convention.  The right-had side apportions asset ownership among creditors and owners.  Creditor obligations have finite lives whereas shareholder RESIDUAL claims extend over a corporation’s indefinite life.  The deductibility of interest, which the U.S. Tax Code has permitted since 1894, makes a firm’s capital structure a determinant of firm value.  Some debt gives protection against income taxes; too much exposes the firm to bankruptcy. 

A common form of debt is leasing; an asset owner, known as a Lessor, rents equipment or other property in exchange for payments made by a Lessee.   Rental payments compensate asset owners for wear and tear plus financing costs.  Leases can extend from a couple of hours for a set of golf clubs, to twenty years or more for railroad equipment.  No one believes renting a car for one day constitutes ownership; however, the issue becomes less clear if the lease agreement continues for weeks, months, or years.  More important is a consideration of the key issues that have transformed accounting from a tool used by American railroad managers to communicate with absent British investors into an enabler of Global Capital Markets.  FAS Statement 13, Accounting for Leases, issued in November 1976, represents the ultimate rules-based accounting standard.  The FASB commissioned a post implementation review of Statement 13.  They analyzed financial statements, surveyed finance professionals, performed in-depth interviews, and studied stock and bond returns.  The team found Statement 13 caused companies to structure contracts to avoid capitalization.  However, the team found that capitalizing leases under Statement 13 had no identifiable, adverse effect on bond yields or stock prices. 

The FAS-IASB Boards continue to state that the objective of their lease accounting project is to provide users of financial statements with a complete and understandable picture of an entity’s leasing activities.  As the debate on Lessor financial presentation has shown, critics can find problems with both a rules based approach and with a principles based approach, suggesting that neither preparer judgment, nor explicit regulation, is the answer to financial accounting policy issues.  Kant’s categorical imperative “Act only according to that maxim by which you can at the same time will that it should become a universal law” leaves no room for any exceptions.

 Perhaps it’s time for reasonable minds to differ.

Prudence is the ability to deliberate and choose both good ends and good means.[i]

This month’s post provides a status update of the Board’s recent deliberations of lease project activities as reported by the FASB and ISAB on October 28, 2011.  Board decisions remain tentative, may change, are subject to extensive due process, and do not change current GAAP accounting and reporting requirements.

The Board’s Technical Plan now calls for a re-exposure of revised leasing proposals in the First Half of 2012.  The re-exposure will provide interested parties an additional opportunity to comment on revisions that the Boards have made since the publication of the original Exposure Draft in August 2010.

The Boards continue to state that the objective of the lease accounting project is to provide users of financial statements with a complete and understandable picture of an entity’s leasing activities which they feel requires affirming their previous decision (in the original August 2010 lease Exposure Draft) to apply a “right-of-use” model to all lease arrangements.  While this approach requires a lessee to recognize an asset representing its “right to use” an underlying asset during the lease term and a liability representing its obligation to make lease payments during the lease term, Lessor lease accounting guidance needs to be updated to be consistent. 

This area of Lessor accounting and presentation remains a key area for continuing input, contribution collaboration, and participation in the Boards’ continuing deliberation process. 

In their most recent meeting the Boards tentatively decided that a Lessor’s lease of “investment property” would not be within the scope of the receivable and residual approach.  Rather, for such leases the Lessor would continue to recognize the underlying asset and recognize lease income over the lease term.  Lessor lease contracts that fall within the Boards’ receivable and residual approach would use the “derecognition” approach we have described in earlier Blog posts.  With regard to leveraged leases Lessor accounting the Boards’ tentatively decided that a Lessor would account for leveraged leases under the yet to be issued proposed new leases guidance (i.e. there would not be a different Lessor approach for leveraged leases, AND existing leveraged lease transactions would NOT be grandfathered.

For short term leases (a lease that, at the date of commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less) Lessors may elect to not recognize lease assets or lease liabilities and to continue to recognize payments in profit or loss on a straight-line basis over the lease term (unless another systematic and rational basis is more representative).

What form the Board’s ultimately propose for Lessor lease accounting and reporting in the yet to be issued 2012 Exposure Draft will be subject to a further comment and a re-deliberation period.   Given the size and complexity of many firms lease investment portfolios how Lessors will be required to report the economic effects their investment transactions and transition and application of the coming new reporting rules remain a topic of key importance for all industry participants.

A Compromise on Transition to IFRS?

This past May 26, 2011 the SEC staff floated a concept that would redefine convergence of US GAAP with IFRS and establish the FASB as an “endorsement” body for application of IASB standards in the U.S.  The Staff emphasized that its discussion was not intended to suggest that the Commission had determined to incorporate IFRS or that it suggested framework is the preferred approach or the only approach.

The paper suggests a concept informally referred to as “condorsement” that redefines convergence and establishes the FASB as an endorsement body for IASB standards in the U.S.  Under convergence jurisdictions do not adopt IFRS rather they maintain local standards and make efforts to converge those with IFRS over time.  An example is China which is moving its standards closer to IFRS without incorporating it fully into its national financial reporting framework.  Based on the staff’s research a large number of countries, including many in the European Union appear to be following an endorsement approach where IFRS standards are incorporated into their local body of standards.  Under the endorsement approach deviations from IFRS are made to address the perceived need for industry (or country) specific needs.  The SEC staff paper suggests a form of convergence that draws primarily from the endorsement approach, hence the term “condorsement”.

This approach would retain the FASB as the U.S. standard setter to facilitate the transition process by incorporating existing IFRS into U.S. GAAP over a defined period of time, such as five to seven years.  And, after such a transition was complete the FASB would continue as the U.S. “endorsement” body to ensure ongoing changes meet the needs of U.S. capital markets.

The staff suggests that IFRS projects (including Leasing) subject to the 2002 Memorandum of Understanding between the FASB and IASB will result in “reasonably” converged standards in 2011.  It expects that completion of these projects would have little effect on the transition plan, as both U.S. issuers and entities applying IFRS would be required to follow the effective date and transition provisions specified in each standard resulting from the Memorandum of Understanding.

A Second Exposure Draft for Lease Reporting is expected in the fourth quarter of 2011 that will allow, among other issues, a further evaluation Lessor concerns regarding the true representation of the economics of a lease transaction.   The current Lease project timeline projects a final standard to be issued in the second half of 2012 with an effective date likely to be aligned with the revenue recognition project (e.g. not before January 2015).

Last month, on September 19, 2011, the Joint IASB – FASB Board met to continue to discuss issues relating to the development of the second Exposure Draft addressing leases.  Their technical plan calls for the new exposure draft to be issued in the fourth quarter of 2011.  Plan on returning next month to find out if the new exposure draft has been issued; if it has you will find a summary of the proposals along with our comments and views and an invitation to submit your comments.

October 10, 2011

Aristotle once said, “Wealth does not lie in ownership but in the use of things.”

The issue of how to report leasing transactions is a classic case of substance versus form.  Although legal title does not pass in lease transactions, the benefits from the use of the property do pass.

A classic example is the airline industry.  If an airline borrows $70 Million on a 10 year note from the Bank of America to purchase a 737, they should clearly report an asset and related liability of that amount on their balance sheet.   Similarly, if an airline purchases that same unit from Boeing through an installment purchase over 10 years, it should also report an asset and related liability.

However, if an airline leases that 737 for 10 years through a lease transaction with payments of the same amount as the installment purchase, what is the proper reporting for the Lessee, or for that matter, the Lessor? 

Currently, airlines choose to lease many of their aircraft due to more favorable lease pricing, document terms and conditions, and the accounting treatment they receive if they lease rather than purchase.  While this results in a great deal of so called “phantom fleets” of “off balance sheet aircraft”, analysts currently adjust reported debt levels for the effects of these non-capitalized leases as they have been doing for decades.

Yes, reporting should mirror the economics of the transaction while providing transparency. 

However, there is more. 

The challenge is to encourage standard setters to consider the full range of impacts new reporting requirements will have on access to liquidity, impacts on borrowing costs, and the ability of sophisticated Lessor investors to invest in products that best meet their risk tolerance and investment preference.  Human nature is such that regardless of accounting reporting requirements there will always be certain market participants who attempt to hide their exposure to risk, or otherwise manipulate their financial statements by engineering transactions to obtain desirable accounting results.  Is the drive of international standard setters toward global harmonization of accounting rules necessarily a good thing? Remember standardization may actually inhibit not encourage capital formation as entrepreneurs are faced with new,  more complex and less intuitive reporting requirements.

Conceptual Nature of a Lease 

The current FAS/IASB property rights approach was originally recommended in a research study by the AICPA, Accounting Research Study No. 4  in 1964, and, subsequently in Financial  Reporting in the 1990s and Beyond , A Position Paper by  Peter H. Knutson in 1993 and later in Accounting for Leases: A New Approach, a Special FASB Report in 1996. 

Historical forces of globalization and financial innovation have themselves affected how transactions evolve and are reported.  Standard setters should not stop but must nevertheless factor into their decision making process sufficient opportunity for deliberation, participation, comment, discussion and dialogue.  We will discuss an alternative approach suggested by an SEC Staff Paper “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers[1]” in our next post.

Lease Accounting: August 2011

What Basics May Drive Lease Accounting change

RESIDCO

Leasing is a global business.  Lessors and lessees enter into arrangements with one another without regard to national boundaries.  Although U.S. GAAP and iGAAP for leasing are similar, both the FASB and IASB have decided that the existing accounting does not provide the most useful, transparent, and complete information about leasing transactions that should be provided in financial statements.   

The iGAAP leasing standard is IAS 17, first issued in 1982.  This standard is the subject of only three interpretations.  One reason for this small number of interpretations is that iGAAP does not specifically address a number of leasing transactions that are covered by U.S. GAAP.  Examples include sale-leasebacks, real estate leases, and leveraged leases.

Leasing was on the FASB’s initial agenda in 1973 and SFAS No. 13 was issued in 1976 (before the conceptual framework was developed).  SFAS No. 13 has been the subject of more than 30 interpretations since its issuance.  U.S. GAAP for leases in much more “rule-based” with specific bright-line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; iGAAP is more general in its provisions; both share the same objective of recording leases by lessees and lessors according to their economic substance.

One of the first questions to be asked is “What are the assets and liabilities to be recognized related to a lease contract?”  Should the focus remain on the leased item, or the right to use the leased item?  It is the FASB’s recent conceptual framework’s “definition” of assets and liabilities along with lack of transparency caused by “financial engineering” (i.e. off balance sheet borrowing) that is driving the current exposure drafts requirement for all leases to be shown “broad” on balance sheet for all Lessees.

Think of the objectives of financial reporting in three levels:

1)      The “why” (goals and purposes) of financial reporting,

2)      The conceptual building blocks that explain the qualitative characteristics of accounting information and that define the elements of the financial statements, and

3)      The “how” or implementation of recognition and measurement concepts including (i) assumptions, (ii) principles, and (iii) constraints.

You, as a user of financial statements ultimately decide what is appropriate.  Constraints include cost/benefit analysis and materiality of items under consideration.  Information presented must be understandable and useful in decision making (i.e., relevant and reliable); and be timely, verifiable, comparable and consistent. 

Reporting of business transactions use many terms with specific meanings; these terms surround the theoretical structure, or basic elements, of how transactions should be reported.  One such term is asset.  Is an asset merely something you own?  Or is an asset something you have the right to use, as in the case of leased equipment?  Or is it anything of value used by a company to generate revenues – in which case shouldn’t you consider your employees as assets?  These issues are all worth considering as   the IASB/FASB Lease Accounting Convergence Project continues. 

Lease Accounting: Update July 27^th 2011

Don’t Get Standard Setting Fatigue!

RESIDCO

ELFA’s July 27^th Web Seminar entitled “Lease Accounting Update” provided the following updated review of the status of the IASB/FASB Lease Accounting Convergence Project.   Here’s a summary.

On July 21^st the Boards decided a second Lease Accounting Convergence Exposure Draft (the “ED”) was needed.  This second ED is expected to be issued in the IV Quarter of 2011 and will address the more than 800 industry comments received from the Board’s initial August 2010 ED.  Given the review and deliberation process the Boards go through, a final standard is now not expected to be issued until the second half of next year (2012).  Further, the effective date of the new standard is expected to be tied to the Board’s “revenue recognition” project which could possibly extend the effective date of the new lease accounting standard out to 2015.

Here are the important points from this ELFA update session.

·Prior to issuing the updated Exposure Draft the Board’s redeliberations will consider:

o   Lessor Accounting

o   Mutiple Element Arrangements

o   Accounting for lease incentives, modifications, reassessments

·         The Third Quarter of this year is expected to provide a “final” opportunity to you to make your recommendations known.  Whether you are a Lessor or Lessee, the new reporting standards will have an impact beyond the complexity and cost of simply reporting lease activity.  These changes can impact customer behavior and as a result will likely impact your business model.  It’s time to double down and stay involved in the process.  If you are a Lessor, you still have an opportunity to influence the Board’s decision making. 

·         Lessee accounting is expected to follow an asset liability approach, where a “right to use” asset (for all leases other than short term leases, i.e. less than one year, which will continue to be treated on an operating lease basis) are to be reflected on balance sheet along with a related liability for lease payments.   Lease and “non-lease” components of any lease agreement will be separated and accounted for separately.   This reporting change will “upfront” the book expense pattern for lessees as compared to current flat operating lease rental accounting.

·         Lessor accounting appears to be headed toward a single alternative, the “derecognition” approach, where a Lessor will “derecognize” the leased asset and replace it with a right to receive Lease payments plus a residual.  Importantly, residual “accretion” will be allowed. 

·         Further, last week July 20^th, the FASB reaffirmed that leveraged lease accounting will no longer be appropriate.

A question: should reporting for current leases be grandfathered?  Regardless of the outcome there will be significant impacts beyond the accounting and reporting changes.  It’s time to consider the impacts of the proposed changes to your business model that may result  and  consider your systems, processes, and people.   Take every opportunity to engage the IASB/FASB as this process continues to unfold.   Establish a project management office now, stay current, participate in the process and as Ralph Petta, COO of the ELFA encouraged everyone “Don’t get standard setting fatigue!”

Say No to Investment Tax Credit (“ITC”) for Aerospace & Rail

Recently the Equipment Leasing and Finance Association (ELFA) made a recommendation to National Economic Council Director Lawrence Summers to re-institute the ITC as part of the pending economic stimulus package.

Ten Percent ITC was available when I first became a lessor in January of 1979.  ITC led to severe oversupply portfolio devaluations of the two asset classes i.e. Aerospace and Rail in the early 1980's in which I continue to invest.   Large backlogs and idle equipment make ITC a two fold problem.  We are oversupplied in both categories right now as 2000 commercial aircraft are stored and over 200,000 railcars are idle with both numbers rising daily.  The Boeing backlog of over 3400 aircraft has never been greater and it is nearly eight years out. The backlog for rail car production of over 35,000 cars is several quarters out and is still healthy.  Therefore ITC for Aerospace and Rail will not increase near term production given these backlogs but it would have a destabilizing effect on existing portfolios, if ITC encourages or accelerates deliveries in any way as it always does.  Paucity of debt for both categories impairs capital formation far more than any lack of equity investors. ITC will do nothing to stimulate debt for leveraged leasing.  Many of today's financial industry based equity investors are swimming in tax operating loss carry forwards or are tax neutral.   So ITC will put them at a competitive disadvantage for new business and ITC will weaken the value of their existing portfolios in these categories.

Vincent Kolber

January 23, 2009

Stimulus with Entitlement Action Possible

Simultaneous stimulus/entitlement action

CNN's two hour very informative "IOUSA" documentary this weekend concluded on the comments of former Senator Bill Bradley and Brookings Institute's  Alice Rivlin in agreement on a key approach to our economic crisis.  Namely that stimulus should only be implemented with entitlement reform on a simultaneous basis.  The CNN program highlighted the enormity of the unfunded entitlement liabilities of Social Security and Medicare which total over $60 trillion according to Obama's advisor Austin Goolsbee.    Add the direct borrowings of the federal government now more  than $10 trillion which are accelerating and the nation is facing a greater than $70 trillion liability juggernaut.  This liability juggernaut (the "LJ") amounts to more than $550,000 per taxpayer.  The big surprise last week was that Obama put Social Security and Medicare entitlements as reform candidates firmly on the table during his ABC Sunday morning interview and during his remarks to appoint Nancy Killefer as performance chief.  A simultaneous stimulus/entitlement action would enable the stimulus to be offset by a reduction of the LJ and thereby enable another of the widely touted axioms of PayGo to actually occur.  Rather simple fixes to the entitlement programs such as delaying the starting age for benefits will wipe trillions off the LJ and give the stimulus the opportunity of meeting PayGo.   

Please do all you can to demand "Stimulus with Entitlement Reform Only" and maybe for once and in the context of the prevailing crises with our newly elected charismatic leadership, federal government could do the right thing. 

Vincent Kolber

Chicago , Illinois

January 12, 2009

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