American Accounting Association

Electronic copy available at: http://ssrn.com/abstract=1768083

Johnson School Research Paper Series #16-2011

A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases

Yuri Biondi—National Center for Science Research Robert Bloomfield—Cornell University

Jonathan C. Glover—Carnegie Mellon University Karim Jamal—University of Alberta

James A. Ohlson—New York University Stephen H. Penman—Columbia University

Eiko Tsujiyama—Waseda University T. Jeffrey Wilks—Brigham Young University

February 2011

This paper can be downloaded without charge at The Social Science Research Network Electronic Paper Collection.

Electronic copy available at: http://ssrn.com/abstract=1768083Electronic copy available at: http://ssrn.com/abstract=1768083

A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases

American Accounting Association

Financial Accounting Standards Committee 2010 – 2011

Yuri Biondi (Principal author), Cnrs -Ecole Polytechnique (Paris Tech)

Robert Bloomfield, Cornell University

Jonathan Glover, Carnegie Mellon University

Karim Jamal (Chair), University of Alberta

James A. Ohlson New York University and CKGSB (Beijing) Stephen Penman, Columbia University

Eiko Tsujiyama, Waseda University

Jeff Wilks, Brigham Young University

Acknowledgment We thank C. Richard Baker (Adelphi University), Rolf Fuelbier (Bayreuth University), Louis

Klee (Cnam of Paris) and Vincent Decroocq (Banque de France) for fruitful comments and

discussions.

February 23, 2011

Electronic copy available at: http://ssrn.com/abstract=1768083Electronic copy available at: http://ssrn.com/abstract=1768083

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A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases

ABSTRACT

The International Accounting Standards Board (IASB) and The Financial Accounting Standards Board (FASB) recently issued a joint exposure draft on accounting for leases. This exposure draft seeks to shift lease accounting from an “ownership” model to a “right-to-use” model. Under the current ownership model, leases can be reported on balance sheet (finance leases) if certain tests are met, or off balance sheet (operating leases) if those tests are not met. The new model seeks to report all leases on the balance sheet based on the present value of lease obligations without any bright line tests, and no sharp on or off the balance sheet classifications. We are sympathetic to the standard setters concern that the current lease standard is being manipulated improperly by managers resulting in large amount of debt being reported off balance sheet. We provide a discussion of current lease accounting and the proposed exposure draft. We also comment on five key issues covered by the exposure draft: the definition of a lease, the initial measurement and eventual reassessment at fair values, the accounting for lessors, the impact of lease accounting on recognition and income measurement, and classification of lease accounting elements and their impact on accounting ratios.

This comment was developed by the Financial Accounting Standards Committee of

the American Accounting Association and does not represent an official position of the American Accounting Association.

Electronic copy available at: http://ssrn.com/abstract=1768083

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A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases

INTRODUCTION

The International Accounting Standards Board (IASB) and The Financial Accounting

Standards Board (FASB) recently issued a joint exposure draft (ED2010/9) on accounting for

leases. The current accounting for leases (based on an ownership model) is probably the

clearest example of a dysfunctional accounting standard because the rules-based approach of

that standard has led to widespread non compliance with the intent of standard setters to have

lease contracts reported on the balance sheet. The American Accounting Association’s

Financial Accounting Standards Committee (henceforth the committee) views the goal of

reporting all lease contracts on the balance sheet as important for a well functioning

accounting system. The committee thus responded to the lease exposure draft, which proposes

to shift the underlying model of lease accounting from an “ownership model” to a “right-of-

use model.” In this article we discuss the key issues relating to lease accounting and the

challenges that standard setters face with respect to recognition and measurement issues.

The rest of the paper is organized as follows. The first section provides a discussion of

the current state of accounting for leases, including a summary of its claimed shortcomings.

The second section summarizes the basic argument provided by the ED2010/9 and its new

usage model. The third section provides a comment on this new lease accounting model, with

a more specific discussion of five issues namely, the definition of a lease, the initial

measurement and later reassessment at fair values, the accounting for lessors, the impact of

lease accounting on recognition and income measurement, accounting classification of lease

accounting elements, and their impact on accounting ratios. The fourth section concludes on

the efficacy of the proposed ED 2010/9 in attaining the goal of having lease contracts reported

on balance sheet..

1. The current state of accounting for leases On 17 August 2010, IASB and FASB published the joint ED 2010/9 devoted to

accounting for leases. The proposal is one of the main projects included in the boards’

Memorandum of Understanding of 2006 and builds on two Special Reports issued by a group

of international standards setters (including FASB and IASB representatives), referred to as

“the G4+1,” in 1996 and 1999, respectively: “Accounting for Leases: A New Approach” and

“Leases: Implementation of a New Approach.”

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Current accounting standards for leases - FASB Statement No. 13, Accounting for

Leases, issued in 1976, and IAS 17, Leases, issued by the IASC in 1982 – adopt an

“ownership approach” based on the extent to which risks and rewards incident to ownership

of a leased asset lie with the lessor or the lessee. Accordingly, a lessee should recognize both

an asset and a liability for a lease that transfers substantially all benefits and risks incident to

the ownership of property, and a lessor should recognize such a lease as a sale or financing.

Vice-versa, a lease that does not transfer substantially all benefits and risks incident to the

ownership of property is classified as an operating lease by the lessee. Under operating lease

classification, the lessee does not recognize any elements of the lease on its balance sheet;

rather, the lessee recognizes rental expense as it becomes payable.1

The major criticism of the existing lease standards is that lessees often do not

recognize lease obligations on their balance sheets, based on what is now considered to be an

inappropriate distinction between operating and finance leases. According to the World

Leasing Yearbook 2010, quoted by the IASB (2010), leasing activity in 2008 amounted to

US$640 billion, while the assets and liabilities arising from many of those contracts are not

shown in a lessee’s statement of financial position (balance sheet). Franzen, Rodgers and

Simin (2009) documented that from 1980-2007 off-balance sheet (OBS) lease financing as a

percentage of total debt increased a remarkable 745%. If leased assets were brought onto the

balance sheet over our 27 year sample period, average debt-to-capital ratios would increase by

50-75%. According to the 2005 SEC Report, undiscounted total non-cancellable future

payments required under OBS leases for US companies would be approximately $1.25

trillion. According to a recent research study by PwC (2009) using a sample of 3,000

companies, reported interest bearing debt in 2008 financial statements would increase by 58%

after adjusting for OBS leases.

Although both standards

have been amended several times, their most recent versions retain the ownership approach to

the accounting for leases contained in the original standards, especially the fundamental

distinction between “finance” and “operating” leases.

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a) Knife-edged accounting, whereby small changes in a transaction lead to large differences in how the transaction is accounted for. Current lease accounting

Inappropriate distinctions between operating and financing leases are achieved by

managers due to the following weaknesses of current lease standards:

1 More precisely, as it becomes attributable to the period according to the accrual principle (IAS 17, §33). 2 Goodacre (2001), Fuelbier et al. (2008), and Duke et al. (2009) provide further estimates on UK, German and US samples.

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standards create such knife-edged accounting whereby small changes in a transaction can result in either 0% or 100% of the transaction reported on the Balance Sheet.

b) Bright line tests to determine accounting classifications as described above in point a (e.g., 75% and 90% thresholds in current lease standards) make it easy for managers to structure transactions to achieve the accounting treatment they desire.

c) There is lack of symmetry in the way a transaction is accounted for by the

lessee and the lessor. Having the same transaction reported differently by the two parties to the same transaction creates lack of comparability and consistency.

d) Scope exceptions create loopholes that can be used by management to defeat

the intent of the standard (Jamal and Tan 2010).

e) Executory service contracts are not considered to be part of the lease standard (and are not reported on the balance sheet), so management can get around the lease standard by structuring a lease transaction as a contract for services and not report any debt (See Ryan et al., 2001)

f) Management can use renewal terms, options and contingent payments to get

around the intent of the standard (Jamal and Tan, 2010).

g) Management can use special purpose entities to move leases off Balance Sheet.

2. The new approach suggested by the Exposure Draft (ED2010/9) The lease exposure draft aims at providing a new accounting model for both lessees

and lessors. The boards are proposing a “right-to-use” accounting model where both lessees

and lessors recognize assets and liabilities arising from lease contracts. These assets and

liabilities would be initially measured at the present value of the lease payments. They would

be subsequently measured using a cost-based method. Accordingly, a lessee would record an

asset based on its right to use the underlying resource, amortized over the term of the lease (or

the useful life of the underlying asset if shorter) and tested for impairment. Under IFRS, this

right may be revalued in some circumstances. A lessee would further recognize a liability for

lease payments, initially equal to the capitalized right-to-use asset. For contingent rentals and

optional renewal periods, amounts are measured on an expected likelihood basis.

Concerning lessors, the proposed exposure draft allows two choices, one of which

maintains the ownership approach based on the exposure of the lessor to the risks and benefits

of the underlying asset. If the lease transfers significant risks or benefits of the underlying

asset to the lessee, then the lessor can apply the “derecognition” approach. The derecognition

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approach requires the lessor to remove all or a portion of the underlying asset from its balance

sheet and to record a right to receive lease payments. A lessor may then record a gain at the

inception of the lease under this approach. The second (performance obligation) approach is

consistent with the “right to use” model applied to the lessee and requires the lessor to retain

the underlying asset on its balance sheet together with a right to receive lease payment (as an

asset) and a liability to permit the lessee to use the underlying asset (a lease liability). The

lessor recognizes income over the expected life of the lease, while a net lease asset (liability)

is recognized, comprising the underlying asset plus right to receive lease payments minus

lease liability. Given the strong emphasis on achieving comparability and consistency in

accounting, it is a bit puzzling why the exposure draft would permit a divergence in

accounting for the same transaction between the lessee and lessor.

We prefer one accounting approach based upon the symmetry between the lessor and

the lessee. This method should capture the specificities required by accounting for a lease as a

structured operation comprising an operational and a financing dimension. Income and asset-

liability recognition and measurement should follow the structure of the whole operation over

its entire duration and comprehensive effect. Related accounting criteria should further be

designed in order to prevent representational manipulation and abuse.

Furthermore, many lease contracts include variable features. They often include

options to renew or terminate the lease, contingent rentals (for example, rentals that vary

depending on sales) or residual value guarantees. The proposed standard would further require

lessees and lessors to determine the assets and liabilities on the basis of the “longest possible

lease term that is more likely than not to occur”, including options to extend or terminate, and

to consider all lease payments due over the expected lease term, including estimated

contingent rentals and residual value guarantees (so-called “expected outcome technique”).

According to IASB (2010: 9), “if optional periods are not included, the related right-of-use

asset and right to receive lease payments may be understated, or structuring opportunities may

be created”.

We agree that management should not be allowed to use renewal options to move debt

off balance sheet (Jamal and Tan 2010). One easy way for management to circumvent the

intent of the standard is by adding in an option to extend the lease term. Including all lease

extensions blocks this type of opportunistic behavior. Using convoluted tests like “term that

is more likely than not to occur” however, creates a loophole which management can exploit.

Management can argue that certain renewal options will not meet the “more likely than not”

test. Experimental evidence suggest that auditors are likely to go along with these managerial

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judgments (Kadous et al., 2003) thus defeating the intent of the standard. One objection to

including all lease extensions is that they may overstate the obligation assumed by the lessee

since the extension is not a liability as per the FASB/IASB’s definition of a liability.

However, on a more practical basis, our view is that if all lease renewal periods are included

in the initial measure of the lease, lease contracts are likely to contain options only for periods

that are most likely to occur.

3. Specific Comments on Elements of the Exposure Draft Major concerns with OBS financing, accounting loopholes and structuring

opportunities in general were raised during the recent financial crisis. The proposal aims at

addressing this issue in the field of lease accounting. According to ED2010/9 §BC6(b), the

new approach “would result in the same accounting for the majority of leases. This would

increase comparability of the statement of financial position and the statement of

comprehensive income for users of financial statements and reduce the opportunity to

structure transactions to achieve a desired accounting outcome” (p. 8). This purpose and scope

imply a working definition of a lease together with suitable methods of recognition and

measurement of lease assets and liabilities by taking into consideration their impact on

income and asset-liability recognitions.

According to the ED2010/9 (§BC6(d)), leases are divided into short term leases and

long term leases. Short term leases are for a period of 12 months or less (including renewal

options). A simplified reporting structure is proposed for short term leases whereby the lessee

would measure the lease liability at the undiscounted amount of lease payments and expense

the lease payments over the lease term. The lessor would not recognize any lease assets or

liabilities while maintaining the recognition of the underlying asset in accordance with other

standards and recognizing the lease payments in the income statement.

This approach basically treats short leases the same as executory contracts for

purchase of services. For such short term contracts, there is no need to report present values of

cash flows. The standard does however create a logical inconsistency. For short term contracts

a lease is accounted for the same way as an executory contract (and is off balance sheet).

However, for a longer term contract, the accounting treatment diverges between that of an

executory contract and a lease (and the lease is on balance sheet). We would prefer that all

leases and executor contracts be accounted for on a consistent basis.

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3a. The definition of a lease The exposure draft starts with a scope paragraph. The proposed scope exceptions (e.g.,

oil and gas, regenerative assets) involve large and material assets and create loopholes that

managers know how to exploit (see Jamal and Tan 2010). We recognize that these changes in

the lease standard are being proposed before a new conceptual framework is finalized.

However, these scope exceptions together with the misalignment in treatment of executory

contracts discussed earlier open up several loopholes that managers can use to circumvent the

intent of the lease standard.

The proposal sets out specific accounting requirements for lease features. In particular,

a lease is defined as a “contract in which the right to use a specified asset or assets is

conveyed, for a period of time, in exchange for consideration.” A lease is distinguished from

a contract that represents a purchase or sale, including sale and leaseback, or a service

contract. These attempts to partition lease and service components provide structuring

opportunities by including both lease-and-service, and sale-and-leaseback arrangements, in

order to undermine the recognition and disclosure requirements introduced by the proposed

accounting model. If contracts are bundled together in one structured operation, they should

be considered as one unique operation and should be accounted as such under lease

accounting. However, the distinction between lease and service components (or contracts)

may allow intentional avoidance of the proposed treatment of options and contingent rentals

that is expected to better represent the economic substance of the lease operation. Such a

structuring opportunity is especially sensitive for sale-and-leaseback contracts. If the contract

involves a lease, then the transferor should not derecognize the transferred asset as a sale

(then recognizing the profit or loss on the sale) and should recognize any amount received as

a financial liability.

To distinguish a lease from a purchase or sale, the application guidance (ED2010/9,

§B9-B10) stresses the transfer of the entitlement of the asset at the end of the contract term

and the inclusion of a bargain purchase option. However, in both cases, the contract would

cease to be a lease (to become a purchase by the lessee and a sale by the lessor) only at the

end of the contract, or when such an option is exercised.3

3 Comp. ED2010/9 §BC61, p. 22, and ED2010/9 §BC164, p. 51.

These conditions do not change the

economic substance of the lease contract, which implies a financing component that should be

accounted for. In particular, gains, incomes and costs that arise from a lease, including lease-

and-service and sale-and-leaseback transactions, should be recognized continuously during

8

the lease term. In sum, required distinctions between lease or service, and sale or lease

contracts (or contract components) may reintroduce a classification requirement that would

increase the complexity of the proposals and undermine their intended scope and purpose

(comp. ED2010/9 §BC62, p. 22).

3b. Initial measurement and eventual reassessment at present values The initial measurement of a lease asset and liability is at present values of cash flows

using a discount rate. This is like current practice but materially undermines the overall debt

load recognized in the balance sheet. In this way, the maturity analysis of lease liabilities

(showing the undiscounted cash flows on an annual basis for the first five years and a total of

the amounts for the remaining years) would only be disclosed in the notes, consistent with the

maturity analyses required by FASB for leases and other financial liabilities.. The proposal

allows revaluation gains and losses to be recognized if all the assets in that class of property

plant and equipment are revalued. This revaluation of the right-of-use asset at its fair value

factually disconnects the lease asset from the corresponding liability, even though they are

clearly linked at the inception of the lease (ED2010/9 §BC10(b)). This may undermine the

overall debt exposure, even though leased assets are assumed to have features that distinguish

them from other owned assets and that require then specific requirements for recognition,

presentation, and disclosure. In fact, FASB would not permit lessees to revalue right-of-use

assets unless doing so to recognize an impairment loss (ED2010/9 §BC76(b), p. 26). We

prefer a conservative approach with use of impairment testing, rather than repeated re-

measurement which can favor structuring opportunities and upward revaluation of asset and

liability amounts (comp. ED2010/9, §19, p. 21).

Problems with disconnection between lease asset and liability further occur with the

amortization of the right-to-use asset, which should follow the amortization period, method

and review in line with other intangible assets (ED2010/9 §20, p. 22). Specific problems may

then arise by estimates of residual values and other amortization criteria. In order to avoid

structuring opportunities and income manipulation, the amortization pattern may be kept in

line with the financial amortization of the related liability (rental expense). This is in line with

the required recognition of the interest charge as a financial charge (instead of an operational

charge) by the lessee. Furthermore, the right to use asset should be recognized as a distinct

intangible asset (contrary to ED2010/9 §25 and BC143-145).

There is considerable debate on the appropriate discount rate to use in lease accounting

measurement if present values are adopted. Basically, three possibilities exist: a risk-free

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discount rate, a company-specific borrowing rate that will reflect its credit-risk, and a lease-

specific rate (implicit in the terms of the lease) that will reflect the risk involved in the

contract. For the lessee (ED2010/9 B11), the proposed standard requires using the lessee’s

incremental borrowing rate (company-specific rate) or the rate the lessor charges the lessee if

that rate can be reliably determined (contract-specific rate). For lessors (ED2010/9 B12), the

discount rate should be that the lessor charges the lessee (contract-specific) that may be equal

to the lessee’s incremental borrowing rate, the rate implicit in the lease, or the yield on the

property (for property leases). This choice of rates reflects the economic substance of the

lease contract, and that the riskiness of the two contracting parties may be different. Forcing

everyone to use the same discount rate creates consistency of form, but not of substance. An

alternative view suggests three concerns with this approach: it undermines comparability

between companies, since the same lease contract will be valued differently; it will lead to a

situation in which riskier lessees will report a lower liability for the same lease contract

because they will discount at a higher rate; it involves double-counting since expected

payments are already estimated at their most probable values . However, discounting at the

risk-free rate allows calculating the implicit return rate of a lease as the contract-specific

return that facilitates its return-risk assessment and related profit-sharing (Biondi 2010). In

addition, the use of one discount rate chosen once for all at initial recognition undermines

comparability over time between different transactions and firms, and make accounting

amounts sensitive to the change of interest rates of reference; alternatively, the allowance of

discount rate update over time introduces all the problems related to unwinding of

discounting, including structuring opportunities and manipulation. Recognition of discounted

amounts at risk-free rates, or undiscounted amounts, appears therefore to be preferable to

avoid these problematic consequences

3c. Accounting for Lessors Concerning accounting for lessors, two methods are allowed pursuant to an ownership

approach based on retention of exposure to significant risks or benefits associated with the

underlying asset. The choice must be done at the inception date of the lease. Under the right to

use model (performance obligation approach), the lessor adds lease asset and liability to its

balance sheet (measured at the present value of lease payments) together with the underlying

asset. These gross elements are then linked together to present a net lease asset or lease

liability (ED2010/9 §BC148, p. 47). The lessor further recognizes: interest income on the

right to receive lease payments; lease income as the lease liability is satisfied; and continues

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depreciating the underlying asset pursuant to other standards. Under the ownership model

(derecognition approach), the lessor derecognizes the portion of the carrying amount of the

underlying asset that represents the lessee’s right to use the underlying asset (the remaining

part being reclassified as residual asset), and recognizes a right to receive lease payments. The

residual asset would not be remeasured unless there are changes in lease term or impairment;

remeasurements at fair value are excluded. A lessor further recognizes: immediate lease

income – at the date of the inception of the lease – regarding the present value of the lease

payments, and lease expense representing the cost of the portion of the underlying assets that

is derecognized; the interest income regarding the right to receive lease payments; and

continues depreciating the residual asset pursuant to other standards.

According to the boards’ basis for conclusion (ED2010/9 BC16-B22), the

performance obligation approach would recognize revenue continuously during the lease

term, whilst the derecognition approach allows the lessor to recognize at the date of inception

of the lease revenue that is not attributable to the financing component of the lease. In

particular (ibidem, BC27), the derecognition approach is likely to be appropriate when the

entity’s business model is primarily the provision of finance, because the profit of that

business is derived from interest income and the principal risk associated with the business is

credit risk. In contrast, the performance obligation approach is likely to be appropriate when

the entity’s business model is primarily to generate (possibly variable or contingent) return

from the active management of the underlying assets either from leasing these assets to

multiple lessees during the useful life of them or from use or sale of the asset at the end of the

lease. In that business model the principal risk is asset risk.

The dual accounting treatment for lessors violates the symmetry between accounting

for the same transaction by the lessee and the lessor. This distinction and related choice of

accounting method materially shapes the amounts, timing, and uncertainty of the cash flows

arising from different kinds of lease. Furthermore, the impact is material for income

recognition. Structuring opportunities may arise then especially with regard to the differences

on income recognition at inception. This distinction may indeed introduce structuring

opportunities to arrange operations to obtain a specific accounting outcome. In particular,

application guidance (ED2010/9, §B22-B27) focuses on asset-specific criteria to make the

distinction decision, while financing components specific to the lease transaction - such as the

credit risk of the lessee - are excluded. If the lease transaction deserves specific accounting

treatment, it should be accounted for as a single operation including both operating and

financing components bundled together under the same lease arrangement. Under the ED

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accounting model, this composite economic substance is already taken into account from the

lessee’s side of the lease, but would be obscured from the lessor’s side because of the

distinction between different accounting methods. In particular, the amounts, timing and

uncertainty of the cash flows related to the lease transaction should have the same accounting

treatment from both sides of the transaction.

Therefore, a single method appears to be preferable. This method should recognize

lease and interest incomes continuously during the lease term, splitting gains and incomes

over its duration whilst avoiding recognizing gains at the inception of the lease. In addition, it

should reclassify the leased asset as a financial asset (or receivable) since it is – by definition

– no longer under the lessor’s control. This latter recommendation is based on the idea of

symmetry, whereby the lessee’s acquisition of a property right necessarily results from the

lessor’s disposition of it (ARS4, p. 64). Information about the current and future ownership of

the leased resource should be disclosed in the notes. This symmetry is needed especially when

lessor and lessee shall be consolidated in the same accounting entity for the purpose of

consolidated financial statements, as it may be the case under asset securitization and

structured lease finance.

3d. Lease recognition and income measurement Gaps, differences and inconsistencies between tax and accounting regulatory

frameworks for leases can generate important structuring opportunities (Huang 2009;

Weidner 2000). This particularly concerns the impact of lease accounting on net taxable

income. It is then important to analyze lease accounting in the broader context of asset

securitization and structured finance, which may utilize synthetic lease transactions in order to

avoid accounting recognition while taking advantage of depreciation deductions. These

structuring opportunities should be reduced by the accounting model proposed for lessees that

requires recognition of the lease liability and the related right-to-use asset. Nevertheless, a

problem remains with the depreciation of the underlying asset. According to the ED, the

lessee does not recognize the rental expense as an operational charge, but it depreciates the

related right to use the asset as an operational charge (the lease interest being recognised as a

financial charge). The lessor depreciates the asset to the extent that it remains under

ownership control. Generally speaking, the symmetry between lessor and lessee accounting is

important for consolidation, taxation and other regulatory purposes. For instance, the leased

asset is amortised twice; once by the gross revenue, through the lease payments by the lessee,

and second as an owned asset by the lessor. This lack of symmetry is then problematic:

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Depreciation deduction should be either assigned once to the party in the lease transaction

who has an overwhelming share of the benefits and burdens of ownership control (usually, the

lessee), or alternatively shared on this basis among the parties. The same problem with double

counting holds with asset recognition in the balance sheet. Asset recognition should be

assigned or shared in a similar way.

Furthermore, structuring opportunities usually utilize “special purpose entities” (SPE)

without economic substance (see EITF 90-15 and EITF 96-21). As long as the SPE achieves

the minimum initial equity investment, the SPE is not consolidated by the lessee. This makes

it possible to avoid the proposed accounting model if the lessor and the lessee agree to

interpose an off-balance sheet SPE that acquires title through the lessor while dealing with the

substantial lessee to avoid the application of either sublease accounting4

3e. Accounting classification and impact on financial and regulatory ratios

or consolidation of

the SPE. If the latter party is the real debtor and substantial holder of the asset, that entity

should apply the proposed model of accounting for lessee. In contrast, the standard and its

application guidance pay little attention to synthetic leases and other structured transactions

involving SPEs that are of utmost importance for structuring opportunities (Weidner 2000).

This section examines the impact of lease accounting on widespread ratios of financial

performance and position computed on accounting numbers. Fuelbier et al., (2008) provide a

comprehensive review of previous literature on the matter.

Following the proposal, the most important change to a lessee’s financial statements is

the grossing-up of the balance sheet that would result from recognizing both an asset and a

liability for all lease transactions previously accounted for as operating leases. As a result,

several key leverage and capital ratios may be affected. Furthermore, interest coverage ratios

would suffer, but measures such as EBIT and EBITDA would improve because rental

expense would be reclassified as interest expense, including the amortisation charge.

Operating cash flows would also improve under the proposed model as cash payments for

leases would be classified as financing activities rather than operating activities in the

statement of cash flows. At the present, cash payments by a lessee for operating leases are

classified as operating charges.

4 According to ED2010/9, Appendix A, p. 40, a sublease is “a transaction in which an underlying asset is re- leased by the original lessee (or ‘intermediate lessor’) to a third party, and the lease agreement (or ‘head lease’) between the original lessor and lessee remains in effect.” In our example, the third party is the lessee, whilst the SPE is the intermediate lessor.

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Concerning lessors, both methods appear to accelerate the recognition of revenue

relative to the existing operating lease accounting. This is especially true for the derecognition

method that allegedly allows recognizing income at the inception of the lease.

Concerning classification, the lessee should recognize lease liabilities separately, while

leased assets should not be mixed among other categories such as tangibles and investment

properties. Even though the lessee has acquired the right to use those assets, it does neither

own nor control them in full. Furthermore, these rights are not tangibles or properties in

themselves, but merely related to them. Therefore, leases should be disaggregated and

reported separately on financial statements, including reporting “rights of use” as intangible

assets, with details disclosed in the notes. Symmetrically, the lessor should move the leased

assets among financial assets (or receivables) and recognize the corresponding liability like a

deferred income.

Specific attention should be devoted to ratios related to regulatory capital reserves. Since

both assets and liabilities would increase, those ratios should be less affected because they

generally focus on net assets or shareholders’ equity. However, much depends on the

classification of the right to use recognised by the lessee. This asset does not fit the conditions

required by an asset under a prudential perspective of solvability and liquidity. Therefore,

these assets should be classified as intangible assets and disregarded for prudential regulatory

capital reserves. This implies that accrued liabilities for leases should be backed by other

assets than rights to use.

4. Conclusion The committee members are in agreement about the importance of lease accounting

for users of financial statements. Overall, we are pleased to see that this exposure draft

introduces the “right-of-use” model, rather than the ownership model which has worked so

poorly in practice. Unfortunately, current lease accounting is plagued by loopholes,

transaction structuring and other actions by management to circumvent the intent of the

standard. Preventing all transaction structuring is of course a difficult endeavor. The ED

makes a good effort at dealing with the current problems of lease accounting, but some big

loopholes (concerning especially scope, SPE and intra-group operations, definition of lease

term, discounting, and executory contracts for services) remain that need to be closed off.

Therefore, we prefer conservative accounting (including impairment testing) but are opposed

to assessments and reassessments that create structuring opportunities.

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References

AICPA (1962), ARS4 – Reporting of Leases in Financial Statements.

Biondi, Yuri (2011) “Cost of Capital, Discounting, and Relational Contracting: Endogenous Optimal Return and Duration for Joint Investment Projects,” Applied Economics, Forthcoming. URL: http://ssrn.com/abstract=1330587

Duke, C. Joanne, Hsieh, Su-Jane, Su, Yuli (2009), Operating and synthetic leases: Exploiting financial benefits in the post-Enron era, Advances in Accounting, incorporating Advances in International Accounting 25 (2009) 28–39

ED2010/9, Leases, August 2010.

EIFT 90-15, FASB – EIFT (1990), Impact of nonsubstantive lessors, residual value guarantees, and other provisions in leasing transactions.

EIFT 96-21, FASB – EIFT (1996), Implementation issues in accounting for leasing transactions involving special-purpose entities.

Franzen, A. Laurel, Rodgers, J. Kimberly, Simin, T., Timothy (2009), “Capital Structure and the Changing Role of Off-Balance-Sheet Lease Financing”, mimeo, August 2009.

Fuelbier, Rolf U., Jorge, Silva, Jorge L., Pferdehirt, Marc H. (2008), Impact of Lease Capitalization on Financial Ratios of Listed German Companies, Schmalenbach Business Review, 60 April 2008, 122-144 G4+1 (1996) Special Report Accounting for Leases: A New Approach G4+1 (1999) Special Report Leases: Implementation of a New Approach Goodacre, Alan 2001, “The Potential impact of enforced lease capitalization in the UK retail sector”, University of Stirling working paper, August 2001.

Huang, Eva (2009), Cross-Regulatory Arbitrage: An Illustration from Leasing, 8 (1), June 2009: 8-13

IASB (2010), Shapshot: Leases, August 2010.

Jamal, K., and H.T. Tan. 2010. Joint Effects of Principles-Based versus Rules-Based Standards andAuditor Type in Constraining Financial Managers’ Aggressive reporting. The Accounting Review, Vol 85(4), 1325-1346. Kadous, K., J.S. Kennedy and M.E. Peecher. 2003. The Effect of Quality Assessment and Directional Goal Commitment on Auditors' Acceptance of Client-Preferred Accounting Methods. The Accounting Review, 78(3): 759-778. PricewaterhouseCoopers (2009). The future of leasing: Research on impact of companies’ financial ratios.

Ryan, S., R. H. Herz, T. E. Iannaconi, L. A. Maines, K. G. Palepu, K. Schipper, C. M. Schrand, D. J. Skinner,and L. Vincent. 2001. Evaluation of the lease accounting proposed in G4_1 Special Report, Accounting Horizons:15 _3_: 289–298. Securities and Exchange Commission (SEC), 2005, Report and recommendations pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on arrangements with off-balance sheet implications, special purpose entities, and transparency of filings by issuers. Washington, D.C.

Weidner, J. Donald (2000), Synthetic Leases: Structured Finance, Financial Accounting and Tax Ownership, Journal of Corporation Law, 25 (2000)