Results are a bad omen
The FASB had their first meeting on Leases Topic 842 implementation issues at the end of November. The FASB staff has been receiving questions from many parties and they teed up four issues for the Board to discuss. Three of the issues were not very consequential to the equipment leasing industry (more important to the real estate industry), but one issue raises some serious questions and the discussion set an ominous tone for future issues. They basically took no action on any of the issues but, in my opinion, one issue they chose to not address really needs their attention.
The issues of little consequence to equipment leasing were:
- For lessees, should an operating lease that was part of a prior period impairment of an asset group be re-opened and allocated to the operating lease? They decided no in keeping with their efforts to keep transition and implementation simple. This, in my opinion was a good “no action needed” result.
- For lessees, in testing for impairment should the imputed interest component of the lease payment be included as a cash outflow. They decided to let the preparer set their own policy to do it either way. In my opinion this was the right decision.
- For lessees, how should the lease term of a head lease be evaluated when the terms are the same as the sublease? They decided to allow current practice which is to include only options controlled by the lessor and the clarity of the guidance at 842-10-30-1(c). In my opinion this was the right decision.
The consequential issue is with lessor classification. The issue is there are alternative energy transactions with variable payments based on performance and the lease term is for a major part (as in 75%) of the asset’s useful life. The result is a transaction classified as a sales type lease yet the variable payments are not lease payments to be booked by the lessor as they are variable. The result is the write off of the asset and a day one loss. This result does not reflect the economics of the transaction as it can be demonstrated that there will be sufficient usage to create lease payments that will result in a profit. This issue was actually brought before the Board as a sweep issue but they did not deal with it prior to the issuance of the standard. They said at the time they were not sure it impacted real world transactions in a significant amount. They are now finding it is an issue of significance for certain leased assets, particularly in the renewable energy space. One Board member suggested that all the lessor had to do was structure the deal as a sale to avoid the day one loss. This shows that the Board does not understand that these leases are structured to maximize tax benefits for the lessor who then passes the benefit on in the form of lower rents. A change in the structure changes the economics in an unfavorable way.
This is an issue that does exist in current GAAP. Today lessors generally account for leases with significant variable payments as operating leases in accordance with paragraph 840-10-25-42(b) as this provision precludes sales type or direct finance classification as there are important uncertainties – the rule states: “No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.” This item was not carried forward to Topic 842. This is an acceptable outcome under current GAAP as the variable rents recognized as incurred would “match” the depreciation expense of the operating lease asset. The problem is the Board did not retain this clause in Topic 842 despite their objective of not changing lessor accounting. The IASB version does not have this issue as they carried over the risks and rewards classification tests as-is from their current GAAP.
The core issue is that Topic 842 uses certain concepts in the new revenue recognition standard, Topic 606, for lessor accounting but does so in a way that leaves gaps in the literature. Under Topic 606 the probable variable payments could be recognized as a receivable whereas Topic 842 does not allow that. The IASB version does not have this issue as they did not conform lessor accounting to their Revenue Recognition standard.
So we have a standard with some flaws due to the mixing of Topic 606’s control approach with the traditional risks and rewards model in leasing (Topic 842). When they discussed this at the meeting they acknowledged the conflicts but they decided not to fix the flaw. They certainly have the power to carry over the topic 840 clause or conform 842 to 606 for probable payments. Three of the Board members were in favor of a fix as they recognize that the rules as written result in a day one loss that does not reflect the economics of the transactions. They also realize their control vs risks and rewards conflict.
I had always thought that Topic 842 should stand alone from Revenue Recognition as a “Broad Transaction” due to the uniqueness of lease accounting and lease structures. The majority’s view to stay with the existing guidance under Topic 842 was principally grounded on preserving symmetry in the accounting for variable lease payments between lessee and lessor, a symmetry which arose from the decision made to exclude variable lease payments from capitalization. This decision was controversial in that it led to Board member’s dissent to the standard. However, as a Board member pointed out in the discussion about preserving symmetry, in today’s purchase sale-accounting, i.e. in a transaction where one party sells an asset to another for variable consideration, only the seller and not the buyer accounts for variable consideration at the time of the sale. Therefore, a change to the leasing literature would only improve the comparability of lease and purchase transactions.
In what I see as a major problem, the other 4 Board members took a position that the rules are clear and they would not change them. They even said that this request was a result of stakeholders not liking the answer and asking them to re-open deliberations. One Board member said he dissented because of the treatment of contingent rents so he would not vote to redeliberate. It almost sounded like he did not accept responsibility for the new standard because of his dissent. In my opinion all members of the Board whether they dissented or not should correct issues where the accounting does not reflect the economics. This issue is not a question of not liking an answer, rather it is a question of fixing “bad” accounting. The four Board members who would not agree to fix the issue even went so far as saying they did not want to open up the process to all who did not “like” the answers they got from Topic 842. They said they did not want to give the impression that it was “open season” for changing what stakeholders do not “like”.
The outcome of the discussions on this issue were very surprising. While the Board was willing to give reasonable consideration to the practical issues arising from the standard, as long as they could be addressed in a public meeting, there was a clear message that the core standard was done and that there would not be any actions taken to fix issues through a revision of the words written in the standard. Some of the problem may be due to changes in the composition of the Board as there seems to be a line of professional accountants on one side that see the issues in financial reporting problems and the need to fix them differently than the balance of the Board. Previous Boards continually entertained questions and issues related to FASB 13. There were over fifty changes to FAS 13 through new standards, FINs, FTBs and EITFs to deal with issues that came up from new structures or things that had not been properly addressed. In all of my interactions with the Board I have taken a high ground approach only arguing for things that improve financial reporting. Although the Board agreed that the staff should continue to interact with stakeholders on Topic 842 issues, it seems the Board is not going to be as open to issues that require a change to the rules. They should realize that leases can be complex and structures change as the business world reacts to changes from tax laws to technology changes to innovation. When preparers implement new rules there will always be things that come up that were not contemplated. Accounting rules should not be viewed as static. In my opinion they have a “deliberated and done” attitude. Accounting rules are hard to get “right” and possible changes should be addressed with an open mind to keep financial reporting as meaningful to users as possible.
About the Contributing Author
Bill Bosco is the Principal of Leasing 101, a lease consulting company. Bill has over 40 years experience in the equipment finance and leasing industry. He has been on the ELFA financial accounting committee since 1988, served as chairman for 10 years, and currently is the association’s retained lease accounting advisor. Bill also served on FASB’s working committee for the Leases project ASU 842. At the same time, he has worked closely with Alan Bushell and the ProLease development team as a consultant assisting with research, testing and programming of the new FASB-IASB lease accounting guidance in ProLease.