A Dual Model for Lease Accounting: 
Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy

Bob Jensen at Trinity University 

 

FASB, IASB disagree on converged financial-reporting standard for leases

What Financial Analysts Don't Want  

Operating Leases Are Forward Contracts, Not Debt (Yeah Right!)

Why are major revisions desperately needed lease accounting standards?

Anticipated (Dual-Model) Revisions Summary as of May 3 2013?

Correction of Jensen Messaging:  Forecasted Transaction Controversies

Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy

Are the proposed changes to booking of lease accounting renewals in conformance with the Conceptual Framework?

Scenarios on how companies tweak lease contracts to avoid having to book them as assets and liabilities

Controversies Over Long-Term Leases:  Why are they sometimes more like long-term purchase contracts?

Subsequent conversations with AECMers

 


IASB Says the Tentative FASB Lease Accounting Model is Too Complicated

From the CFO Journal's Morning Ledger on August 11, 2014

About $2 trillion in off-balance sheet leases needs to be brought onto companies’ books, U.S. and international rule makers agree. But that’s about where the agreement ends. When the final version of their lease accounting overhaul arrives next year, it’s likely to involve different models for lease expensing, creating a potential headache for corporate financial staff in applying the divergent rules.

The U.S. Financial Accounting Standards Board plans to stick with its proposed dual model for lease accounting, which treats some leases as straight-line expenses and others as financings. But the International Accounting Standards Board said last week that it has tentatively decided to go with just one model for all lease expenses, because it views the FASB’s plan as too complicated, CFOJ’s Emily Chasan reports.

But it’s also possible that the differences won’t be too difficult to reconcile. “While it looks like we won’t have one complete joint solution in the end, the actual impact of the differing models over time may not be as dramatic as one might first think,” said Nigel Sleigh-Johnson, head of the Institute of Chartered Accountants of England and Wales’ financial reporting faculty.

Jensen Comment
Neither the FASB nor the IASB will ever make headway with short-term lease accounting rules until they factor in probabilities of lease renewals.

Bob Jensen's Document on How to Avoid Booking Leases Under FAS 13 and the Dual Model ---
http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

Also see
http://www.trinity.edu/rjensen/Theory02.htm#Leases


Two Teaching Cases Featuring Proposed Major Differences (FASB versus IASB) in Lease Accounting

IASB Says the Tentative FASB Lease Accounting Model is Too Complicated

From the CFO Journal's Morning Ledger on August 11, 2014

About $2 trillion in off-balance sheet leases needs to be brought onto companies’ books, U.S. and international rule makers agree. But that’s about where the agreement ends. When the final version of their lease accounting overhaul arrives next year, it’s likely to involve different models for lease expensing, creating a potential headache for corporate financial staff in applying the divergent rules.

The U.S. Financial Accounting Standards Board plans to stick with its proposed dual model for lease accounting, which treats some leases as straight-line expenses and others as financings. But the International Accounting Standards Board said last week that it has tentatively decided to go with just one model for all lease expenses, because it views the FASB’s plan as too complicated, CFOJ’s Emily Chasan reports.

But it’s also possible that the differences won’t be too difficult to reconcile. “While it looks like we won’t have one complete joint solution in the end, the actual impact of the differing models over time may not be as dramatic as one might first think,” said Nigel Sleigh-Johnson, head of the Institute of Chartered Accountants of England and Wales’ financial reporting faculty.

Teaching Case
From The Wall Street Journal's Weekly Accounting Review on March 21, 2014

Rule Makers Still Split on Lease Accounting
by: Emily Chasan
Mar 18, 2014
Click here to view the full article on WSJ.com
 

TOPICS: Financial Accounting Standards Board, International Accounting Standards Board, Lease Accounting

SUMMARY: On Tuesday and Wednesday, March 18 and 19, 2014, the U.S. Financial Accounting Standards Board (FASB) and London-based International Accounting Standards Board (IASB) met to further their "aim to issue a final standard later this year that would move about $2 trillion dollars of lease obligations onto corporate balance sheets." According to the article, their differences have to do with the amortization of the lease cost into the income statement: straight-line presentation of the rental cost in the income statement or presentation as a long-term financing of an asset which involves depreciation expense and interest expense on the lease obligation. The former treatment is argued to be more appropriate for, say, storefront rental leases. The latter system can show higher expenses in the early years of a lease obligation.

CLASSROOM APPLICATION: The article is an excellent one to introduce impending changes in lease accounting in financial accounting classes.

QUESTIONS: 
1. (Advanced) Summarize accounting by lessees under current reporting requirements.

2. (Advanced) How do current requirements lead to lack of comparability among financial reports? How do they result in financial statements which often lack representational faithfulness? In your answer, define the qualitative characteristics of comparability and representational faithfulness.

3. (Introductory) Summarize the two proposed methods of accounting for all leases as described in this article. Identify a timeline over which these proposals have been made.

4. (Introductory) Summarize company reactions to these proposed accounting changes.

5. (Advanced) Are company arguments and reactions based on accounting theory? Support your answer.
 

Reviewed By: Judy Beckman, University of Rhode Island

"Rule Makers Still Split on Lease Accounting," byEmily Chasan, The Wall Street Journal, March 18, 2014 ---
http://blogs.wsj.com/cfo/2014/03/18/rule-makers-still-split-on-lease-accounting/?mod=djem_jiewr_AC_domainid

U.S. and international rule makers remained divided Tuesday in the first of two days of meetings aimed at resolving differences on lease accounting.

The U.S. Financial Accounting Standards Board and London-based International Accounting Standards Board aim to issue a final standard later this year that would move about $2 trillion dollars of lease obligations onto corporate balance sheets. But they are still split on the fundamental model companies should use to measure those liabilities.

“We have been struggling with this standard for many years,” Hans Hoogervorst, chairman of the IASB said at the meeting in Norwalk, Conn. “There is no simple answer.”

The major difference is whether to restrict companies to one method to account for leases, or to let them choose between two. The debate will continue Wednesday.

Since 2005, the Securities and Exchange Commission has recommended an overhaul of lease accounting because large off-the-books lease obligations can obscure a company’s true finances.

Under current rules, lease accounting is based on rigid categories that let companies keep operating leases for items such as airplanes, retail stores, computers and photocopiers off the books, mentioning them only in footnotes. In other cases, where the present value of lease payments represents a very large portion of the asset’s value, they are called capital leases and treated more like debt.

In their efforts to revamp the rules, accounting standard setters have gone back to the drawing board several times. In 2010, they proposed a method aimed at bringing leases on-the-books by categorizing them as “right of use” assets, which would treat them like financings.

Companies pushed back, claiming it would be costly to implement and could unnecessarily front-load lease expenses.

So the rule makers agreed to compromise in 2012 on a two-method approach: The first would let companies treat some leases like financings, such as when a company can purchase the asset at the end of a lease. The second would treat other leases as straight-line expenses, such as rental payments for retail storefronts.

That move also drew criticism from analysts, who were concerned they wouldn’t get comparable financial information because the choice would be left up to companies.

On Tuesday, some board members said they preferred to return to the “right of use” approach because they think the compromise is weak. Others were in favor of the two-method approach because it would be easier to implement.

The dual method approach is the “more operational one, at least initially,” said FASB Vice Chairman Jim Kroeker.

To speed a resolution, the boards also generally agreed to eliminate potential changes to lessor accounting from the proposal.

The boards had received feedback from investors and analysts that the current lessor model works well and that changes could result in more work.

Continued in article

Teaching Case
From The Wall Street Journal's Weekly Accounting Review on August 15, 2014

Accounting Rule Makers Diverge on Lease Expensing
by: Emily Chasan
Aug 08, 2014
Click here to view the full article on WSJ.com
 

TOPICS: FASB, IASB, Lease Accounting

SUMMARY: U.S. and international accounting rule makers are getting closer to a final version of their long-awaited lease accounting overhaul, but the two boards are unlikely to use the same lease expensing model in their final rules. The London-based International Accounting Standards Board published an update saying it has tentatively decided to propose a single model for lease expenses, rejecting a 2013 compromise with the U.S. Financial Accounting Standards Board for a dual model amid concerns that it is too complex.

CLASSROOM APPLICATION: This article is a good update regarding accounting for leases.

QUESTIONS: 
1. (Introductory) What is FASB? What is IASB? What do they have in common? How do they differ?

2. (Advanced) What are the current rules regarding accounting for leasing? Will this be changing? If so, how?

3. (Advanced) Why do some parties take issue with the current model of accounting for leases? Do you agree that this is a problem? Why or why not?

4. (Advanced) What is the reasoning behind the idea that there is no real difference between the FASB and IASB methods? Do you agree?
 

Reviewed By: Linda Christiansen, Indiana University Southeast

"Accounting Rule Makers Diverge on Lease Expensing," by Emily Chasan, The Wall Street Journal, August 8, 2014 ---
http://blogs.wsj.com/cfo/2014/08/08/accounting-rule-makers-diverge-on-lease-expensing/?mod=djem_jiewr_AC_domainid

U.S. and international accounting rule makers are getting closer to a final version of their long-awaited lease accounting overhaul by next year, but the two boards are unlikely to use the same lease expensing model in their final rules.

The London-based International Accounting Standards Board this week published an update saying it has tentatively decided to propose a single model for lease expenses, rejecting a 2013 compromise with the U.S. Financial Accounting Standards Board for a dual model amid concerns that it is too complex.

FASB has tentatively decided to retain the dual model, because it believes it better reflects the economics of different types of leases, such as real estate and equipment leases. The models may not result in significant financial differences, but it could have big operational differences for corporate financial staff applying the standards, industry analysts say.

The primary goal of the joint lease accounting overhaul has long been to push companies to bring about $2 trillion in off-balance sheet leases onto the books. Investors complain that today’s off-balance sheet leases obscure a company’s true liabilities, and that they often have to adjust calculations to include these expenses. Off-balance sheet leases may be understating the long-term liabilities of companies by 20% in Europe, by 23% in North America, and by 46% in Asia, according to IASB research.

But the overhaul has been delayed by disagreements over how companies should measure leased assets and liabilities.

The IASB’s single model would treat all leases like financings, requiring companies to recognize a so-called “right of use” asset and amortize it over time. FASB’s dual model would treat some leases like financings, such as when a company has the option to purchase equipment at the end of a lease term, and treat other leases, such as store rental payments, as straight-line expenses.

“While it looks like we won’t have one complete joint solution in the end, the actual impact of the differing models over time may not be as be dramatic as one might first think,” said Nigel Sleigh-Johnson, head of the Instituted of Chartered Accountants of England and Wales’ financial reporting faculty.

The real estate industry has primarily been concerned that the single financing model for lease accounting would force them to front-load lease expenses. But when companies include the additional lease service components or tenant improvements into the straight-line expensing model, the final result is often similar to the financing model, according to a study of dozens of real-world leases earlier this year by leasing firm LeaseCalcs LLC.

“In practice, the difference in the IASB and FASB positions is expected to result in little difference,” the IASB said in its update.

Jensen Comment
Neither the FASB nor the IASB will ever make headway with short-term lease accounting rules until they factor in probabilities of lease renewals.

Bob Jensen's Document on How to Avoid Booking Leases Under FAS 13 and the Dual Model ---
http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

Also see
http://www.trinity.edu/rjensen/Theory02.htm#Leases

 


"Accounting Standards Board Chairman Hans HoogervorstHow the lease accounting proposal may change," by Ken Tysiac, Journal of Accountancy, February 8, 2014 ---
http://journalofaccountancy.com/News/20149547.htm

Acknowledging that the converged leases project poses difficulties for standard setters, International Accounting Standards Board (IASB) Chairman Hans Hoogervorst described some possible solutions Wednesday during a speech in Tokyo.

The IASB and FASB are involved in new deliberations on their converged leases project after receiving feedback from financial statement preparers that said implementation costs would be high and benefits would be low if a proposal released in May is approved.

“We take these concerns very seriously,” Hoogervorst said. “As we take our final decision in the next couple of months, you can rest assured that we will do our utmost to keep these costs at a minimum.”

Hoogervorst said the boards may make the following changes to the proposal:

  • Excluding small-ticket items. One possibility is permitting requirements to be applied to a portfolio of leases, Hoogervorst said. For example, if a business leases 100 photocopiers, they could be accounted for as one item.
  • Limiting the changes to lessor accounting. Many stakeholders do not consider lessor accounting to be broken, Hoogervorst said.
  • Simplifying the distinction between Type A and Type B leases. The current proposal classifies leases as Type A when a more-than-insignificant amount of the value of the asset is consumed during the lease period. These include most equipment and vehicle leases. Type B leases under the proposal have an insignificant amount of the value of the asset consumed during the lease. Most property leases would be considered Type B leases.


The AICPA Financial Reporting Executive Committee (FinREC)
recommended a dividing line that it said would be simpler. In its comment letter, FinREC said leases consistent with in-substance finance purchases should be accounted for as Type A leases, and other leases should be accounted for as Type B.

Hoogervorst said the overwhelming majority of financial statement users have said they agree with the boards’ conclusion that leases contain a heavy amount of financing.

“They do not like the present situation, in which they have to make their own estimates of the hidden leverage underlying lease contracts,” Hoogervorst said. “They simply want to see leases on the balance sheet and want the rigor and comparability that only an accounting standard can offer.”

In addition, Hoogervorst said, the boards have found that many investors, when making their adjustments to balance sheets, actually exaggerate the implicit leverage in leases. So the leases standard could make many companies look better in the eyes of investors, he said.

Hoogervorst also predicted that the leases standard will be similar to standards that brought pensions onto balance sheets, providing transparency that changed business practices.

“I expect that more than a few executives are not fully aware of the implicit leverage caused by leases,” Hoogervorst said. “The leases standard will help them to make better-reasoned decisions between purchasing and leasing.”

Jensen Comment
I don't think there's any hope for operating lease capitalization until standard setters come to grips with renewal options. Perhaps this is one of those problems that just does not fit the double entry model and the undefined index we call earnings-per-share.

I recall a comment years ago to the effect that "Boeing reports it sold an airliner to Eastern Airlines, but Eastern Airlines only reports that it leases that airliner."


From the CFO Journal's Morning Ledger on Januaary 22. 2014

Lease-accounting overhaul likely to be scaled back
The FASB and IASB moved forward with plans that could limit the scope of their project to overhaul lease-accounting rules and allow them to refocus their efforts on bringing over $1 trillion in off-balance-sheet leases onto corporate books,
Emily Chasan reports. In a joint meeting, the accounting rule makers discussed scaling back their efforts to simultaneously revamp so-called “lessor” accounting for companies that lease assets, such as airplanes or photocopiers, to other firms. Investors and other users of financial statements “are telling us this isn’t something we need,” Scott Muir, a FASB staff member, said at the meeting. Some users and analysts have told the board that the cost of making changes to lessor accounting outweighs the benefits, and significant changes may harm their analyses, Mr. Muir said.

From the CFO Journal's Morning Ledger on December 10, 2013

Boards Review Feedback on the Revised Leases Exposure Draft

The revised exposure draft issued by FASB and IASB on accounting for leases has received more than 600 comment letters to date. The proposal would significantly change the current accounting for leases, especially for lessees, which would be required to account for all leases on the balance sheet. For a summary of the key themes of feedback received from constituents on the revised exposure draft, see the latest issue of Deloitte's “Heads Up.

From Deloitte on December 8, 2013

Following is a summary of the key themes of the comments received on the ED³ from the latest issue of Deloitte’s Heads Up. For SEC comments on other matters, in addition to leases, see SEC Comment Letters—Including Industry Insights: Constructing Clear Disclosures.

Overall Feedback

Objectives

In general, most constituents support the boards’ stated objectives for the lease project.⁴ Many agree that the current lease model is complex, may not provide enough decision-useful information and can result in different accounting for similar economic transactions. Many also believe that a lease contract gives rise to rights and obligations that should be recognized as an asset and obligation in the financial statements.

However, most constituents indicated that the revised ED fails to meet the lease project’s objectives. Specifically, a large number of respondents noted that the proposal would not reduce complexity, with some even claiming that it would make the accounting for leases more complex. These respondents asserted that the proposed dual-classification model and reassessment requirements would not improve current GAAP.

Some constituents indicated that the boards should consider an approach that retains the current lease accounting guidance but introduces additional disclosure requirements. Others questioned whether the project should focus on lessee accounting issues only and whether symmetry between lessee and lessor accounting is necessary.

Nearly all preparer respondents asserted that the costs of adopting the new guidance would be significant, especially those associated with implementing (or modifying) accounting systems to comply with it. Other costs mentioned include those related to hiring and training of new employees, renegotiating debt covenants and educating investors.

Definition of a Lease

Most respondents agree with the proposed definition of a lease,⁵ which is broadly consistent with the definition under existing GAAP. Under the proposal, an entity would determine whether a contract contains a lease by assessing whether (1) fulfillment of the contract depends on the use of an identified asset and (2) the contract conveys the right to control the use of such asset. Many respondents expressed concerns related to performing this assessment and suggested that the boards draft implementation guidance, particularly on:

  • Assessing substitution rights—Respondents expressed concern about the requirement to determine whether a substitution right for an identified asset is considered substantive, and many requested additional guidance on how to assess whether there are barriers to substitution.
  • Evaluating “the right to control the use” of the identified asset—Respondents requested additional guidance on evaluating whether a lessee controls the use of the identified asset. They noted numerous situations in which such guidance would be warranted, including those in which two or more parties each have the ability to make unilateral decisions that significantly affect the economic benefits to be obtained from an identified asset, those in which a lessee is not in physical possession of the asset and those in which a customer was involved in the design of the asset. Some respondents indicated that the guidance should align with that on control in the proposed revenue recognition standard and existing consolidation standards.
  • Determining assets that are “incidental to the delivery of services”—The ED states that an arrangement is not a lease but rather the delivery of a service if (1) the “customer can obtain the benefits from use of the asset only in conjunction with additional goods or services that are provided by the supplier and not sold separately by the supplier or other suppliers” and (2) the “asset is incidental to the delivery of services.” Some respondents believe that the boards should add more examples illustrating this concept, and others had questions about the conclusions in the ED’s examples. In addition, some respondents suggested that the boards clarify how an asset’s value affects the evaluation of whether the asset is “incidental” to the delivery of a service.
  • Identifying and separating lease and nonlease components—Respondents indicated that they may have difficulty distinguishing between lease components and service components in a single arrangement. In addition, many expressed concerns about how to allocate consideration between the various components, particularly when a lessee cannot determine the stand-alone selling price of each component. Some indicated that when separation is prohibited, recording the nonlease component as part of the lease liability would not be appropriate.

Short-term Leases

The short-term lease exemption in the ED allows both lessees and lessors to elect, as an accounting policy choice by asset class, whether to apply the ED to lease contracts that have a maximum possible lease term of 12 months. Entities applying such exemption will treat eligible contracts in a similar manner as operating leases under the existing guidance in ASC 840.⁶

Many constituents support the short-term lease exemption as a way to reduce the burden on preparers. However, several suggested broadening the exemption, generally by expanding it to leases that are shorter than 24 or 36 months or are for noncore assets.

In addition, some respondents questioned the requirement to consider the maximum possible lease term in the assessment of a lease’s eligibility for the exemption. Such respondents were concerned that a lease that is ineligible for the exemption because of the existence of a renewal option may be measured on the basis of a lease term that is less than 12 months since the lessee does not have a significant economic incentive to renew the lease.

Lease Term

Constituents had mixed views on the proposed definition of lease term and the related reassessment requirements. While many support the proposed definition—which would include the noncancelable period of the lease as well as renewal periods for which the lessee has a significant economic incentive to exercise the renewal option (or not exercise a termination option)—some urged the boards to retain the “reasonably certain” notion in current GAAP.

A number of constituents argued that if the proposal was not intended to change the evaluation of lease term, as suggested in the ED’s basis for conclusions, then the boards should retain the current concepts. Some constituents also argued that renewal periods should be excluded from the lease term until the renewal option is exercised and the lessee has an obligation to make lease payments. Further, certain lessor constituents noted that it would be too difficult (if not impossible) to determine whether a lessee has sufficient economic incentive to exercise a renewal option (or not exercise a termination option) and expressed concerns that requiring such an assessment would reduce comparability of lessor entities’ financial statements.

Most constituents also disagreed with the proposal’s requirement to reassess lease term on an ongoing basis, and some suggested that reassessment be performed only upon the occurrence of a significant triggering event. These constituents cited the costs as well as the complexity of performing individual reassessments of potentially thousands of leases.

Variable Lease Payments

Under the proposal, measurement of the right-of-use (ROU) asset and lease liability would include variable payments that are (1) based on an index or rate and (2) in-substance fixed lease payments (e.g., disguised fixed lease payments). For the most part, respondents agree with these provisions and believe that variable payments based on usage and performance of the underlying asset should be excluded from the measurement of the ROU asset and liability. Some respondents requested additional clarity about what would constitute an in-substance fixed payment and recommended that the boards add guidance on, and examples of, such payments.

Most respondents, however, are opposed to the requirement to remeasure the ROU asset and lease liability in response to changes in the index or the rate used to measure the ROU asset and lease liability. These constituents cited the undue burden, costs and complexity associated with the requirement and suggested that changes in an index or rate be (1) recognized in earnings with no adjustment to the ROU asset and lease liability or (2) reassessed at reasonable intervals (e.g., annually) or when the change is significant.

Lease Classification

Under the proposal, the lease classification would affect the lessee’s subsequent accounting for its ROU assets (i.e., financing approach versus the straight-line approach) and whether a lessor accounts for the transaction as an operating lease or by using the receivable-and-residual approach. The lease classification depends on the nature of the leased asset (i.e., either property or something other than property) as well as the terms and conditions of the lease.

Constituents’ views on the proposal’s classification guidance are mixed. Some oppose any dual-model approach for lessees. Accordingly, lessees would classify all leases similarly, though respondents disagree about whether a single model should be based on a straight-line expense model, financing model, or some other hybrid model.

Those supporting a financing model expressed concerns about the conceptual merits of the proposed Type B leases model, which would result in an increasing amount of amortization over the term of the lease. They also indicated that this amortization approach could increase the potential risk of impairment of the ROU asset.

Certain respondents preferred a dual-model approach for lessees but had different views about applying such approach. For example, some agreed with the ED’s proposal to distinguish between “property” and “not property” while others would expand the definition of property to include other assets with economic characteristics that are similar to property (e.g., railcars, storage containers). Many also suggested that the boards retain the classification guidance in ASC 840 and IAS 17.⁷

Many respondents also noted that in the evaluation of the classification of a lease, the analysis of the lease’s terms and conditions for assets that are considered property would focus on whether the lease term is for a major part of the asset’s remaining life whereas the analysis for assets that are considered other than property would focus on whether the lease term is for an insignificant part of the asset’s total life. Such respondents indicated that the boards should avoid inconsistency by selecting one metric (i.e., either a major part or an insignificant part) and specifying whether the evaluation would be based on the remaining economic life or the total economic life of the asset. Other respondents suggested that regardless of the metric selected, the boards should add guidance on the definition of “major part” and an “insignificant part.” Some suggested that the classification be based solely on the nature of the asset and not take into account the lease’s terms and conditions.

Lessor Considerations

Respondents generally noted that they were unable to understand how the proposal and its related complexities would improve current lessor accounting. They recommended that the boards retain the existing guidance since there has been little criticism of the model or resulting information by financial statement users.

Related Parties

The majority of constituents agreed with the proposals to eliminate the current GAAP requirements specific to accounting for related-party leases and that no new disclosures would be required for such leases. These constituents agreed with the view that related-party leases should be accounted for in accordance with their contractual terms, although some believe that additional disclosures would be warranted. A number of constituents also expressed concerns that not retaining the current “substance over form” guidance on related-party leases would allow entities to structure such leases with terms that do not reflect the true economics of the leasing arrangement.

Transition

Although some constituents believe that full retrospective adoption is appropriate, many are concerned that this method would be too costly and onerous to apply. They recommended a modified retrospective approach (similar to the method outlined in the proposal) or a fully prospective transition approach. Other respondents indicated that the ED’s transition provisions should align more closely with those in the proposed revenue recognition guidance.

Other constituent recommendations include grandfathering the existing leveraged leases requirements and the current requirements in ASC 840-10-15 (formerly EITF Issue No. 01-8⁸) for existing leases. Many preparer respondents also commented that they would need at least three years from the final standard’s issuance date to adopt the new guidance, and some noted that they would prefer an even longer transition period.

A recurring theme in the feedback, however, was that implementing the proposed requirements would be time-consuming, arduous and expensive.

Next Steps 

At a joint meeting in late November 2013, the boards’ staffs presented (1) a summary of feedback received on the proposal and (2) a plan for redeliberating the significant issues associated with it. Redeliberations are expected continue into the first half of 2014 (if not longer). The boards have not yet established an expected effective date for the final standard.

—Produced by by Trevor Farber, Tim Kolber, Justin Truscott and Sean Prince, Deloitte & Touche LLP


Endnotes
1. FASB Proposed Accounting Standards Update, Leases.
2. For further information on the revised ED, see Deloitte’s May 17, 2013, Heads Up.
3. For more information, see the boards’ summary of feedback of comments received on the ED.
4. See paragraph BC3 of the ED for further discussion of the boards’ objectives for the lease project.
5. See paragraphs 842-10-15-2 and 15-3 of the ED for the proposed definition of a lease.
6. FASB Accounting Standards Codification Topic 840, Leases.
7. IAS 17, Leases.
8. EITF Issue No. 01-8, “Determining Whether an Arrangement Contains a Lease.”

Related Resources

Bob Jensen's threads on leases as schemes for hiding debt ---
http://www.trinity.edu/rjensen/Theory02.htm#Leases

 

"Type A or Type B? Lease concerns emerge at round table," by Ken Tysiac, Journal of Accountancy, September 23, 2013 ---
http://journalofaccountancy.com/News/20138792.htm

"FASB’s Investor Advisory Committee opposes leases proposal," by Ken Tysiac, Journal of Accountancy, September 3, 2013 ---
http://journalofaccountancy.com/News/20138651.htm

The converged proposal on financial reporting for leases continues to face resistance with the deadline for comment letters little more than one week away.

FASB’s Investor Advisory Committee (IAC) last week declined to support the proposal, stating that the proposal is not an improvement to current accounting. And the Equipment Leasing and Finance Association (ELFA), a U.S. trade group, continued its campaign against the proposal with a news release drawing attention to the advisory committee’s dissent.

“This raises another key question,” ELFA President and CEO William Sutton said Tuesday in a news release seizing upon the IAC’s conclusion. “Is the cost-benefit analysis in the exposure draft sound if key users and other stakeholders maintain that current GAAP gives them better information than the proposed exposure draft and that the proposed rules are too complex?”

Comments are due Sept. 13 on the proposal at the websites of FASB and the International Accounting Standards Board (IASB). The proposal calls for lessees to report a straight-line lease expense in their income statement for most real estate leases. In most equipment and vehicle leases, lessees would recognize leases as a nonfinancial asset measured at cost, less amortization. This would result in a total lease expense that generally would decrease over the lease term.

Former FASB Chairman Leslie Seidman said when the proposal was released that it reflects investors’ views that leases are liabilities that belong on the balance sheet.

During the IAC’s meeting with FASB on Aug. 27, IAC member David Trainer, CEO of investor research company New Constructs, said it’s helpful to get more transparency on the liabilities related to leases. But he said the complexities of leasing activity make it almost impossible to create a one-size-fits-all solution that can be put on the balance sheet.

The IAC recommended that the boards increase disclosure requirements about leases rather than placing them on the balance sheet.

“Having to unwind an accounting construct put on the balance sheet and then having to do my own analysis is not very desirable,” Trainer said. “I’d rather just have the data there, and let me do with it what I think I ought to do with it.”

In the spring, Moody’s Investors Service Managing Director Mark LaMonte expressed a similar view, saying the proposal would force investors and analysts to deconstruct the information placed on the balance sheet before performing their own calculations to determine lease liabilities.

Continued in article

Shedding Light on the Proposed Leases Standard
For instructors who are teaching about the proposed joint FASB/IASB revision to the lease accounting standard, a rather nice summary of the proposed revisions and the Power and Utilities industry, July 2013 ---
http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/AERS/ASC/us_aers_pu_spotlight_0713.pdf

Bob Jensen's threads on lease accounting are at
http://www.trinity.edu/rjensen/Theory02.htm#Leases

FASB, IASB release 2013 converged financial-reporting standard for leases
"IASB chair: Lease changes unpopular, but necessary," by Ken Tysiac, Journal of Accountancy, May 18, 2013 ---
http://www.journalofaccountancy.com/News/20138001.htm

"FASB lease proposal moves forward (4-3 vote) despite dissenting views,"  by Ken Tysiac, Journal of Accountancy, April 10, 2013 ---
http://www.journalofaccountancy.com/News/20137752.htm

FASB decided Wednesday to move forward with a re-proposal on financial reporting for leases that will be converged with that of the International Accounting Standards Board (IASB).

FASB Chairman Leslie Seidman cast the deciding vote in a 4–3 decision. Board members Tom Linsmeier, Marc Siegel, and R. Harold Schroeder dissented.

The lease proposal, which is scheduled to be released for public comment by FASB in May, would put all leases on the balance sheet. It would require a dual expense-recognition approach for lessees (excluding short-term leases), depending on whether significant consumption occurs during the lease period.

So in general, equipment and vehicle leases that tend to depreciate significantly during the life of a lease would be accounted for differently from property leases, in which the asset usually does not depreciate and sometimes increases in value over the lease period.

In some cases, the dividing line between the two types of leases can be murky. And the very idea of having two models for accounting for leases is troubling for some because it can create complexity for users.

“Many people think that there should be one model here,” Seidman said. “That is not universal. But they do not agree about which model. So we’ve done our best to try and articulate a distinction that reflects what some perceive as the economics of the difference between what I’ll call ‘rentals’ and what I’ll call ‘finance-type leases.’ ”

During Wednesday’s meeting, FASB’s staff asked board members to address the effects the proposal would have on financial reporting complexity. Linsmeier said the proposal introduces significant complexity for users because it divulges lease information in multiple places in the financial statements without bringing it all together in one footnote.

“If [users] are trying to bring all that information that’s spread throughout the financial statements together to understand what the rights and obligations are under a lease, and what the related income statement and cash flows effects are, we did not provide them sufficient information to do so,” Linsmeier said.

The leases project has been watched carefully by various constituents because of its breadth, as many organizations are parties to lease contracts. Because of the extent to which leases are used, arriving at a converged standard could bring significant global comparability to financial statements.

The IASB plans to release its exposure draft by June 30.

“We have worked tirelessly with the IASB on this proposal, and we are going out with a converged proposal, which I think is a significant accomplishment,” Seidman said. “I would like to try to end up with a converged improvement on the accounting for leases, and so on that basis, I’d like to move forward with this exposure draft.”

From CFO.com Morning Ledger on May 3, 2013

Lease-accounting proposal still seen costing companies
Despite significant changes, companies and investors expect that a coming proposal aimed at overhauling lease-accounting rules will be more costly in some areas than the current standard,
Emily Chasan writes. The FASB and IASB are preparing to shortly release a new lease-accounting proposal for public comment, FASB Chairman Leslie Seidman said at a Baruch College accounting conference in New York on Thursday. “It’s appropriate at this point to re-expose that revised set of conclusions,” Ms. Seidman said. Both versions of the proposal contemplate bringing trillions of dollars of leasing obligations onto corporate balance sheets, but the new proposal allows companies to record lease expenses in two ways, among other changes. Some investors worry that the boards have made so many compromises that the new rule won’t give them a clear picture of corporate leasing obligations. “Ultimately, what’s going to end up back on the balance sheet as a result of applying the standard really isn’t going to satisfy too many users of financial statements,” Mark LaMonte, managing director at Moody’s.

From the CFO.com Morning Ledger on May 16, 2013

The FASB and IASB just rolled out a revised proposal to overhaul lease-accounting rules—a move that could effectively boost U.S. companies’ reported debt by hundreds of billions of dollars, the WSJ’s Michael Rapoport reports. If adopted, the new proposal would require companies to carry all but the shortest leases on real estate, construction equipment and other items on their balance sheets as obligations akin to debt. The current rules allow companies to keep many leases off their books, drawing criticism from regulators that firms sometimes structure the terms of their leases to keep them off the balance sheet.

The change could have a big effect on a wide range of companies, from retailers and restaurant chains, which lease real estate at hundreds or thousands of locations, to airlines and package-delivery companies, which finance aircraft through leases.

The proposal also would change how some companies reflect the costs from leases in calculating their earnings, Rapoport notes. It would set up a two-track system in which the costs of leasing real estate would be recognized evenly over the term of the lease, while the costs of leasing other items would be more front-loaded—higher in the early years of a lease, lower in the later years. We’ll have more updates on the new proposal at CFOJ throughout the day, so stay tuned.

 

Jensen Question
So how do lessees minimize the balance sheet impact of booking operating leases such as a sandwich shop in a Galleria Mall?
I would consider just shortening the operating lease period to a year or less in the case where the former operating lease had a longer term. The FASB has never really seriously taken up the issue of anticipated lease renewals of "operating leases."  Of course shortening a lease could alter the rental prices, especially if the lessor is taking on more risk of non-renewal.

Of course the sandwich shop will now have to post the contracted liabilities for monthly rent for 12 months or less, but the shortened contract gets the shop out of having to post 60 months of future rent obligation if the 60 months lease is no longer contracted with the Mall. Both the Galleria and the sandwich shop of course expect to renew the lease annually.

One problem with putting lease renewal debt or assets on the balance sheet is deciding when the anybody's-guess number of renewals should be terminated. For example, neither the Galleria or the sandwich shop has any idea of how many times the lease will be renewed. The number or future renewals is subject to all sorts of unknowable events of the future.

A huge difference between renting space in a Galleria Mall versus renting a jumbo jet is that the Galleria normally does not provide options to actually own leased apace in such a mall that was not intended to be a condo mall.

FASB, IASB release 2013 converged financial-reporting standard for leases
"IASB chair: Lease changes unpopular, but necessary," by Ken Tysiac, Journal of Accountancy, May 18, 2013 ---
http://www.journalofaccountancy.com/News/20138001.htm


"How Managers Do Love the Leasing ED: Let Me Count the Ways," by Tom Selling, The Accounting Onion, June 9, 2013 ---
http://accountingonion.com/2013/06/how-managers-do-love-the-leasing-ed-let-me-count-the-ways.html

An excerpt from a WSJ blog:

“Outgoing FASB Chairman Leslie Seidman has had plenty of time to tackle long-standing questions about whether accounting principles are more desirable than specific accounting rules, writes Emily Chasan. The debate over whether detailed rules and bright-line exceptions are more or less useful than broad principles that require management judgment has dominated her past 1o years on the board. “I think it’s undeniable that we Americans like our rules,” Ms. Seidman said …  in her final public speech as chairman of the U.S. accounting rule maker.” [emphasis added]

I guess that settles it.  Now we know for certain why FASB standards have gone from bad worse.

Even if Ms. Seidman is correct, the FASB has come up way short of the mark.  The three super major projects she leaves for others to complete when her second five-year term soon comes to an end are the most direct evidence of the dysfunction: loan impairment, revenue recognition and leases.

Focusing on lease accounting by lessees should be enough to make the point; and I want to focus on that since I just finished preparing my presentation on the most recent ED for my upcoming update course in Chicago.  There may be some rules in that ED, but all except for the requirement to recognize some modicum of a lease liability on the balance sheet, are not near as consequential as the smorgasbord of loopholes set out for managers to manipulate their earnings without waking up their auditors or getting a call from an SEC investigator.

Some of these are carryovers from existing U.S. GAAP, but If any of the rest were to make you think they were concocted in the IASB’s central sausage factory, I wouldn’t argue with you:

The lease smoothie—For assets that meet the definition of “property” (a judgment call all by itself), subjective criteria will determine whether management can choose to recognize lease expense straight-line — as opposed to a pattern approximating the actual economics).  The boards are leaving it to management to determine if: the lease term is not for a “major” part of the remaining “economic life” of the asset; or whether the present value of the lease payments is not a “significant” part of the value of the asset; or whether there is a “significant economic incentive” to exercise a purchase option; or that land and/or building is the “primary asset” under contract.

Hide-the lease-payment trick #1—The lease payments to be recognized as an asset and corresponding liability generally are limited to the payments in the contract that are fixed.  However, judgment is required to determine if payments that are contingent on a level of activity (e.g., retail sales in leased store space) are in fact “disguised” as fixed lease payments.  In other words, management is supposed to say, “HA!  I caught myself disguising fixed lease payments as variable payments.”  (Gimme a break.)

Hide-the-lease-payment trick #2Judgment (are we getting tired of that word yet?) is required to treat “expected” (not defined—what a surprise) amounts to be paid under residual value guarantees as lease payments to be capitalized.

Who said buy-borrow?—Options to purchase the asset if they they are in-substance lease payments. (Another “HA!  I caught myself doing a bad thing.”)

Mix and matchJudgment is required to determine if part of the cash flows are not actually lease payments; and more judgment is required to estimate how much should be accounted for according to some other standard.  It could even get to the point that a lessee would have to estimate the fair value—i.e., a sales price—for services that it would never purchase separately and arbitrarily carve them out of the cash.

My all-time favorite—When to take account of renewal or termination options when estimating the lease term is based on whether there is a “significant economic incentive.”  For that, we have the old IASB chestnut of “management intent” as one of the factors to consider.

Don’t wake me from my dreamsJudgement is required to determine that the factors originally used to account for a lease have changed significantly enough to make reassessment appropriate.

There is still more, but that should be more than enough to illustrate that the FASB’s latest gift to investors is far from a compendium of “rules.”  More than a decade ago, a much more attuned SEC issued a clarion call to accounting standards setters, to finally end operating lease treatment; for it was seen then as now as the most pernicious form of off-balance sheet accounting.  This ED is nothing more than one last-ditch effort to take what was an extremely modest proposal for lease capitalization off life support.

Continued in article

Jensen Comment
I'm not sure which managers love the ED. Finance executives absolutely hate the ED.

"When Is an Asset not an Asset?  A new lease accounting proposal by regulators is still getting pummeled by finance executives." by Kathleen Hoffelder, CFO Journal, September 14, 2012 ---
http://www3.cfo.com/article/2012/9/gaap-ifrs_lease-accounting-fasb-iasb-convergence-equipment-lease

Note that the above criticism was published before the latest ED from the FASB. This begs the question of whether the items that made finance executives unhappy were corrected in the 2013 ED. In my opinion the answer is generally no to anticipated financial executives satisfaction.

A good example of this dissatisfaction is the May 31, 2013 reaction to the FASB from ELFA (Equipment Leasing and Finance Association) ---
http://www.elfaonline.org/issues/accounting/pdfs/ELFACreditLossesCommentLtr.pdf

The main concern seems to be the anticipated impact on earnings (especially for Type A leases subject to accelerated expense booking) --- which is something fair value accountants don't care much about since they are almost entirely focused on the balance sheet.

Bob Jensen's threads on lease accounting are at
http://www.trinity.edu/rjensen/Theory02.htm#Leases


How to Mislead With Brief Summaries of Respondent Outcomes

"International Users Press to Put Leases on Balance Sheet, by Tammy Whitehouse, Compliance Week, November 6, 2013 ---
http://www.complianceweek.com/international-users-press-to-put-leases-on-balance-sheet/article/319727/

Even as some U.S. investors are lobbying the Financial Accounting Standards Board to ease up on their plans to revise lease accounting, a user advisory group at the International Accounting Standards Board is urging its board to persist unswayed.

The IASB's Capital Markets Advisory Committee took the rare step of putting its views in writing, says committee member Jane Fuller, who also chairs the Accounting Advocacy Committee of the CFA Society of the United Kingdom. The group met after the Investor Advisory Group for the Financial Accounting Standards Board said it believes FASB should back away from making significant changes to lease accounting and simply require new disclosures that would help users of financial statements better understand the full scope and weight of an entity's lease obligations.

“For some reason, they think you can start with disclosure only,” says Fuller. “We happen to think that disclosure only would still cost preparers. They've got to find the information and put it into a form good enough to make it public. We feel very strongly that these obligations and assets should be on the balance sheet, so why not go that extra step as has been proposed for a long time?”

CMAC's brief letter to IASB Chairman Hans Hoogervorst says the group determined unanimously among those who attended a recent meeting that a disclosure-only approach to lease accounting would be a “sub-optimal solution” because it would not materially reduce the cost to preparers and would not give users of financial statements the information they want in a “decision-useful fashion.” 

Fuller says she was surprised to hear the IAG tell FASB it would settle for a disclosure-only standard. The  CMAC represents both buy-side and sell-side analysts as well as credit analysts, she says, and they are in agreement that leased assets and liabilities belong on the balance sheet. “We do know there is tremendous pushback from companies who would basically prefer not to make a change at all,” she says.  “In some parts of the world, company executives have a lot of influence over politicians.”

Continued in article

Jensen Comment
The above summary by Ms. Whitehouse leaves out some of the "bad stuff." Readers come away feeling that users want operating lease capitalization in all instances. Actually, the survey really says users want lease capitalization only when the numbers meet certain tests of reliability and do not contain numbers for optional lease renewals beyond the first lease term maturity date.

From the CFO Journal's Morning Ledger on November 19, 2013

  • Compromise for lease-accounting overhaul starts to fall apart
    Accounting-rule makers are set this week to begin their latest round of deliberations on a lease-accounting overhaul and aim to have a new rule ready by the end of the first quarter,
    Emily Chasan reports. But a proposed compromise on how to record leased assets appears to be falling apart as investors and companies raise concerns it’s too complex. “The last decisions here are going to be very tricky,” Hans Hoogervorst, chairman of the IASB, said at a conference Monday. The FASB and the IASB have been working since 2006 on a lease-accounting overhaul, spurred by investor complaints that huge off-balance-sheet leases can muddy the picture of a company’s true financial obligations

  • Jensen Comment
    This may be a good thing. The compromise for lease-accounting will motivate lessees to shorten operating lease terms to a point that reporting the booking of operating lease debt is relatively small unless renewal options are also valued and booked. Standard setters have not seriously considered booking of lease renewal options because valuing such contingency options is so unreliable to a point where financial analysts declared that they don't want these wild valuations on the balance sheet.

    The problem with only booking operating lease liabilities for shortened first terms tends to greatly underestimate the total contingency debt --- debt contingent upon circumstances that motivate lessees to renew leases.

    The Rest of the Story:  From the IASB:  What Financial Analysts Do Not Want
    Leases — Summary of outreach meetings with investors and analysts on proposed accounting by lessees
    May – September 2013 --- Click Here
    http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/Lessee-accounting-investor-outreach-summary-May-to-September-2013.pdf

    . . .

    Measurement of lease assets and liabilities
    23. Investors and analysts consulted generally support the proposed measurement of variable lease payments and options, ie
    excluding variable lease payments linked to sales or use and, in most cases, excluding optional renewal periods. Almost all noted that they would not want subjective estimates about variable lease payments and renewal options included in the reported asset and liability amounts. In their view, it would make the balance sheet amounts less reliable and, thus, less useful for their analyses. A number of investors and analysts also think that it is more appropriate to reflect the economic difference between fixed and variable lease payments, and non-cancellable and optional lease periods, on a lessee’s balance sheet as proposed — a lessee with contracts with variable lease payments and optional renewal periods has a lot more flexibility than those making fixed payments in non-cancellable period.

    Teaching Case on Lease Accounting
    From The Wall Street Journal Weekly Accounting Review on November 17, 2014

    A Sure-Fire Way to Harm The Economy
    by: Brad Sherman and Peter King
    Nov 10, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Lease Accounting

    SUMMARY: For hundreds of years companies have treated most lease payments as operating expenses, like rent, and not put them on their balance sheets. Under new accounting standards they would report the leases they hold on their balance sheets as liabilities-equal to the net present value of all future lease payments, which in some cases run for 20 or 30 years. That little-known and seemingly benign change in accounting rules could cost millions of jobs and billions in lost economic growth. Most business owners and their employees have no idea what may be coming. The agencies that establish accounting standards in the U.S., Europe and Asia have a proposal, now gaining momentum, to change how companies present leased property and equipment on their financial statements. If it is implemented, the effect would be dramatic.

    CLASSROOM APPLICATION: This opinion piece provides good information regarding current and proposed accounting rules for leases, as well as the problems that could result from the proposed changes.

    QUESTIONS: 
    1. (Introductory) What are the current accounting rules for leases? What are the proposed changes to those rules?

    2. (Advanced) What are the benefits of the proposed rules? What are the potential problems associated with those changes?

    3. (Advanced) Who is proposing the changes to lease accounting rules? Why does this group have authority?

    4. (Advanced) Who wrote this article? Is it a news story or an opinion piece? How do these writers have knowledge to comment on this issue? Do you respect or trust what they are saying?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "A Sure-Fire Way to Harm The Economy," by Brad Sherman and Peter King, The Wall Street Journal, November 10, 2014 ---
    http://online.wsj.com/articles/brad-sherman-and-peter-king-a-sure-fire-way-to-harm-the-economy-1415574014?mod=djem_jiewr_AC_domainid

    Just as it seems the U.S. economy might be turning a corner, a little-known and seemingly benign change in accounting rules could cost millions of jobs and billions in lost economic growth. Most business owners and their employees have no idea what may be coming.

    The agencies that establish accounting standards in the U.S., Europe and Asia have a proposal, now gaining momentum, to change how companies present leased property and equipment on their financial statements. If it is implemented, the effect would be dramatic.

    For hundreds of years companies have treated most lease payments as operating expenses, like rent, and not put them on their balance sheets. Under new accounting standards they would report the leases they hold on their balance sheets as liabilities—equal to the net present value of all future lease payments, which in some cases run for 20 or 30 years.

    IHS Global Insight has estimated that the new rule would add $2 trillion to the liabilities on companies’ balance sheets, while also adding $2 trillion in “assets” (the right to use the property or equipment). The U.S. Financial Accounting Standards Board (FASB) says this will “provide users of financial statements with a complete and understandable picture of an entity’s leasing activities.” That’s the supposed benefit. But the costs are extraordinary.

    An economic analysis by Chang and Adams Consulting for several leading nonprofit and commercial organizations found that the changes—first proposed in 2010 by the FASB and the London-based International Accounting Standards Board (IASB)—would raise the cost of capital for lessees, in the process destroying 190,000 U.S. jobs and shrinking the economy by $27.5 billion annually. And that was the best-case scenario. At worst, the cost would be 3.3 million lost jobs and an economic hit of over $400 billion a year, indefinitely.

    Businesses of all sizes have long-term loans from banks and other financial institutions. Those loans typically contain covenants allowing the bank to demand immediate repayment when liabilities grow unusually quickly, upsetting, for instance, the ratio of the company’s debt-to-equity agreed upon at the time of the loan. Because the new accounting rules would fabricate trillions in new debt, they would trigger widespread violations of these covenants. Banks could then pull the loan, demand higher interest, or require new collateral and guarantees.

    Some have proposed a five-year transition to the new rules. But this won’t solve the problem, because many business loans are for much longer terms. Pushing the effective date of the rules into the future merely delays the impact.

    The additional burdens associated with constantly tracking and remeasuring the “fair value” of leases of every kind, from a business’s office space to the photocopier down the hall, will hit businesses, and their employees and consumers, directly in the pocketbook. According to some critics, the accounting-rule change would distort the financial condition of businesses by accelerating expenses over a short timeline rather than reflect expenses over the life of a lease.

    Many private parties have sent public comment letters to the FASB urging it and the IASB to conduct field tests to see how much it would really cost lessees and tenants to do all the work the new leasing rules would require. Congress has asked the FASB for a rigorous cost-benefit analysis and field testing to objectively assess the risks of the accounting changes. Neither has been undertaken. Yet all indications are that the U.S. and international accounting-standards boards are going ahead with only minor revisions to their proposal, which may be finalized next year.

    In 1973 the Securities and Exchange Commission formally outsourced the job of writing accounting rules to the FASB. While the SEC is authorized to seek help from private standard-setting bodies on this issue, the Sarbanes-Oxley Act of 2002 explicitly reminded the SEC that these quasi-government agencies can only “assist the Commission” in fulfilling the SEC’s own responsibility to establish accounting standards for publicly held companies.

    Continued in article

    Teaching Case on Pending Lease Accounting Rule Changes
    From The Wall Street Journal Accounting Weekly Review on September 5, 2014

    The Big Number: Changes in Lease Accounting Rules Draw Closer
    by: Emily Chasan
    Sep 01, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Debt Covenants, Financial Accounting, Lease Accounting

    SUMMARY: U.S. and international accounting-rule makers are edging closer to completing a decade-long effort to overhaul lease accounting rules. The rules, which could be issued in 2015, threaten to bring roughly $2 trillion of off-balance-sheet leases onto corporate books. But adding assets and liabilities for store leases, airplanes and the like could force companies to renegotiate the terms of their loans with lenders. Banks and lenders often require companies to maintain covenants, such as a specific debt-to-equity ratio, fixed-asset ratio or earnings metric, which could all be thrown out of whack by such a significant accounting change.

    CLASSROOM APPLICATION: This is an interesting article about the changes to lease accounting because it highlights an important ripple effect: calculations for debt covenants will be affected. This is important to note for students that any change to accounting rules can change the financial statements and any corresponding financial statement analysis calculations. These ripple effects can cause problems for the firms and should be anticipated and addressed.

    QUESTIONS: 
    1. (Introductory) What changes have been proposed for accounting for leases? Why are rule-makers working on these changes?

    2. (Advanced) What are some of the ripple effects resulting from the changes to the lease rules? More specifically, what is the impact on calculations for debt covenants?

    3. (Advanced) How should lenders react? Should they adjust their calculations? How should they approach enforcing existing contract requirements?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "The Big Number: Changes in Lease Accounting Rules Draw Closer," by Emily Chasan, The Wall Street Journal, September 1, 2014 ---
    http://online.wsj.com/articles/the-big-number-changes-in-lease-accounting-rules-draw-closer-1409613447?mod=djem_jiewr_AC_domainid

    50%

    Percentage of global companies with bank-debt covenants potentially affected by lease accounting changes

    U.S. and international accounting-rule makers are edging closer to completing a decadelong effort to overhaul lease accounting rules. The rules, which could be issued next year, threaten to bring roughly $2 trillion of off-balance-sheet leases onto corporate books.

    But adding assets and liabilities for store leases, airplanes and the like could force companies to renegotiate the terms of their loans with lenders. Banks and lenders often require companies to maintain covenants, such as a specific debt-to-equity ratio, fixed-asset ratio or earnings metric, which could all be thrown out of whack by such a significant accounting change.

    Some 50% of global companies have business loans with debt covenants that could require them to repay a loan if they break any covenants, according to a survey of more than 2,000 directors and C-level executives by accounting firm Grant Thornton International Ltd. But only about 8% of those companies currently believe that putting leases on their balance sheet will affect their compliance with bank covenants.

    "Many companies are in for a big surprise when this comes out and they have to go to the bank," said Ed Nusbaum, chief executive of Grant Thornton International. "They need to start talking to their bankers."

    In North America, about 75% of the executives polled said their loans could be recalled if they break this type of covenant, but less than 5% of executives thought the lease accounting change would affect them.

    The American Bankers Association has been pushing rule makers to build a long transition period into the new rules, so that they wouldn't take effect until at least 2018.

    "There has to be a huge amount of education for loan officers, who have to start figuring out what the right ratios are and what they will have to adjust," said Michael Gullette, vice president of accounting and financial management at the ABA.

    From EY:  FASB addresses sale and leasebacks, US GAAP topics in leases project
    http://www.ey.com/Publication/vwLUAssetsAL/TothePoint_BB2822_Leases_3September2014/$FILE/TothePoint_BB2822_Leases_3September2014.pdf
    What you need to know

    • The FASB decided that repurchase options exercisable at fair value would not preclude sale accounting for sale and leaseback transaction s involving non - specialized underlying assets that are readily available in the marketplace .

    • The FASB decided that l essees that are not public business entities could make an accounting policy election to use the risk - free rate for the initial and subsequent measurement of lease liabilities. This is consistent with the Board’s 2013 proposal.

    • The Board affirmed its 2013 proposal to eliminate today’s accounting model for leveraged leases but decided that leveraged leases that exist at transition would be grandfathered.

     • The Board also affirmed its 2013 proposal for lessees and lessors to account for related party leases on the basis of the legally enforceable terms and conditions of the lease .

    Overview

    The Financial Accounting Standards Board (FASB or Board ) continued to redeliberate its 2013 joint proposal 1 t o put most leases on lessees’ balance sheets . At last week’s FASB - only meeting, the Board made more decisions to clarify the proposed guidance on the accounting for sale and leaseback transactions. The Board also affirmed its 2013 proposed decisions about the discount rate for lessee entities that are not public business entities (PBE) , the accounting for leveraged leases and the accounting for related party leasing transactions. The Board’s latest decisions, like all decisions to date, are tentative. No. 201 4 - 333 September 2014 To the Point FASB — proposed guidance

    Continued in article

    Bob Jensen's threads on lease accounting ---
    http://www.trinity.edu/rjensen/Theory02.htm#Leases


    My reply to private messaging from Dane Mott on February 17, 2014

    Hi again Dane,

    "Operating Leases Are Forward Contracts, Not Debt," by Dane Mott Research, August 15, 2013 ---
    http://www.danemott.com/leasecommentletter/ 

    I recommend that you change the title of your paper, because it no longer makes sense to accountants. In the 1990s the FAS 133 standard of the FASB and the IAS 39 (soon to be IFRS 9) standard of the IASB significantly changed accounting for derivatives by requiring that forward contracts and swaps (portfolios of forward contracts) be booked into the ledgers.

    The fastest way for the FASB and IASB to require booking of operating leases into the ledgers would be to follow your proposal to define operating leases as forward contracts.

    Lessors would be required under FAS 133 and IAS 39 to book leases as forward contract assets at fair values and adjust them to fair values at least every 90 days.

    Lessees would be required under FAS 133 and IAS 39 to book leases as forward contract liabilities at fair values and adjust them to fair values at least every 90 days. Hence operating leases would be liabilities as forward contracts --- which is inconsistent with the title of your paper.

    Renewal options would be carried at zero because you define spot values as strike values. Option Values = Intrinsic Value + Time Value. Intrinsic value is the current difference between spot and strike values. Time value is the potential future settlement difference between spot and strike value. If you define the difference between spot and strike value as always being zero, options have no value.

    Defining operating leases as forward contracts is the fastest way that the FASB and IASB could require booking such leases as assets of lessors and liabilities of lessees. But the FASB and IASB do not define operating leases as forward contracts and probably never will define such leases as forward contracts because, among other things, spot value underlyings are not independent of the lease negotiations.

    As a result the FASB and IASB must write an entirely new or greatly revised leasing standard dictating if and when operating leases must be booked into the ledgers. Reactions to the exposure draft by accountants, financial analysts, investors, and business firms were so vocally negative that it's now back to the drawing boards to rewrite the exposure draft into something more acceptable to standard's constituencies ---- http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

    Thanks for this interesting private exchange of email messaging.

    Bob Jensen

     

    Jensen Earlier Comment on Dane's Paper
    This seems like a very sophisticated argument against reporting operating leases as debt. But I have some questions about the analysis.

    1. Mott makes a distinction between operating leases and capital leases without defining operating leases for this particular analysis. There's not always a clear distinction in some lease contracts, which is why FAS 13 drew four highly controversial bright lines.

    2. Mott's analysis is the same whether or not the operating lessee has a series of renewal options. For example, Consider Mott's Example 2:

    Example 1:

    Assume Coffee Shop signed an operating lease in 2010 with an initial lease term of 10 years and four 5-year renewal options.  Coffee Shop has a weighted-average cost of capital (WACC) of 10%.  The initial annual rent in 2010 is $100,000 and is scheduled to grow at 3% each year in the initial lease term and renewal option periods.  The risk-free rate yield curve and time value of money discount factors are presented in the table that follows.

    Jensen Comment
    Mott's illustration calculations make no difference between an initial lease of 30 years versus a lease of 10 years with four 5-year renewal options versus a lease on one year with 30 1-year renewal options. There are tremendous differences between these three operating lease contracts. An academic can add lease renewal probabilities into the analysis, but the lessee wants renewal options because of the difficulties of setting such probabilities, especially for probabilities of renewals 20 or more years into the unknown future.

    More importantly, Mott assumes that the bundle of forward contracts covers a fixed 30 year period. In fact, the embedded renewal options means that, possibly at no cost, the lessee can opt out of future forward contracts. What we have is a bundle of "possible forward contracts," and that's a whole lot different than having a bundle of "actual forward contracts." Mott makes no distinction between the "possible" forward contracts versus the "actual" forward contracts in a lease "bundle" of forward contracts. I would argue that this distinction is enormous.

    3. Mott makes a belabored argument that the operating lease contract is a "bundle of forward contracts" between the lessor and the lessee. Forward contracts are indeed custom contracts not traded on exchanges, but beyond that there are differences between forward contracts in the derivative financial instruments literature and lease contracts.

    Firstly, forward contracts generally assume spot prices are set by a deep market for fungible items like corn, wheat, gold, stocks, and bonds. A leased item like a coffee shop at 113 Main Street is highly unique and not a fungible item relative to any other coffee shop like the one on 346 State Street. And if Starbucks leases the both coffee shops with 1-year leases for 30 years there is no spot price set in a deep market of spot prices set by potential lessees at the end of each year because potential lessees would only bid on available leased property if Starbucks does not exercise its renewal option. With the lessee having an option to renew each year the property is not available until the current lessee declines the option. Hence the market for a non-fungible, unique leased item is at best hypothetical.

    Secondly, in forward contracts it's generally assumed that all cash flows of the forward contract flow between parties to the contract (e.g., lessors and lessees) and that the party going long on the contract (the lessee) will have a gain/loss equal to the party going short on the contract (the lessor) for each forward contract in the "bundle" of contracts. In other bundles like swap bundles of forward contracts, each contract is often net settled for cash between the parties to each forward contract.

    Suppose that at the end of 2019 in the above Example 1, the 113 Main Street location has become a complete bummer due demolition of all nearby office buildings (e.g., as in Detroit) and startup of a giant pig farm. The lessee, Starbucks, decides not to renew and simply cancels all the remaining four renewal contracts at virtually zero cost to the lessee. The lessor, however, has a huge loss if the lessee cancels the future forward contracts in the bundle, because the anticipated lease payments for the next 25 years will be much smaller and even zero if there is no longer any demand for this piece of poorly located property next to a stinking pig farm.

    The lease contract actually has two sources of cash flow for the lessee. Firstly there's the rent cash flow that's specified in the lease contract. Secondly, there's the operating cash flow such as the revenue coming in from sales of coffee and other items in a coffee shop. Unless the rents are directly tied in some way to operating profits of the lessee, there can be very low correlation between the cash flows of the lease contract and the cash flows of the business using the leased property. This can lead to great disparity between the value of the lease renewal options and the lease contract cash flows. Mott does not factor in the value of the renewal options into the bundle of lease forward contracts when in fact the lease renewal options may be far more valuable then the forward contract cash flows.

    Hence, if Mott is going to carry through the forward contract accounting, the lease renewal options should be bifurcated and valued separately. However, there is no deep market for such options and they would be very difficult to value. And they are not settled separately from the forward contracts making the valuation even more difficult.

    Jensen Conclusion
    The main problem that neither the accounting standard setting boards nor Dane Mott want to address is how to value renewal options. If lessees are hell-bent to keep operating lease debt off the balance sheet under the FASB/IASB proposed solution, lessees will simply write shorter leases with more renewal options. Mott's proposed solution is no panacea because he offers no solution to how to value renewal options since there is no forward contract cash flow tied to the renewal options --- only the operating cash flows of the business using the leased property. Valuing a renewal option 20 years out for a noin-fungible unique asset boggles the mind in the real world.

    The assumption of a known and fixed WACC across 30 years can be assumed to be to simplify the illustration. But the real world estimation  is extremely complicated and enormously uncertain.  Fortunately solutions are not so sensitive to WACC errors 20 or more years into the future.

    February 15, 2014 reply by Bob Jensen to a private message from Dane Mott


  • Hi Dane,

    Thank you for your long reply. I just don't think these contracts meet the definitions of derivative contracts. You use the terms "forward contracts" and "options" without showing how lease contracts meet the traditional definitions in the finance literature.

    Take for example, a call option on corn. The buyer of the option and the seller (writer) of the option agree on on a purchase price of the option and a strike price at the expiration of the option. The spot price for corn is assumed to be set in an open market that is not affected (up or down) by the buyer and seller of the option for a specific commodity --- e.g. corn of a particular grade in a particular market (e.g., the CBOT in Chicago). This differs for the spot price of another grade of corn and/or the market in another city (e.g., Minneapolis). The spot price corn is not affected by a particular buyer of a call option or the writer of that single option.

    In the case of a lease renewal option the "spot price" of a particular piece of real estate is a closed market and is determined by value in use by a particular lessee rather than a deep market other buyers and sellers.

    For example, in a huge mall in San Antonio the decisions of a lessor to put in movie theaters and some other teen attractions resulted in greatly increased mall crime including several murders and an enormous increase in stolen cars, rapes, parking lot muggings, etc. Most of the shops elected not to renew their operating leases. By the time the lessor decided to buy out the teen attraction lessees it was already too late. By then the mall had a reputation as a crime center. The mall eventually folded and was sold in bankruptcy to a school district for pennies on the dollar.

    My point is that a decision of a lessee or lessor can directly affect the spot value of the option contracts and forward contracts. Another example is where the lessee is somewhat dependent upon how much the mall owner invests in promotion and security. This is assumed not to be the case for spot prices of derivative contracts where the writers of options have no obligations to invest in actions that impact the spot price of corn.

    When buyers and sellers of options and forward contracts directly impact the spot values over time, you no longer have derivative contracts with values set independently of the parties to derivative contracts.

    I merely used corn as an illustration of a forward contract. Having taught accounting for derivatives for 40 years, I'm well aware of the difference between forward and futures contracts. Farmers can also write customized forward contracts on corn. We had accounting for futures and options long before FAS 133 introduced accounting for forwards and swaps. Be we always implicitly assume that parties to derivatives contracts cannot manipulate the underlying upon which payoffs are based.

    The accounting literature does not distinguish debt from liabilities such that you are really arguing that as leases as derivatives contracts cannot be liabilities. However, since FAS 133 we've been booking derivatives as assets and liabilities. Hence, if we buy into your theory that operating leases are derivatives they they can be net assets or net liabilities as derivatives if the numbers have credibility.

    Numbers that do not have credibility, such as long-term purchase contracts and forecasted transactions, are not booked into financial statements because the best estimates possible are not credible.

    Your 30 year Starbucks renewable lease is more like a forecasted transaction than a bookable item. Any number set for the value of a lease renewal option 30 years from now is a vapor number that is not enforceable in court.

    Why are long-term purchase contracts such as the 50-year contract for Dow Jones to purchase paper from St. Regis Paper Company before the trees for that paper have even been planted not bookable bookable as a liability for Dow Jones? The reason is quite simple. The estimated present values of paper purchases 30, 40, and 50 years from now are pure vapor. In court the judges will set the value on damages incurred to date and not the present-value vapor of paper purchases over the next 50 years. And who can predict what judges will set as damage values 10 or even 20 years from now for a 50-year purchase contract?

    Your renewable lease options 30 years from now are more like forecasted transactions or long-term purchase contracts in terms of vapor numbers. If the contracts are broken 10 or 20 years from now on a 30 year lease renewal option the courts will set the option values at damages to date rather than discounted vapor numbers of the future.

    You ignore the survey of financial analysts that suggests the analysts do not want the financial statements polluted with such vapor numbers. If we start booking such vapor into the financial statements it would destroy the credibility of the financial statements of current transactions.

    I also cannot imagine a derivative that assumes the spot and strike prices are identical. It's the difference between spot and strike prices that lends value to the option. How can your options have time values (as opposed to the intrinsic values portion of an option values) if there's no difference between spot and strike prices?

    Since executives appoint their own boards of directors they can pretty well write their own compensation contracts --- even backdating options so they are always sure to win and providing themselves with platinum parachutes if they are lousy executives. I don't consider a CEO's stock options as derivatives if the CEO manipulates the stock price upon which option time value and intrinsic values are based.

    You are correct in that we will probably always agree to disagree. However, if your theory works its way into major finance textbooks and Harvard teaching cases please let me know. I am flexible when the Academy eventually picks up on new theory and new applications.

    I do applaud your willingness to investigate a new theory. In this instance, however, I think it is too easy to vaporize your numbers, especially for long-term lease renewal "options."

    Thanks,
    Bob

     


     

    Why are major revisions desperately needed lease accounting standards?
     


    Sadly, the FASB loves (sort of in 4-3 voting) that controversial dual-recognition model for lease accounting
    "FASB lease proposal moves forward despite dissenting views," by Ken Tysiac, Journal of Accountancy, April 10, 2013 ---
    http://journalofaccountancy.com/News/20137752.htm

    Jensen Comment
    This is disappointing since I think many, many operating lease contracts will simply be rewritten to circumvent the new standard:

    A Dual Model for Lease Accounting: 
    Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy
    See Below


     

    Despite a Post-Enron Push, Companies Can Still Keep Big Debts Off Balance Sheets.
    "How Leases Play A Shadowy Role In Accounting," by Jonathan Weil, The Wall Street Journal, September 22, 2004, Page A1 --- http://online.wsj.com/article/0,,SB109580870299124246,00.html?mod=home%5Fpage%5Fone%5Fus 

    Despite the post-Enron drive to improve accounting standards, U.S. companies are still allowed to keep off their balance sheets billions of dollars of lease obligations that are just as real as financial commitments originating from bank loans and other borrowings.

    The practice spans the entire spectrum of American business and industry, relegating a key gauge of corporate health to obscure financial-statement footnotes, and leaving investors and analysts to do the math themselves. The scale of these off-balance-sheet obligations -- stemming from leases on everything from aircraft to retail stores to factory equipment -- can be huge:

    • US Airways Group Inc., which recently filed for Chapter 11 bankruptcy protection, showed only $3.15 billion in long-term debt on its most recently audited balance sheet, for 2003, and didn't include the $7.39 billion in operating-lease commitments it had on its fleet of passenger jets.

    • Drugstore chain Walgreen Co. shows no debt on its balance sheet, but it is responsible for $19.3 billion of operating-lease payments mainly on stores over the next 25 years.

    • For the companies in the Standard & Poor's 500-stock index, off-balance-sheet operating-lease commitments, as revealed in the footnotes to their financial statements, total $482 billion.

    Debt levels are among the most important measures of a company's financial health. But the special accounting treatment for many leases means that a big slice of corporate financing remains in the shadows. For all the tough laws and regulations set up since Enron Corp.'s 2001 collapse, regulators have left lease accounting largely untouched. Members of the Financial Accounting Standards Board say they are considering adding the issue to their agenda next year.

    "Leasing is one of the areas of accounting standards that clearly merits review," says Donald Nicolaisen, the Securities and Exchange Commission's chief accountant. The current guidance, he says, depends on rigidly defined categories in which a slight variation has a major effect and relies too much on "on-off switches for determining whether a leased asset and the related payment obligations are reflected on the balance sheet."

    A case in point is the "90% test," part of the FASB's 28-year-old rules for lease accounting. If the present value of a company's minimum lease payments equals 90% or more of a property's value, the transaction must be treated as a "capital lease," with accounting treatment akin to that of debt. If the figure is slightly less, say 89%, the deal is treated as an "operating lease," subject to certain other conditions, meaning the lease doesn't count as debt. The lease commitment appears not in the main body of the financial statements but in footnotes, often obscurely written and of limited usefulness.

    The $482 billion figure for the S&P 500 was determined through a Wall Street Journal review of the companies' annual reports. That's equivalent to 8% of the $6.25 trillion reported as debt on the 500 companies' balance sheets, according to data provided by Reuters Research. For many companies, off-balance-sheet lease obligations are many times higher than their reported debt.

    Given the choice between leasing and owning real estate or equipment, many companies pick operating leases. Besides lowering reported debt, operating leases boost returns on assets and often plump up earnings through, among other things, lower depreciation expenses.

    "It's nonsense," Trevor Harris, an accounting analyst and managing director at Morgan Stanley, says of the 90% rule. "What's the difference between 89.9% and 90%, and 85% and 90%, or even 70% and 90%? It's the wrong starting point. You've purchased the right to some resources as an asset. The essence of accounting is supposed to be economic substance over legal form."

    This summer, Union Pacific Corp. opened its new 19-story, $260 million headquarters in Omaha, Neb. The railroad operator is the owner of the city's largest building, the Union Pacific Center, in virtually every respect except its accounting.

    Under an initial operating lease, Union Pacific guaranteed 89.9% of all construction costs through the building's completion date. After completing the building, the company signed a new operating lease, which guarantees 85% of the building's costs. Unlike most operating leases, both were "synthetic" leases, which allow the company to take income-tax deductions for interest and depreciation while maintaining complete operational control. A Union Pacific spokesman declined to comment.

    Neither lease has appeared on the balance sheet. Instead, they have stayed in the footnotes, resulting in lower reported assets and liabilities. On its balance sheet, Union Pacific shows about $8 billion of debt, while its footnotes show about $3 billion of operating-lease commitments, including for railroad engines and other equipment.

    The 90% test goes to the crux of investor complaints that U.S. accounting standards remain driven by arbitrary rules, around which companies can easily structure transactions to achieve desired outcomes.

    It means different companies entering nearly identical transactions can account for them in very different ways, depending on which side of the 90% test they reside. Meanwhile, as with disclosures showing employee stock-option compensation expenses, most investors and stock analysts tend to ignore the footnotes disclosing lease obligations.

    Three years ago, Enron's collapse revealed how easily a company could hide debt. A big part of the energy company's scandal centered on off-balance-sheet "special purpose entities." These obscure partnerships could be kept off the books -- with no footnote disclosures -- if an independent investor owned 3% of an entity's equity. Responding to public outcry, FASB members eliminated that rule and promised more "principles-based" standards, which spell out concise objectives and emphasize economic substance over form, rather than a "check the box" approach with rigid tests and exceptions that can be exploited.

    The accounting literature on leasing covers hundreds of pages. The FASB's original 1976 pronouncement, called Financial Accounting Standard No. 13, does state a broad principle: A lease that transfers substantially all the benefits and risks of ownership should be accounted for as such. But in practice, critics say, FAS 13 amounts to all rules and no principles, making it easy to manipulate its strict exceptions and criteria as needed. One key rule says a lease is a "capital lease" if it covers 75% or more of the property's estimated useful life. One day less, and it can stay off-balance-sheet, subject to other tests.

    Continued in the article

    "Group (the IASB) to Alter Rules On Lease Accounting," The Wall Street Journal, September 23, 2004, Page C4

    BRUSSELS -- The International Accounting Standards Board next week will unveil plans to overhaul the rules on accounting for leased assets, the board's chairman said yesterday.

    Critics long have contended that the rules for determining whether leases should be included as assets and liabilities on a company's balance sheet are easy to evade and encourage form-over-substance accounting. "It's going to be a very big deal," Chairman Sir David Tweedie told Dow Jones Newswires after testifying to the European Parliament. International accounting rules on leasing exist already, but they are useless, Mr. Tweedie said.

    Airlines that lease their aircraft, for instance, rarely include their planes on their balance sheets, he said. "So the aircraft is just a figment of your imagination," Mr. Tweedie said. The board will convene a meeting next week to discuss changes to current rules, he said.

    The Wall Street Journal yesterday reported (see the above article) that the U.S. Financial Accounting Standards Board is considering adding lease accounting to its agenda of items for overhaul.

    From The Wall Street Journal's The Weekly Review: Accounting on September 24, 2004

    TITLE: Lease Accounting Still Has an Impact 
    REPORTER: Jonathan Weil 
    DATE: Sep 22, 2004 
    PAGE: A1 
    LINK: http://online.wsj.com/article/0,,SB109580870299124246,00.html  
    TOPICS: Financial Accounting, Financial Accounting Standards Board, Financial Statement Analysis, Lease Accounting, off balance sheet financing

    SUMMARY: The on-line version of this article is entitled "How Leases Play a Shadowy Role in Accounting." The article highlights the typical practical ways in which entities avoid capitalizing leases; reports on a WSJ analysis of footnote disclosures to assess levels of off-balance sheet debt; and comments on the difficulties the FASB may face in trying to amend Statement of Financial Accounting Standards No. 13.

    QUESTIONS: 

    1.) What accounting standard governs the accounting for lease transactions under U.S. GAAP? When was that accounting standard written and first put into effect?

    2.) When is the Financial Accounting Standards Board (FASB) considering working on improvements to the accounting for lease transactions? Why is the FASB likely to face challenges in any attempt to change accounting for leasing transactions?

    3.) What are the names of the two basic methods of accounting for leases by lessees under current U.S. standards? Which of these methods is he referring to when the author writes, "U.S. companies are...allowed to keep off their balance sheets billions of dollars of lease obligations..."

    4.) What are the required disclosures under each of the two methods of accounting for leases? What are the problems with financial statement users relying on footnote disclosures as opposed to including a caption and a numerical amount on the face of the balance sheet?

    5.) How do you think the Wall Street Journal identified the amounts of lease commitments that are kept off of corporate balance sheets? Specifically identify the steps you think would be required to measure obligations under operating leases in a way that is comparable to the amounts shown for capital leases recognized on the face of the balance sheet.

    6.) What four tests must be made in determining the accounting for any lease? Why do you think the author focuses on only one of these tests, the "90% test"?

    7.) What financial ratios are impacted by accounting for leases? List all that you can identify in the article, and that you can think of, and explain how they are affected by different accounting treatments for leases.

    8.) What is a "special purpose entity"? When are these entities used in leasing transactions?

    9.) What is a "synthetic lease"? When are these leases constructed?

    Reviewed By: Judy Beckman, University of Rhode Island


    Security Analysts and Investors Versus the IASB and FASB on Lease Accounting:  Dual Model Unanimously opposed

    "Diversity among Analysts Makes Objective of FASB-IASB Lease Accounting Difficult to Achieved," Bloomberg BNA Accounting Blog, July 31, 2012 ---
    http://www.bna.com/diversity-among-analysts-b12884910914/

    The diversity in how analysts and investors look at leases in practice appears to be making it much harder for the Financial Accounting Standards Board and the International Accounting Standards Board to achieve their objectives for the joint lease accounting project.

    The boards have said that one of the key reasons for addressing lease accounting was that current lease accounting standards under both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRSs) have been criticized as failing to meet the needs of financial statement users and presents structuring opportunities. The standards-setters have been redeliberating towards issuing an exposure draft in the fourth quarter this year-their second proposal.

    In June the FASB and IASB decided upon an approach in which some lease contracts would be accounted for using an approach similar to that proposed in the 2010 leases Exposure Draft and some leases would be accounted for using an approach that results in a straight-line lease expense.

    If financial statement users were unified in the manner in which they looked at leases it would be much easier for the boards to tailor the outcome to meet investors' needs. However, during a July 24 discussion with the FASB, members of its Investors Technical Advisory Committee made it clear that given the divergent views among analysts, the boards' solution is a compromise that misses the mark.

    ITAC members held diverse views on how--in their analysis--it is most useful to present leases, said Gary Buesser, Director of Lazard Asset Management, LLC.  ITAC's views fell among three categories:

    Form of Financing.

    The crux of the whole issue may be stemming from the broad based belief among investors, financial statement users and analysts that leases are a form of financing. A significant number of analysts and investors who are using financial statements will make adjustments to put an item back on the balance sheet for leases, according to the ITAC discussion.

    Some ITAC members said the boards may be in better position if they left the accounting guidance as it is currently with some minor improvements, including enhancements to disclosures that will further improve the ability of analysts and financial statement users and investors to make the adjustments they want to make to get to the numbers that they want to look at.

    "Though current lease accounting rules are not ideal, the accounting today allows analysts to adjust in the way they want to adjust," said Mark LaMonte, Managing Director, Chief Credit Officer of Moody's Investors Service Financial Institutions Group.

    "I think it's easier for me to adjust and get the lease number I want on the balance sheet from the current accounting, than it is to unwind a kind of half way there number and then have to adjust," said LaMonte.

    "In our shop we believe leases belong on the balance sheet, so if they're already on as capital leases we accept it, if they're off balance sheet as operating leases, we're going to put them on," he said.

    The Project.

    Leasing is an important source of finance for many companies who lease assets. A FASB summary states that it is therefore important "that lease accounting provides users of financial statements with a complete and understandable picture of an entity's leasing activities."

    FASB member Lawrence Smith told the ITAC that current GAAP has two different types of leases, but it is based upon the approach that an entity would follow a whole asset approach, that is, that it is either leasing an asset or effectively it is like it is buying the asset.

    "[This is] why we get the difference between operating leases and capital leases," he explained.  "In general does ITAC have a view that perhaps the way we're accounting for it now, following the whole asset is the appropriate way of doing it?" asked Smith.

    With the level of diversity among analysts, even among ITAC, it would be difficult to come up with a one sized fixed all solution, the analysts said. "Maybe the best thing to do is to make sure that the information is there so that people can adjust to what they want," LaMonte said. "Keep it as simple as possible and give information so that people can make the adjustments they want to make," he said.

    Dual Model Unanimously opposed.

    One of the reasons the board decided to go down the route of having a dual model is because the board became convinced during outreach with constituents that there is more than one kind of lease economically, and to properly reflect that a dual model was needed.

    But ITAC members, who unanimously opposed the duel model income statement approach, said they found it complex and confusing. "We thought that if I leave real estate, I continue with today's current accounting, if I moved toward leasing equipments, I go to a financing arrangement and I have amortization plus interest expense, this could require many adjustments in particular for companies that have both real estate leases and equipment leases," said Buesser. "So we felt that there was something about that--that supply," he said.

    Continued in article

    Bob Jensen's threads on lease accounting are at
    http://www.trinity.edu/rjensen/Theory02.htm#Leases

     


    Lease Accounting:  Anticipated Changes on May 3, 2013

    From CFO.com Morning Ledger on May 3, 2013

    Lease-accounting proposal still seen costing companies. Despite significant changes, companies and investors expect that a coming proposal aimed at overhauling lease-accounting rules will be more costly in some areas than the current standard, Emily Chasan writes. The FASB and IASB are preparing to shortly release a new lease-accounting proposal for public comment, FASB Chairman Leslie Seidman said at a Baruch College accounting conference in New York on Thursday. “It’s appropriate at this point to re-expose that revised set of conclusions,” Ms. Seidman said. Both versions of the proposal contemplate bringing trillions of dollars of leasing obligations onto corporate balance sheets, but the new proposal allows companies to record lease expenses in two ways, among other changes. Some investors worry that the boards have made so many compromises that the new rule won’t give them a clear picture of corporate leasing obligations. “Ultimately, what’s going to end up back on the balance sheet as a result of applying the standard really isn’t going to satisfy too many users of financial statements,” Mark LaMonte, managing director at Moody’s.

    Jensen Question
    So how do lessees minimize the balance sheet impact of booking operating leases such as a sandwich shop in a Galleria Mall?
    I would consider just shortening the operating lease period to a year or less in the case where the former operating lease had a longer term. The FASB has never really seriously taken up the issue of anticipated lease renewals of "operating leases."  Of course shortening a lease could alter the rental prices, especially if the lessor is taking on more risk of non-renewal.

    One problem with putting lease renewal debt or assets on the balance sheet is ruling on when the number of renewals should be terminated. For example, neither the Galleria or the sandwich shop has any idea of how many times the lease will be renewed. The number or future renewals is subject to all sorts of unknowable events of the future.

    A huge difference between renting space in a Galleria Mall versus renting a jumbo jet is that the Galleria normally does not provide options to actually own leased apace in such a mall that was not intended to be a condo mall.

    Bob Jensen's threads on lease accounting are at
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm 

    As I am writing this on June 17, 2012 the Exposure Draft is not yet available. But here's a summary of what we expect.
    A dual model for lease accounting: redrawing the lines --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8VAMTX&SecNavCode=MSRA-84YH44&ContentType=Content
     

    In brief: A dual model for lease accounting: redrawing the lines

    Source: PwC
    Author name: Assurance services

    Published: 06/15/2012

    Summary:
    After more than a year of redeliberations, the FASB and IASB (the boards) took a big step forward this week in finalizing their revised proposals for lease accounting. They made significant decisions about how a lessee should recognize lease expense. In addition, they revisited some previous decisions concerning lessor accounting. This In brief article provides an overview of their decisions and what's next.

    Full article:



    What's new?

    After more than a year of redeliberations, the FASB and IASB (the boards) took a big step forward this week in finalizing their revised proposals for lease accounting. They made significant decisions about how a lessee should recognize lease expense. In addition, they revisited some previous decisions concerning lessor accounting.

    All decisions noted in this In brief are tentative and therefore subject to change, as the boards have not yet concluded their deliberations.

    Lessee accounting

    The boards reconfirmed that lessees will recognize all leases with a maximum lease term of more than 12 months on balance sheet. Short term leases, with a maximum lease term of less than 12 months, will not be required to be put on balance sheet.

    There will be two approaches to recognizing lease expense in the income statement:
     
    1. Lessees will apply the approach proposed in the 2010 exposure draft for some leases, which results in a “front loading” of lease expense.
       
    2. For other leases, lessees will apply a straight-line expense recognition pattern, similar to current operating lease accounting.

    The boards agreed on a dividing line to determine when each approach should be applied. In principle, the dividing line will depend on whether a lessee acquires or "consumes" more than an insignificant portion of the underlying asset. The boards decided that, as a practical expedient, this principle will be applied based on the nature of underlying asset.

    It is presumed that leases of property − defined as land and/or a building or part of a building − should be accounted for using a straight-line expense recognition pattern. This presumption is overcome if:
     
    • The lease term is for the major part of the underlying asset’s economic life; or
       
    • The present value of the fixed lease payments accounts for substantially all of the fair value of the underlying asset.

    These criteria are similar to some of the criteria used today for capital lease classification under U.S. GAAP.

    For leases of assets other than property − such as equipment – it is presumed that lessees should apply the approach proposed in the 2010 exposure draft, unless:
     
    • The lease term is an insignificant portion of the underlying asset’s economic life; or
       
    • The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

    Lessor accounting

    The boards decided that there should be symmetry between lessors and lessees in how they determine which approach to apply. They agreed that lessors should use the same dividing line and presumption as lessees (as outlined above). The boards previously decided that lessors of investment property should apply an approach similar to existing operating lease accounting. The boards’ latest decisions are expected to produce similar results in that most lessors of investment property will not apply the receivable and residual approach.

    Where a lease gives a lessee the right to acquire or consume more than an insignificant portion of the underlying asset (typically presumed when the underlying asset is not property), the lessor will apply the receivable and residual approach. For a description of this approach, see
    In brief 2011-44, FASB and IASB make significant decisions related to lessor accounting and transition.

    Conversely, where a lease gives a lessee the right to acquire or consume an insignificant portion of the underlying asset (typically presumed for leases of property), the lessor will apply an approach similar to today’s operating lease accounting. The underlying asset will remain on the lessor’s balance sheet and income will be recognized on a straight-line basis over the term of the lease.

    While there are similarities in the criteria, there could be differences in the dividing line under the new model and existing U.S. GAAP. For example, real estate lessors may have to apply the receivable and residual approach for certain longer term real estate leases that are considered operating leases under current guidance.


    Continued in article

    Also see Ernst & Young's take on the Dual Model --- Click Here
    http://www.ey.com/Publication/vwLUAssetsAL/TothePoint_BB2366_Leases_14June2012/$FILE/TothePoint_BB2366_Leases_14June2012.pdf


    Security Analysts and Investors Versus the IASB and FASB on Lease Accounting:  Dual Model Unanimously opposed

    "Diversity among Analysts Makes Objective of FASB-IASB Lease Accounting Difficult to Achieved," Bloomberg BNA Accounting Blog, July 31, 2012 ---
    http://www.bna.com/diversity-among-analysts-b12884910914/

    The diversity in how analysts and investors look at leases in practice appears to be making it much harder for the Financial Accounting Standards Board and the International Accounting Standards Board to achieve their objectives for the joint lease accounting project.

    The boards have said that one of the key reasons for addressing lease accounting was that current lease accounting standards under both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRSs) have been criticized as failing to meet the needs of financial statement users and presents structuring opportunities. The standards-setters have been redeliberating towards issuing an exposure draft in the fourth quarter this year-their second proposal.

    In June the FASB and IASB decided upon an approach in which some lease contracts would be accounted for using an approach similar to that proposed in the 2010 leases Exposure Draft and some leases would be accounted for using an approach that results in a straight-line lease expense.

    If financial statement users were unified in the manner in which they looked at leases it would be much easier for the boards to tailor the outcome to meet investors' needs. However, during a July 24 discussion with the FASB, members of its Investors Technical Advisory Committee made it clear that given the divergent views among analysts, the boards' solution is a compromise that misses the mark.

    ITAC members held diverse views on how--in their analysis--it is most useful to present leases, said Gary Buesser, Director of Lazard Asset Management, LLC.  ITAC's views fell among three categories:

    Form of Financing.

    The crux of the whole issue may be stemming from the broad based belief among investors, financial statement users and analysts that leases are a form of financing. A significant number of analysts and investors who are using financial statements will make adjustments to put an item back on the balance sheet for leases, according to the ITAC discussion.

    Some ITAC members said the boards may be in better position if they left the accounting guidance as it is currently with some minor improvements, including enhancements to disclosures that will further improve the ability of analysts and financial statement users and investors to make the adjustments they want to make to get to the numbers that they want to look at.

    "Though current lease accounting rules are not ideal, the accounting today allows analysts to adjust in the way they want to adjust," said Mark LaMonte, Managing Director, Chief Credit Officer of Moody's Investors Service Financial Institutions Group.

    "I think it's easier for me to adjust and get the lease number I want on the balance sheet from the current accounting, than it is to unwind a kind of half way there number and then have to adjust," said LaMonte.

    "In our shop we believe leases belong on the balance sheet, so if they're already on as capital leases we accept it, if they're off balance sheet as operating leases, we're going to put them on," he said.

    The Project.

    Leasing is an important source of finance for many companies who lease assets. A FASB summary states that it is therefore important "that lease accounting provides users of financial statements with a complete and understandable picture of an entity's leasing activities."

    FASB member Lawrence Smith told the ITAC that current GAAP has two different types of leases, but it is based upon the approach that an entity would follow a whole asset approach, that is, that it is either leasing an asset or effectively it is like it is buying the asset.

    "[This is] why we get the difference between operating leases and capital leases," he explained.  "In general does ITAC have a view that perhaps the way we're accounting for it now, following the whole asset is the appropriate way of doing it?" asked Smith.

    With the level of diversity among analysts, even among ITAC, it would be difficult to come up with a one sized fixed all solution, the analysts said. "Maybe the best thing to do is to make sure that the information is there so that people can adjust to what they want," LaMonte said. "Keep it as simple as possible and give information so that people can make the adjustments they want to make," he said.

    Dual Model Unanimously opposed.

    One of the reasons the board decided to go down the route of having a dual model is because the board became convinced during outreach with constituents that there is more than one kind of lease economically, and to properly reflect that a dual model was needed.

    But ITAC members, who unanimously opposed the duel model income statement approach, said they found it complex and confusing. "We thought that if I leave real estate, I continue with today's current accounting, if I moved toward leasing equipments, I go to a financing arrangement and I have amortization plus interest expense, this could require many adjustments in particular for companies that have both real estate leases and equipment leases," said Buesser. "So we felt that there was something about that--that supply," he said.

    Continued in article

    Bob Jensen's threads on lease accounting are at
    http://www.trinity.edu/rjensen/Theory02.htm#Leases

     


    Correction of Jensen Messaging:  Forecasted Transaction Controversies of Lease Renewals

    In early June 2012 Bob Jensen incorrectly anticipated that the lease revisions would entail booking of lease renewals

    We don't book long-term purchase commitment contracts such as a newspaper's 50-year contract to buy newsprint from the St. Regis Paper Company.

    We don't book forecasted transactions such as an intention (not a contract) for Southwest Airlines to buy 1 million gallons of jet fuel a year from now at the best spot price available from competitive bidders --- although we do book hedging derivative contracts that hedge the cash flow of this forecasted transaction.

    In the past we did not book forecasted transactions for operating lease renewals (that were not under contract to even renew at renewal dates), but now we're supposed to book these forecasted transactions using non-verifiable and future-negotiable renewal rental rates.

    Does anybody else see anything asymmetric in the reasoning of the FASB and IASB with respect to booking forecasted transactions that are not even contracts?

    If Southwest Airlines now must book 30 years of annual renewals of an operating lease (sorry for the use of the obsolete term "operating lease") of an airport gate, why not book 30 years worth of forecasted purchases of jet fuel for each airliner using that gate?

     

    Given the solid bedrock of our Conceptual Framework, how could such an inconsistency in accounting for forecasted transactions possibly arise?


    Keep in mind that the dispute has never been about disclosure of estimated future cash flow streams of all operating leases. That's already required in FAS 13. The new 2012 issue is the booking of some forecasted transactions (e.g., for lease renewals on a airport gate) and not other forecasted transactions (e.g., forecasted purchases of jet fuel).

    Bob Jensen incorrectly assumed that many lease renewal cash flow forecasted transactions were going to be booked under the forthcoming Exposure Draft in late 2012.

    In retrospect it appears that this is not the case.

    Hence Bob Jensen was wrong in anticipating the booking of forecasted transactions for lease renewals.

    But he was not entirely wrong.


    Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy

    Bob Jensen incorrectly assumed that many lease renewal cash flow forecasted transactions were going to be booked under the forthcoming Exposure Draft in late 2012.

    In retrospect it appears that this is not the case.

    Hence Bob Jensen was wrong in anticipating the booking of forecasted transactions for lease renewals.

    But he was not entirely wrong.

    June 16, 2012 reply from Patricia Walters

    Bob

    That was why I asked you if you had kept up with the changes to the proposal. Only renewals for which the lessee has "a significant economic incentive to exercise the option" would be included in the initial measurement. Whether that will meet your virtually certain test remains to be seen.

    Yes, I expect companies will play their usual games.

     

    The "a significant economic incentive to exercise the option" requirement for booking forecasted lease renewals raises the same concern

    Companies will probably shorten their leases and increase the likelihood of lease renewal.
    Hence the amounts of anticipated booked leases payable/receivable will probably be much less than anticipated by the FASB and IASB.

    Example of New Strategies for Keeping Leases from Being Booked
    Consider the leasing of Gate 10 by Southwest Airlines in Manchester, New Hampshire. Suppose that the current lease contract is a 36-month lease requiring monthly rental payments of $10,000 per month for Gate 10. Current accounting requirements call for full disclosure of the lease terms but the 36-month discounted cash flows are not booked by the lessee as a liability or the lessor as a receivable.

    The anticipated new lease rules will require booking of the discounted 120T-month cash flows as a liability on the lessee's balance sheet and a receivable on the lessor's balance sheet.

    How can the booking of lease amounts be reduced or avoided entirely or kept at smaller amounts with revised lease contractual terms.?


    Generally, we expect lessee and lessor accounting to be symmetrical. If the lessee has a booked liability we expect the lessor to have a booked asset. Defining only the asset side of things ignores this symmetry.

    I'm reminded of ancient history before FAS 13 when even capital leases were not booked.

    I recall the following (paraphrased) quotation by Roman Weil: "It's very confusing if Boeing reports the sale of an airplane to Eastern Airlines when Eastern Airlines does not book the asset it purchased."

    What Eastern Airlines was actually doing was reporting (but not booking) the "purchase" of the airplane as an unbooked lease (before FAS 13) instead of a purchase.

    Because so much off-balance-sheet financing (OBSF) was going on with capital leases, the FASB adopted FAS 13 so that when Boeing reported an airplane's sale the purchase was booked as an asset and a liability by Eastern Airlines no matter whether Eastern Airlines financed the purchase with bond debt or a capital lease.

    Defining an asset as "something that as future economic benefit" does not resolve the problem of contracts versus forecasted transactions. For example, the option to annually renew the lease on an airport gate has a "future economic benefit" to Southwest Airlines even if Southwest is not contractually obligated to do so.

    My point is that booking of forecasted lease renewals that are highly probable is still a paradigm shift in terms of the Conceptual Framework built upon contracts rather than forecasted transactions.

    We've just not yet fully considered booking forecasted transaction assets and liabilities that can be wiped off the books with zero penalty costs. The booking of a forecasted transaction to renew a lease on something very, very different from our definition of our previous conception of a contractual liability.

    Rewriting the Conceptual Framework for guidance as to what forecasted transactions must be booked versus forecasted transactions that cannot be booked is a very, very, very complicated challenge.

    The problem is somewhat different if the lessor actually extends (for a premium fee) a contractual option to renew the lease of an airline gate. This is no longer quite the same as when the lessor or lessee can choose not to renew an operating lease.

    If the lessee buys a renewal option there's a contract involved. Perhaps the option can even be sold to another qualified airline. This is perhaps one way around the forecasted transaction problem of booking operating lease renewals.

    The problem is that lessors are usually not willing to sell renewal options when they like to retain their own discretion on lease renewals. Thus many lease renewals remain forecasted transactions rather than adding on renewal option contracts.


    Inconsistencies in Two Proposed IFRS Changes: The Ups and Downs of International Accounting Standard "trigger events"

    In the context of FAS 39, a "trigger event" is an event that changes the likelihood of fully collecting or paying out a forecasted stream of future cash flows. The forecasted cash flows could be contractual such as the contracted stream of cash flows from a forward contract used as a speculation or a hedge. The fair value of the future stream is said to have become "impaired" by the "trigger event" that is material in nature. Auditors are required to test for impairments in cash flow streams. The net impact on the balance sheet may vary greatly when the contract is a speculation versus when the contract is a hedge and the amount of impairment loss/gain is offset by the amount of impairment gain/loss on a hedged item and vice versa.

    For items carried at fair value, trigger events should be automatically recognized in changes in fair value unless the trigger event itself makes it impractical to measure fair value (such as a freezing or collapse in the market used to measure fair value). If a receivable is carried at amortized cost, trigger events are especially important and may signal the need to anticipate a loss such as an estimated bad debt loss.

    An example of a common trigger event is a hugely lowered credit score/rating of a debtor.

    For later reference, I might define a "wipeout trigger event" as one that reduces the NPV of a future cash flow stream to zero or virtually zero. Although such a trigger event might be analogous to when Madoff's arrest was announced, a wipeout trigger event may also be perfectly legal such as when a lessee announces in advance that a short-term lease will not be renewed.

    It seems to me that in two current proposed changes to IFRS standards, one proposal is reducing the role of explicitly defined trigger events whereas the other is increasing the role of implicitly defined wipeout trigger events. The two IASB proposed change documents are as follows:

    Financial Instruments
    IAS 39 to IFRS 9:  "IFRS 9: Financial Instruments (replacement of IAS 39)
    --- Click Here

    The objective of this project is to improve the decision usefulness for users of financial statements by simplifying the classification and measurement requirements for financial instruments. In November 2008 the IASB added this project to their active agenda. The FASB also added this project to their agenda in December 2008.

    Leases
    FASB-IASB Joint Proposal on Lease Accounting (August 17, 2010 before the 2012 changes)
    --- Click Here
    http://www.ifrs.org/Current+Projects/IASB+Projects/Leases/ed10/Ed.htm

    ... the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) published for public comment joint proposals to improve the reporting of lease contracts. The proposals are one of the main projects included in the boards’ Memorandum of Understanding. The proposals, if adopted, will greatly improve the financial reporting information available to investors about the financial effects of lease contracts.

    The accounting under existing requirements depends on the classification of a lease. Classification as an operating lease results in the lessee not recording any assets or liabilities in the statement of financial position under either International Financial Reporting Standards or US standards (generally accepted accounting principles). This results in many investors having to adjust the financial statements (using disclosures and other available information) to estimate the effects of lessees’ operating leases for the purpose of investment analysis. The proposals would result in a consistent approach to lease accounting for both lessees and lessors—a ‘right-of-use’ approach. This approach would result in all leases being included in the statement of financial position, thus providing more complete and useful information to investors and other users of financial statements.

    Financial Instruments ED That Plays Down Trigger Events
    IAS 39 to IFRS 9:  "IFRS 9: Financial Instruments (replacement of IAS 39)
    --- Click Here

    This Financial Instruments Exposure Draft (ED), among other things downplays, the role of trigger events in impairment tests. In IAS 39 an anticipated loss may be delayed until a trigger event transpires to require immediate write down of an asset such as a receivable. Presumably this will not be the case in the new IFRS 9.

    When IAS 39 is replaced by IAS 9, the ED proposes to recognize losses (prior to trigger events) by earlier use of probability-weighted estimates of the amounts to be collected in a future cash flow stream. Presumably these probabilities must be subjective (Bayesian) since it is difficult to imagine circumstances where the probability distribution can be objectively estimated. Implicit in the ED is the estimation of probabilities of future states of the domestic and/or world economy.

    Auditors are no objecting to the replacement of trigger events with probability-weighted estimates on the grounds that attesting to such probability-weighted estimates before trigger events will not operational in auditing.

    "Deloitte comment letter on financial instruments," July 6, 2010 ---
    http://www.iasplus.com/dttletr/1007amortcost.pdf

    Excerpt
    We agree with the Board’s objective in this phase of the IASB project to replace IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) to address weaknesses of the incurred loss model in IAS 39 that were highlighted during the global financial crisis. An impairment loss model that focuses on an assessment of recoverable cash flows reflecting all current information about the borrower’s ability to repay would be an improvement on the current approach in IAS 39 which relies on identification of trigger events and often leads to a delay in loss recognition. However, we have concerns about the specific requirements proposed by the IASB, in particular those to determine, and allocate, the initial estimate of expected credit losses on a financial asset and to use a probability-weighted outcome approach. We believe that this approach will in many cases be unnecessarily complex. Further, the incorporation of potential future economic environments in estimating recoverable cash flows would be extremely complex, costly and burdensome to apply by preparers.
    The requirement in the ED to forecast future economic environments and events without providing sufficient guidance with respect to the level of objectivity, verifiability, or support for the underpinnings of these inputs presents significant challenges to internal auditors, external auditors, and regulators. Overall, we believe that the measurement principle would not be operational if the Board were to adopt the ED in its current form.

    Leases ED That Plays Up Wipeout Trigger Events
    FASB-IASB Joint Proposal on Lease Accounting
    --- Click Here
    http://www.ifrs.org/Current+Projects/IASB+Projects/Leases/ed10/Ed.htm

    The most controversial and in most instances welcome proposed change is the required capitalization of operating leases that were previously and commonly used to hide debt in what was tantamount to off-balance sheet financing.

    And the most controversial of the controversial proposed changes is that short term operating leases having renewal options are to assume (for accounting purposes) renewals will take place even though they are not contractually required. For example, a store in a mall may have a year-to-year lease that was not booked on the lessee or lessor balance sheets until the monthly rent is due. The ED requires assumption of renewals that are not contractually required. Hence, the NPV of a year-to-year store lease must be booked as an asset on the lessor's books and a liability on the lessee's balance sheet for a rent cash flow stream across many years in which it is estimated that the lease will be renewed.

    However, the ED does allow for what are tantamount to wipeout trigger events (not called as such in the ED). If it becomes known that the lessee or lessor will not renew the year-to-year lease, then the lessor may no longer record the NPV of future rentals that will not be received and the lessee need not book the NPV of future rentals that will not be paid.

    Jensen Comment

    For these two exposure drafts to be consistent, it would seem that either the probability-weighted requirement in the new IFRS 9 should be deleted or that a probability-weighted requirement should be imposed on short-term lease accounting. In the case of leases, probability weights would be assigned to assumed lease renewals.

    The probability-weighted short-term lease requirement would most likely be objected to by auditors for the same reasons that auditors object to the probability-weighted requirement proposed for the IFRS 9.

    I can anticipate the Deloitte objection letter to be as follows if auditing of lease renewal probability weightings were to (hypothetically) be required::

    Excerpt
    We agree with the Board’s objective to book operating leases in a manner consistent with how capital leases are booked. An impairment loss model that focuses on an assessment of renewable lease cash flows reflecting all current information about the lessee's intent to exercise a renewal option  would be an improvement on the current approach of keeping operating leases entirely off the balance sheet. However, we have concerns about the specific requirements proposed by the IASB, in particular those to determine probability weightings of lease renewals. We believe that this approach will in many cases be unnecessarily complex. Further, the incorporation of potential future economic environments in estimating lease renewal cash flows would be extremely complex, costly and burdensome to apply by preparers.
    The requirement in the ED to forecast future economic environments and events without providing sufficient guidance with respect to the level of objectivity, verifiability, or support for the underpinnings of these inputs presents significant challenges to internal auditors, external auditors, and regulators. Overall, we believe that the measurement principle would not be operational . . . .

    In general, use of probability-weighted impairment accounting before trigger events transpire is probably an auditing nightmare in general. Trigger event impairment tests are much more realistic for auditors. However, at present the lease accounting ED does not take up the issue of how to deal with trigger events that are not wipeout trigger events.

    Increasingly we are adding subjectivity and hypothetical transactions to financial statements. The biggest example is the transitioning to fair value accounting where assets and liabilities are adjusted for transactions that did not and might not ever transpire such as the interim changing of the value of a forward contract used as a hedge when, at the maturity date, the net cash flows are absolutely certain irrespective of the "hypothetical" changes in fair value before the maturity date.

    If we're going to be so subjective about hypothetical transactions, we might as well impose subjective probability weights to short-term lease renewals rather than assume they will always be renewed until a wipeout trigger event transpires.

    The Controversy of Booking Forecasted Transactions

    Accounting standards are built upon contracts. Assets and liabilities are not booked on the bases of forecasted transactions. For example, if Southwest Airlines has an anticipated purchase of one million gallons of jet fuel in 18 months, that forecasted transaction is not allowed to be booked even if it is allowed to be hedged with a derivative contracts (e.g., call options or futures contracts) that are required to be booked under FASB and IASB rules because these are contracts and not forecasted transactions.

    There are of course some forecasted transactions that affect booked amounts. For example, companies are required to forecast bad debt losses and create contra accounts that reduce the booked contractual amounts to a lesser percentage. In a sense depreciation and depletion amounts forecasted reductions of the of the future value carrying amounts. Even unrealized fair value adjustments to financial instruments are forecasts in the sense that at best they are only predictions of possible booked amounts that will ultimately be realized.

    But as a rule, forecasted transaction adjustments of carrying amounts of assets and liabilities are only adjustments of booked contracted amounts. Forecasted transactions like the forecasted purchase of one million gallons of Jet Fuel by Southwest Airlines would be, in my judgment, a significant paradigm change in accounting traditions and standards.

    Now what about lease renewals that are highly probable?
    If my predictions are correct about the expected new changes to lease accounting rules, companies will quickly reduce lease accounting termination dates (except in the case of capital leases that are merely alternate means of ownership). For example, the 10-year airport gate leases may be reduced to 1-3 years for the sole purpose of reducing booked lease amounts significantly or entirely.

    The FASB and IASB will most likely then more seriously address the issue of booking forecasted renewals of leases. But this will be a paradigm shift steeped in enormous controversy as implied in the following quotation.

    "Deloitte comment letter on financial instruments," July 6, 2010 ---
    http://www.iasplus.com/dttletr/1007amortcost.pdf

    Excerpt
    We agree with the Board’s objective in this phase of the IASB project to replace IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) to address weaknesses of the incurred loss model in IAS 39 that were highlighted during the global financial crisis. An impairment loss model that focuses on an assessment of recoverable cash flows reflecting all current information about the borrower’s ability to repay would be an improvement on the current approach in IAS 39 which relies on identification of trigger events and often leads to a delay in loss recognition. However, we have concerns about the specific requirements proposed by the IASB, in particular those to determine, and allocate, the initial estimate of expected credit losses on a financial asset and to use a probability-weighted outcome approach. We believe that this approach will in many cases be unnecessarily complex. Further, the incorporation of potential future economic environments in estimating recoverable cash flows would be extremely complex, costly and burdensome to apply by preparers.
    The requirement in the ED to forecast future economic environments and events without providing sufficient guidance with respect to the level of objectivity, verifiability, or support for the underpinnings of these inputs presents significant challenges to internal auditors, external auditors, and regulators. Overall, we believe that the measurement principle would not be operational . . ..

    "When Is an Asset not an Asset? A new lease accounting proposal by regulators is still getting pummeled by finance executives," by Kathleen Hoffelder, CFO.com, September  14, 2012 ---
    http://www3.cfo.com/article/2012/9/gaap-ifrs_lease-accounting-fasb-iasb-convergence-equipment-lease

    When a corporation leases a building, is the adjoining parking lot automatically included? Or should the lot be accounted for separately? Does it make economic sense to count the lot as a separate asset from the building, since in a typical suburban office complex one generally doesn’t exist without the other?

    Such questions are getting tougher and tougher to answer for CFOs and other executives who account for lease expenses that their companies incur – especially when you consider that the parties in the debate can’t even agree on such a basic element as the definition of an “asset.” In the example above, for instance, is the parking lot an asset owned by the lessee, or is it simply a piece of rented property?

    The confusion stems from a lease accounting proposal jointly agreed upon by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in June that requires lease expenses to be recorded on corporate balance sheets. The boards decided that lessees should distinguish between equipment and property leases, and that the distinction should be based on whether the lessee acquires and/or uses up more than an “insignificant” portion of the underlying asset. Along with other criteria, if a lessee buys or consumes more than that amount, it would have to account for its cost on a property-lease basis; if less, than the arrangement would be deemed an equipment lease.

    FASB and IASB further came to an agreement on having property leases accounted for using a straight-line approach (in which a single lease expense is recognized over the life of a lease) and equipment leases accounted for in a front-loaded manner (in which larger interest charges occur at the beginning of a lease than at the end).

    Ralph Petta, chief operating officer at the Equipment Leasing and Finance Association (ELFA), notes that the boards’ decision to make the equipment lease expense recognition front-loaded creates a lot of problems. “It makes the accounting more complex than it needs to be,” he says. Since equipment leases have not previously been front-loaded, lessees would have to do a whole lot more calculating of asset values if the plan goes through.

    While ELFA supports having leases recorded on lessees’ balance sheets and incorporating two types of leases for property and equipment, the association’s leaders find fault with the way the boards are addressing those issues now.

    Critics of the proposal like Rod Hurd, CFO of Bridgeway Capital Advisors and chair of ELFA’s financial committee, don’t think the standard setters’ plan correctly addresses most lessees’ accounting needs.

    For one thing, he notes the “economics” of the FASB/IASB proposal don’t jibe with general accounting principles. In a front-loaded lease on a balance sheet, as in the case of an equipment lease, the asset appears to be worth less than its present economic value, notes Hurd.

    FASB and IASB’s front-loaded approach for equipment leases considers all equipment leases as purchases, perhaps reasoning that, in many cases, short-term lessees resemble owners more than renters. ELFA and others, however, say that the concept doesn’t match reality.

    Continued in article

    "Diversity among Analysts Makes Objective of FASB-IASB Lease Accounting Difficult to Achieve," BNA, July 31, 2012 ---
    http://www.bna.com/diversity-among-analysts-b12884910914/

    Jensen Comment
    In my opinion, standard setters, corporations, and financial analysts are avoiding the most important and the most troublesome aspect of lease accounting --- how to account for lease renewals. As long as lessees and can simply look at one lease term for accounting purposes, the leases will be written for shorter terms and thereby defeat the purpose of getting OBSF debt on the balance sheet.

    Bob Jensen's threads on lease accounting ---
    http://www.trinity.edu/rjensen/Theory02.htm#Leases

     


    Question
    Are the proposed changes to booking of lease accounting renewals in conformance with the Conceptual Framework?

    Suppose we define the event as the signing of a 12-month lease of Gate 12 at the Manchester, New Hampshire airport. The lease contract calls for 12 monthly payments of $10,000 each. In addition, the lease has a forecasted transaction of renewal on each year thereafter at the discretion of Southwest Airlines for ten years at a monthly rate of $10,000 per month plus or minus a rental premium or discount pegged to the change in U.S Treasury Rates. For simplicity ignore cancellation fees, leasehold improvement costs, and rental rate inflation adjustments. The treasury rate adjustment is probably unrealistic, but for educational purposes this does add a hedgeable component to the forecasted transaction prices. I think it is common in lease renewals to have hedgeable components.
     

    Into this case we insert the assumption that Southwest Airlines has a "significant incentive to renew annual gate lease" thereby making companies and auditors seriously consider booking lease renewal cash flows under the new lease accounting rules. Note, however, that lease renewal is still a forecasted transaction since Southwest airlines is not under contract to renew the lease after 12 months. There is no penalty for deciding not to renew the lease even though renewal is very, very probable,

     

     

     
    The future annual renewals are forecasted transactions in the same sense as forecasted transactions of jet annual jet fuel purchases of an airliner. The forecasted transactions of fuel expenses cannot be booked under GAAP even if they are hedged items. I assume that the forecasted transactions of gate lease renewals will be booked under the new joinrt lease capitalization standard. Thus there'a a quetion about consistency in terms of the Conceptual Framework.
     
     
    My question is whether capitalizing some forecasted transactions (e.g., lease renewals) while not capitalizing most other forecasted transactions (e.g., forecasted jet fuel purchases) are both in formal logic conformance with the FASB's Conceptual Framework.
     
     
    Another way of putting this questionj is whether cherry picking what forecasted transactions are required to be booked under new or revised standards is consistent with the Conceptual Framework. And are there any Conceptual Framework guidelines for deciding whether a forecasted transacgtion must be booked?
     
     
    Note that no contracts are signed for forecasted transactions. These are defined in FAS 133, and you can read about them by scrolling down at
    http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
    Page references are to Version 1 of FAS 133.
     
     
    Forecasted Transaction =
     
    a transaction that is expected, with high probability, to occur but as to which there has been no firm commitment. Particularly important is the absence penalties for breach of contract.  Paragraph 540 on Page 245 of FAS 133 defines it as follows:
     
    A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.
     
    To my students I like to relate firm commitments and forecasted transactions to purchase commitments or sales contracts that call for future delivery.  If the contract specifies an exact quantity at a fixed (firm) price, the commitment is deemed a "firm commitment."   Cash flow is never in doubt with a firm (fixed-price) commitments and, therefore, a firm commitment cannot be hedged by a cash flow hedge.  For example, suppose Company A enters into a purchase contract to purchase 10,000 tons of a commodity for $600 per ton in three months time.  This a firm commitment without any doubt about the cash flows.  However, if the price is contracted at "spot price" in three months, the commitment is no longer a "firm" commitment.  The clause "spot price" makes this a forecasted transaction for 10,000 at a future price that can can move up or down from its current level.  It is possible to enter into a cash flow hedge with a derivative instrument that will lock in price of a forecasted transaction.  In the case of a firm commitment there is no need for a cash flow hedge.
     
    In the case of a firm commitment the cash flow is fixed but the value can vary with spot prices.  For example, in three months time the firm commitment cash flow may be ($600)($10,000) = $6,000,000.  If the spot price moves to $500, the cash flow is more than the value of the commodity at the time of purchase.  It is possible, however, to use a derivative financial instrument to hedge the value at a given level (called a fair value hedge) such that if the spot rate falls to $500, the hedge will pay ($600-$500)(10,000 tons) =  $1,000,000.
     
    In the case of a forecasted transaction at spot rates, the value stays fixed at ($ spot rate)(10,000 tons).  However, the cash flow accordingly varies.  It is possible to enter into a cash flow hedge using a derivative financial instrument, however, such that the cash flow is fixed a desired level.  In summary either cash flows are fixed and values vary (i.e., a fixed commitment) or cash flows vary and values are fixed (forecasted transaction).  If hedging takes place, firm commitments are only hedged with respect to value, whereas forecasted transactions are only hedged as to cash flow.
     
    Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or obligations for future sacrifices.  Firm commitments differ from forecasted transactions in terms of legal rights and obligations.  A forecasted transaction has no contractual rights and obligations. Forecasted transactions are referred to at various points in FAS 133. For example, see FAS 133 Paragraphs 29-35, 93, 358, 463-465, 472-473, and 482-487. A forecasted transaction, unlike a firm commitment, may need a cash flow hedge.  
    Paragraph 29b on Page 20 of FAS 133 requires that the forecasted transaction be probable.  Important in this criterion would be past sales and purchases transactions.  An on-going baking company, for example, must purchase flour.  It does not have to purchase materials for a plant renovation, however, until management decisions to renovate are firmed up.
    Paragraph 325 on Page 157 of FAS 133 states that even though forecasted transactions may be highly probable, they lack the rights and obligations of a firm commitment, including unrecognized firm commitments that are not booked as assets and liabilities. 
    Forecasted transactions differ from firm commitments in terms of enforcement rights and obligations. They do not differ in terms of the need for a specific notional and a specific underlying under Paragraph 440a on Page 195 of FAS 133.  Section a of that paragraph reads as follows:
     
    a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign
    currency. It also may be expressed as a specified interest rate or specified effective yield.
    In Paragraph 29c on Page 20 of FAS 133, the forecasted transaction cannot be with a related party such as a subsidiary or parent company if it is to qualify as the hedged transaction of a cash flow hedging derivative.  An exception is made in Paragraph 40 on Page 25 for forecasted intercompany foreign currency-denominated transactions if the conditions on Page 26 are satisfied. Also see Paragraphs 471 and 487.  Paragraph 40 beginning on Page 25 allows such cash flow hedging if the parent becomes a party to the hedged item itself, which can be a contract between the parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133.  However, a consolidated group may not apply cash flow hedge accounting as stated in Paragraph 40d on Page 26. 
    Cash flow hedges must have the possibility of affecting net earnings.  For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign subsidiary.  The reason is that these dividends are a wash item and do not affect consolidated earnings.  For reasons and references, see equity method.
    Suppose a company expects dividend income to continue at a fixed rate over the two years in a foreign currency.  Suppose the investment is adjusted to fair market value on each reporting date.  Forecasted dividends may not be firm commitments since there are not sufficient disincentives for failure to declare a dividend.  A cash flow hedge of the foreign currency risk exposure can be entered into under Paragraph 4b on Page 2 of FAS 133.  Whether or not gains and losses are posted to other comprehensive income, however, depends upon whether the securities are classified under SFAS 115 as available-for-sale or as trading securities.   There is no held-to-maturity alternative for equity securities.
     
    One question that arises is whether a hedged item and its hedge may have different maturity dates.  Paragraph 18 beginning on Page 9 of FAS 133 rules out hedges such as interest rate swaps from having a longer maturity than the hedged item such as a variable rate loan or receivable.  On the other hand, having a shorter maturity is feasible according to KPMG's Example 13 beginning on Page 225 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998) states the following.  A portion of that example reads as follows:
     
    Although the criteria specified in paragraph 28(a) of the Standard do not address whether a portion of a single transaction may be identified as a hedged item, we believer that the proportion principles discussed in fair value hedging model also apply to forecasted transactions.
     
    Paragraph 29d precludes forecasted transactions from being the hedged items in cash flow hedges if those items, when the transaction is completed, will be remeasured on each reporting date at fair value with holding gains and losses taken directly into current earnings (as opposed to comprehensive income).  Also see Paragraph 36 on Page 23 of FAS 133.  Thus, a forecasted purchase of raw material inventory maintained at cost can be a hedged item, but the forecasted purchase of a trading security not subject to APB 15 equity method accounting and as defined in SFAS 115, cannot be a hedged item. That is because SFAS 115 requires that trading securities be revalued with unrealized holding gains and losses being booked to current earnings.  Conversely, the forecasted purchase of an available-for-sale security can be a hedged item, because available-for-sale securities revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.
    Even more confusing is Paragraph 29e that requires the cash flow hedge to be on prices rather than credit worthiness.  For example, a forecasted sale of a specific asset at a specific price can be hedged for spot price changes under Paragraph 29e.  The forecasted sale's cash flows may not be hedged for the credit worthiness of the intended buyer or buyers.  Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.  Because the bond's coupon payments were indexed to credit rating rather than interest rates, the embedded derivative could not be isolated and accounted for as a cash flow hedge.
    A forecasted transaction must meet the stringent criteria for being defined as a derivative financial instrument under FAS 133.  This includes the tests for being clearly-and-closely related.  It also includes strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being hedged.  Those tests state that if the forecasted "transaction" is in reality a group or portfolio of individual transactions, all transactions in the group must bear the same risk exposure within a 10% range discussed in Paragraph 21.    Also see Footnote 9 on Page 13 of FAS 133.  The grouping tests are elaborated upon in the following Paragraphs:
    Paragraph 21 on Page 13,
    Paragraph 29 beginning on Page 20,
    Paragraph 241 on Page 130,
    Paragraph317 on Page 155,
    Paragraphs 333-334 beginning on Page 159,
    Paragraph 432 on Page 192,
    Paragraph 435 on Page 193,
    Paragraph 443-450 beginning on Page 196
    Paragraph 462 on Page 202,
    Paragraph 477 on Page 208.
     
     
    For example, a group of variable rate notes indexed in the same way upon LIBOR might qualify, whereas having different indices such as LIBOR and U.S. Prime rate underlyings will not qualify.    Also, anticipated purchases cannot be combined with anticipated sales in the same grouping designated as a forecasted transaction even if they have the same underlying.Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of differing risk exposures for financial instruments designated in foreign currencies so not to conflict with Paragraph 20 of SFAS 52.  It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  For more detail see foreign currency hedge.
    Merely meeting the tests of being a forecasted transaction or a firm commitment does not automatically qualify the item to be designated a hedge item in a hedging transaction.  For example, it cannot be a forecasted transaction cannot be hedged for cash flows if it is remeasured at fair value on reporting dates.  For example, trading securities under SFAS 115 are remeasured at fair value with unrealized gains and losses going directly into earnings. 
    Paragraph 40 beginning on Page 25 bans a forecasted transaction of a subsidiary company from being a hedged item if the parent company wants to hedge the cash flow on the subsidiary's behalf.  However Paragraph 40a allows such cash flow hedging if the parent becomes a party to the hedged item itself, which can be a contract between the parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133.  Also see Paragraphs 471 and 487.
    Paragraph 21c on Page 14 and Paragraph 29f on Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a consolidated subsidiary from being designated as a hedged item in a cash flow hedge.   Reasons are given in Paragraph 472 beginning on Page 206 of FAS 133.
     
    Respectfully,
    Bob Jensen

     

    Bob Jensen's threads on lease accounting are at
    http://www.trinity.edu/rjensen/Theory01.htm#Leases


    Scenarios on how companies tweak lease contracts to avoid having to book them as assets and liabilities

    Years ago Roman Weil stated (paraphrased):
    "Boeing booked the sale of an airplane to Eastern Airlines. But with a lease, Eastern airline booked neither the airplane nor the financial obligation for the lease."

    Leasing was and still is a major way to achieve off-balance-sheet financing (OBSF)
    Before 1976, companies used acquired assets with lease financial obligations that did not have to be booked. Thereby trillions of dollars of financial obligations were being kept off balance sheets in a way that distorted Debt/Equity ratios and appearances of low leverage in often very risky leverage situations.

    In FAS 13 the FASB tried to put an end to OBSF financing that for all practical purposes was equivalent to purchasing with debt. When Eastern Airlines used debt, the airplane was booked as an asset and the debt was booked as a liability. The FASB in FAS 13 defined a capital lease to be equivalent to a purchase and required that the airplane be booked as an asset and the capital lease be booked as a liability. There were four conditions that all had to be met to define a lease as a capital lease:

    FAS 13 put an end to much OBSF by setting up bright lines distinguishing capital leases from operating leases. Capital leases that are essentially a form of financing capital assets are required to be booked as debt on the balance sheet --- http://ez13.com/rules.htm

    A lease is capital if any one of the following four tests is met:  
    1)
    The lease conveys ownership to the lessee at the end of the lease term;  
    2) The lessee has an option to purchase the asset at a bargain price at the end of the lease term  
    3)
    The term of the lease is 75% or more of the economic life of the asset.  
    4) The present value of the rents, using the lessee's incremental borrowing rate, is 90% or more of      the fair market value of the asset
    .

    Strategies Used to Defeat the Purpose of FAS 13
    For many years many companies lived with booking capital leases but they developed ploys of forming leasing subsidiaries that they owned 100% but avoided putting on their principal balance sheets by not consolidating those leasing subsidiaries.

    Until FAS 13, leases did not have to be booked. Companies entered into complex leasing arrangements to avoid showing debt on balance sheet. For example, Safeway borrowed heavily to build hundreds of grocery stores across the United States and then transferred the stores and their mortgages to a leasing subsidiary. The stores were then leased from Safeway's leasing subsidiary. The leasing subsidiary was not consolidated in Safeway's financial statements. Hence all the debt on all Safeway stores was hidden on Safeway balance sheets. Safeway was not unique. This ploy was used by hundreds of companies to keep millions in debt off balance sheets. FAS 94 put an end to much of this type of OBSF by requiring consolidation of financing subsidiary corporations --- http://www.nysscpa.org/cpajournal/old/07551314.htm

    The Financial Accounting Standards Board has implemented Statement of Financial Accounting Standards (SFAS) 94, requiring consolidated financial statements for all majority-owned subsidiaries with their parent firms, in order to eliminate off balance sheet financing. The manufacturing sector of the economy is expected to be heavily affected, with highly leveraged subsidiaries causing an increase in total debt and the debt to equity ratio after consolidation. The likely effects of SFAS 94 on extant debt and management contracting agreements include increased operating costs due to the: negative effects in the securities markets; increased costs inherent in the recontracting of debt covenant restrictions in light of likely violations; and the renegotiation of dividend restrictions, management compensation agreements, and loan agreements.


    After FAS 94 it appeared that companies would at last bring trillions of dollars of capital lease assets and liabilities into their principal balance sheets. And they did but only to a small and disappointing extent. To continue the fanaticism over having OBSF, the firms now commenced to tweak the leases themselves to avoid one of the above four conditions defining a capital lease. One ploy was to make the lease term less than 75% of the economic asset to the firm. For example, an airplane might have a 40-year economic life to Eastern Airlines plus another 30-year life to African Airlines. Eastern could tweak the lease of that aircraft to 28 years and, thereby, have an "operating lease" that did not have to be booked. Or the option to buy at the end of a 40-year lease may not be at a bargain price.

    The bottom line is that it became extremely common for airlines and other companies to continue OBSF with such obvious tweaking of lease contracts.

    How to Avoid Lease Booking Under FAS 13 ---
    http://www.ehow.com/how_8648539_avoid-lease-asset-capitalization.html

    Instructions

    1
    Avoid inclusion of a non-cancelable clause for the lease term. This clause, plus the inclusion of one of the following statements, will result in lease asset capitalization.

    2
    Ensure the lease agreement does not transfer ownership. Ownership transfer requires lease asset capitalization.

    3.
    Prevent an agreement that allows for a bargain purchase option. Leases that allow for the transfer of ownership at lease end is a capital lease characteristic.

    4
    Review the non-cancelable clause if one is in the agreement. A non-cancelable lease term that is equal to or greater than 75 percent of the asset's economic life will require lease asset capitalization. 5

    Conduct a present value analysis for the asset in the lease agreement. Minimum lease payments that are equal to or greater than 90 percent of the asset's fair value results in a capital lease.

    Tips & Warnings

    A public accountant can help review any lease agreements and ensure the stated agreement results in an operating lease.

    Events in 2012
    And so now in 2012 the IASB and FASB appear to be coming to an agreement to stop these deceptions by no longer partitioning leases into capital leases (to be booked) versus operating leases (until now not booked but disclosed in footnotes). Instead leases will be booked unless certain conditions are met such as not booking leases expiring in 12 months or less.

    As I am writing this on June 18, 2012 the Exposure Draft is not yet available. But here's a summary of what we expect.
    A dual model for lease accounting: redrawing the lines --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8VAMTX&SecNavCode=MSRA-84YH44&ContentType=Content

    A Dual Model for Lease Accounting: 
    Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

    PwC supports dual model with a twist --- the lease, in effect, transfers the risks and rewards of ownership --- Click Here
    http://www.pwc.com/us/en/cfodirect/publications/point-of-view/lease-accounting-financial-reporting-model.jhtml?display=/us/en/cfodirect/publications/point-of-view&j=271226&e=rjensen@trinity.edu&l=550390_HTML&u=12702412&mid=7002454&jb=0

    Jensen Comment
    My son Marshall was recently stopped in his leased car for a red light in downtown Lewiston (where he works for a hospital) when he was rear ended by a woman who was paying more attention to her baby than her driving at the time. Although her insurance company paid the $5,700 slight damages to his leased car, it would have been his responsibility to fix the car if she had no insurance. Thus leasing is no different than ownership in the case of a leased car in the case to collisions. However, not all "risks and rewards of ownership" are transferred to lessees of cars, including capital gains and losses of the entire car at the end of the lease term.

    The problem is even more dramatic in the case of operating leases of real estate like a store in a strip mall. If the store changes dramatically in value the capital gain or loss usually accrues to the lessor who will adjust the rent accordingly at the end of the lease term or simply refuse to write another lease if the mall is going to be sold or destroyed.

    My point is that I don't think there will be many leases booked under the PwC model. One reason is that any operating  lease that meets the PwC model might be re-written to get out of having to book the lease.

    From the IASB:  What Financial Analysts Do Not Want
    Leases — Summary of outreach meetings with investors and analysts on proposed accounting by lessees
    May – September 2013 --- Click Here
    http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/Lessee-accounting-investor-outreach-summary-May-to-September-2013.pdf

    . . .

    Measurement of lease assets and liabilities
    23. Investors and analysts consulted generally support the proposed measurement of variable lease payments and options, ie
    excluding variable lease payments linked to sales or use and, in most cases, excluding optional renewal periods. Almost all noted that they would not want subjective estimates about variable lease payments and renewal options included in the reported asset and liability amounts. In their view, it would make the balance sheet amounts less reliable and, thus, less useful for their analyses. A number of investors and analysts also think that it is more appropriate to reflect the economic difference between fixed and variable lease payments, and non-cancellable and optional lease periods, on a lessee’s balance sheet as proposed — a lessee with contracts with variable lease payments and optional renewal periods has a lot more flexibility than those making fixed payments in non-cancellable period.

     

    How to Avoid Lease Booking Under the New Dual Model 

    Scenario 5 (Airplane Leases of 5-Years Each)
    Depending on how the new 2012 Dual Model deals with booking versus non-booking of forecasted transaction lease renewals, it might be possible to avoid part or all booking of a lease for a new airplane and most any other asset. For example, instead of a 40-year lease on an airplane, Southwest Airlines can negotiate a lease for five years with an option to renew in a separate contract that might be free or might have a premium price. Assume that after the 5-year lease expires there is no penalty fee if Southwest simply decides not to renew. If the lease renewal cash flows for subsequent years of the economic life of this aircraft are not booked, this is not the same as booking the full amount of a 40-year economic life of that aircraft to Southwest Airlines.

    Why would a lessor agree to such a deal?
    There are various possible reasons. The lessor might place a serious price that Southwest Airlines must pay initially (in year 0) for the option to renew in five years. The lessor might devise a diminishing rental schedule with very high monthly rental prices for the first 5-year lease and substantial rent savings with subsequent lease renewals. Or the lessor may lease 40 such aircraft to Southwest Airlines knowing that there's a very high probability that almost all of then will be renewed.

    What will Southwest Airlines book for the lease(s) in Scenario 5?
     It's not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will only have to book the first five-year lease initially (the present value of monthly rents for five years) and will not have to book possible renewals until the renewals are contracted.

    However, there is wiggle wording in the dual model proposal that opens the door to required booking forecasted transactions of renewal if there is very high subjective probability that the leases will be renewed. Sadly, this wiggle wording encounters all sorts of problems of uncertainty regarding forecasted renewals and forecasted renewal rental amounts (that are not verifiable at time zero if there is no contract for a rental renewal. The whole thing is beginning to look like a mess in terms of overcoming the OBSF problem.

     

    Scenario 4 (Airplane Leases of 1-Year Each)
    Scenario 4 is the same as Scenario 5 except that instead of a 5-year lease on an airplane Southwest Airlines negotiated a 1-year lease for that aircraft. In this case Southwest would not have to book the aircraft lease unless required to book it plus forecasted transactions of future renewals. This might be a relatively expensive lease with 12 months of very high rents, although the rents might be reduced if the lessor can instead sell option contracts to Southwest Airlines to renew the leases. In that case the monthly rentals might be lower, but Southwest would have to buy the lease renewal options.

    What will Southwest Airlines book for the lease(s) in Scenario 4?
    It's not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will only have to book nothing for the Scenario 4 annual leases over the many years of use of this airplane by Southwest Airlines.

    However, there is wiggle wording in the dual model proposal that opens the door to required booking forecasted transactions of renewal if there is very high subjective probability that the leases will be renewed. Sadly, this wiggle wording encounters all sorts of problems of uncertainty regarding forecasted renewals and forecasted renewal rental amounts (that are not verifiable at time zero if there is no contract for a rental renewal. The whole thing is beginning to look like a mess in terms of overcoming the OBSF problem.

     

    Scenario 3 (Airport Gate Leases of 5-Years Each)
    Scenario 3 is similar to Scenario 5 except that in Scenario 3 the lease is for Gate 12 at the Manchester, NH airport rather than an airplane. There are differences between airport gate leases and airplane leases. For example, if the lease terms are five years each, Southwest has a small number of possible forecasted transactions for lease renewals say between 4-8 such renewals. In the case of a gate renewal there are in theory an infinite number of such renewals. Also in the case of an airport gate the lessor probably pays the maintenance costs. In the case of a leased airplane the lessee most likely pays the maintenance costs (that usually increase with the age of the aircraft).

    What will Southwest Airlines book for the lease(s) in Scenario 3?
    It's not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will book the each 5-year lease only when a contract is signed for that lease. Booking forecasted transactions for lease renewals is two uncertain since there may be an infinite number of such renewals.

    Scenario 2 (Airport Gate Leases of 1-Year Each)
    Scenario 2 is similar to Scenario 4 except that in Scenario 3 the lease is for Gate 12 at the Manchester, NH airport rather than an airplane. There are differences between airport gate leases and airplane leases. For example, if the lease terms are one year each, Southwest has a small number of possible forecasted transactions for lease renewals say between 1-39 such renewals. In the case of a gate renewal there are in theory an infinite number of such renewals. Also in the case of an airport gate the lessor probably pays the maintenance costs. In the case of a leased airplane the lessee most likely pays the maintenance costs (that usually increase with the age of the aircraft).

    What will Southwest Airlines book for the lease(s) in Scenario 2?
    It's not yet clear what the FASB and IASB will require in terms of booking of lease renewals that have zero penalty costs if the lessee does not renew). My reading of the proposal to date is that Southwest Airlines will book the each 1-year lease only when a contract is signed for that lease. Booking forecasted transactions for lease renewals is two uncertain since there may be an infinite number of such renewals.

    Scenario 1 (Forecasted Transaction of the Purchase of One Million Gallons of Jet Fuel)
    Southwest has a forecasted transaction for purchasing one million gallons of jet fuel in 12 months. This is called the forecasted transaction "hedged item."
    Southwest purchases a call option for $200,000 that locks in the strike price at $3.12 per gallon for each gallon purchased up to one million gallons.

    What will Southwest Airlines book for the hedged item and hedging contract in Scenario 1?
    Southwest will does not book forecasted transactions or long-term purchase contracts under current GAAP rules. Hence there will be no booking of the forecasted purchase of one million gallons, the amount (notional) of which can be changed at any time in those 12 months.

    Under FAS 133 rules Southwest Airlines must book the hedging contract (in this case an option) at $200,000 initially and then adjust the fair value of that option at least every 90 days or less. This is a common type of cash flow hedging contract used by Southwest Airlines and it qualifies for hedge accounting treatment under FAS 133 such that changes in the value of the option contract are booked to AOCI rather than current earnings. If the forecasted transaction is changed say to something like 500,000 gallons, the option contract must still be carried at fair value but hedge accounting is no longer allowed on the full 1-million gallon notional.

     

    Possibly the Conceptual Framework Must Be Expanded
    I don't anticipate that forecasted transaction purchases of jet fuel will ever be booked as described in Scenario 1. However, the forecasted transaction lease renewals in Scenarios 2-4 could possibly force us to rewrite the Conceptual Framework since the Conceptual Framework is built around contractual obligations rather than forecasted transactions.

    An the Conceptual Framework would have to deal with such issues as a finite number of lease renewals (e.g., for an airplane) versus an infinite number of lease reneals (e.g., for an airline gate).

    I'm just glad it's not my job to rewrite the Conceptual Framework.


    Controversies Over Long-Term Leases:  Why are they sometimes more like long-term purchase contracts?

    I don't think the IASB and FASB are envisioning leases such as Tom illustrated. The illustration seems to be extremely artificial and does not have a spot price market of traders setting the spot rates. If net settlements are negotiated only between a lessor and a lessee (with or without depreciation)  this is not consistent with settlements of forward contracts based upon spot prices set by traders outside the contract party and counterparty.

    Rather than envision leases with contracted future rentals as forward contracts, I think lease contracts should be envisioned as purchase contracts. This raises a very interesting question in accounting theory as to why we must soon book non-capital long-term lease contracts and not long-term purchase contracts.

    Questions of theory beg the question of why long-term purchase contracts are not booked as assets or liabilities.
    I think the main reason is that, if a long-term purchase contract is breached, the in-court or out-of-court settlement may be minuscule compared with  the present value of the contract's future cash flow stream. For example, if Southwest Airlines signed a long-term purchase contract to buy jet fuel from Exxon for the next 30 years, the jet fuel has not been refined beyond a few months let alone for each of the next 25 years of remaining time on the contract if the purchase contract is breached after Year 5. The court would never require Exxon to pay for 25 years of jet fuel purchases that Southwest subsequently decides not to buy from Exxon

    Lease contracts may be very similar or very different from long-term purchase contracts.

    If lessor builds a custom drug store for Rite Aid rental lease, the damages of a breach of contract by Rite Aid may be very significant at most every point in the lease term except maybe very near the end of the lease.

    On the other hand, if the Rite Aid lease calls for ten rental cars from Hertz for the next 30 years (where Hertz replaces the cars every two years), then the damages for a breach of contract in Year 5 are relatively small since most of the cars supposedly to be leased over the next 25 years have mot even been manufactured let alone sold to Hertz.

    I think the FASB and the IASB should one day take up the question of estimated damages of breach of contracts when deciding the amount to book as an asset and as debt. I don't think Exxon should book the estimated future payments of 25 years of jet fuel purchases as an asset if the breach of contract will be settled for a penny on the dollar. Nor do I think that Hertz should recognize an asset for cars to be purchased and leased 25 years from now if the breach of contract damages will be two pennies on the dollar.

    But the lessor of a Rite Aid drug store has a better case for booking the discounted rentals of a store 25 years from now.if the breach of contract settlement might be 60 or more cents on the dollar. The problem, of course, is that it is very difficult to estimate what breach of contract settlement might be reached for a Rite Aid drug store. It must be significant since Rite Aid claims that it intends to keep hundreds of stores open until their leases expire but not a day after the leases expire.
     

     

    Subsequent Conversations with AECMers

    June 17, 2012 reply from Chauncey M. Dupree Jr. (Marc)

    In another AECM thread, Marc replied as follows. I posted his reply to this new thread and added my own responses in CAPS:

    Hi Bob, Pat, et al,

    To keep my thoughts straight, I'll post a comment then respond. I've seen you and other's do that and it works well. I was using my iPhone when I responded Friday night to your comment, Pat's was in the middle, and my comment was so disconnected from what I was responding to, it may have seemed peculiar to say the least.

    Bob: "Generally, we expect lessee and lessor accounting to be symmetrical. If the lessee has a booked liability we expect the lessor to have a booked asset. Defining only the asset side of things ignores this symmetry."

    Response: Agreed. I may be reading into your comment. I did not get to the liability side of the CF analysis of our Gate 12 at M-NH Airport agreement. I can do that, if you'd like. I got sidetracked and, by the time I got back to it, I wasn't sure anyone would be interested. .

    JENSEN  REPLY TO MARC
    ACTUALLY I'M PROBABLY MORE INTERESTED IN THE LESSEE'S FORECASTED TRANSACTION OF A LEASE RENEWAL, BUT FOR SYMMETRY I'M ALSO INTERESTED IN THE FORECASTED TRANSACTION LEASE RENEWAL AS AN ASSET ON THE BOOKS OF THE LESSOR.

    Bob: "Defining an asset as "something that has future economic benefit" does not resolve the problem of contracts versus forecasted transactions."

    Response: Agreed. I think I can demonstrate what I put forward in my last comment, repeated next. It may be so obvious, I don't have to. You tell me: "IF a forecast were to satisfy the definition of asset from the criteria in a CF--including your notion of predicting future economic benefits, it doesn't follow that it, the asset, should be reported in the financial statements as an asset. The recognition statement is a conjuction of recognition conditions. Satisfying the definitional criteria being but one of them. A "forecasted asset" might get tripped up anywhere along the paths considering the relevance, reliability, or measurement criteria. (I'm not convinced a "forecasted asset" even satisfies a CF's criteria of its asset definition.) A CF is equipped to deny the reporting of a transaction or event, when any one or more of the recognition conditions are not satisfied. Please remember, I'm not advocating a CF, I'm testing, using, and evaluating it/them."

    Bob: "For example, the option to annually renew the lease on an airport gate has a "future economic benefit" to Southwest Airlines even if Southwest is not contractually obligated to do so."

    Response: Maybe, depending on the fact situation. Clarify the fact situation and I'll offer a CF analysis. It will be easier for our readers to amplify or criticize an explicit analysis. Also, I didn't offer a CF analysis of the "forecasted asset" because I wasn't sure it was any longer of interest since Pat had properly cited the watered down version of FASB/IASB lease accounting. I would be happy to offer a CF analysis of "forecasted asset."

    IN THIS CONTEXT I ASSUME THE LESSEE PAID (THE PREMIUM)  AT THE START OF THE LEASE TERM FOR AN OPTION TO RENEW THE LEASE ON THE OPERATING LEASE'S EXPIRATION DATE. THIS OPTION PROBABLY IS NOT SCOPED INTO FAS 133 SINCE IT DOES NOT HAVE AN APPROPRIATE UNDERLYING UNDER FAS 133 DEFINITIONS.

    NEVERTHELESS, IT IS AN OPTION CONTRACT AND WOULD HAVE TO BE BOOKED AT THE PREMIUM COST. SUBSEQUENT ADJUSTMENT TO FAIR VALUE IS PROBLEMATIC SINCE THERE'S SUCH AN UNCERTAIN CHANGE IN FAIR VALUE OVER THE LIFE OF THE OPTION. LET'S IGNORE THE PROBLEM OF CARRYING THE OPTION ON THE LESSEE'S BOOKS.

    EVEN THOUGH THE OPTION HAS A FUTURE ECONOMIC BENEFIT TO THE LESSEE (AS EVIDENCED BY THE PURCHASE OF THIS OPTION), THE LESSEE IS UNDER NO OBLIGATION TO EXERCISE THE OPTION. HENCE, I DON'T THINK THIS REALLY CHANGES THE FORECASTED TRANSACTION NATURE OF THE LEASE RENEWAL. THE LESSEE HAS THE OPTION OF NOT RENEWING WHETHER OR NOT THE OPTION WAS PURCHASED.

    AS I SAID PREVIOUSLY, SOME LESSORS MAY SELL SUCH OPTIONS, BUT IN MANY CASES THE LESSOR MIGHT PREFER TO RETAIN AN ALTERNATIVE TO NOT RENEW THE LEASE.

     

    Bob: "My point is that booking of forecasted lease renewals that are highly probable is still a paradigm shift in terms of the Conceptual Framework built upon contracts rather than forecasted transactions."

    Response: I'm inclined to agree. But the CF may not affirm the paradigm shift, if it is taken. My caveat is that until I think through a CF analysis my priors is that a CF will reject reporting a "forecasted transaction" in the financial statements. I just haven't thought it through, yet. The CEO can blather about forecasted transactionsI all s/he wants to in the management report section of the financial report, but it might be rejected by a CF analysis for inclusion in the financial statements.

    I keep getting interrupted here at home. I'm going to stop with my comments above, but you have many interesting ideas that I haven't commented on. Let me know what you suggest for "keeping me busy this summer."

    Marc

    KEEP IN MING THAT THE MY ORIGINAL CHALLENGE SPECIFIED A 12-MONTH LEASE THAT WOULD ONLY HAVE TO BE BOOKED UNDER THE REVISED STANDARD IF THE LEASE RENEWAL HAD HIGHLY PROBABLE BENEFIT TO THE LESSEE. IF THE LESSEE PURCHASED A RENEWAL OPTION THIS IS PRIMA FACIE EVIDENCE THAT THERE IS SUCH A BENEFIT.

    IF THE 12-MONTH LEASE AND ITS RENEWAL CASH FLOWS MUST BE BOOKED UNDER THE FORTHCOMING STANDARD THERE ARE ENORMOUS REMAINING QUESTIONS.

    ONE HUGE QUESTION IS HOW MANY FORECASTED LEASE RENEWALS SHOULD BE BOOKED. SHOULD ONLY THE FIRST RENEWAL FOR ANOTHER 12 MONTHS BE BOOKED, OR SHOULD THE SECOND RENEWAL BE BOOKED, AND SHOULD THE THIRD, FOURTH, FIFTH, ETC. RENEWALS BE BOOKED.

    THE WHOLE IDEA OF BOOKING RENEWALS BOGGLES MY MIND.


    June 18, 2012 reply to my document at
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm#Scenarios

    Bob, Pat, et al,

    Keep in mind that this is the empirical part of an application of a CF. This is not intended to be done alone. The logic is subject to review and that is available from ssrn (“A Sound Foundation”). So, if the statements below are true, and we decide that--not me, not you, but we, then where ever there's a "therefore," it signals a conclusion which follows as necessarily true. (I just wanted to let you know what you're getting into. True propositions structured in a valid argument form produces true conclusions, ie, sound reasoning.) I’m also trying to accurately identify reality with regard to the transaction from Bob’s Case 1. You decide if I’ve been successful. I may very well be wrong anywhere along the process. If I'm wrong, jump in and help out. I’ll do it again with any recommended corrections. Or better yet, give the CF a try yourself.

    CASE 1: x provides Southwest at time t an option to buy one million gallons of jet fuel from Oil Company in twelve months at a strike price of $3.12 per gallon in exchange for a $200,000 payment at time t to Oil Company.

    x provides Southwest probable future economic benefit at time t for one million gallons of jet fuel in 12 months at $3,120,000 from Oil Company, or less than $3,120,000 for one million gallons of jet fuel if Southwest decides to purchase from another source at an available market price of less than $3.12 per gallon 12 months from time t.

    Or [You take a stab at affirming or denying “future economic benefit for the transaction.]

    x provides the right/assurance that Southwest can control others’ access to purchase the jet fuel in 12 months.

    x has been signed and is a past event.

    Therefore, x satisfies the conditions of asset. Note that x must also satisfy the other recognition criteria before it is to be (booked in Southwest's records) reported in the financial statements at time t as an asset.

    x is timely because it occurred during reporting period of time t.

    x provides predictive value because we have confidence that a right is established for us to purchase the jet fuel for $3.12 or an available market price less than $3.12. (CF states this part of relevance as “feedback or predictive value.” A disjunction is true if either disjunct is true. Feedback is just as straightforward to support for x.)

    Therefore, x is relevant.

    x faithfully represents our right at time t to purchase the jet fuel in 12 months because it corresponds to what is available to us in 12 months.

    x is verifiable because anyone at time t can read and confirm the information in it.

    x is neutral because at time t it states the rights of each party to the agreement. That x grants rights to purchase is not slanted by Southwest or Oil Company at time t.

    Therefore, x satisfies the CF’s reliability criteria.

    x identifies an amount of $3,120,000 at time t for one million gallons of jet fuel in 12 months or an amount less than $3,120,000 for an available market price less than $3.12 per gallon.

    Therefore, x is measurable. And, since x satisfies the recognition criteria as an asset, it is to be reported (booked in Southwest’s records) at time t as an asset of $3,120,000.

    Is x also a liability according to the FASB’s CF?

    x leaves little discretion at time t to avoid the sacrifice of cash to Oil Company. FALSE. x does not require Southwest to exercise the option. Therefore, x is not to be booked in Southwest's records or reported in its financial statements as a liability at time t.

    Marc

    June 19. 2012 reply from Bob Jensen

    Hi Marc,

    I think you are describing a purchase commitment rather than a forecasted transaction. See below.

    Actually Southwest Airlines forecasted transactions for jet fuel work more like this. The forecasted transaction by Southwest Airlines has no contract with anybody (that's why it's a forecasted transaction). Southwest need not hedge the price at all and take whatever spot price is available 12 months later.

    At any time during the 12 months, say after 11 months, Southwest can change the notional of one million gallons at will, e.g., to 500,000 gallons. There is no contract or penalty for changing the notional of a forecasted transaction.

    To lock in the $3.12 price 12 months from now or at any time before the 12 months has passed, Southwest can lock in a price of $3.12 with a derivatives instrument contract --- Southwest generally prefers call options but it could enter into futures or forward contracts. The reason Southwest prefers purchased options as hedges or speculations is that losses of purchased options are limited to the prices paid for the options.

    Southwest does not usually enter into hedging contracts with an oil company. Instead it buys the options on a jet fuel price options exchange market such as the CBOT or CME. However, I suppose Southwest could buy the options directly from an oil company. But the exchange markets are really better for buying and selling derivative financial instruments hour-by-hour (except for forward contracts that are usually negotiated through banks).

    If Southwest instead has a purchase commitment from an oil company to buy 1 million gallons at $3.12 per gallon, this is no longer a forecasted transaction. Southwest thereby has locked in a contracted underlying (the $3.12 price) and a contracted notional (one million gallons). Thereby, Southwest has no cash flow risk like it has with a forecasted tranasaction. But it now has fair value risk because the spot price of jet fuel 12 months later may be above or below the $3.12 strike price. Southwest need not hedge nonexistent cash flow risk in this instance. However, it can hedge its fair value risk with derivative financial instruments.

    FAS 133 and IAS 39 require different hedge accounting treatments for cash flow hedges versus fair value risk hedges. The AOCI account is not used for fair value risk hedges.

    I have two cases regarding Southwest Airlines hedging contracts: Two Teaching Cases Involving Southwest Airlines, Hedging, and Hedge Accounting Controversies ---
    http://www.trinity.edu/rjensen/caseans/SouthwestAirlinesQuestions.htm 

    I discuss hedge effectiveness testing at http://www.trinity.edu/rjensen/CaseAmendment.htm 

    Respectfully,
    Bob Jensen

     

    June 19, 2012 reply from Marc Dupree

    Need for clarification. Bob: "For example, discounted future cash flows of pension obligations is derived from written contracts. Discounting forecasted transactions of jet fuel purchases and airport gate lease renewals may not be based upon contracts that obligate the company to make particular transactions that it now forecasts that it will make in the future."

    Forecasted transactions: You mean because there is an active market for something, now, and the market is expected to continue in the future, management can recognize a "transaction" today without any specific counterparty?

    June 20, 2012 reply from Bob Jensen

    Hi Mark,

    This reply refers to the five scenarios at http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm 

    No, I don't agree Marc.
    In Scenario 1 if Southwest Airlines has a forecasted transaction to buy one million gallons of jet fuel in 12 months. Along about Month 11 Southwest must place actual orders (contracts) to buy that much fuel. When the fuel arrives the inventory gets booked along with any debt used to finance the purchase. The hedging contracts also get net settled for cash such that the net price of the fuel is $3.12 per gallon even if Southwest actually paid a spot price of $5.18 per gallon or a spot price of $2.85 per gallon. By the way, the inventory gets booked at spot price rather the price after the hedges are net settled. Southwest Airlines hedges cash flow rather than accrual earnings.

    In Scenario 4, Southwest Airlines has a 12-month lease on Gate 12 of the Manchester Airport. To renew the lease, along about Month 11 of each lease period Southwest must sign a contract to renew the lease for another 12 months.

    The difference between Scenarios 3 (five-year lease periods) versus Scenario 4 (one-year lease periods) is that in Scenario 4 under the anticipated new 2012 Dual Model accounting the lease contracts themselves and their renewals never get booked, because leases of 12 months or less are not required to be booked under the Dual Model. Hence, in Scenario 4 there is always $0 reported as a liability for the lease contracts and their anticipated lease renewals. The FASB and IASB will not be happy with Scenario 4 because an intended very long (infinite) stream of cash flow obligations under the gate leases never gets booked as debt (unless the Dual Model requires the booking of lease renewals, which will change the entire ball game for 12-month leases subject to forecasted transaction lease renewals).

    I really think the IASB and FASB would prefer to book any forecasted stream of lease payments. But it's just not politically feasible, under the eyes of Congress and the EU lawmakers, to book leases that run only 12 months or less. Businesses want an escape clause for not having to book most of their leases.

    In Scenario 3 the five-year leases will be booked every renewal period. Actually, Scenario 3 is the only scenario in my illustrations that works according to the FASB and IASB intent for the Dual Model. The FASB and IASB will probably be happy with Scenario 3 even if it does reduce an infinite stream of forecasted transaction lease renewals to a series of five-year cash flow streams.

    The same difference arises between Scenarios 4 and 5. In Scenario 4 the leased aircraft financial obligation never gets booked because the leases are 12 months or less. In Scenario 5 the leases do get booked every five years, but in the case of the aircraft five-year lease renewals this is not what the FASB and IASB intended for the Dual Model.

    If the economic intent of Southwest Airlines is to lease a $24 million dollar aircraft for 30 years, the FASB was thinking in terms of projected cash flows for a 30-year lease. Reducing that to a mere five-year series of projected cash flows over 30 years grossly understates the forecasted transaction debt (by 5/6) if Southwest really intends to renew each five-year lease six times over 30 years. The FASB and IASB will not be happy with either Scenarios 4 or 5.

    In conclusion, the FASB and IASB both want leases booked over the years a business firm intends to use leased assets. But if forecasted transaction lease renewals are not booked, many (most?) business firms will either re-write lease contracts to book $0 (e.g., 12-month renewable leases in Scenarios 2 and 4) or a small fraction of the financial obligation (e.g., 5-year renewable leases in Scenarios 3 and 5).

    Respectfully,
    Bob Jensen

     


    June 27, 2012
    Hi again Tom,

    This exchange is interesting in that it begs the question of what is a "derivative" financial instrument.

    In the context of FAS 133, a "derivative" is mapped to a price/rate/credit index such as a standardized grade corn price, LIBOR, or credit rating of an investor's collateralized bond. FAS 133 scopes in derivative contracts in commodity prices, interest rates, and credit ratings.

    FAS 133 scopes out weather indexes such as average daily rainfall in Kossuth County during July. We can certainly have a derivative financial instrument such as a call option based upon a weather index, but these contracts are not scoped into FAS 133.

    The contracted index constitutes the "underlying" of a derivative financial instruments contract. In virtually all derivative financial instruments contracts the index measurement is verifiable and becomes the basis for ultimate contract settlement. For example, when settling a call option on corn price, the CBOE contracted strike price of corn is net settled against the CBOE ( http://www.cboe.com/default.aspx  ) spot price (which is the underlying). The CBOE defines "standard" contracts for this index in terms of detailed chemical grading of corn (not any old puny corn qualifies for the CBOE grading standard). Interestingly, the hedged item might be puny corn but the farmer may net settle hedging CBOE corn derivative financial instruments contracts on CBOE-quality corn he's unable to grow. From a FAS 133 standpoint, this can lead to ineffectiveness of a hedge contract that is actually hedging the farm yield of puny corn.

    I think the definitional implication is that contracting parties are "takers" and not "makers" as far as the underlying is concerned. Derivative financial instruments are then "derived" from fluctuations in that underlying index outside the control of the contracting parties in a derivative financial instrument.

    My main point is that a given farmer cannot control the CBOE spot price of corn or the rainfall in Kossuth County in July that are used as an underlying in a derivative financial instrument. He can control to some extent the price of the corn he actually grows or what he's willing to pay to lease his crop land.

    In my opinion, the contract is no longer a derivative financial instrument if both the party and the counterparty totally or partially "make" the index. Hence I assume that an option contract renew a lease is not a derivative financial instrument contract if the contracting parties negotiate the rent rather than use some rent index outside their control. I don't think a rent index exists for most operating leases in the same sense that commodity price and interest rate indexes exist in such places as the CBOE, CBOT, and CME markets.

    The bottom line is that what we call lease renewal options and some other types of options are not derivative financial instruments contracts that are defined in FAS 133 or IAS 39 (soon to be IFRS 9). Hence, when we write that a business firm has an "option" contract that contract is not necessarily a derivative financial instrument. To be a derivative financial instrument it must have an underlying that contracting parties take rather than make in the market. Additionally, FAS 133 requires that to be eligible for hedge accounting there must also be a net (cash) settlement provision based upon that index rather than a requirement for physical delivery of the commodity in question.

    Lease renewal contracts are more apt to be financial instruments rather than derivative financial instruments.
    As such, they are accounted for as other financial instruments. However, there can be huge complications when attempting to carry lease renewal contracts at fair value. The leased property is almost always highly unique and not a fungible item.. The leased Gate 12 at the Manchester, NH airport is very different from the leased Gate 57 in Baltimore. The CBOE has no standardized contracts for airport gate rentals, building rentals, and equipment rentals like it has for a chemical grade of corn in CBOE options contracts.

    The main problem with lease renewals is that for operating leases these are typically forecasted transactions that are not contracts. This is outside the paradigm of an accounting Conceptual Framework built upon the paradigm of contracts. I discuss this in greater detail above in this document
     

    A Dual Model for Lease Accounting: 
    Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

    Respectfully,
    Bob Jensen


    Hi Tom,

    Perhaps I can get to you on a different tack. A "spot price" in finance is the current price of an item at a current point in time say the end of the trading day on June 30, 2012 where we can look up the current spot price of of hundreds of commodities  in the newspaper or at the CBOE Web site --- http://www.cboe.com/default.aspx

     

    On June 30, 2012 there is is a vector of pre-determined future prices to accompany any spot price for each of those hundreds of commodities.

    For Example, on June 30, 2012 we might have the following for Commodity C at the close of the day on the CBOE:
     


    I assume if you are going to use the term "forward contract" that you have a distinction between "forward" and "spot" prices that are determined at the start of the contract period (June 30, 2012). Spot prices on the CBOE go up and down every hour of every day into the future whereas June 30, 2012 forward prices are history written into June 3, 2012 contracts for purposes of computing cash settlements based on those historic prices and current spot prices.

     

    Now my questions to you, Tom, focus on your $900, $1,089 and $1,198  presumably forward prices negotiated on June 30, 2012:
     

    1. Have you made any distinction between a vector of three forward prices set on June 30, 2012 and a single spot price on June 30, 2012?

       
    2. Have you made any distinction between a vector of three forward prices set on June 30, 2012 and ultimate June 30 spot prices in 2013, 2014, and 2015?

       
    3. Are your forward contract spot prices and forward prices synonymous in your forward contracts that have no future uncertain cash flow?
      If this is the case then you truly are not dealing in forward contracts since there is no vector of forward prices that can differ from eventual spot prices.
       

     

    Please explain the difference between spot and forward prices in your conception of a forward contract that has no future cash flow uncertainty.

    You still have not explained to me why a plain vanilla annuity of $900, $1,089 and $1,198 is different from a rent annuity of the same cash flow stream.

    What makes a rent annuity a series of forward contracts vis-a-vis annual cash flows of a plain vanilla annuity that supposedly are not forward contracts?
     

    Your definition is not at all clear to me and certainly is not teachable to my theory students (if I have any left on the AECM).

    Not using consistent terminology with finance will make FASB and IASB really, really confusing.


    You can make everything consistent by either dropping the term "forward contract" or by making your illustrations truly forward contracts such as by making the rent payments a function of LIBOR (the underlying).


    Putting the term "real" in front of your terms makes it even more confusing. Real options were invented to deal with higher levels of uncertainty, and using them in the context of fixed annuity streams is totally inconsistent with the conceptualization of real options.

    Respectfully,
    Bob Jensen