Biondi, Yuri, R. J. Bloomfield, J. C. Glover, K. Jamal, J. A. Ohlson, S. H. Penman, E. Tsujiyama, and T. J. Wilks. 2011. Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases. Accounting Horizons. 25, 4: 861?871 The Biondi article is a critique from an American Accounting Association committee on the Joint IASB/FASB Exposure Draft on Accounting for Leases. What is the role of due process and feedback from stakeholders in the standard-setting process? Do you find this critique persuasive? Which of the issues presented here do you believe the IASB/FASB use in their revision of the exposure draft? Why?
Johnson School Research Paper Series #16-2011 A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases Yuri BiondiNational Center for Science Research Robert BloomfieldCornell University Jonathan C. GloverCarnegie Mellon University Karim JamalUniversity of Alberta James A. OhlsonNew York University Stephen H. PenmanColumbia University Eiko TsujiyamaWaseda University T. Jeffrey WilksBrigham Young University February 2011 This paper can be downloaded without charge at The Social Science Research Network Electronic Paper Collection. Electronic copy available at: http://ssrn.com/abstract=1768083 A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases American Accounting Association Financial Accounting Standards Committee 2010 - 2011 Yuri Biondi (Principal author), Cnrs -Ecole Polytechnique (Paris Tech) Robert Bloomfield, Cornell University Jonathan Glover, Carnegie Mellon University Karim Jamal (Chair), University of Alberta James A. Ohlson New York University and CKGSB (Beijing) Stephen Penman, Columbia University Eiko Tsujiyama, Waseda University Jeff Wilks, Brigham Young University Acknowledgment We thank C. Richard Baker (Adelphi University), Rolf Fuelbier (Bayreuth University), Louis Klee (Cnam of Paris) and Vincent Decroocq (Banque de France) for fruitful comments and discussions. February 23, 2011 Electronic Electronic copy available at: http://ssrn.com/abstract=1768083 A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases ABSTRACT The International Accounting Standards Board (IASB) and The Financial Accounting Standards Board (FASB) recently issued a joint exposure draft on accounting for leases. This exposure draft seeks to shift lease accounting from an \"ownership\" model to a \"right-to-use\" model. Under the current ownership model, leases can be reported on balance sheet (finance leases) if certain tests are met, or off balance sheet (operating leases) if those tests are not met. The new model seeks to report all leases on the balance sheet based on the present value of lease obligations without any bright line tests, and no sharp on or off the balance sheet classifications. We are sympathetic to the standard setters concern that the current lease standard is being manipulated improperly by managers resulting in large amount of debt being reported off balance sheet. We provide a discussion of current lease accounting and the proposed exposure draft. We also comment on five key issues covered by the exposure draft: the definition of a lease, the initial measurement and eventual reassessment at fair values, the accounting for lessors, the impact of lease accounting on recognition and income measurement, and classification of lease accounting elements and their impact on accounting ratios. This comment was developed by the Financial Accounting Standards Committee of the American Accounting Association and does not represent an official position of the American Accounting Association. 1 Electronic Electronic copy available at: http://ssrn.com/abstract=1768083 A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases INTRODUCTION The International Accounting Standards Board (IASB) and The Financial Accounting Standards Board (FASB) recently issued a joint exposure draft (ED2010/9) on accounting for leases. The current accounting for leases (based on an ownership model) is probably the clearest example of a dysfunctional accounting standard because the rules-based approach of that standard has led to widespread non compliance with the intent of standard setters to have lease contracts reported on the balance sheet. The American Accounting Association's Financial Accounting Standards Committee (henceforth the committee) views the goal of reporting all lease contracts on the balance sheet as important for a well functioning accounting system. The committee thus responded to the lease exposure draft, which proposes to shift the underlying model of lease accounting from an \"ownership model\" to a \"right-ofuse model.\" In this article we discuss the key issues relating to lease accounting and the challenges that standard setters face with respect to recognition and measurement issues. The rest of the paper is organized as follows. The first section provides a discussion of the current state of accounting for leases, including a summary of its claimed shortcomings. The second section summarizes the basic argument provided by the ED2010/9 and its new usage model. The third section provides a comment on this new lease accounting model, with a more specific discussion of five issues namely, the definition of a lease, the initial measurement and later reassessment at fair values, the accounting for lessors, the impact of lease accounting on recognition and income measurement, accounting classification of lease accounting elements, and their impact on accounting ratios. The fourth section concludes on the efficacy of the proposed ED 2010/9 in attaining the goal of having lease contracts reported on balance sheet.. 1. The current state of accounting for leases On 17 August 2010, IASB and FASB published the joint ED 2010/9 devoted to accounting for leases. The proposal is one of the main projects included in the boards' Memorandum of Understanding of 2006 and builds on two Special Reports issued by a group of international standards setters (including FASB and IASB representatives), referred to as \"the G4+1,\" in 1996 and 1999, respectively: \"Accounting for Leases: A New Approach\" and \"Leases: Implementation of a New Approach.\" 2 Electronic copy available at: http://ssrn.com/abstract=1768083 Current accounting standards for leases - FASB Statement No. 13, Accounting for Leases, issued in 1976, and IAS 17, Leases, issued by the IASC in 1982 - adopt an \"ownership approach\" based on the extent to which risks and rewards incident to ownership of a leased asset lie with the lessor or the lessee. Accordingly, a lessee should recognize both an asset and a liability for a lease that transfers substantially all benefits and risks incident to the ownership of property, and a lessor should recognize such a lease as a sale or financing. Vice-versa, a lease that does not transfer substantially all benefits and risks incident to the ownership of property is classified as an operating lease by the lessee. Under operating lease classification, the lessee does not recognize any elements of the lease on its balance sheet; rather, the lessee recognizes rental expense as it becomes payable. 1 Although both standards have been amended several times, their most recent versions retain the ownership approach to the accounting for leases contained in the original standards, especially the fundamental distinction between \"finance\" and \"operating\" leases. The major criticism of the existing lease standards is that lessees often do not recognize lease obligations on their balance sheets, based on what is now considered to be an inappropriate distinction between operating and finance leases. According to the World Leasing Yearbook 2010, quoted by the IASB (2010), leasing activity in 2008 amounted to US$640 billion, while the assets and liabilities arising from many of those contracts are not shown in a lessee's statement of financial position (balance sheet). Franzen, Rodgers and Simin (2009) documented that from 1980-2007 off-balance sheet (OBS) lease financing as a percentage of total debt increased a remarkable 745%. If leased assets were brought onto the balance sheet over our 27 year sample period, average debt-to-capital ratios would increase by 50-75%. According to the 2005 SEC Report, undiscounted total non-cancellable future payments required under OBS leases for US companies would be approximately $1.25 trillion. According to a recent research study by PwC (2009) using a sample of 3,000 companies, reported interest bearing debt in 2008 financial statements would increase by 58% after adjusting for OBS leases. 2 Inappropriate distinctions between operating and financing leases are achieved by managers due to the following weaknesses of current lease standards: a) Knife-edged accounting, whereby small changes in a transaction lead to large differences in how the transaction is accounted for. Current lease accounting 1 More precisely, as it becomes attributable to the period according to the accrual principle (IAS 17, 33). Goodacre (2001), Fuelbier et al. (2008), and Duke et al. (2009) provide further estimates on UK, German and US samples. 2 3 standards create such knife-edged accounting whereby small changes in a transaction can result in either 0% or 100% of the transaction reported on the Balance Sheet. b) Bright line tests to determine accounting classifications as described above in point a (e.g., 75% and 90% thresholds in current lease standards) make it easy for managers to structure transactions to achieve the accounting treatment they desire. c) There is lack of symmetry in the way a transaction is accounted for by the lessee and the lessor. Having the same transaction reported differently by the two parties to the same transaction creates lack of comparability and consistency. d) Scope exceptions create loopholes that can be used by management to defeat the intent of the standard (Jamal and Tan 2010). e) Executory service contracts are not considered to be part of the lease standard (and are not reported on the balance sheet), so management can get around the lease standard by structuring a lease transaction as a contract for services and not report any debt (See Ryan et al., 2001) f) Management can use renewal terms, options and contingent payments to get around the intent of the standard (Jamal and Tan, 2010). g) Management can use special purpose entities to move leases off Balance Sheet. 2. The new approach suggested by the Exposure Draft (ED2010/9) The lease exposure draft aims at providing a new accounting model for both lessees and lessors. The boards are proposing a \"right-to-use\" accounting model where both lessees and lessors recognize assets and liabilities arising from lease contracts. These assets and liabilities would be initially measured at the present value of the lease payments. They would be subsequently measured using a cost-based method. Accordingly, a lessee would record an asset based on its right to use the underlying resource, amortized over the term of the lease (or the useful life of the underlying asset if shorter) and tested for impairment. Under IFRS, this right may be revalued in some circumstances. A lessee would further recognize a liability for lease payments, initially equal to the capitalized right-to-use asset. For contingent rentals and optional renewal periods, amounts are measured on an expected likelihood basis. Concerning lessors, the proposed exposure draft allows two choices, one of which maintains the ownership approach based on the exposure of the lessor to the risks and benefits of the underlying asset. If the lease transfers significant risks or benefits of the underlying asset to the lessee, then the lessor can apply the \"derecognition\" approach. The derecognition 4 approach requires the lessor to remove all or a portion of the underlying asset from its balance sheet and to record a right to receive lease payments. A lessor may then record a gain at the inception of the lease under this approach. The second (performance obligation) approach is consistent with the \"right to use\" model applied to the lessee and requires the lessor to retain the underlying asset on its balance sheet together with a right to receive lease payment (as an asset) and a liability to permit the lessee to use the underlying asset (a lease liability). The lessor recognizes income over the expected life of the lease, while a net lease asset (liability) is recognized, comprising the underlying asset plus right to receive lease payments minus lease liability. Given the strong emphasis on achieving comparability and consistency in accounting, it is a bit puzzling why the exposure draft would permit a divergence in accounting for the same transaction between the lessee and lessor. We prefer one accounting approach based upon the symmetry between the lessor and the lessee. This method should capture the specificities required by accounting for a lease as a structured operation comprising an operational and a financing dimension. Income and assetliability recognition and measurement should follow the structure of the whole operation over its entire duration and comprehensive effect. Related accounting criteria should further be designed in order to prevent representational manipulation and abuse. Furthermore, many lease contracts include variable features. They often include options to renew or terminate the lease, contingent rentals (for example, rentals that vary depending on sales) or residual value guarantees. The proposed standard would further require lessees and lessors to determine the assets and liabilities on the basis of the \"longest possible lease term that is more likely than not to occur\
