As the comment period on the draft lease accounting standard drew to a close, two leading voices from the audit profession have argued that the proposals by the standard setting bodies – the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) are flawed.
These respondents are the leading UK accountancy firm Grant Thornton (GT), together with its US member firm; and the European Accountants Federation (FEE).
GT and FEE both say that before doing more work to find acceptable ways to bring all leases on-balance-sheet for lessees, the Boards should concentrate on strengthening disclosure rules for notes to the accounts on the presently off-balance-sheet operating leases.
GT says: “We believe that the latest proposal would not improve financial reporting and would require substantial implementation costs. Despite our concerns with the current Exposure Draft (ED), we encourage the Boards to continue to work together to improve lease accounting.”
“We believe that it should be possible to develop an alternative model that would provide account users with information that is more relevant and representationally faithful, more understandable, less complex, and conceptually consistent with accounting for [comparable] transactions.”
“In our view, the comments on the 2010 ED indicated broader conceptual issues with using the right of use [ROU] asset as the unit of account for lease accounting … The current ED has not adequately addressed these concerns and has led us to believe that the proposed unit of account is the root cause of many of the problems with the proposals.
“By focusing mainly on the right to use tangible assets, the model creates a distinction between rights to use tangible assets, intangible assets and service assets …
“Moving forward with the ROU model is supportable only if the lease can be defined in a manner that satisfactorily distinguishes leases from executory contracts (service contracts) … The proposals fail to achieve this – quite possibly because in many instances such a distinction does not exist.”
“We do not believe that the end result in this ED is conceptually consistent with … the latest draft of the forthcoming revenue recognition standard or recent developments in the Boards' consolidation projects – both of which are founded on control-based principles … The concept of sub-diving an asset into individual bundles of rights is not well supported or developed in the Boards' current Conceptual Frameworks or the IASB's [current review of its] Framework.”
Among other criticisms of the ROU model, GT says: “... Various aspects of … ROU … accounting [in the ED] are also problematic. For example, we are not sure that … existing [accounting rules] on impairment [of fixed assets], or the application of the revaluation model in IAS 16 [(on accounting for property, plant and equipment (PPE)] are appropriate for a ROU asset.”
The above point on revaluation, which PPE owners are not permitted to recognize in US GAAP, is pertinent to international financial reporting standards (IFRS) only; but GT's point on impairment rules applies to both IFRS and US GAAP.
FEE suggests that “the ROU model could achieve the objective of increased transparency sought by the [Boards]”. However, it believes that more work needs to be done on its conceptual basis and it appears to share GT's concern about inconsistency with the Frameworks.
FEE says: “We do not support the ED on conceptual and practical grounds … We regret that the [Boards have] not followed our [earlier] suggestion to clearly establish why a lease contract constitutes an executed, rather than executory, contract. This is regrettable since work on this issue may have resolved some of the issues that led to the introduction of a dual model [for P&L expensing by lessees and income recognition by lessors].”
It adds: “... The [IASB] should take advantage of its current [review of its] Conceptual Framework to address the fundamental and cross-cutting issues [affecting lease accounting] … Once these questions have been dealt with, the Board will be in a better position to propose robust improvements to lease accounting.”
Echoing one of GT's points, FEE says: “Conceptually, we believe that the ROU is based on the notion that an asset is a bundle of rights, one of them being the ROU. However, it may be premature to use a definition of an asset that seems to go beyond the current [Framework] definition ...Accordingly, [we believe] that the issues surrounding the ROU asset should be considered as part of the [IASB Framework review] ...”
Like a number of other respondents, FEE suggests that the P&L expensing method as proposed in the ED for “Type B” leases (in practice mainly for real estate leases) is particularly flawed. It says: “The lack of conceptual basis in the proposed accounting treatment for Type B leases is evidenced by the fact that [their balance sheet] treatment … is not consistent with their treatment in P&L and in the statement of cash flow (it results in a financing liability for which the expense is not a financing charge and for which the cash outflows are classified as operating).”
“The ED also introduces an amortization method for [these leases] ... that is inconsistent with methods generally applied to assets under IFRS … Further, we are concerned that the [proposed] classification of leases between Type A and Type B … is in fact more complex and more subjective than the current operating versus finance lease classification in IAS 17. ”
Grant Thornton's alternative suggestion
GT is in effect suggesting a new lease classification line, based on whether the lease transfers control of the underlying asset to the lessee. Where control is passed, the contract would be classed as a sale and the lessee would recognize the underlying asset, as under a current finance or capital lease. Where the lease reflects a residual value (RV) not guaranteed by the lessee, the latter would be capitalizing a larger asset than under the ROU model; and would account for the RV as a liability to return the asset to the lessor, together with the financial liability for the lease payments as under the ROU model.
Where control was not passed to the lessee under its proposed criteria, GT suggests that the lease be treated as an executory contract. Perhaps the logical outcome of that view would be that such deals should remain off-balance-sheet, unless at some later stage the standard setters could formulate a rule for capitalizing all long term executory contracts.
However, GT seems to envisage that these leases would be capitalized, at a lower value than that of the underlying asset. It says: “When control of the underlying asset has not transferred … to the lessee, the contract is the unit of account and the rights and obligations are best represented by net assets and liabilities. How those assets and liabilities are measured and recognized should be a key feature of the Boards' future work on leasing.”
Exactly where GT's suggested control-based lease classification line would end up, along the spectrum of current operating leases, would remain to be seen if such a model were to be developed. GT itself says that it would expect more leases to be characterized as sales (with lessees therefore subject to front loaded expensing of finance charges in P&L accounts), compared with those classified as finance leases under current rules.
It nevertheless seems likely that this could affect fewer leases compared with the lease classification line proposed in the ED, based on the lessee consuming a “more than insignificant part” of the asset's value, which would treat almost all equipment leases as financing transactions.
GT says: “We acknowledge that much of this new model would need to be developed, and that its practical effects, operationality, and acceptance by constituents cannot be determined at this time. However, we believe that this 'direction of travel' has the best potential to deliver significant improvements to lease accounting while avoiding the problems that have beset the ROU model.”
Call for stronger disclosure rules
Having noted that its alternative solution would take time to develop, GT suggests that in the meantime stronger disclosure rules for off-balance-sheet operating leases should be the priority.
It says: “In the short term … the Boards should focus on enhancing disclosures about lease arrangements ...[Account] users would derive significant benefits from comprehensive disclosure information about total rights and obligations and related income and cash flow effects inherent in lease contracts … preferably in a single location ...”
FEE makes the same point. It says: “While we are unable to support the proposals in the ED, [we acknowledge] that [account] users have been requesting more transparency around the obligations from leases. Accordingly, [we support suggestions] that the [IASB] should bring improvement to the existing requirements of IAS 17 without delay through relevant and meaningful disclosures.”