Lease accounting: are current rules as bad as some say?

Since 1995, calls to revise lease accounting standards have come from a number of regulatory and standards-setting bodies, including the Financial Accounting Standards Board (FASB). Articles portraying leasing rules as inadequate continue to appear in the financial press. But, criticism of the lease accounting standard, FAS 13, is plagued with myths. FAS 13 is a rules-based system that some want to replace with a standard that is principles-based. The following attempts to dispel some myths:

* Myth: Leases are engineered to avoid capitalization. The reality is "structured" operating leases, also know as synthetic leases, represented only 1 percent of leasing business in 2004. Most operating leases occur naturally as a result of tax rules requiring lessors to take residual risk, and competition is pushing assumed residuals increasingly higher.

* Myth: Current lease accounting rules do not recognize material assets and liabilities arising from operating leases. Over 70 percent of the dollar volume of operating leases is real estate-related. However, a look at equipment operating lease statistics only shows that the vast majority of the transaction volume is comprised of small and mid-sized transactions of less than $250,000, with average lease terms of less than four years, whose capitalized value would be less than 0.4 percent of assets and 1.2 percent of debt.

* Myth: The operating lease vs. capital lease distinction is based on bright-line tests that are arbitrary. The truth is that bright-line tests serve the important purpose of ensuring consistency of reported results among the thousands of public companies who use large, medium and small accounting firms to certify their financial statements. FAS 13's 10 percent guide delineating where risk is substantial was not selected at random and without reason in 1976 when the standard was adopted; rather, it was founded in the logic that retaining risk in amounts equal or greater than 10 percent represents substantial risk.

* Myth: Lease accounting rules are overly complex. Indeed, lease transactions often are multi-faceted. But, the view that capitalizing all leases is the simple fix that will result in consistency is flawed as well. Such a change will be at the expense of usefulness, understandability and meaningfulness of the financial reports and create a costly compliance burden. Capitalizing all leases would only simplify the process of classifying a lease. It would add complexity, burdens and costs to lessee accounting, particularly to small businesses.

* Myth: Capitalization of operating leases by preparers clearly would give better information. Better information does not always result from simply putting more on the balance sheet, however. It is misleading to capitalize the minimum lease payments of true lease small-ticket assets with a short lease term that may be replaced by a new lease again and again. Expanded disclosures, including projected future rent expense to predict future cash flow needs, would, in fact, be more useful and informative.

What Is the Right Approach?

If the current lease rules are as seriously flawed as FASB insists, it could choose to make interim adjustments to FAS 13 to eliminate synthetic leases and expand disclosure requirements in order to create the desired transparency.

The leasing industry agrees with the regulators' current thinking that the right to use a leased asset is an asset and the obligation to pay rent should be capitalized, but there should also be a place for not capitalizing certain leases. Specifically, immaterial leases should not be capitalized. Immaterial could be defined as the lease of an asset of less than $50,000 in cost where the original lease term is 48 months or less and the lease is a true lease under the IRS rules.

This approach would eliminate the burden of having to capitalize immaterial items and account for deferred taxes, and it more truly portrays the commercial intent that these transactions are an operating expense. Additionally, this materiality cutoff would cause less than 15 percent of the current volume of reported minimum lease payments under operating leases to avoid capitalization.

One hopes that, as the FASB tackles lease accounting, it recognizes that there are many types of leases that reflect truly legitimate business objectives, and that the ultimate goals of more meaningful and useful financial statements, simplicity and cost/benefit may not be achieved by capitalizing all leases without judgment.

--Contributed by Michael Fleming, President of the Equipment Leasing Association (www.ELAOnline.com), and William Bosco, Principal of Leasing 101 (www.ChooseLeasing.org).