This column was almost ready to submit when the Financial Accounting Standards Board and the International Accounting Standards Board announced that they changed some tentative decisions concerning lease accounting. Before the announcement, we identified six unproductive positions. That list has now been reduced to four-and-a-half, leaving most of our criticisms unchanged, but at least now we have a glimmer of hope that they will produce a better standard.
The truth is sinking in that accounting students, professionals, educators and standard-setters should study our history to avoid Santayana's warning that, "Those who cannot remember the past are condemned to repeat it."
The impetus for this complaint is movement by FASB and the IASB to converge on a lease standard that is not so new after all. We get an image of a landlubber with one foot on a rowboat's gunnels and another on the dock; as the boat starts to slip, indecision forces the poor soul into a split that soon leads to an embarrassing splash.
The boards announced that at long last they are moving to capitalize every lease, which sounds great because it reflects the bold idea that financial statements are useful if, and only if, they reveal the truth, the whole truth and nothing but. Because lessees acquire valuable rights to use the lessor's property along with obligations for future cash payments, truth demands that they report assets and liabilities.
On the other side, the lessor's property consists of two component assets: first, separable rights to use it in the future, and second, the residual right to use, lease, pledge or dispose of it. Initiating a lease sells all or some of the separable rights with upfront revenue and cost, creates a receivable, and alters (up or down) the residual right's fair value.
Unfortunately, the boards put one foot on this asset/liability platform but left the other firmly planted in existing practice. This failure to commit fully to the new model will lead to a figurative splash when this compromised position spawns more finagled leases designed to under-inform the markets through off-balance-sheet financing.
TWO KINDS OF LEASES?
Both SFAS 13 (from 1975) and IAS 17 (from 1982) begin from the premise that leases are either operating or financing. The former are conveniences to temporarily use someone else's property, while the latter accomplish asset acquisition with debt financing.
In fact, these coprolitic standards created a different pair of lease types:
Those with legitimate purposes; and,
Those designed to produce misleading financial statements.
This latter dysfunctional pursuit of false but cosmetically favorable images produced myriads of convoluted lease features to ensure lessees' balance sheets show no lease-related liabilities or assets.
In vain, we hoped the boards would heed multiple demands over several decades to eliminate bogus leases by forcing managers to report all leases as debt-financed asset purchases. If the non-existent "advantages" of sanctioned lying could be eliminated, then leasing would be used only when it makes economic sense.
Apparently, old habits die hard, because the boards were buying into the idea that lessees still lease for two distinct reasons: for financing and for "other purposes."
For a financing lease, an asset and a liability go on the lessee's balance sheet. The asset is depreciated according to a 180-year-old convention; the liability is systematically amortized with the interest method that has been around for more than 40 years. Although a liability is recognized, the subsequent accounting is anachronistically based on matching, despite the boards' claim in their Conceptual Framework that this rationale is dead. That loud sucking sound you hear is true reform going down the drain.
Up until the most recent change in thinking, the boards had decided to have the lessee in a non-financing lease recognize an asset and a liability, but with some very squirrelly subsequent accounting. The independent depreciation and interest allocations were to be replaced by a Rube Goldberg earnings manipulation that would rig the combined annual allocations of depreciation and interest to add up to the same total each period. This poppycock would report the same smoothed annual expense now reported for operating leases, while leaving meaningless dangling debits and credits on balance sheets.
Hooray for the truth, for the boards' latest tentative decision is to jointly jettison this nonsense. A glimmer of hope, perhaps?
SHORT-TERM LEASES - BAH!
Subsequent to issuing the August 2010 exposure draft, the boards conjured another counterproductive compromise such that lessees don't have to capitalize so-called short-term leases that last 12 months or less.
Ta-dah! This misbegotten decision resuscitates original operating lease accounting with level rent expense and nothing on balance sheets. This ghastly move seems intended to assuage complaints about preparation costs. After all, a junior accountant might need as much as three minutes with an Excel template to figure out what amounts to capitalize. Even our intermediate accounting students rolled their eyes when we described this proposal to them.
Can't the board members see that a 12-month lease can be incredibly material? This loophole allows auditors to not take exception when, for example, a retailer like Abercrombie and Fitch that leases all its store space amasses a portfolio of 12-month leases, none of which would show up on its balance sheet, despite creating billions of dollars of debt in the aggregate.
If the boards want to provide relief for immaterial situations, they don't have to create this gaping loophole. Instead, they should just state that immaterial lease portfolios don't need to be capitalized.
INITIAL DIRECT COSTS
As more proof that rumors of matching's death are greatly exaggerated, the boards propose capitalizing and amortizing all initial direct costs.
We call this practice "defer and spread, like jam on bread," and we know it produces utter nonsense. No economic value underlies those account balances, because the costs lack characteristics of assets except for being debits. IDCs are one-time expenses and that's all there is to it.
Another GAAP deficiency is treating sale-leaseback transactions as legitimate, even though something like 999 out of 1,000 are flimsily disguised borrowing. Seller-lessees can structure the lease as operating, thus going deep in debt with nothing on the balance sheet. Even worse, they may dribble a gain from the "sale" into later years' income. This nonsense is obviously fabricated to produce misleading financial statements.
The boards have proposed some changes, notably capitalizing the lease but, of course, only if it lasts beyond 12 months.
It would be much better to report all sale-leasebacks as collateralized debt financing. No gain or loss and the property remains on the seller/lessee's balance sheet, while the buyer/lessor shows only a loan receivable collateralized by an option to take control of the property. This approach would not only tell the truth, but also stop management shenanigans.
We've previously criticized the boards' ludicrous plan to capitalize the lease payments plus renewal options that are "more likely than not" to be exercised. It's clear the IASB inserted this provision to create acres of wiggle room. Who will assess the likelihood? Management. And what evidence will be persuasive? Mostly their wishes to minimize reported assets and liabilities!
We say make it simple: Capitalize all option payments in the contract. Why would the lessee pay to create options that aren't likely to be exercised? If management wants to reduce reported debt, then it should create concrete agreements, instead of burdening leases with lame arrangements.
Alas, the boards have fallen into a matching black hole by twisting the liability definition to include a lessor's "performance obligation" to allow a lessee to use the leased property. Because the members seem to think a contract isn't sufficient to prove the lessor relinquished a separable right to the lessee, it puts a liability on its balance sheet to represent an unfulfilled obligation that is smoothly amortized straight-line into lease revenue.
It's clear FASB and the IASB suffer from the oft-observed but hitherto unnamed psychological syndrome that we call "frontendophobia." This affliction is imbedded in many accountants' DNA and drives them to avoid recognizing income when transactions occur, even when real value has changed hands.
Instead, their ailment forces them to postpone revenue until later, preferably in equal annual amounts. In recognizing deferred revenues, frontendophobia victims demonstrate co-dependence with managers who suffer from volatilaphobia.
However, the boards announced in May that this approach to the lessor's accounting is being reconsidered. We strongly encourage them to treat the lease as an asset sale and reduce the property's book value. Although the property ought to be marked to market, it isn't likely the boards will force that much truth into the statements.
AS IF MORE PROOF IS NEEDED ...
Looking now beyond leases, traditional petty politics simply have no place in real reform efforts to produce truly high-quality financial reporting standards.
Supporters have so frequently and falsely preached quality as the goal of international convergence that it has lost all meaning. If the boards and their constituents seriously want to produce useful reporting standards, they would not countenance this bad accounting for leases.
Most important, the lease project undeniably proves that, as we explained last month, the convergence movement has been, is and will be a smokescreen designed to put positive spin on clinging to the seriously flawed status quo.
Unless the glimmers of hope blossom into the real thing, this golden opportunity to create useful financial statements for lessors and lessees will be lost for another generation or two. And that would be unfortunate beyond measure.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authorsâ€™ views are not necessarily those of their institutions. Reach them at email@example.com.
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