Ready or not, lease accounting is going to be reformed

Implications: I believe the main issue that is or ought to be under discussion is what FASB will do in the future with regard to lease accounting.  To answer that question, it is appropriate to look at the forces that are at work now and the kind of thinking that has been going on more recently.  While there’s nothing wrong with looking to the past to get some insight into what happened then, it doesn’t do much good to look there if the goal is to predict the future.  As I see it, forces are in place that will bring significant reform in lease accounting, especially for operating leases.

Analysis: With appropriate respect for Mr. Pugh and with due appreciation for his thorough historical scholarship into the origins of today’s 30-year old generally accepted accounting principles for leases, it appears to me that he is addressing the wrong issue in the wrong way.

The question at hand is not what the long-disbanded Accounting Principles Board thought in the 1960s or what the Financial Accounting Standards Board wrote in the 1970s.  While the ideas expressed in those writings were sufficient for their day, their analyses and conclusions have been made obsolete by several developments.

One change was the creation of FASB’s Conceptual Framework over 25 years ago.  A key definition in Statement of Financial Accounting Concepts number 3 (now number 6) states that assets include future benefits that are controlled even when they are not owned outright.  This provision was added specifically to ensure that a company’s assets include those that it controls through leases, without regard to whether they are traditional capital or operating leases.  Importantly, the definition makes it clear that a real asset can exist for the lessee even if the tangible property is owned by someone else.  Indeed, this point was in alignment with practice in SFAS 13.  Specifically, a lessee that will not acquire title at the end of a capital lease still recognizes an asset and amortizes its cost over the lease period.  This lease is not an in-substance purchase of a tangible asset but a purchase of an intangible asset in the form of the right to use the property.  The old distinction between rental contracts and purchase leases was artificially clean and no longer describes today’s situations with any clarity.

A second change was a shift in thought at the standard setting level away from reporting on the basis of form to reporting on the basis of substance.  Standard setters grew tired of seeing manipulations and “loopholing” by managers (aided by experts, including their auditors) that were designed to avoid reporting requirements in their standards.  Leases are the poster children for this kind of behavior, as illustrated by the numerous amendments and addenda to SFAS 13 over the years.  Consider these words from a 2005 SEC report on off-balance sheet financing:

“Problems with the all-or-nothing character of the accounting have been magnified because many issuers involved in leases, taking advantage of the bright-line nature of the lease classification guidance, structure their lease arrangements to achieve whatever accounting (sales-type/capital or operating) is desired. These issuers have been aided in these endeavors by a large number of attorneys, lenders, investment banks, accountants, insurers, industry advocates, and other advisers. Indeed, lease structuring to meet various accounting, tax, and other goals, has become an industry unto itself in the last 30 years.”

(The irony of this activity that escapes most managers and their experts is that manipulating financial statement numbers tends to achieve an effect opposite the one that is sought.  By engaging in these manipulations, they show the capital markets that they cannot be trusted, which leads to the certain consequence that their stock values are driven down instead of up.  A window-dressed positive representation that’s known to be false will kill a stock price quickly.)  The impact of this second change is that future standards are going to be principles-based, not rules-based.  Leases are a perfect example of the latter, such that an agreement that covers 75.0% of a property’s expected future life is capitalized while one that covers 74.9% of that life is not capitalized.  This classic approach to standard setting is not likely to be carried forward into the future.

A third development is the burgeoning acknowledgement among all standard setters over the last fifteen years that the established accounting methods for leases fail to provide statement users with information they need to have.  For example, a report prepared several years ago jointly by five standard setting bodies proposed putting an asset and liability on the balance sheet for all leases.  In addition, a recent monograph from the CFA Institute pleads for capitalization of all material leases.  Mr. Pugh’s focus on the original language simply misses the tide that has turned over the last 40 years.

Still another development that is only now beginning to come clear is the great boost in FASB’s independence from its constituents, especially those who used political and economic pressure on the board, primarily by threatening to withhold their charitable contributions to the Financial Accounting Foundation.  Sarbanes-Oxley created the Public Company Accounting Oversight Board, of course.  What some have missed is that the PCAOB now collects a fee from public companies for its own costs as well as the cost of operating FASB.  As a result, the FAF stopped accepting contributions from corporations, auditors, and others in 2003.  Has this made the board more independent?  It certainly hasn’t hurt.  For evidence, one needs to look no further than SFAS 158, issued on September 29.  This standard is essentially identical to its exposure draft even though about 250 opposing comment letters were sent to the board.  It is also pertinent to note that FASB put the project on its agenda less than 11 months before issuing the standard.  In short, the current board members are feeling strong and empowered, and they’re showing their inclination to advance reform over the complaints of those who are satisfied with the status quo.

To return to my first point, then, the issue at hand is not what the APB said, not what the old FASB said, not what practice has been for 30 years, not what Mr. Pugh prefers, and certainly not what I prefer.  The past pronouncements, while accurately quoted and interpreted by Mr. Pugh, simply no longer matter in the current debate.  What does matter is what today’s FASB is inclined to accomplish in the future.  By putting leases on the agenda, this board declared its willingness to “comprehensively reconsider the existing accounting for leases,” to use the language from FASB’s website.  The goal is ensure that “investors and other users of financial statements are provided useful, transparent, and complete information about leasing transactions in the financial statements.”

This determination of what is useful will be accomplished by a newly empowered and independent FASB that does not feel encumbered by past rationalizations of its predecessors.  Rather, it is focused on the needs of financial statement users around the world and will not be held back by anachronistic thinking.  

So, will the board leave lease accounting intact, as Mr. Pugh seems to believe it surely will, or will it move to current value accounting as I would have it go?  Probably neither of those things will be accomplished.  However, we can be sure that the board will require managers to capitalize all material leases, whether short- or long-term, and perhaps implement other new practices as well.  Keeping today’s 30-year old GAAP intact is simply not one of the alternatives for the future.