Our August column ("Debunking lease propaganda by CPAs in Congress, and others, too," page 22) dismantled an early barrage of the kind of self-serving arguments the Financial Accounting Standards Board will hear once it issues its exposure draft on lease accounting. This month, we explain how the board can produce a successful lease standard through a straightforward analysis different from the status quo.

 

A DEATH SPIRAL

Lease accounting's long, ugly history reveals a "death spiral" where managers fabricate false but pretty pictures with off-balance-sheet financing. When standard-setters try to rein them in with new rules, managers find loopholes and proceed to engineer more complex leases to go off-balance-sheet again, followed by more tweaked standards and more complicated leases. This process has gone on for decades, like the "lather, rinse, repeat" instructions on shampoo bottles. The only way FASB can break this spiral is to adopt a completely new approach.

The key is to jettison the old paradigm that there are two kinds of leases: operating (allowing temporary use as a convenience) and capital (acquiring property through debt financing). Although this simplistic dichotomy is appealing, experience proves it doesn't work. Instead, practice has created two different categories: leases that produce OBSF and those that don't.

Alas, the alluring chance to hide debt tempts far too many managers to enter into uneconomic leases, even though their behavior amounts to lying in the financial statements. Ultimately, SFAS 13's criteria for distinguishing operating and capital leases not only failed to get more leases on balance sheets but, what's even worse, actually promoted OBSF by providing guidelines on how to achieve it.

The resulting incomplete statements hide the truth about contrived (and uneconomic) leases and poorly serve users' needs, while besmirching financial reporting in general. It's clear that FASB (and the International Accounting Standards Board) will not forge a solution by reworking the criteria.

 

A NEW PARADIGM

We support a new paradigm that reflects the undeniable fact that all leases create assets for lessees, while obligating them to transfer cash now or in the future. From the lessors' side, leases create receivables for any future cash receipts arising from selling some or all their rights to use the leased property. (We'll explain more in a moment.)

A standard based on these truths would treat all leases the same and make all financial statements more straightforward, uniform and useful.

FASB heard this different drum but stumbled, in large part because it was shackled to the IASB through the convergence effort. Although they said that all leases create assets and liabilities, they proposed politically expedient exceptions for short-term leases and for recognizing lessors' income in a straight-line pattern.

We suspect that many, if not most, board members aren't committed to a new solution for fear of upheaval. If so, we admonish them to not let mindless opposition bludgeon them into crafting loopholes that could last another 40 years.

 

UNDERSTANDING LEASES ANEW

The new paradigm acknowledges that the owner of tangible property has two different and separable rights. Specifically, it holds the right to use the property, and the residual right to dispose of it. In effect, a lessor sells all or some of the first right to a lessee who takes custody of the property for the lease period. While the lessee can use the property, only the lessor can sell it or pledge it as collateral.

Thus, the lessee obtains an intangible asset in the right to use the property, whether the lease term lasts for little or all of its useful life. This asset (not the tangible property) belongs on the lessee's balance sheet, along with debt for any future payments.

On the other hand, the lessor retains a different asset in the residual right to dispose of the property, as well as any remaining untransferred rights to use it. Although entering a lease alters the remaining aggregate value of these rights, that amount doesn't necessarily go down. In fact, the value can be enhanced, as when a new shopping mall's owner lands a strong anchor tenant that will attract other lessees at higher rents.

Of course, the lessor's receivable ought to equal the lessee's liability.

 

WHAT ABOUT INCOME?

This new paradigm also leads to radically different income presentations.

The lessee would put two expenses on its income statement, instead of a traditional rent expense. The first is an operating charge for consuming the intangible right's usefulness, which can and should be measured directly as the change in its value. The second is interest expense from the liability.

Apart from recognizing interest income from the receivable, the lessor's accounting should be reformed. The lease's initiation is actually a sale transaction because the lessor transfers a right to use the property to the lessee in exchange for present and future payments. This revenue would be offset by a cost, but only if the market value of the retained rights in the property were to decline. As we mentioned, lessors can experience gains if the residual rights' value increases as a result of the sale. Even if reporting upfront income causes chilblains for conventional thinkers, it is a real underlying economic fact.

This analysis completely exposes the total inadequacy of the boards' proposal to recognize lease income in a straight-line pattern characteristic of operating lease accounting.

 

WHAT IS THE LEASE TERM?

Although the new paradigm is useful, it doesn't eliminate all implementation problems, including the bugaboo question of how long a lease lasts. For example, is there any real difference between, say, a five-year lease, a series of five one-year leases, a one-year lease with four options to renew for one more year, or a one-year lease that management intends to renew four times?

Ah, this is where FASB (and the IASB) started to fall back into the death spiral when this topic came up several years ago. The boards hopefully proposed that the lessee's recorded liability would reflect renewal options that are "more likely than not" to be exercised. Because OBSF proves that many managers are comfortable lying, they could reduce their reported debt by winking and saying they're happy to be in the leased space but don't want any renewal options. They could even sign new one-day leases every day.

Instead, we recommend that the lessee's recognized liability's amount be based on all facts and circumstances surrounding the transaction, not merely the lease's nominal terms. Accountants and auditors would have to consider all the puzzle pieces, including relevant past practices and current strategies, to see how the leased property fits into the two parties' long-term plans.

 

MATERIAL LEASES?

At one point, the standard-setting boards also indicated that leases lasting less than a year would be automatically considered immaterial and not reported on balance sheets. While we understand their desire to simplify, this answer is deficient because it looks at each lease separately.

The problem is that the entire portfolio of leases could be quite material, even though each individual lease might be judged immaterial on its own. We suggest that any materiality test be applied to all leases taken together, thus causing the whole portfolio to appear on the balance sheet, even if none of them lasted as long as 12 months. Otherwise, managers who want to produce misleading financial statements could make sure all their leases qualified as short term in order to avoid recognizing any debt at all.

 

NO CAPITALIZATION, NO ALLOCATION

We think the process of recognizing lease assets and liabilities should not be called "capitalization," because that term implies using the cost to record the acquired intangible asset. This practice doesn't hold water, because that cost is the result of only one transaction out of a population of many similar ones and cannot reliably represent the intangible asset's fair market value.

For the sake of both truth and simplicity, the lessee's liability should be recorded at fair value, based on other debts with similar risk factors. However, recognizing the asset at the liability's estimated value won't necessarily describe its own value. It's also true that useful information will not be produced by systematically amortizing the asset's cost over the lease term and allocating interest expense with the original market discount rate. Those measures are unreliable, because they're based on unverifiable predictions and assumptions, instead of empirical observations.

Instead, the lessee should establish the intangible asset's initial value independently of the liability measure and then mark it to market through its life. Before anyone cries "Nonsense," this information should be available whenever managers make a rational lease-or-buy decision by comparing the fair values of the intangible asset and the lease liability. Of course, auditors would have no issues applying this technique if they thought the asset's value needed to be written down!

 

THE BEST ANSWER

In addition to a better standard, solving the lease puzzle requires tough discipline by regulators and auditors aimed at stopping those who play the lease-and-lie game.

Straightforward truth-telling would make everyone undisputed winners because the markets would have more certainty about financial statements and more trust for those who prepare them. They would thus be more efficient because they would no longer be compelled to penetrate the leasing ruse or impose immense discount penalties because of uncertainty.

We would much rather see FASB apply this new approach (with or without the IASB), instead of making another insane and vain attempt to tighten up loopholes, accomplishing nothing more than triggering the next round in the death spiral.

 

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 authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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