IMPROVING LEASE ACCOUNTING Financial Accounting Standards Advisory Council December 1, 2005

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1 ATTACHMENT C IMPROVING LEASE ACCOUNTING Financial Accounting Standards Advisory Council December 1, 2005 BACKGROUND In September, the Board directed the staff to begin preagenda research work associated with a possible project on accounting for leases that might amend or replace FASB Statement No. 13, Accounting for Leases, and related guidance. The Board s direction to the staff was a response to the criticisms of Statement 13 by constituents, including criticisms noted in past input from the Financial Accounting Standards Advisory Council (FASAC) and User Advisory Council (UAC), and the SEC s 2005 Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers (referred to as the Off-Balance-Sheet Report). Also, the IASB and FASB agreed in 2004 that the accounting for leases is in need of overhaul, and improvements should be made through a major project conducted jointly when resources permit. Statement 13 was issued in 1976 and provides guidance on accounting for leases by both lessors and lessees. The provisions of Statement 13 derive from the view that a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing by the lessor. Under Statement 13, a lease that does not transfer substantially all of the benefits and risks incident to the ownership of property is classified as an operating lease by the lessee. Operating lease classification results in the lessee not recognizing any elements of the lease on its balance sheet (that is, no asset for the right to use the asset and no related obligation for the future lease payments). Note: These materials are provided to facilitate understanding of the issues to be addressed at the December 1, 2005 FASAC meeting. These materials are presented for discussion purposes only; they are not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations leases 6/13/2006

2 2 Following the issuance of Statement 13, the FASB, EITF, SEC, and AICPA issued numerous pieces of guidance addressing various issues relating to the application of Statement 13. As a result, the accounting for leases is viewed by many as a posterchild of the complexity inherent in rules-based standards. Standard-setting activity during the past 20 years has not been limited to merely interpreting Statement 13, however. For example, a group of international standards setters (including FASB representatives) referred to as the G4+1 developed two Special Reports describing a conceptual approach to lease accounting. The focus of that approach was accounting for the fundamental components of lease transactions. The FASB issued the second of those Special Reports for public comment in The IASB has an active research project on its agenda relating to the accounting for leases. That project is being led by the United Kingdom s Accounting Standards Board (ASB). Those research efforts have largely focused on reviewing and updating the conceptual approach set forth in the G4+1 Special Report issued in Recent Criticisms of Existing Standards In June 2005, the SEC issued the Off-Balance-Sheet Report, which recommends that the FASB undertake a project on lease accounting, conducted jointly with the IASB. The SEC cites the following reasons for its recommendation: 1. The current all-or-nothing lease accounting guidance is not designed to reflect the wide continuum of lease arrangements that are used, and, therefore, it cannot transparently and consistently reflect the varying economics of the underlying arrangements. 2. Sophisticated users, such as credit-rating agencies, often adjust balance sheets in their work so they can analyze companies as if all leases were reflected on the balance sheet. 3. The lease accounting standards rely extensively on bright lines, greatly increasing the potential for similar arrangements to be portrayed very differently; the brightline tests have served to facilitate significant structuring of leases to obtain particular financial reporting goals. The extensive restructuring further erodes the effectiveness of the standards. An extrapolation of the findings from the sample of issuers in the SEC s Off-Balance- Sheet Report to the approximate population of active U.S. issuers suggests that there may

3 3 be approximately $1.25 trillion (undiscounted) in noncancelable future cash obligations committed under operating leases that are not recognized on issuer balance sheets but that are instead disclosed in the notes to the financial statements. In the 2005 FASAC Survey, Council members identified the accounting for leases as one of the top five areas the Board should focus on. Council members who specifically mentioned leases in the 2005 FASAC Survey pointed to the issues of bright-line tests, the complexity of the current accounting, and the lack of transparency as issues for the Board to address. Council members also ranked leases second in priority of the five specific standard-setting recommendations made by the SEC staff in its Off-Balance-Sheet Report. Objective of the December 1 Council Meeting At the December 1, 2005, FASAC meeting, the Board seeks advice from Council members on the specific leasing issues that should be the focus of the Board s attention and the approach the Board might use to address them. An additional consideration is whether Council members agree that convergence of accounting standards internationally should be an objective of a comprehensive project on leasing. The purpose of the meeting is not to discuss the relative merits of possible solutions to particular issues. POSSIBLE APPROACHES TO A MAJOR PROJECT In addition to researching technical issues, the staff is evaluating alternative approaches the Board might use in tackling a leasing project. Some of those approaches are described below. Clean-Sheet-of-Paper Approach Accounting thinking has evolved since Statement 13 was issued (it was developed and issued before the existing conceptual framework). Some believe the best approach to improving financial reporting in this area would be to undertake a comprehensive project that starts with a clean sheet of paper. Under this approach, the first step is a research project to develop coherent conceptual guidance for accounting for lease arrangements. The second step is a standards-level project to develop accounting and reporting standards based on those concepts that would apply to

4 4 leases of all kinds. One advantage of this approach is that the conceptual guidance for leases could reflect the refinements and improvements to related accounting concepts under development in the joint conceptual framework project. It also would allow the staff and Board to consider, in the initial research phase, how the developing standards of accounting for revenue recognition might affect financial reporting accounting by lessors. The Board could undertake such a project in a variety of different ways, such as: 1. Modified joint project with the IASB. Under this approach, the FASB would leverage the existing IASB research project. That is, FASB members would not directly participate in the research phase. Instead, the FASB would issue the IASB discussion paper produced by that research project for comment by its constituents. The analysis of those comments would be the basis for a decision to add a standards-level project to the Board s agenda. Given the Board s full agenda, some perceive the minimal Board involvement as a significant advantage of a modified joint project. 2. A comprehensive joint project. The initial phase would be a joint research project with the IASB. Under this approach, the FASB and IASB would jointly develop a proposed conceptual lease accounting model. The research project would culminate in the issuance of a Preliminary Views by the FASB (and a Discussion Paper by the IASB) for comment by its constituents. The analysis of those comments would be the basis for a decision to add a standards-level project to the Board s agenda. 3. A comprehensive project for which the initial phase would be an FASB-only research project. Under this approach, the FASB would develop a proposed conceptual lease accounting model. The research project would culminate in the issuance of a Preliminary Views by the FASB for comment by its constituents. The analysis of that feedback would be the basis for a decision to add a standardslevel project to the Board s agenda. This approach might make sense if the FASB members or staff concluded that an alternative to the components approach in the 2000 G4+1 Special Report (the basis for the IASB research project) should be developed and considered. The clean-sheet-of-paper approach is consistent with the FASB s three objectives improvement and simplification of U.S. GAAP by principles-based standards grounded in the conceptual framework, and convergence of accounting standards internationally. A disadvantage of the approach is that it will take many years to complete. Improvements to financial reporting in the United States and needed simplification of the existing literature will not be realized for years to come. In light of those perceived disadvantages, the staff is evaluating other approaches.

5 5 A Statement 13 Modernization Approach In years past, some have suggested that significant improvements to existing lease accounting could be made by modernizing the guidance in Statement 13. For example, some have suggested eliminating or modifying the bright-line tests to focus more on the substance rather than the form of the transaction. That might be accomplished by amending Statement 13 to require capital lease treatment when the present value of expected lease payments exceeds 50 percent of the asset s fair value. Those suggesting this FASB-only approach believe it might take less time to accomplish than a comprehensive joint project. While the standard produced by such a project might not be as conceptually grounded (compared with the standard produced by the clean-sheet-of-paper approach), it has the advantage of not letting perfection stand in the way of improvement. Other possible changes that might be considered under this approach include: 1. Expanding the scope of Statement 13 to encompass other similar financing transactions, such as acquisitions of software systems and other intangible assets 2. Improving disclosure requirements. A significant disadvantage to this approach is that it is less likely that the Board would achieve two of its three important goals: (1) international convergence of accounting standards and (2) issuance of principles-based standards based on the conceptual framework. The approach also may not produce the level of simplification that some desire. A Combination Approach A combination approach might balance the need for timely improvements to financial reporting with the Board s broader improvement, simplification, and convergence goals. Under this approach, the Board would undertake a comprehensive leasing project as described under the clean-sheet-of-paper approach. In addition to a first phase research project, the Board might also undertake one or more projects to deliver near-term incremental improvements in reporting by entities following U.S. GAAP. The comprehensive project could be undertaken jointly with the IASB, while the short-term improvements project would be an FASB-only project. The significant disadvantage of the approach is the cost associated with making piecemeal, incremental changes in accounting.

6 6 The Statement 13 Modernization Approach and the Combination Approach could be appealing to those that believe lease accounting should be improved sooner rather than later. Those short-term incremental improvements would most likely result in financial information that is superior to that produced under the existing standards; however, shortterm improvements are not always accomplished in a short-term. QUESTIONS FOR COUNCIL MEMBERS 1. What are the primary deficiencies in financial reporting that should be remedied by a possible leasing project? 2. Which approach to a leasing project would be the most effective in remedying those deficiencies? Why do you favor that approach? 3. Do you see targeted opportunities to improve the current state, such as through improved disclosure?