Our most recent column ("To the SEC: Forget the timetable and stop the runaway train," March 15-April 18) reported that the Financial Accounting Standards Board and the International Accounting Standards Board are racing to complete a long list of major projects. We warned that this dash will produce less than the best standards, and promised to describe some specifics, leases in particular.

The lease project has generated some tentative conclusions about lessor revenue recognition issues that concern us. We urge the boards to not make them final because they're compromised, anachronistic, misleading and otherwise certain to produce unfaithful representations that won't serve managers, users, capital markets or society. We also believe that a standard based on these decisions would cause lessors to make dysfunctional decisions.

We find the boards threw the heart and soul of the Conceptual Framework overboard while resurrecting matching and smoothing practices that FASB declared dead back in 1980. Recent proposed revisions to the framework continue to declare matching to be unsuitable, so it looks like something political is going on, perhaps because of the sprint to the finish and some board members' lingering embrace of matching.


Although FASB carefully explains how the framework guides every project's due process, none comply with the guidance perfectly. In the case of lessor accounting, the shortfall is painfully obvious.

In particular, FASB's framework (and the new one under construction jointly with the IASB) incorporates the asset/liability theory that is far different from the resuscitated matching convention. Under matching, income is reported when it's anticipated or desired, instead of when it occurs. For example, unrealized gains on appreciated assets cannot be reported until they're sold, but impairment losses must be reported immediately. Depreciation expense is based on assumptions, not observations, spreading the cost over a predicted service life in a predetermined pattern, even though the real value cannot possibly behave that way.

The framework was supposed to have ended accounting based on imagination by asserting that income is adequately evidenced only by observed changes in assets and liabilities. That is, because income always changes assets and liabilities, it can be reported usefully only if and when they do change and in the amount of the change. Thus, assets' value changes should be reported as soon as they occur, not merely when a sale occurs and surely not only when they are losses.

Concerning depreciation, it should be based on factual observations of real value changes. In fact, assets might actually appreciate, an idea that is completely ignored in traditional matching-based accounting. even though it is the foundation for all market-based economies.

Simply put, the two evils of the proposed lessor accounting are that financial statements will not reliably report the consequences of lease transactions, and that the accounting will discourage good leasing practices.


The boards propose that a lessor record a lease's inception by debiting a receivable for the rents and crediting a liability for its "performance obligation" to allow the lessee to use the property. The balance for the property is unchanged. Collections reduce the receivable and produce interest income, while the performance obligation is amortized ratably into revenue.

* Mistake No. 1. The treatment doesn't acknowledge that the property consists of two imbedded assets: the right to use the property and the residual right to control its future deployment. Creating the lease essentially monetizes the former, with the consequence that something surely happens to the property's real value. Because the value changes, useful financial statements would report an adjusted amount for the property. By ignoring this reality, lease descriptions will be incomplete and the statements will surely provide misleading information.

* Mistake No. 2. Because the lessor irrevocably transfers the right to use the property to the lessee in exchange for consideration, the lease is clearly a sale of that right. Accordingly, it's more useful to debit the receivable and credit sales revenue. The revenue would be offset on the income statement by any sacrifice related to giving up the right, which would be measured as the change in the property's market value.

Actually, we envision situations where the lessor has no cost because the lease actually increases the property's value. Suppose, for example, that the owner of an empty office building leases significant space to a prestigious lessee. Having this anchor tenant will enhance the property's value because more income could be achieved from leasing out the remaining space or from selling the residual to someone else.

Alas, the boards' proposal doesn't acknowledge this obvious fact, but perpetuates the old blind-to-reality matching notion that insists that no revenue, expense or income can possibly arise from entering into leases.

* Mistake No. 3. In order to avoid front-loading revenue, the boards would defer all of it on the balance sheet, but only by pretending it's a liability. Their dubious rationalization is that the lessor is obligated to let the lessee use the property.

We suggest that if this fairy tale were true, then grocers would remain obligated to their customers until they had eaten their groceries, and auto dealers would be obligated until buyers had driven their cars. Of course, that's not sensible, and nor is the performance obligation notion.

To be clear, a lease is a clean transfer by the lessor to the lessee of a valuable asset in the form of that right to use the property, not the property itself. Once the lessee takes possession, the lessor has no obligation to do anything because it no longer has the ability to do anything. Indeed, all it can do is stand by and collect payments for giving up the right. Thus, its only ongoing income stream is interest on the receivable. In addition, the lessor will experience gains and losses as the property's residual right changes in value.

In contrast, the proposed model smoothes reported income by amortizing the illusory "performance obligation." This accounting for imaginary things and events looks to us as if it is designed to produce a predetermined nonvolatile result without regard to real economics. We don't think the board members can defend it as providing useful information.

* Mistake No. 4. As we mentioned, it isn't hard to imagine that a lease could actually enhance the property's value. After all, can't an owner sell a leased building at a higher price than one that is vacant? Yet the boards' answer is intended to avoid reporting any change. This isn't just incomplete accounting, it's intentionally misleading. Indeed, the definition of fraud says that it occurs when someone knowingly reports false information as if it is true.

* Mistake No. 5. Our final point is that this treatment radically misrepresents the lessor's risk situation. For example, suppose a lessor owns a vacant new building worth $10 million that it financed with $8 million of debt, producing a debt-equity ratio of 4-to-1 for the project. Now, suppose it leases out some space for lease payments worth $4 million. Under the boards' proposal, the lessor would report assets of $14 million and debt of $12 million, thereby increasing (!) the debt-equity ratio to 6-to-1 and making the project look more risky. However, the lease actually reduced the lessor's risk by creating contractual future cash inflows and increasing its ability to repay the mortgage.

Herein lies the second evil for the lessor: This balance-sheet depiction will cause the enterprise to appear more encumbered and more risky when just the opposite is true.

If implemented, the performance obligation approach will discourage lessors from signing long-term leases because they're going to look worse off. Such image consequences are always hard to assess, but we're convinced this accounting will stimulate game-playing with bogus short-term leases to avoid reporting the performance obligation. This disruptive impact on sound decisions is unwise and unnecessary.


The asset/liability theory in the Conceptual Framework suggests the best answer: Report what is observed, which includes sales revenue, a receivable, and a change in the property's value, but no new liability. This simplicity would put truth in the statements.

Opponents of this strategy should not bother to object by asking, "How are you going to measure the value?" After all, the lessor and lessee make reliable estimates of asset values and costs before entering into leases. If they act on those numbers, then they can be audited or otherwise safely used in the statements.


We provide this analysis for two reasons. The first is to encourage the boards to abandon their tentative conclusions. The second is to illustrate the bigger point that a hasty convergence process will lead to bad standards.

We're afraid one main impetus for this bad accounting is the mad rush to find a palatable answer, any palatable answer, even if it's not a good answer. More than 20 board members are collectively at work on both sides of the Atlantic, and we think many cling to matching in that they abhor front-loaded revenue (even when it happens), they want original cost on balance sheets (even though it doesn't describe cash flow potential), and they have no problem deferring revenue and trickling it onto the income statement (even though there is no liability and no earnings process).

Furthermore, this debate is taking place while trying to meet a years-old artificial deadline while juggling a multitude of major projects. We think logrolling is surely happening, as board members position themselves to win on other projects, even if they have to give up on leases. These immense political pressures are anathematic to good standards.


Accounting standards should not be established by picking the lesser of evils. The only consequences are higher capital costs, inefficient markets, and under-compensated accountants who are compelled to prepare and audit useless financial statements. What an incredible waste of time, talent and money. It would be far better if the Securities and Exchange Commission were to encourage FASB and the IASB to do things slow and right, instead of fast and wrong.

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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