Given the continued interest regarding the proposed changes to Lease Accounting, I decided to write another entry on this controversial topic with colorful commentary from our resident accounting expert, Seamus Moran.

Background (A History Lesson)

Back in 1976, the FASB issued FAS 13, “Accounting for Leases” that permitted leases to be either an operating lease or capital (finance) lease. In substance, operating leases are a form of off-balance sheet financing.

According to Seamus, operating leases date back to the launch of the Boeing 707 in the 1950s.  Because the aircraft was so much more expensive than previous aircrafts, the industry came up with the operating lease concept to accommodate these jet liners that dominated air transport.  How it worked was the bank would buy the plane and lease it to the airline.  Because the bank never controlled or flew the plane, they never placed the asset on their balance sheet, and because the airline never owned the plane, they didn’t place it on their balance sheet either. They simply treated the monthly lease payments as rental expenses on the P&L.  

August 2010 Original Lease Accounting Changes

In August 2010, FASB and IASB decided to overhaul lease accounting as part of their joint commitment “to insure that investors and other users of financial statements are provided useful, transparent, and complete information about leasing transactions in the financial statements.”  Some say that the current lease accounting standards are broken because it keeps assets off the balance sheet, hidden from investors’ view.

The original proposal abolished operating leases and only permitted capital leases where all leases would be recorded on the balance sheet as assets and liabilities. The asset side would reflect the right to use the asset for the leased term, and the liability side would reflect the obligation to make lease payments.  

Why Companies Were Freaking Out

According to the SEC, the financial impact of the aforementioned lease changes was estimated to add more than $1.3 trillion of operating lease obligations to corporate balance sheets. Many companies in various industries, especially retail, are concerned because the changes are significant and will impact existing leases with no grandfather clause for existing operating leases. Of course, the banks and airlines I mentioned earlier really hate this because neither wants to report the airplane (now costing around $60 M) as an asset.

Regular companies were concerned that they would have to report routine short term leases of real estate or equipment as fixed assets, even though they were really just longer term rentals.  One company we spoke to leased roadside billboards, and really did not consider them to be fixed assets in any way.

Obviously, these changes would have had a profound and lasting effect on a company’s financial and real estate strategies and significantly impact its financial statements.  Financial statements would show higher depreciation and interest expense with significantly higher total assets and debt. In terms of financial metrics, they’re negatively impacted. It would raise a company’s debt-to-capital ratio to reflect the higher debt compared to equity, it would negatively impact their return-on-assets because now companies will appear more asset intensive, and it will decrease EPS, lowering shareholder ROI.

Feb. 2011 Recent Update

The comment period on leases closed in December 2010.

The FASB and the IASB have met several times since then and published their initial responses to the input they received from the various interested parties.  They are “redeliberating” the principles involved in Lease Accounting.  Some of the issues they are looking at include:

• The core definition of a lease.  This will articulate principles on what is a lease and what is “not-a-lease.” One theory or supposition is that they might define a lease as the transfer of certain but not all major ownership attributes for a certain period of time.  So a year’s lease of an aircraft might be a “lease,” but a year’s lease of half a floor in an office building would be “not-a-lease.”  The ownership attributes transferred from the core owner to the user are different; the airline must maintain, paint, and do whatever it needs to do on the aircraft. However, the office renter will have strictly limited rights in respect to the rented space.
• The differences between a lease contract and service contract.  Even if they call them “leases” for the purpose of commercial law, a service contract might not be accounted for as a lease.
• The accounting to be done by the lessee.  They would define when the bank or landlord would retain the asset on their balance sheet, and perhaps by implication, when the lessor would not need to include the asset on theirs.  So if the finance house keeps the airplane or office on their balance sheet, the tenant doesn’t need to.  I’m not sure that I can draw the opposite conclusion where the finance house doesn’t report but the tenant must.
• The difference, if any, between a financing lease and other leases, and the implications to the accounting.
• The present value calculation when renewable terms exist. They have reduced the circumstances in which one must look at the renewable terms of a lease in calculating the present value.  In most circumstances, you will use the lease term rather than the potential renewable term.
• Their latest discussion this past week with the contents of the discussion was not available at the time of me writing this entry.  For more details, the results of the discussions are posted on both the FASB and the IASB websites.

Implied Software Changes

Whatever the final rules turn out to be, all ERP systems, such as Oracle E-Business Suite, PeopleSoft Enterprise, JD Edwards, and Oracle Hyperion will need to change their software to accommodate the new rules.

The following lists some changes that might have to be made to accounting software depending on what the final standards will be in June 2011:

• Lease tracking may require modifications with tracking of additional lease details that might require a centralized repository to maintain
• Accounting may need to be modified as there are many changes to how capital leases and the new “other than finance” leases are accounted for both on the lessee and lessor side.  For example, valuation, amortization, and disclosure will be considerably different requiring different types of data to be captured.
• Companies may need to modify their chart of accounts depending on how they want to track leases, which could then impact financial reporting and consolidation
• Business processes may require changes which could then impact internal controls
• Software applications may need to perform more advanced computations on leases
• Reports and KPIs may need to reflect new operating metrics

Hold Onto Your Seats          

Before you redo all your lease agreements and call your software vendors asking when the changes to the software will be made, remember that the rules are not finalized yet, and from appearances, will not reflect the proposals in the exposure draft.  Not only are there objections to putting the operating lease assets on anyone’s balance sheet, there are lots of objections to subjectivity and the data required for the valuation. 

According to Seamus, there is huge opposition from New York bankers, the airlines, the EU, the Communist Party of China (since it impacts their exporting business), and Republicans (hearing complaints from small and large businesses). Even if everyone can agree on the proposed changes, 2013 might be the earliest that companies would need to change how they report leases.

The Boards will finish their deliberations in April, May or June 2011.  As we’ve seen with other Exposure Drafts, if the changes are minor and the principles met the General Acceptance consensus criteria, the Standard could be finalized at that time.  However, if substantial changes are made, a fresh exposure draft, comment period, and review period might be involved, too.

Seamus added an interesting perspective. Even if the proposed changes do pass, don’t you think our customers, such as Boeing, GE Capital, United Airlines, etc. will be clever enough to come up with a new kind of financing arrangement that complies with the new accounting? How about the large retail customers, such as Best Buy and Macerich? Don’t you think they might simply cut deals around retail locations with new contracts that prevent their leases from being capital leases?

Instead of blindly adapting the software to meet the principles outlined in the final standard, our software needs to accommodate how businesses will respond to the new rules. We cannot know our customers’ responses until the rules are finalized. Oracle is aware of the potential changes and is staying abreast of the developments through our domain expertise staff, our relationship with customers, our market awareness, and, of course, our relationships with the Big 4. This is part of our normal process with respect to worldwide regulatory compliance. Oracle products have been IFRS and GAAP compliant for years and we will continue to maintain those standards going forward.