Attention lessors — especially banks or other regulated financial institutions. Implementation of the new lease accounting rules may bring advocacy issues regarding the regulatory capital treatment of operating leases. This is a warning! Companies in the industry may not only face issues that will affect regulated industry lessee customers but, perhaps more importantly, regulated parent companies that are also lessees. Regulators may treat the newly capitalized right of use (ROU) asset and operating lease liability as any other asset and debt, which will adversely affect capital requirements.
Many financial institutions, like banks, have utilized operating leases to acquire the use of equipment and real estate rather than using precious capital and borrowing to buy. The operating lease has been an off balance sheet obligation arising from an executory contract that is voided if a bank is liquidated. If the contract becomes void in liquidation, no capital is required either to cover a loss in the value of the contract or to satisfy any lease liability. The major credit rating agencies recognize this flexibility to return the asset and eliminate the lease liability as a plus regarding the treatment of operating leases in a bankruptcy.
The bank capital issue has become more important as Basel III will require 10.5% minimum total capital against assets. When capital is dear, it is harder for banks to achieve attractive returns on equity for shareholders.
Regulators have traditionally used the reported assets and liabilities under generally accepted accounting principles (GAAP) promulgated by the Financial Accounting Standards Board (FASB) for capital calcuations. While that strategy has worked over the years, FASB has recently taken an esoteric approach to setting GAAP, changing the definition of an asset and liability.
There is a possibility that FASB is catering to interests that have their own ratios and measures to develop conclusions, but the rating agencies have stated that they do not follow GAAP in all cases because of the unique purposes of their analyses. Equity analysts want to know the value of “assets employed” to create revenue when comparing companies that lease versus those that do not — they don’t care if the asset is owned or rented. Credit analysts and lenders want to know what owned assets of a company are available as collateral to repay loans. They also want to know the debt obligations of a company that will compete for the collateral in liquidation.
I once asked an IASB board member for his definition of debt, and he said, “Anything that is owed.” To me, that is too broad, but that is now the IASB’s definition — operating lease liabilities are presented as debt for IASB companies. In my opinion, debt is an obligation that has a claim against assets in bankruptcy liquidation. The leases project began with the idea that renewals, contingent rents and services in a full-service lease should be capitalized since certain analysts supported that view. Fortunately, only contractual rents and renewals that are reasonably certain of exercise must be capitalized.
I am a frustrated old accountant who thinks that only legally owned assets should be on the balance sheet. Right-to-use of an asset in an operating lease would not qualify — at best, it must be highlighted and clearly reported as an asset that is not legally owned. In liquidation, an owned asset is sold to repay obligors, lenders, depositors and equity while an asset subject to an operating lease is returned to the lessor. Owned assets need an equity cushion to absorb possible losses on liquidation. Likewise, an executory contract liability, like an operating lease liability, has no claim in bankruptcy. The key concept regarding the need for equity is that the operating lease liability disappears in liquidation as the ROU asset is returned to the lessor. Since any future liability disappears, there is no debt claim in liquidation that the ROU asset needs to satisfy.
The purpose of the Office of the Controller of the Currency and Federal Reserve Bank capital regulations (capital adequacy ratios) is to ensure that in a liquidation of its assets, a bank can absorb sufficient losses through its capital rather than through customer deposits or other funding sources. The purpose of SEC broker dealer net capital and aggregate indebtedness rules is to ensure the broker dealer can absorb losses through its capital in a liquidation of assets and still meet its financial obligations to customers and other creditors. Both the bank and broker dealer ratios, liabilities and capital calculations use GAAP accounting balance sheet assets and liabilities. The lease accounting change adds new types of assets and liabilities that need analysis as to their nature to determine the impact, if any, on regulatory capital.
The ELFA and I have had preliminary talks with bank regulators who have not reached conclusions regarding ROU asset treatment. We presented the arguments expressed in this article. Their preliminary view is anything FASB defines as an asset must have capital against it. We argued that the legal nature of the operating lease — an executory contract that requires no regulatory capital under current GAAP — has not changed because the FASB now says the rights in the lease contract create something of value that should be reported on balance sheet. The regulators have not ruled yet. Although there is time, we cannot forget about this. The big dollars are in real estate leases of banks with large branch networks — the lease ROU assets are significant.
A Big 4 auditor recently warned that the SEC broker/dealer aggregate indebtedness rules that measure (and limit) liabilities in assessing capital will be adversely affected by operating lease liabilities. Those operating lease liabilities are not debt in liquidation and, in my opinion, should not affect the amount of capital held to repay obligors in liquidation.
The regulators need to understand that GAAP is not what it used to be. The new direction of FASB may suit some users of financial statements but not all. This situation will require more thought and analysis on the part of regulators or any user.
FASB Chairman Russ Golden explained this in remarks at an AIPCA conference in December 2015: “Stakeholders did not agree on how operating leases should be reflected in the income statement or the statement of cash flows. As a result, during redeliberations, the FASB decided to retain existing GAAP in the income statement with respect to the distinction between leases that are accounted for as an in-substance purchase and those that are accounted for as operating leases. To further mitigate concerns, the FASB has decided that most lease liabilities should be characterized as operating obligations in the financial statements rather than obligations that are equivalent to debt. This decision recognizes that most lease obligations are not treated like debt in situations such as bankruptcy of the lessee. With regard to the potential economic impact and behavioral effects, the proposed leasing standard, like all accounting standards, is intended to reflect — not drive — economic activity and behavior and to promote reporting that neutrally reflects in the financial statements accompanying standards… FASB is not a government agency, accounting standards are not regulations and the FASB does not make economic policy decisions.
“The FASB recognizes that accurate financial reporting can have economic consequences, both positive and adverse, and that some consequences are the natural result of more relevant and neutral financial information or the consequence of unintentional bias resulting from the proposed standard. In other words, the FASB constantly assesses and re-assesses the neutrality of the information that would result from a proposed accounting standard. If an analysis reveals that proposed financial reporting outcomes are representationally faithful and neutral, complete in all material respects and presented in a way that allows users to comprehend its meaning and significance, then the perceived adverse consequences would be the result of a better-informed realignment of capital. In this case, the board does not attempt to alter financial reporting to mitigate such effects, because doing so would be to bias the reporting in favor of a particular company or organization, which could reduce its usefulness.”
My interpretation of Golden’s comments, vis-a-vis the issue of regulatory capital against operating leases, is that 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 and will leave it to the regulators to understand the substance before making informed regulatory capital decisions.
The regulators have not made their decisions, but early indications are not good. The ELFA will advocate for continuing to treat any operating lease ROU asset as capital free and any capitalized operating lease liability as a non-debt liability. However, the trade association alone may not be able to win the argument. Affected organizations must release public comments to bring more attention to the issue. The banking and financial industry has already suffered from the new capital regulations, which were needed in many cases. Imposing an illogical, extra conservative capital requirement is just plain wrong. Your influence counts — use it!