The Financial Accounting Standards Board and the International Accounting Standards Board are working together on resolving the knotty problems involved in lease accounting.

The U.S. and international standards-setters have published a joint discussion paper laying out their preliminary views, and opening the floor to public comments and consultation.

The discussion paper, “Leases: Preliminary Views,” comes in response to concerns from investors and other financial statement users on the differing treatment of lease contracts under International Financial Reporting Standards and U.S. generally accepted accounting principles. The two standards-setters have been working on converging the standards for lease accounting for several years, and those concerns have been exacerbated by the global economic crisis.

“While much of public attention rightly focuses on accounting issues relating to the financial crisis, this is a project of great importance and deserves public interest,” said IASB Chairman Sir David Tweedie (pictured) in a statement. “Leasing is a significant source of financing for many companies. It is therefore important that interested parties should take the time to familiarize themselves with our proposals and give their views through the comment letter process.”

According to the World Leasing Yearbook 2009, total annual leasing volume in 2007 amounted to $760 billion, yet many of those lease contracts do not appear in an entity’s statement of financial position or balance sheet. This is because IFRS and U.S. GAAP split leases into two categories—finance leases (or capital leases under U.S. GAAP) and operating leases—and only the assets and liabilities arising from finance leases are recognized in the statement of financial position. For an operating lease the lessee simply recognizes lease payments as an expense over the lease term.

The different accounting treatment of finance and operating leases has given rise to various problems. For example, many users of financial statements believe that all lease contracts give rise to assets and liabilities that should be recognized in the financial statements of lessees. Therefore these users routinely adjust the recognized amounts in the statement of financial position in an attempt to assess the effect of the assets and liabilities resulting from operating lease contracts.

In addition, the split between finance leases and operating leases can result in similar transactions being accounted for very differently, reducing comparability for users of financial statements. The difference in the accounting treatment of finance leases and operating leases also provides opportunities to structure transactions so as to achieve a particular lease classification.

In the discussion paper, the IASB and FASB discuss a possible new approach to lease accounting. The boards propose that lease accounting should be based on the principle that all leases give rise to liabilities for future rental payments and assets (the right to use the leased asset) that should be recognized in an entity’s statement of financial position. This approach is aimed at ensuring that leases are accounted for consistently across sectors and industries.

“The proposals contained in this discussion paper are intended to improve the transparency, credibility and usefulness of lease accounting,” said FASB Chairman Robert Herz. “We encourage our constituents to review the discussion paper, and to let us know whether or not they agree that these proposals would better reflect the rights and obligations arising from leasing contracts on the balance sheets of lessees.” The discussion paper is open for comment until July 17, 2009.

The boards have not yet discussed the method of transition or the effective date. Those issues will be discussed after comments are received on the discussion paper, and included in the provisions of a subsequent exposure draft of the proposed standard. The boards decided last July to defer consideration of lessor accounting in order to resolve the problems associated with lessee accounting as quickly as possible. Consequently, the discussion paper deals mainly with lessee accounting. However, it also describes some of the issues that will need to be addressed in a future proposed standard.

Reaction to the discussion paper got off to a rocky start on Thursday when the Equipment Leasing and Finance Association released a statement expressing several concerns. “ELFA appreciates the boards’ openness and responsiveness in seeking input in developing the new lease accounting model and we believe transparency and decision-usefulness in financial reporting is vitally important to companies that participate in our capital markets,” said ELFA president Kenneth E. Bentsen Jr.

“However, we are concerned that the concepts embodied in the discussion paper may add more complexity, subjectivity and uncertainty, particularly as it relates to small and medium-sized enterprises that are generally not publicly held," he added. "If the proposed changes do not reflect an appropriate balancing of costs and benefits, they could result in an unwarranted increase in cost of capital to U.S. companies that utilize leasing as a means of capital formation through the acquisition and investment in capital plant and equipment or real estate. Further, we are disappointed that the boards decided to split the project and not take up lessor accounting commensurate with lessee accounting.”

Bentsen noted, however, that the ELFA remains committed to working with the boards throughout the process “in order to achieve the most efficient standard for all parties.”

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