The paper analyzes 57 of the largest publicly traded equipment lessors in the U.S., focusing particularly on disclosure quality, the reporting of residual values, and the balance sheet impact of the so-called performance obligation approach. The key takeaways that I noted include the following:

• Existing disclosures vary considerably in content and aggregation levels, with some of today’s lessors disclosing essentially nothing at all. The authors argue that given the proposed new standard that provides more latitude in determining what to disclose than current standards do, it is unlikely that disclosures about lessor arrangements will improve.
• Although current standards require disclosure of unguaranteed residual values, 8 or the 27 firms that disclosed anything at all about leases didn’t specify whether residual values were guaranteed or unguaranteed. The authors argue that standard setters should call for transparent disclosure that indicates the dollar amount of residual values that are guaranteed and not guaranteed.
• Only 7 of the 27 disclosing firms provide quantitative sensitivity disclosures regarding residual values.
• The balance sheet effect of eliminating the operating lease classification are not material for lessors. Because of the net presentation proposed in the exposure draft, the impact of the proposed standard on the liabilities-to-assets ratio is minimal.

As the authors point out, some of the most interesting research on lessor issues cannot be done at this point because lessors do not provide uniform transparent information about residual values. However, this paper at least provides a starting point for the discussion of what lessors should be required to disclose under any new accounting standard. If you are interested in this topic, I encourage you to read this paper. It’s short, and more than anything, it underscores how little we know and how little can be known about lessor accounting issues given the paucity of data that exists today. But, perhaps we can hope for better data in the future.

The proposal in the boards proposed ASU on lease accounting would have allowed lessees to book the right of use asset and the associated lease obligation at the undiscounted amount of the lease payments (which is different than what would be required for long-term leases) or to book nothing at all. Either way, the income statement effect would be similar to what we have today for typical operating leases, but the balance sheet would look different depending on which of the three methods a company chose to adopt. Moreover, this option would exist at the individual lease level, rather than at the level of the reporting entity.

In my opinion, the point of representational faithfulness and comparability is to get the underlying economics correct so that users can identify true similarities and differences across firms (or for the same firm across time). Personally, I don’t see a clear benefit from allowing firms discretion over how to account for short-term leases on their balance sheets, especially on a lease-by-lease basis.

During redeliberations, the boards have shifted position slightly. According to a recent update on the joint project (available here),

The boards tentatively decided that, for short-term leases, a lessee need not recognise lease assets or lease liabilities. For those leases, the lessee should recognise lease payments in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis is more
representative of the time pattern in which use is derived from the underlying asset. Nine IASB members and six FASB members agreed.

The boards also tentatively decided that a lessee may elect to apply the recognition and measurement requirements in the leases guidance to short-term leases. Twelve IASB members and five FASB members agreed.

If I understand this correctly, it seems the boards have moved from three options back to two – either measure all lease assets/obligations the same or treat a short-term lease like a current operating lease. Seems like a step in the right direction, especially if the latter option is available more for practicability than for conceptual soundness.

Despite 30 years of defending a balance sheet perspective, the Board still on occasion makes decisions that seem to be driven by a belief about the “right” amount of income to recognize in a given period. Balance sheet line items are, in those moments, stripped of their conceptual primacy and become mere plugs between income statement amounts.

While there are (unfortunately) numerous examples of this inconsistency (e.g., anytime the possibility of a day-one gain arises), I was prompted to write this post by a recent tentative decision as part of the redeliberations on leasing. One of the proposed changes to the leasing ED would be to create a distinction between “finance” leases and “other-than-finance” leases. Unlike the current distinction between a capital and an operating lease, both of these new lease types would be capitalized on book. However, similar to the current distinction, a finance lease would show up on the income statement as interest and amortization amounts, whereas the other-than-finance lease would simply reflect rent expense.

Given that the right-of-use asset associated with the other-than-finance lease will have to be amortized, you might wonder how a straight-line expense pattern would arise. The tentative decision is to measure the amortization of the right-of-use asset as the difference between the straight-line expense amount and the interest expense amount.

While there might be economic meaning in the asset measurement being proposed for an other-than-finance lease, I’m not seeing it. Seems like a plug to me…a plug necessary to get the income statement expense to the “right” amount.

I wonder what Sprouse would say if he were at the table during these redeliberations?

During today’s round table, I promised a cite to a working paper that provides evidence consistent with credit ratings failing to reflect currently off-balance sheet obligations related to operating leases. Click here to see that working paper by Steve Lim, Steven Mann, and Vassil Mihov. The paper’s evidence suggests that despite rating agencies’ adjustments that capitalize operating leases, those rating agencies do not treat operating leases in the same manner as on-balance sheet debt when determining credit ratings. If the FASB-IASB proposals are implemented, the term operating lease may virtually disappear from accounting terminology, and all lease obligations will be recorded on the balance sheet. If implemented, it will be interesting to see whether credit ratings change as a result of the accounting changes.

So, as it pertains to leases, “speak now or forever hold you peace.” Comment letters are due December 15th.

Of course, with such a significant change, there are bound to be questions and concerns. Here are a few that have occurred to me.

1. One of the debates we had in the early days of this project was whether to define revenue, or just address how revenue should be recognized. As this exposure draft makes clear (see paragraphs 1-2), the boards ultimately decided not to define revenue, but instead only to address when revenue is recognized in contracts with customers. This made me wonder whether the boards will be happy with revenue being recognized in the absence of contracts with customers. Does revenue recognition require a customer? Apparently not. Revenue is recognized today for changes in the value of some mineral, biological or agricultural assets (IAS 41), even in the absence of a contract with customers. Why do we get a difference for revenue recognition principles across various industries or types of assets? The proposed new standard scopes out non-contractual situations (such as biological and agricultural assets) as well as contractual situations (such as leases, insurance, financial instruments, and guarantees). Conspicuously absent from the exposure draft is any rationale for scoping these areas out of the proposed standard. From experience working on this project, I’m guessing that’s because there was no general agreement about WHY these would be scoped out. There is simply a consensus that they should be scoped out. Wouldn’t it be great if the boards could provide some rationale for scoping out particular types of transactions?
2. The exposure draft states that an entity shall account for each promised good or service as a separate performance obligation only if that good or service is distinct (see paragraph 22). A good or service is distinct if either (a) an entity  sells an identical or similar good or service separately, or (b) the entity could sell the good or service separately because (i) it has a distinct function AND (ii) it has a distinct profit margin. My question–how do you know whether something has a distinct profit margin unless you (or someone else) actually sell that something separately? And if you already sell it separately, then there’s no need for condition (b). The exposure draft states that a distinct profit margin exists if that good or service is subject to distinct risks and the entity can separately identify the resources needed to provide the good or service. This is one area of the proposed new standard that I think people may have some difficulty with—determining whether a potentially separate good or service has distinct risks. If there’s anything our recent past has taught us, it’s that people are pretty bad at identifying and quantifying risks. Who knows, perhaps it won’t be so hard to do for revenue recognition purposes! (By the way, don’t misinterpret my tone here…I actually like the direction the boards have gone with this guidance, but I think it will be a little perplexing at first.)
3. Determining the transaction price in a contract receives lots of attention in the exposure draft. The boards decided that the transaction price should be adjusted based on the time value of money (if financing is a significant component of the arrangement), customer creditworthiness, collectibility, any non-cash consideration received from the customer, and any consideration payable to the customer (such as rebates). I don’t really have a question here, but I do want to highlight how this will be a significant departure from past practice in some situations. Previously, revenue would not be recognized in some situations if certain criteria were not met, for example in real estate sales. If the criteria were met, revenue for the full contract amount would be recognized. Instead of asking whether to recognize revenue, this standard moves more toward asking how much revenue to recognize. So, for instance, if you have sufficient history selling real estate to particular classes of customers, and your history suggests to you that 60% of the time customers follow through with their promises to pay over time, then either through discounting with a high interest rate or through an adjustment due to collectibility, you would recognize the sale of real estate at a drastically reduced amount. Any amount received beyond the original revenue recognized would be treated as a gain or loss. Personally, I think this is an improvement over the criteria approach, but it has its own problems as well, including the estimation process required to determine the amount of revenue to recognize in such a sale.

I’ll stop here for now. I still want to go through the application guidance with a finer tooth comb, but I’m pretty impressed with most of what I’ve read. As much as the project was originally conceived to be a general standard on revenue to replace all other revenue standards, I think the boards have appropriately scaled back their ambitions to focus strictly on settings where a contract with a customer exists. This represents the lion’s share of situations in which revenue is recognized today, and the proposed new guidance will not change most accounting out there. However, what it does change could be pretty significant—including construction contracts, real estate sales, and software revenue recognition. I look forward to reading the comment letters over the next few months!

On the other hand, the article points out that this “simplification” of lease accounting may not be so simple. The article lists two major complications.

1. Renewal options:

Management must make a judgment regarding what is the most “likely” lease term, and that means considering any renewal options attached to the lease. Since companies negotiate such options because they are unsure of what they will be doing at the end of the lease term, that uncertainty would now have to be factored into assets and liabilities. . . .

The intent is to “portray the best shot at economic reality,” he says, but the draft rule “adds complexity” because it is asking companies to make an up-front judgment about the future.

Uncertain where you’ll be in 5 years? As far as leases are concerned you’ll need to put your best guess on the balance sheet.

2. Contingent rent:

Under the draft rule, the company is required to forecast what its sales will be over the lease term, apply to that the agreed-on percentage, and put that total on the balance sheet.

In other words, if your rent payment is tied to some contingent item (e.g. sales, CPI, real estate prices, etc.) you need to estimate that in figuring the value of the lease. Sounds a little bit like the level 1, 2, 3 fair value debate doesn’t it? Audit the process, but what about the inputs?

Watch for the exposure draft coming out soon.

“June 30, 2011, is an arbitrary deadline and it’s not one that’s been put in place by the SEC or by our road map,” said Kroeker. Citing FIN 46(R) as an example of an accelerated project that later needed to be reworked, Kroeker said that what’s most important is to ensure through the exposure process that the final standards are a “long term, sustainable solution.”

I suspect the FASB is not all that surprised by Kroeker’s view, given how good the lines of communication typically are between the FASB and the SEC. However, I suspect the IASB and other supporters of a single, global accounting standard will be a little surprised and will interpret Kroeker’s comments as (further) evidence that the US will not be adopting IFRS any time in the near future. They may even increase the volume on their arguments that the IASB should not give so much preferential treatment to the FASB and SEC in its standard setting activities. Should make for some interesting articles over the next few weeks!