By John Hintze
The US Chamber of Commerce says FASB’s proposed leasing standard may result in substantial costs to businesses, lack any benefits for investors and drive economic activity rather than reflect it.
Imagine an accounting proposal that causes companies to breach loan covenants and contracts. As a result, it adversely impact banks’ capital, businesses’ ability to borrow, lease costs, capital formation, and equipment valuations, and even cost a bundle in terms of compliance and revamping accounting systems.
Those are less than half the concerns the US Chamber of Commerce lists in its June 26 comment letter on the Financial Accounting Standards Board’s (FASB) proposed standard to update accounting for leases.
“In its current state, it is our opinion that the proposed leasing standard may result in substantial costs to businesses, lack any benefits for investors and drive economic activity rather than reflect it,” the Chamber sums up.
Some Solace
The current version of the proposal, for which comments are due September 13, offers significant refinements from the original version issued in 2010, especially by exempting real estate leases—a major sticking point back then. The project to update lease accounting has been driven by FASB’s concern that the current rules-based approach has enabled many operating leases to be taken off-balance-sheet, disguising companies’ liabilities. The latest version puts all leases more than a year in length on the balance sheet, a comfort to at least some financial statement users.
Robert Moulton-Ely, an investor supporting FASB’s proposal, commented in May that pharmaceutical chain Walgreen’s reported debt at a mere 7.6 percent of equity for its 2008 fiscal year. However, he added, its operating lease commitments of more than $33 billion would have brought pro forma debt to 166 percent of equity, and other credit ratios would have been similarly impacted.
Public companies must already report lease obligations in the footnotes of their financial statements. Including them on the balance sheet may more directly display the level of a company’s debt obligations for many investors. Companies filing financial statements, however, would have to report higher expenses at the start of the lease, similar to a debt obligation, a requirement that could significantly impact the economy.
“In essence they’re very much front-loading the expenses, because when you own something and account for financing it, there’s more interest in the beginning. FASB is saying everything should look like debt,” said David Mirsky, co-founder and CEO of Pacific Rim Capital, a major lessor of forklifts. “I’ve already had one customer say that it’s not leasing anymore, because if they have to book the equipment leases they might as well buy the forklifts,
although they don’t have the money to buy.”
John Althoff, a partner at PriceWaterhouseCoopers, said the proposal—as currently written—could impact treasurers from several perspectives. Large companies often have thousands of operating leases, and depending on the circumstances many of those would have to be treated as financings. Companies that don’t want additional debt on their balance sheets may now reconsider their lease-versus-buy decisions and may simply opt for buying over leasing.
As a result, the proposal would impact the appearance of companies’ financial statements, and it could impact critical financial ratios, loan covenants and other financial measures, Mr. Althoff said. A less obvious result, he added, may stem from leases that combine contracts; for example, an operating lease with a contract to service the equipment wrapped into it.
“Now, if the lease is on balance sheet, the company must split those components apart and account for the service contract separately from the lease,” Mr. Althoff said.
The Chamber notes in its comment that recognizing lease expenses upfront “could have an adverse impact on the ability of businesses to borrow, the cost of leases, and capital formation.” Leasing is estimated to comprise upwards of one third of companies’ capital expenditures, and the vast majority of Fortune 500 companies lease equipment despite their typically strong cash positions. The accounting change may not adversely impact their sourcing of equipment.
However, for companies carefully monitoring their capital expenditures in a slow-growth economy, the accelerated upfront expenses they would have to report could make the difference between sourcing more equipment or not.
Lessors will need to change
Mr. Mirsky said that as a lessor the proposal would require Pacific Rim Capital to make some accounting changes, although as a private company the impact will be relatively minor.
Toyota/Lexus Financial Services would primarily be impacted as a lessor by the change, and then only in a minor way because a relatively small portion of its business involves leasing to other commercial entities, according to Grace Mullings, director of accounting policy and governance at Toyota/Lexus Financial Services. Nevertheless, the company will have to make a one-time adjustment to its books, to account for the accelerated revenue recognition.
“I have to take everything that’s on my books now and switch to the new method, so that’s a big one-time change,” she said. “As we go forward, we’ll be recognizing revenue at an accelerated level in the beginning, and assuming the portfolio remains the same size it won’t have a big impact on the volatility of our revenues. If the portfolio were to grow, we’d see the trajectory of revenue growth at a higher rate than under the old rules.”
The greater material impact would be on the lessee, such as Toyota’s fleet customers or customers of its forklift unit, since leasing would require the lease obligation to be recorded. “If a company is not going to own the equipment, then a lease is just another way for it to find capital to source equipment,” Mr. Mirsky said, adding the current proposal would likely result in less demand for equipment. “You’re going to see less equipment purchased, and that’s going to cause a ripple effect through the economy.”
Mr. Mirsky said his comment letter will instead suggest identifying an amount of money, whether the present value of the lease streams, the sum of the payments, or even the cost of the equipment, and put that on the balance sheet as the asset. The liabilities then become the payments the company owes. “You would reduce the asset and the liability, and it would straight-line the expenses to match what’s actually happening in an operating lease,” he said.
a new asset class
The FASB’s approach, instead, creates a new “right to use” asset by arguing that leasing a piece of equipment to a company gives the lessee a right to use it, making it an asset. The accelerated recognition of lease expenses stems from this new asset, because companies would depreciate it from the onset and account for that depreciation as well as the “interest” component of lease payments. The new accounting proposal creates both the interest and the depreciation components of the lease.
Sherif Sakr, a partner in Deloitte’s financial accounting, valuation and securitization practice, noted that generally accepted accounting principles (GAAP) in the US have been very rules based, prompting concerns that companies have excessively designed lease contracts to fit the rules and achieve off-balance-sheet treatment.
“The proposal is trying to make a more principles-based approach, so you have the right to use any assets you lease, and that right is a kind of asset that should be recognized on the balance sheet. And you would also have an obligation to make lease payments, and that obligation should also be shown on the balance sheet as liability,” Mr. Sakr said.
While that may seem a balanced approach, it strays from the traditional concept of a lease, in which equal payments are made over the term of the lease. The Chamber notes that accounting standards are intended to present financial information so financial statement users can make informed decisions about how best to deploy their capital, and FASB’s proposal will “drive economic activity rather than reflect it.”
In addition, the proposal appears likely to create a new level of complexity.
“The proposed treatment will require financial statement users to assimilate ‘right to use assets’ and ‘future lease payment liabilities’ with discounting and interest components,” writes Peter Kennedy, audit director at regional
accounting firm Cover Rossiter. “From a purely theoretical standpoint, the treatment may make sense to academically-oriented CPAs, but it will need a lengthy translation to most others.”
operational change?
The proposal could also be complicated from an operational standpoint. Ms. Mullings said Toyota has a team of people working on the company’s comment letter, and analyzing its impact on the company’s systems, what it will need to report, and what that changes from an internal operations standpoint.
“From an internal operations standpoint, you’re going from a straight-line methodology to an effective-yield methodology, and the systems you’re using will need to change to accommodate the new way of doing things,” Ms. Mullings said.
She added that as new accounting standards seemingly approach finalization, Toyota typically runs its internal data through the proposed rules, to better understand the changes it will have to make. That approach has been especially pragmatic when it comes to FASB’s leasing proposal.
“People have been talking about this issue since 2008 and there have been a couple of white papers, two exposure drafts…if we had pulled the switch during the first exposure draft, we would have been going down the wrong path,” Ms. Mullings said.