Four reasons that lease accounting distorted reality… have now become five

From The Uniform Accounting Monthly Report April 2021: I recently had a wonderful conversation with Ralph Nach. Ralph is a former co-author of the Wiley GAAP Guide. He teaches continuing professional education courses for practicing CPAs on many of the most difficult and complex accounting topics. Ralph was also one of the very first members of the UAFRS Advisory Council for Uniform Accounting.

To cover the new accounting rules for lease capitalization, Ralph has a remarkable four-hour module on just this subject alone. It’s not for the faint of heart. Yet, it’s necessary if you want to understand just how confusing lease accounting has become. The new rules that were designed to help the profession. Unfortunately, they haven’t. I shared with Ralph how I had conducted a short seminar called “The Dark Side of Accounting” for a Chartered Financial Analyst (CFA) Society a few years ago. That program title has been quite popular with financial
analysts around the world.

I was discussing the arcane lease accounting rules and the arbitrary, yet material, impact lease classification rules can have. Understanding the directionally-changing impact that lease accounting can have on the cash flow statement and balance sheet are a bane for CPA exam takers as well as seasoned CFOs worldwide.

I asked this group of finance-savvy practitioners if anyone in the audience could even remember the four ways a lease could be deemed a capital lease. A few were able to blurt out some fragments of the accounting code like “present value” or “long lease term.” As others rummaged through old mental cobwebs for answers, there were a few guys sitting together in the back of the room that raised their hands quite confidently. Reading their self-assurance, I called on them to explain to the audience what they knew.

Actually, it was quite impressive. One rattled off the criteria perfectly: shift in ownership; bargain purchase option, lease term exceeding 75% of the asset life, and present value of the lease payments exceeding 90% of the fair value of the leased asset at inception.

I wondered if they were recent CPA exam passers who happened to be in the CFA audience. They were not. I asked if they were public accountants who specialized in this area. I struck out on that as well. How did this group know the rules so well? It turns out they worked at the industrial giant, Siemens, on a team that sells and leases very large and very expensive industrial equipment.

And the reason they knew the accounting so well? Because that is part and parcel of their client contract creation. The team would specifically ask clients whether they preferred the pending lease to be on the books as a capital lease asset, along with associated debt… or to not trigger these criteria so that the client’s books would not reflect any leased asset or associated debt. The team was highly skilled in building contracts for clients so that the terms would pass the criteria tests to book the lease – or not – as the client requested.

Better than I possibly could have, the team gave a wonderful example of how lease capitalizations had been arbitrary in nature. Please don’t hate the player. Hate the game. Years ago, many standards-setters responsible for the FASB and IASB accounting governance regimes identified that this problem effectively made lease capitalization an election by each company. They sought to fix the issue and also find a common path for GAAP and IFRS to have at least one really solid example of globally consistent financial statements.

As the guidance has come to light, and CFOs and their auditors have been implementing the new rules, we have learned that the effort has been a colossal failure on every level possible.
The accounting rules for leases are even more complex than before. US GAAP and IFRS have not fully converged, as US companies are still required to classify their leases as being either finance leases or operating leases. And the four-way criteria test is now a five-way test.

Under the new standard, both operating leases and finance leases are presented on the balance sheet as a right-of-use asset and a corresponding liability.

Where the U.S. version of the standard really tests credulity, however, is in the income statement. The U.S. version of the standard requires the combined interest on the lease obligation – including the amortization of the right-of-use asset subject to an operating lease – to be aggregated and charged as a rent expense on a straight-line basis over the lease term.

There is absolutely no reasonable explanation for this treatment since the economics of leasing are such that the lessee is entering into a financing transaction to purchase the exclusive use of the leased asset over the lease term.

Financing transactions result in more interest expense in the early years of the obligation, and as principal is paid down, that interest expense declines over time.

Only the right-of-use asset (the intangible right to use the leased asset) should be amortized to income using the straight-line method over the term of the lease.

Under the new regimen, as issued by IASB, there would be no need to classify a lease and no five-step test to perform. There also would be no opportunity for lessors and lessees to collude and financially engineer the lease to meet customer/lessee desired accounting treatment.

The accounting standard setters seemed to have been lobbied by the leasing industry such that the new accounting guidance would not produce a higher charge to earnings in the near-term.

Maybe they feared that investors would see a lower earnings number from treating all leases as financing and then sell the stocks of those companies with supposedly deteriorating earnings.

The truth is, no investor worth their salt would ever rely on unadjusted GAAP earnings in performing their investment analysis. So, as Ralph explained quite eloquently, on an operating lease, the imputed interest expense and the amortization expense attributed to the capitalized lease cannot, in aggregate, exceed the artificially derived straight-line expense computed in each year.

This mathematically results in escalating amortization of the lease asset in later years to offset the decreases in the imputed interest expense on the lease obligation. Stated differently, the imputed cost of interest falls over the life of a lease, as it would have had the asset been purchased with debt. That’s not strange.

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