I went to college in the 1960s and graduating with a bachelor’s of business administration (BBA) in public accounting. I got a job as an internal auditor with CIT, and moved on to Arthur Andersen where I passed the CPA exam. Then I went to work for Citibank in 1974 as a financial controller in its leveraged leasing group.

When I took the CPA exam the FASB had not been created. I was fortunate in that timing as I had a lot less to learn and worry about. Back in those days there were accounting concepts that we lived by, such as matching income with expense, respecting the “legal” treatment of financial items and striving to account for the substance of transactions. Things have changed since then. These concepts seem to be going away as the new accounting standards boards rethink accounting rules using new theories that don’t seem to give answers that are most useful in understanding financial results and positions.

Matching Concept

The matching concept does not seem to be the driver it once was. Look at the decision to eliminate leveraged lease accounting. The MISF yield method is considered one of the most “elegant” accounting solutions for a tax-driven transaction. Under that method, earnings are recognized to match the cost incurred by the lessor to fund the net cash invested in the lease transaction. Also, the IASB’s decision that all leases — even those that are legally rental/executory contracts — have the same cost pattern as a financed purchase of the asset.

I also see the issue in the controversy with tax credit accounting regarding energy asset leases in the U.S. If you apply the U.S. tax accounting GAAP, the ITC or tax grant are either taken immediately or amortized straight line on the tax line, yet they represent a cash-flow from the lease investment. The true yield and financial earnings are not evident if the ITC/tax grant is not recognized as revenue at a constant rate versus the declining investment.

One needs to interpret the tax credit accounting treatment to avoid coming under the tax accounting GAAP. You have to convince your auditors that practice developed after the issuance of FAS 13 to treat ITC as revenue in non-leveraged leases analogizing to the treatment of ITC in a leveraged lease. The 1976 board that issued FAS 13 never gave an example of ITC accounting in a non-leveraged lease, but they have told us how to apply ITC in the classification tests and how to include ITC in the implicit rate calculation. That leads to the belief that ITC impacts the net investment in the lease and the mathematical calculation of recognizing revenue using the implicit rate in the lease. ITC was commonly available for all equipment, and practice was developed to treat it as revenue in a direct finance lease. Since ITC was repealed in 1986, the ITC deals have expired and the new batch of auditors, many born after 1986, have not dealt with it in leases — that is until the energy assets tax credits were enacted.

The problem I see in not matching revenue to expenses is earnings are not as predictable or stable due to how revenue and expenses are reported. Investors use earnings per share as a measure in evaluating investment alternatives and they need to know that future earnings will be consistent with the business results and not impacted by accounting-generated issues that create variances.

Legal & Accounting Congruence

I think accounting must match the legal system when determining what items are assets and liabilities. Also, the type of asset or liability should determine its financial presentation. The IASB’s proposed lease standard disregards the legal nature of lease types, mixing capital leases with capitalized operating leases. Fortunately, FASB made the decision to maintain a two-lease model that separately reports the assets and liabilities from capital and operating leases. The board recognizes that lenders and credit analysts need to know which assets are available and which liabilities are debts in bankruptcy liquidations.

The new revenue recognition standard (RRS) follows a “control” concept rather than a risks and rewards concept to determine when an entity records a sale and an asset. The U.S. legal and tax systems continue to use a risks and rewards concept to determine when a sale has taken place and when an entity owns an asset. Any differences present problems to a reader of the financial statements in understanding the financial results. I have to admit that I was not following this revenue recognition project as it did not seem important to the leasing industry as leases are “scoped” out of the RRS. The proposed lease project prescribes the rules for lessor revenue recognition.

The real problem popped up when the boards dealt with sale/leasebacks with non-bargain purchase options in the leaseback that are so common in equipment leasing deals.
Since a sale/leaseback is a two-part transaction, the question arose as to whether to use the revenue recognition rules, including consideration of the leaseback terms, to evaluate whether the sale was really a sale.

The boards have conceptualized linked contracts that simultaneously occur: They collapse the two and treat them as one transaction. In that case, the boards tentatively decided that the RRS trumps the lease project so that any fixed price purchase option (bargain or non-bargain) negates sale treatment because the mere presence of a fixed price purchase option means the seller lessee still “controls” the asset. As I said, it is control — not risks and rewards — that is the basis of the RRS. There is still an opportunity to change this decision, but to do so you would have to write a comment letter to FASB.

Substance

Substance incorporates legal and accounting congruence, but also includes the issue of regulatory capital treatment that requires financial institutions to keep capital against assets. Financial industry regulators are concerned with safety and soundness of financial institutions, which includes the quality of the assets and the nature of the liabilities. Assets that are “true” assets of the institution have to be considered in bankruptcy liquidation, i.e., the value of the asset in liquidating it to pay the depositors and lenders to the institution. Assets that one “controls” may not, in fact, be assets of the institution when it comes to liquidation. That brings into question the IASB (thankfully not the FASB) idea that a capitalized operating lease creates an asset and debt because the right of use is not an asset, and the executory lease obligation is not debt that survives in a bankruptcy.

It also brings into question the idea that an asset sold in a sale/leaseback with an EBO (non-bargain, early buyout option) is still an asset on the books of the seller/lessee. That transaction transferred all of the risks in the sold asset and all the expected rewards and is considered a sale under U.S. commercial and tax law. The only thing the seller has left besides the right of use for the term of the lease is the right to buy the asset at a price that is above what is expected. They only control unexpected value. Yet that whole asset will stay on the accounting books of the seller/lessee because of a theory that is not grounded in the law. Assets that remain in the books from a failed sale/leaseback are not available to lenders or depositors in a bankruptcy liquidation.

As I see it, financial institutions will have to recast the accounting to appeal to their regulators for capital relief for those theoretical — but not legal — assets. That is not so simple, is it?

Where are We on These Issues?

Fortunately, the FASB and IASB are still meeting on the lease project and can fix issues with ITC/tax grant and sale/leaseback accounting. I view these as FASB issues as I believe it is more likely to listen (the FASB has done a great job in improving the proposed rules) than the IASB; and FASB will be issuing its own leasing standard given that there are several large issues that are not converged.

FASB has received a few comment letters on these issues and more may come. The issue of how to change their minds is partly to write a comment letter but too few stakeholders write such letters. The next thing to do is send follow-up comment letters and/or attend meetings. Sadly, many great letters have been written but they lacked follow up. The boards have been deluged with letters so they need pressure when it appears they are not acting on the letters that offer constructive criticisms and better alternatives. The boards and staff are highly intelligent, competent and hardworking people, but they are not experts in the details of every industry and their respective products/structures. It is up to us to make sure they have enough information to make decisions that are furthering the goal of providing the most useful financial information to lenders and investors.

Bill Bosco is the principal of Leasing 101, a lease consulting company. Bosco has more than 40 years of experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the ELFA accounting committee since 1988 and was chairman for 10 years. He is a frequent author and speaker on leasing topics. He has been selected to the FASB/IASB Lease Project working group as a representative of the ELFA. He can be reached at [email protected], www.leasing-101.com or 914-522-3233.