7829 Glenwood Avenue Canal Winchester, Ohio November 19,2013

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1 7829 Glenwood Avenue Canal Winchester, Ohio November 19,2013 Technical Director File Reference Number Financial Standards Accounting Board 401 Merritt 7 Norwalk, Connecticut Dear Sir, The proposed accounting standards update for leases is an improvement over existing principles. It will reduce the profusion of complex and rigid rules that are currently in use and streamline lease accounting into a simpler framework that will better reflect the underlying economics of these transactions. Although the two-model approach is not a perfect solution to the issues surrounding lease accounting, the proposal will achieve a principal goal of eliminating off-balance sheet accounting for operating leases. A one-model approach would be preferable to the dual model as it conforms better to the fundamental principle that all lease transactions represent the financing of a right to use an asset for a specified period of time. The two-model approach, on the other hand, prescribes additional complexity by dividing lease accounting into two distinct categories that are defined by an arbitrarily perceived level of consumption of the economic benefits contained within a non-financial asset. It presumes that some leases should be designated as asset rentals in the belief that the consumption of this type of underlying asset over the lease term is insignificant. However, this seems unrealistic. This concept contradicts the putative principle that all non-financial assets, with the exception of land, will decline in value and service potential over time, no matter how short the duration, through usage. In assessing the economics of a lease, lessors are unlikely to view such transactions as asset loans. More likely, they will factor into the lease payments compensation for depreciation. The dual model also creates an incongruous relationship between the accounting and underlying economics of property leases with the imposition of the straight-line expense method. In applying the straight-line expense method for Type B leases, amortization charges against the right-of-use asset are smaller in the earlier years than in the later years of the economic life of the property. This result is contrary to the general expectation that the economic decline of a non-financial asset is greater in the early years of an asset's useful life. As a consequence, the book value of the asset will likely be greater than the market value during this time period. At a minimum, the potential of future cash flows reflected in the right-of-use asset will be overstated in the balance sheet. Just as important, the gap between book and market values may be significant enough to increase earnings volatility for lessees as they may be exposed to more frequent asset write-downs than if a straight-line or an accelerated depreciation method were applied to the right-of-use asset. Notwithstanding these drawbacks to the dual model, the proposed accounting standards update should be adopted. It will improve financial and operating transparency by placing operating leases and capital leases, which are economically similar, on the same accounting basis in the statement offmancial position. By requiring the recognition of the financial obligations of operating leases on the balance sheet, the proposal will eliminate the use of operating leases as off-balance sheet items, and accordingly,

2 2 it should make the credit risk and the financial leverage of lessees more apparent to users of financial statements. Within the framework of this proposal, the Boards may want to take the following under consideration- Variable Rate and Usage Lease Payments Variable rate and usage lease payments are clearly part of the compensation that is exchanged for the right to use an asset in a lease agreement. Yet, under the proposal, they will not be recorded in the rightof-use asset and the lease liability on the assumption that they cannot be estimated. Therefore, the potential affects that these payments will have on future cash flows will go unrecognized in the balance sheet inasmuch as the right-of-use asset and lease liability will be understated. If the Boards' conclusion that variable rate and usage payments cannot be estimated is true, then it raises questions as to the approach entities take to perform an economic analysis of a proposed lease transaction. The exposure draft, unfortunately, does not provide a basis as to how this conclusion was reached. However, one suspects that estimates are prepared for variable lease payments as most companies strive for an objective analysis in evaluating proposed transactions. It would seem essential to have reasonable estimates of the variable lease payments if entities are to assess the trade-offs between various fixed and variable lease payment proposals and alternative leasing options from different vendors. If entities are in general performing these analyses (and they certainly should), then these variable lease payment estimates are probably suitable for inclusion in the right-of-use asset and lease liability. They at least seem to warrant further evaluation and investigation. Exception Criteria to the Type B Lease Classification The criteria used in the application of the Type B lease classification exception tests are ambiguous and do not appear to be compatible with the underlying economics of property leases: a. The threshold levels of the economic life and fair value exception tests to a Type B lease classification are ill defined and are not on an economically equivalent basis. b. The application of "remaining economic life" for the economic life exception test to a Type B lease classification is contrary to the property lease business model as defined to support the use of "total economic life" in the Type A lease economic life exception test. The "substantially all" threshold level for the fair value exception test to a Type B lease classification does not appear to be on the same economic basis as the "major portion" threshold level for the economic life exception test. On the face of it, "substantially all" appears to be a more stringent requirement than "major portion". However, the exposure draft does not define these terms. There are no benchmarks or bright lines to evaluate this difference. No guidance has been provided as to how "substantially all" and "major portion" should be applied. Presumably, the Boards are not looking to the quantitative threshold levels of the economic life and fair value tests in FASB 13 as no reference has been made to them in the exposure draft. Yet, entities may be tempted to use them as a possible fallback position in practice because of the ambiguities in the exposure draft. It is doubtful that the Boards intend such a result. This undefined and equivocal distinction between "substantially all" and "major portion" should be eliminated. The exposure draft has not provided a systematic method to evaluate these concepts. Confusion in applying them to the exception tests to a Type B lease classification is inevitable. A more coherent approach should be adopted if the exception tests are to be applied consistently. Accordingly, the threshold levels for both tests should be placed on an economically equivalent basis. The threshold level for the economic life exception test to a property lease classification should be changed from "major portion" to "substantially all".

3 3 It also seems paradoxical that the use of "total economic life" of the underlying asset in the economic life exception test to a Type A lease classification has not been extended to the Type B lease economic life exception test. After all, the basis for using "total economic life" for the Type A lease economic life exception test is the property lease business model and Type B leases are property leases. As noted in the exposure draft, property lessors do not generally lease commercial real estate solely to one lessee for substantially all its economic useful life. Rather, property lessors manage commercial real estate to maximize cash by entering into numerous short-term leases in a long-lived asset to various lessees. Consumption by anyone lessee of the economic benefits embedded in the underlying asset is insignificant relative to the total economic life of the property. Property lessors are not financing the lessee's use of the asset; they are principally earning rental income. At the end of the lease term, it is unlikely that the lessee will purchase the property and that the lessor will sell it. Yet, the economic life exception test to a Type B lease classification is based on the remaining economic life of the underlying asset. Under this standard, a lease of property that is near the end of its useful life will be classified as a Type A lease even though the expected consumption of the asset by the last lessee will be insignificant relative to the total economic potential of the asset over its entire life. This type of transaction is not similar to the purchase of property. It represents an asset rental as delineated in the exposure draft. To classify this transaction as a Type A lease would be inconsistent with the underlying economics of the property lease business model. Accordingly, the economic exception test to the Type B lease classification should be changed from "remaining economic life of the underlying asset" to "total economic life of the underlying asset". Overall, the threshold level of the economic life exception test to a Type B lease classification should be changed from "major portion of the remaining economic life of the underlying asset" to "substantially all of the total economic life of the underlying asset". This amendment will eliminate the ambiguity surrounding the difference between "substantially all" and "major portion" and place the economic life exception test to a Type B lease classification in conformity with the property lease business model. Lessor Accounting for Residual Value Guarantees The basis for the proposed accounting of the residual value guarantee is incoherent and fails to focus on the guarantee as a potential source of cash for the lessor. Whether or not a lessor can participate in the price exposure above the amount specified in a residual value guarantee does not seem to be an appropriate economic basis to determine the recognition of the guarantee in the lease receivable. The economic position ofthe lessor in relation to the guarantee is not dependent on price participation. In either case, the lessor should expect to receive at a minimum the guaranteed value at the end ofthe lease term inasmuch as the guarantee is an enforceable right under a binding contract. The only significant uncertainty is the credit risk of the guarantor. At the commencement of the lease, the specified amount to be received from the guarantee is certain and measurable whether or not the lessor can participate in the price fluctuations in the residual asset above the amount guaranteed. Accordingly, the residual value guarantee should be recognized in lease receivable regardless ofthe lessor's right to price participation. Residual Value of the Leased Asset The accrual of interest income on the residual asset is incompatible with the asset risk undertaken by the lessor in retaining ownership of the underlying asset. Although the Boards indicate that the interest accrual is normal business practice, it seems to infer that the expected future value of the residual asset is certain and measurable. This seems unlikely. It is difficult to understand how a non-financial asset is expected to benefit from the time value of money over the lease term. The residual asset is not an annuity. It is not a financial

4 4 instrument that is expected to provide periodic interest payments at regular intervals to maturity. It is a non-financial asset whose value at end of the lease will be determined by lessee usage, technical innovation and obsolescence, and economic and market conditions. These factors would seem to be more relevant in determining future value than the time value of money. Accrued interest should be excluded from the residual asset because it does not represent a potential economic benefit that will be realizable in future cash flows. If the final statement requires that interest be accrued on the residual asset, the Boards should retain the footnote disclosures for accrued interest so that users of financial statements can make the appropriate adjustments to projected cash flows. Financial Statement Presentation The proposed presentations in the statement of financial position of the right-of-use asset within the property, plant and equipment classification for lessees and the aggregation of the lease receivable with the residual asset for the lessor confuse the timing and certainty of the cash flows from these accounts. They give the impression that (i) the prospective cash flows from the right-of-use assets are similar to those expected from the property, plant and equipment owned by the entity, and (ii) the anticipated cash flows from the lease receivable are similar to the expected monetization of residual asset at the end of the lease. This clearly is not the case. The potential cash liquidity of these assets is not the same. Accordingly, these accounts should be reported separately in the statement of financial position. By classifying the right-of-use asset with property, plant and equipment, it implies that the right-of-use asset has the same economic standing as a non-fmancial asset owned by an entity. Although they may share certain economic characteristics, the potential cash liquidity of these assets is dissimilar. The rightof-use asset only represents the economic potential embedded in the underlying asset, which the lessee has the right to use for the duration of the lease agreement. The lessee does not own the underlying asset, and therefore, cannot sell it to raise cash. Although cash may be generated from a right-of-use asset through a sublease, that option will depend on whether the lease contract allows subleasing, and if it does, cash can only be realized over time. Full cash realization cannot be generated immediately as it could with the disposition of a non-financial asset owned by an entity. As for the lessor, the lease receivable should not be combined with the residual asset because the liquidation expectations for these assets are not equivalent. A lease receivable is a monetary asset in which the contractual payments are based on a sum certain amount of money. The residual asset is a nonmonetary asset for which cash realization is less certain. It is unlikely to have a readily available market in which it can be sold. Cash realization will depend on lessee usage of the underlying asset, technical innovation and obsolescence, and current economic conditions. Disclosures The proposed reconciliations ofthe opening and closing balances of the lease liability, lease receivable and residual asset in the footnotes to the financial statements should be eliminated because they are not consistent with the precept that disclosures should focus on the amount, timing and uncertainty of prospective cash flows. Although they may assist in understanding the changes to these accounts for the period reported, they do not provide insights as to when cash outflows and inflows will be realized because many of the reconciling items are non-cash components. A more useful approach would be a tabular disclosure of lease expenses by line item as reported in the statement of comprehensive income, along with a corresponding analysis of the cash payments. This analysis should be broken out between Type A and B leases. The required five-year maturity analysis for lease and variable payments should be divided further to incorporate a separate line item for non-lease component cash payments as they are not directly related to the lease obligation.

5 5 The final standards also should require disclosure of the weighted average discount rates and lease terms used in measuring Type A and Type B lease liabilities. Discount rates are fundamental to understanding the risk profile of an entity and in estimating the weighted average cost of capital. They provide a perspective as to how creditors view the credit and liquidity risks of an entity. To exclude this requirement would deny users of financial statements a basic tool in evaluating the economic potential and risks of an entity. Non-Public Entity Reporting Non-public entities should not be permitted to use the risk-free rate to calculate the lease liability. The results will be misleading as reported right-of-use assets and lease I iabilities will be overstated in the statement of financial position. Users of financial statements will be placed at a disadvantage as they do not have the same means as an entity to evaluate lease obligations. The cost of estimating a discount rate and calculating the lease liability will only shift from the preparer to the user of the financial statements. Non-public entities, therefore, should be required to use the implicit discount rate in calculating the lease liability. If you have questions or require additional information with respect to these comments, please advise. Yours very truly, Q,,~~~ Andrew Prytherch