Basel & EFRAG Decide on New Lease Rules: Two Bad Calls for the Industry

by Bill Bosco July/August 2017

Bill Bosco discusses two recent EFRAG and Basel Committee decisions and outlines the reasons why he believes these regulatory moves are bad for the equipment finance industry.

Bill Bosco,
Principal,
Leasing 101

In March, EFRAG (the European Financial Advisory Group that advises the European Union on accounting issues) issued a report to the IASB endorsing approval of the new lease accounting rules (IFRS 16). In April, the Basel Committee on Banking Supervision, the global banking standard setter, ruled that the operating lease right of use asset should have capital applied to it as any other asset. In my opinion, neither decision is good for the industry. The Equipment Leasing and Finance Association and I fought hard through meetings and comment letters to prevent these decisions to no avail. This article will examine the decisions and the reasons why I believe they are wrong.

The EFRAG Endorsement

The EFRAG report concludes that IFRS 16 would improve financial reporting and would reach an acceptable cost/benefit trade-off. In the report, EFRAG has not identified that IFRS 16 would have major deleterious effects on European financial stability and economic growth. Accordingly, EFRAG assesses that endorsing IFRS 16 is conducive to the European public good.

I take issue with the rationale that IFRS 16 would improve financial reporting because the group did not pay attention to the comment letters from the American Institute of CPAs and American Accounting Association, which said the choice of a one-lease model would eliminate valuable information on operating leases as they have substantially different economic attributes that lenders and credit analysts need (and have under the current rules).

Specifically, the ROU asset represents a temporary right to use an asset that disappears in bankruptcy liquidation. It is not an owned asset (as the ROU asset in a finance lease is), so it does not serve as collateral for lenders claiming in a bankruptcy. The operating lease liability is not debt under commercial law and even credit analysts describe it as a “debt-like” obligation.

I do agree that calculating the ROU asset and liability by the lessee saves the user time and provides an accurate number for use in their work. But the asset and liability are unique as they are capitalized executory contract payments and should be reported separately from assets and liabilities arising from finance leases.

I also agree the costs to transition to the new rules are generally one time (to book the leases and set up the new processes) and would justify getting an accurate number for analysis of the asset and liability arising from an operating lease. However, they do not count the costs a lessee might incur to break out the operating leases’ assets and liabilities. This might occur if there is a debt covenant breach caused by the new liability or a user asking for the breakdown to refine their analysis or to make a lending decision.

The decision does not count the capital costs to the banking system that come from front loading expenses under the one-lease model, as it creates a permanent capital loss and a permanent deferred tax asset, which are both drains on capital. The regulators are requiring capital to be allocated to the ROU operating lease asset. As an example, I estimate the negative accounting effects on operating lease accounting and the erroneous regulatory capital decision will add a capital need of €1 billion ($1.17 billion) for Deutsche Bank. According to recent news reports, Deutsche is seeking to raise €8 billion ($8.5 billion) through a share sale, a move designed to shore up the German lender’s capital. Now, the lease accounting rules will add to its capital raising needs. The new lease rules will further restrict economic growth in an already strained European banking system.

The EFRAG decision would not have been popular with the IASB if it did not endorse IFRS 16 and recommend the FASB two-lease approach that capitalizes operating leases but separately reports the operating lease balance sheet items and keeps the P&L cost as the straight-line average rent. I think EFRAG took the politically correct approach. Under the FASB model, the accounting truly reflects the economics of the different types of leases so the financial reporting benefits for all users are clear, but the IASB would have been embarrassed to have to go back on its decisions.

Basel Committee Decision

The bank regulatory view has always been that operating leases do not need a capital allocation. Generally, regulatory capital accounting rules follow GAAP accounting. Current GAAP treats an operating lease as an off balance sheet item due to its executory nature; it is a rental contract that becomes void in bankruptcy liquidation. The leased asset is returned to the lessor and the liability, being a future executory liability, is extinguished.

The FASB did not intend to affect regulatory capital treatment, so it gave the regulators all the information needed to treat the operating lease ROU asset as capital free. The decision to capitalize operating leases does not change the economic substance of an operating lease — it merely changes the accounting view of the rights under the contract.

I spoke to one of the FASB board members about this, and he agrees. He said when the FASB met with U.S. bank regulators on this issue, the FASB advised them not to change their capital rules just because the accounting view changed. The board member told them the decision implied they had been wrong all along for failing to attribute capital to operating leases. This did not change their minds. The FASB made a decision to change the accounting but also provided detailed background regarding the nature of the new lease assets and liabilities in bankruptcy liquidation. Understanding the substance and making informed regulatory capital decisions was left to the regulators, but they seem to be ignoring it.

The Basel Committee may have acted as it did because the IASB did not continue to separate operating lease and finance lease accounting and presentation as did the FASB in its two-lease model version of the new rules, Topic 842, which truly recognizes the economic differences between operating and finance leases.

I think the decision to cause the ROU operating lease asset to attract capital like any other asset gives cover to the IASB’s decision to use a one-lease model for all types of leases. An IFRS bank will lose the information on operating lease assets versus finance lease assets, and it would be a lot of work to keep two sets of records to get capital relief for the ROU operating lease asset.

This is not so in the U.S. The Office of the Comptroller of the Currency and the Federal Reserve have the ability to refine the rule for U.S. banks allowing the ROU asset to have a 0% risk weight for operating leases, as it does today. Nothing has changed regarding operating leases and their impact on a bank liquidation but an esoteric accounting rule.

Sadly, the U.S. regulators are not breaking from the Basel decision, and U.S. banks will suffer for no good reason. It seems that being conservative is viewed as a good thing in capital decisions, which is not a good thing if the decision is wrong. The regulators are not being open-minded. They do not see that the world of accounting and financial reporting is moving away from the risk and reward concepts shared with commercial law. The move is toward control as the concept of financial reporting ownership. As a result, they should not blindly follow U.S. GAAP as though it represents assets at risk in a bank liquidation.

The issue of bank capital has become more important as Basel III will require 10.5% minimum total capital against assets. This makes capital dear, which makes it more difficult for banks to achieve attractive returns on equity for shareholders. This decision will further restrict banks’ ability to lend and impede their ability to help spur the economy.

Conclusion

In my opinion, EFRAG and Basel were motivated by political correctness. The regulators have all the power. We can only comment through their due process rules. They can choose to listen or not. They are like baseball umpires — a pitch is not a strike until they call it a strike. They can call pitches strikes even if they are obviously off the plate, but their decisions stand regardless of what the rest of the world sees on the instant replay.

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