Q: We’re thinking about entering into some lease transactions, but we’re worried that the accounting rules are going to change, and the assets will appear our balance sheet. Are there any upcoming changes to leasing accounting?
White Plains, N.Y.
A: Leasing accounting will likely remain unchanged for at least four or five years, after which it may come up for examination by international accounting standards regulators.
About a year ago, financial executives and leasing industry executives were closely watching the steady flow of information coming the G4+1, a group of mostly accounting academics and Big 5 representatives representing major accounting rulemaking bodies around the world, which had as its mission a desire to bring forth a radical change in the way leases are accounted for. This movement was the result to a great extent of a paper known in the leasing industry as the McGregor Report, written by Warren McGregor, a well-known accounting standard setter from Europe.
The Financial Accounting Standards Board issued the first newly crafted attempt to provide standards for lease accounting, known as Statement of Financial Accounting Standard 13, “Accounting for Leases,” around 1979. Since then the relevant lease-accounting authoritative literature has morphed into a broad series of announcements, amendments, and papers dealing with many unique structural issues which the leasing industry has created in compliance with the specific nature of those rules established in 1979. The rules, by the way, are meant to define a point when the risks and rewards of ownership transfer from a lessor to a lessee, a seemingly basic concept.
FAS 13 has four basic rules for treating a lease as an operating lease for the lessee’s book accounting purposes.
The rules are summarized in Paragraph 7 of FAS 13 and are generally that:
- The lease does not transfer title at the end of the lease.
- The lease is for less than 75% of the economic life of the assets.
- The lease doesn’t contain a bargain purchase option.
- The present value of the minimum lease payments is less than 90% of the fair value of the asset. (This is known as the ‘90%’ test by most industry insiders.)
These tests are generally known as ‘bright line’ tests, meaning that one either passes or fails the test, and the accounting is driven off that result.
These guidelines of course have a degree of judgement in interpretation, however for the most part, they are relatively straight forward.
As a result of examining transactions structured with these rules in mind, some accountants concluded that assets were being left off balance sheets because they came to just under the 90% test.
Warren McGregor proposed that all leases be capitalized to some extent, by defining the asset for the lessee as being the value of the contractual payments, regardless of the ‘90%’ test. Under McGregor, an asset equal to 89.9% (the PV) WOULD be recorded.
For instance, if the present value of the payment obligation were to equal 89.9%, under FAS 13 the asset would not be recorded on the lessee’s balance sheet.
Sounds simple in theory, but picture this, what if the contractual payments were for only 25% with a contingent obligation for the balance of the value of the asset? Would this type of structure then result in less of an asset being recorded? It seemed like the simple proposal to put more assets on the balance sheet might actually result in less assets on the balance sheet.
In practice, the reality of that simple approach has become much more complicated than had been anticipated. Just as FAS 13 started life as a basic document, over the years it has morphed into a whole complex body of knowledge requiring the interpretation of experts (many of who differ amongst themselves often even within the same Big 5 firm).
Added to this simplistic approach is the trend developing in the U.S. in particular, of U.S. subsidiaries of multi-nationals seeking to adopt an international standard of accounting each with—you guessed it— a different set of rules for leasing.
So, here we have (1) a U.S. set of rules, sometimes being criticized for the manner in which structures just barely pass the tests; (2) a rulemaking body seeking to establish a conceptually universal set of rules; (3) individual countries with their own adoption of leasing rules; and (4) an international standard setting body which conceptually follows U.S. rules but which allows a greater degree of interpretation by accountants.
The mission of McGregor’s report was a noble one: that a standard set of rules would allow anybody, anywhere to be able to compare results (with respect to leasing) in a manner that is consistently applied around the world. The reality has been that just as there are different ways of doing business in each country, different sets of laws that regulate those ways of doing business, and different sets of cultural nuances to those business practices and laws and interpretations have made arriving at a common set of accounting rules a very difficult task to accomplish.
We started this discussion with a reference to the G4+1. Yet the G4+1 has been disbanded and has been replaced somewhat by a new international accounting rulemaking body, with the hope that it can start to make some progress on standardizing rules on a global basis, allowing for global reporting, stock markets and investment opportunities. That body, however, has prioritized its objectives and has concluded that leasing is not as high on its priority list as the attention it seemed to be getting. Rather, other areas are more pressing, such as consolidation accounting.
As a result, leasing is not on the current agenda of the rulemaking body, and given the researching, exposure and discussion periods needed, perhaps a change may come about in 4 — 5 years.
Industry requires capital to continue to grow and expand and leasing provides a substantial portion of that capital. Leasing consistently provides fully one-third of all capital funding requirements in the U.S. a huge industry estimated at about $250 billion a year. Leasing helps form the basis for solving many financial structuring challenges.
The leasing industry is a financial products industry. Just as investment banking and the many variations of investment banking change with the changing market conditions, leasing has also shown this innate ability to change and adapt as needed.
Our conclusion therefore would be that we have seen changes occur many times in the leasing industry and as rules changes, further changes will occur to adjust the way business is accomplished. We hope that the accounting rulemaking bodies consider the implications of their recommended changes and how it may affect industry in general and capital formation specifically.
However, those of us with years in the industry and confidence in the process believe that even if the rules change, some form of leasing will continue to exist because it serves as a critical component in the infrastructure of the capital formation process.
Joe Sebik, CPA
Vice President, J.P. Morgan Leasing
Member, Equipment Leasing Associations Accounting Committee
See previous “Ask the Experts” columns:
Recognizing Upfront Fees
Proving Tax-exempt Status
The ABCs of OECD
Credentials for Credit
Big Five Audits and Venture Funding
GAAP for Private Firms
Insurance for E- business Infrastructure
401(k) Brokerage Links
Navigating the Rough Waters of Sales Tax
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