CFA Institute Supports Balance Sheet Recognition of Leases
Leasing is an important source of financing for businesses. According to the White Clarke Group 2013 Global Leasing Report, the global annual volume of leases amounted to US$724 billion in 2011. Despite their widespread use, the assets and liabilities arising from most leasing contracts (i.e., operating leases) cannot be found on balance sheets of entities engaging in such financing arrangements. This accounting deficiency causes investors to make widespread guesstimates of lease obligations. A 2010 study by Credit Suisse evaluated 494 S&P 500 companies that were obligated to make US$634 billion in total future minimum payments under operating leases. This study showed significant variation in the range of analysts’ estimates of the underlying lease obligations. This imperfect, but necessary, analytical adjustment by investors occurs due to incomplete and inconsistent disclosure of related operating lease information provided in the footnotes.
Accounting Standard Setters Propose Change in Lease Accounting
To address the improvements needed in lease accounting, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB), through a joint revised exposure draft, have proposed the capitalization (i.e., inclusion on balance sheet) of all leases with the exception of short-term and immaterial leases. These IASB and FASB proposals have been exposed for comment and discussed over the last five years through a 2009 discussion paper, 2010 original exposure draft, and recent revised exposure draft (issued in May 2013). These IASB and FASB proposals present an opportunity to enhance the transparency of lease contracts and to improve the comparability of financial statements across the globe. This joint project also provides an opportunity to further converge accounting standards.
CFA Institute’s response to the revised exposure draft, supported by a recently conducted member survey, agrees with the IASB and FASB proposals to capitalize all leases. The support is predicated on the view that capitalization is a necessary first step toward the improvement of lease accounting.
Adverse Economic Impact Unlikely
Several stakeholders, including leasing industry bodies and preparers, have claimed that capitalization of lease obligations will damage the leasing industry (e.g., possible shrinkage in demand for operating leases). Others have argued that the cost of implementing a new leasing standard will exceed the benefits of increased transparency regarding these obligations. Accordingly, we asked our members for their perspectives on these issues; the findings from the survey were as follows:
- 52% of survey respondents expect that preparers’ cost to implement the standard will be less than the cost incurred by investors/analysts in estimating leverage whilst making analytical adjustments. Only 29% expect preparer costs to be greater than costs incurred by investors whilst estimating leverage.
- 49% of survey respondents expect that the cost to implement the standard will be less than savings lessees will experience from leasing costs (i.e., additional financing premiums and cost reimbursements) they will forgo if they cease engaging in operating leases because they are required to capitalize leases. Only 29% expect implementation costs to be greater.
- 67% of survey respondents expect companies to continue engaging in operating leases regardless of these proposed updates to lease accounting.
Similar claims of adverse economic consequences have been made whenever key accounting changes were proposed (e.g., stock options). In many cases the economic consequences never materialized. As a result, such claims tend to lack credibility with investors.
Capitalization of Leases: Improvement Opportunity Notwithstanding Measurement Concerns
Our long-standing support for capitalization of leases can be traced back to the 1970s when our predecessor organization, the Financial Analysts Federation, issued a comment letter supporting capitalization of leases. In our response to the most recent proposal, we re-emphasize that capitalization of leases is important to investors because capitalization provides the best starting point for investors to make analytical adjustments and will be a significant improvement from current practice. Capitalization of leases will enable different market participants (i.e., investors, auditors, academics, preparers) to better assess the lease obligation and, therefore, the total financial leverage of reporting companies. Investor support for our long-standing position is reflected in the recent survey results, which indicate that:
- 55% of survey respondents favor capitalization.
- 37% of survey respondents favor improvement in disclosures (i.e., no capitalization).
- 6% of survey respondents support making no changes to current lease accounting requirements.
The principal reservation with the proposed model for some investors arises from anticipated measurement errors with different aspects of the proposals (e.g., due to the partial recognition of options, dual income statement recognition, etc.). We share many of these measurement concerns. That said, we consider that under current requirements, investors have to make widely varying guesstimates of the obligations arising from the lease contracts. Investors face significant costs in having to make these analytical adjustments. For this reason, we anticipate that management’s measurement of the lease obligation will provide a meaningful and consistent starting point for analytical adjustments, lessen the aggregate estimation error of all investors, and present an improvement to current financial reporting.
CFA Institute has previously articulated its support for a single method for recognizing the expense associated with engaging in leasing obligations. The current proposal would implement two methods of measuring the expense associated with leasing obligations. Type A results in asset amortization and interest expense, and Type B results in the level recognition of lease expense. We do not support the Type B approach as we do not believe it reflects the underlying economics of the leasing transaction or provides the most decision-useful information for investors.
Enhanced Disclosures: Necessary, But Not a Substitute for Capitalization
When items are recorded on the balance sheet, there should be comprehensive disclosures to help investors better discern the measurement uncertainty of reported carrying amounts. While capitalization of leases will inform investors of management’s view on the carrying amounts of the lease right-of-use asset and obligation to pay rentals, enhanced disclosures will enable investors to make any required analytical adjustments to the reported amounts. In addition, there is greater scrutiny of reported amount and disclosures whenever items are recognized on the balance sheet and income statement. For these reasons, the question of whether investors would be comfortable with either capitalization or a comprehensive disclosure only solution would amount to a false choice.
For multiple reasons, we are skeptical about the efficacy of a disclosure only solution, which is seen by some as an alternative to the IASB and FASB’s current proposals. Disclosures almost never provide an adequate substitute for recognition and impose a burden on investors to estimate what the recognized amounts would be using incomplete information. In the case of leases, there is extensive evidence that investor estimates of lease obligations using current disclosures are approximate at best.
Another reason for our concern is the inconsistent posture of various stakeholders on the subject of disclosures. Specifically, some are willing to pursue the comprehensive disclosures only solution, while also expressing reservations about the volume of disclosures and the appropriateness of including forward-looking disclosures in financial statements. Past experience on resolution of investor-desired disclosure requirements makes us question whether a disclosure only option is a plausible solution for enhancing the long-term transparency of lease contracts.
The Imperative: The Need to Reach a Conclusion
Over the last decade, the IASB and FASB and all stakeholders have expended considerable effort and resources in deliberations regarding the lease accounting model required to improve existing deficiencies. We acknowledge that the IASB and FASB have explored multiple models and faced seemingly insurmountable difficulties in gathering consensus around several fundamental issues that have a bearing on preferred accounting choices. That said, we consider the proposed change to capitalize leases an acceptable way forward and an important first step toward enhance transparency of leases. We recommend that the standard setters make refinements as discussed in our comment letter (e.g., require consistent treatment of interest in cash flow statement, provide a tighter distinction of lease versus service to avoid lease contracts being classified as services in pursuit of favorable accounting treatment, and address concerns with income statement treatment). With these refinements, we will consider this proposal to be an evolutionary change that paves the way for further improvements at a future date.
Historically, the IASB and FASB have made similar decisions to recognize obligations, transactions, or instruments (e.g. pensions, stock options, derivatives) because their underlying economics — as in the case of leases — were not properly reflected in the financial statements. Along those lines, we encourage the IASB and FASB to adopt the lease accounting proposals and make progress in improving current requirements and retaining the opportunity for further future improvements.
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