LEASE ACCOUNTING STANDARDS: WHY EXPOSURE DRAFT 56 SHOULD BE REVIEWED BEFORE IMPLEMENTATION
by Vinod Kothari
The International Accounting Standards Committee recently proposed major recast of the Accounting Standard no. 17 (IAS-17) on Accounting for Leases. The draft of the new Standard, seeking to replace IAS-17 was circulated for comments as Exposure Draft 56 (ED 56).
Some of the key changes proposed by ED 56 are:
- The addition of new tests to distinguish financial and operating leases, thereby expanding the meaning of financial leases.
- The placement of operating leases on the lessee’s balance sheet, to the extent of the non-cancellable rentals therein.
- The expansion of the disclosure requirements of both lessors and lessees.
The substance of a lease: difficulties in quantification
IASC’s attempt to rewrite the lease accounting standard is based on a paper titled “Accounting for Leases: A New Approach”, by Warren McGregor which proposed dramatic changes in the way lessors and lessees account for their leases. Traditionally, the distinction between financial and operating leases has been based on the substance of the lease. This “substance test” has been supported by quantitative and relatively mechanical criteria such as the availability of non-cancellable use over substantial part of the life of the asset and the present value test. McGregor’s concern was that while the quantitative tests were meant only to support the substance test, the quantitative tests were subject to large scale misuse.
The substance test is subjective. Faced with similar facts, two accountants may arrive at two conclusions as to the substance of the lease. On the other hand, a classification based on mechanical tests alone is likely to be biased too heavily on numbers, which can be manipulated to suit the convenience of parties. For example, if the present value test was the sole or predominant criterion, a lease could be structured with independent security deposit payments by the lessee thereby bringing down the lease payments, and hence the present value may escape the threshold beyond which the lease is characterised as a financial leaseAlthough this is though not very common, it is nevertheless an inevitable possibility. Still, the mechanical/quantitative tests do not provide a remedy to this subjective aspect.
Inspite of the substance test being the guiding test, the practice has been that an accountant will subject a lease to easier and objective mechanical yardsticks and classify a lease accordingly. Where a subjective and an objective test is laid down as alternative and mutually supportive, it is inevitable that an accountant will favour the latter. This accounts for the predominant use of the present value test for determining the lease character.
No doubt, the substance test would have been a better yardstick. If, based on its substance, a lease is defined as an operating lease or financing transaction, the company’s accountant, under the eye of its auditor, has a responsible view on it. However, it the test determining the definition of the lease is a mechanical test, then it is possible to restructure the lease to avoid these quantitative criteria, thus effectively allowing one to operate under the substance test.
Hence, the observation in the Study that a number of leases in the past have been designed so as to avoid the present value or the lease life tests is hardly surprising. Ironically, however, rather than eliminating the mechanical tests, the ED-56 is adding more such tests.
ED56 has as many as 8 tests as “indicative” of a financial lease. And while Para 9 of ED56 prefaces such tests as being only “indicative”, in the real world, illustrations are mistaken for prescriptions, and can be stretched both to create a lease that avoids these tests and also to include leases which are genuinely operating leases just because they satisfy one or more of the indicative tests.
For example, according to test (g) in Para 9, if the rental agreed on for any year is substantially different from the expected market rent for that year, the lease is a financial lease. This reasoning is understandable because financial lease rentals do not generally relate to market-prevalent hire charges, but test(g) can also be stretched to an extent that even a lessor who signs a genuine contract rental has to assure that the rental he is pre-agreeing to for the n-th year is not substantially less than the expected market rental for that year. For that purpose, what will be expected market rental in the n-th year is again subjective.
The same argument can be made for test (h). This test presupposes that all leases of tailored goods are financial leases. What is the rationale in assuming that tailored assets cannot be subject matter of leases? As long as the lessor takes a risk, what leads to a foregone conclusion that every lease of a specialized asset is a financing transaction and not a true lease? The basis of the lessor taking a risk in an asset which does not have generic utility is not for the accountant or auditor to question.
Or, take a full service lease, one where the lessor not only leases but also fully services the equipment. Logically, this lease is not a financial lease because the risks and rewards the lessor is taking are different from those of a plain financier. But ED-56 , Para 9 will not look at the risks and rewards, but will use one of the 8 tests given, and an application of clause (h) will allow this lease to be categorized as a financial lease merely because the equipment is tailored.
If ED-56 assumes that in the world of leasing there are either plain financings or plain rentals and nothing in between, it is miles away from reality. The truth is that today, between plain financings and plain monthly rentals, there is an enormous variety of lease offerings, where lessors seek to add value in different ways, either by providing a cancellation utility, or adding one or more services. ED- 56 seeks to abolish each of these variations, and groups all lease contracts on either of the two extremes: plain financing or plain rentals.
While appreciating the fact that the 8 tests of ED56 are subordinate to the opening line of Para 9, there is an inescapable tendency among accountants to interpret illustrations as the rule itself. This exactly is the reason why in the past, the quantitative tests were used (or abused) to contrive leases from the definition. Or, to put it differently, where a rule has both a qualitative test and quantitative tests, the latter will almost always overpower the former. This exactly is the situation evident with IAS-17, and this is exactly the situation being compounded in ED-56.
It would be a good idea if the quantitative tests were done away with completely, and the judgement of the substance were left to the auditor. No number of illustrations are a substitute for application of the auditor’s judgement, as he applies his judgement to lot of other accounting information. The issue is not whether the illustrations given in the past were adequate: the real issue is whether these illustrations were required at all. For example, the substance over form rule is a generic accounting principle. But no amount of accounting standards can serve as a complete list of all situations where the substance conflicts with the form. Notably, the Guidance Note of the Institute of Chartered Accountants of India follows the substance test, which is working fairly well, and there has never been a single case where deviations have been made to avoid characterization as a financial lease.
The short rule of the financial/ operating lease distinction remains easy to understand: if it is the lessee who has taken beneficial interest in the asset, it is a financial lease. Otherwise, it is an operating lease. [To read generally about operating and financial leases – click here] This rule, which also governs tax laws of most countries, is adequate and easily understandable, and is supported by past experience governing the application of the concept of beneficial ownership.
Disclosure of operating leases:
McGregor’s study also proposes that a lessee disclose future rentals payable under an operating lease and seems to suggest that all non-cancellable liabilities for future expenses should be put on the balance sheet. However, as long as an operating lease is regarded as an expense arrangement, an expense should not become a balance-sheet item simply because the parties have reached an agreement about future expenses. Or, if this is to be the new understanding of “assets” and “liabilities”, then the approach should not be limited to leases alone. For example, there is little difference between rentals agreed in a lease and salaries payable to an executive under a contractual arrangement since both may trigger penalties for cancellation. Does McGregor’s proposal imply that all future expenses which have a cancellation penalty (which is precisely what a non-cancellable lease period under an operating lease is likely to have) must be put on the balance sheet?
If McGregor’s approach is carried to its totality and the whole concept of assets and liabilities is redefined to include any right to future income as an asset, and any obligation towards future expenses as a liability, our understanding of financial statements must undergo a radical change. In that case, a revised lease accounting standard will be understandable. But as long as an asset is understood as acquisition of an enduring benefit, and not merely a right to enjoy a benefit, there is no reason why operating leases should be put on the lessee’s balance sheet.
Further, the enhanced disclosure requirements, both for lessors and lessees, are unwarranted. If a financial lease were to be equated with a financing arrangement, it should not require any more disclosures than are required by conventional forms of borrowing. The same is true for the lessor’s disclosures. There is no rationale in treating a financial lease as a financial arrangement, and at the same time, mounting it with disclosures not common for generic financing transactions.
For example, para 22 requires a disclosure of the IRRs at which a lessee has borrowed: this amounts to essential commercial information, which is generally not regarded as open to examination by outsiders. Further, in the case of the lessor, disclosure of the unguaranteed residual value (which is often a figure pulled out of hat) is both meaningless and misleading. IAS-32 provides appropriate and adequate disclosure requirement, and the extra requirements proposed by ED56 are unnecessary.
Impact on tax treatment
One should also be concerned about the impact of IAS-17 as proposed on tax treatment of lease transactions. Admittedly, tax principles are not the same as accounting principles. Nevertheless, it is a fact that the tax man’s rules of distinguishing between financial transactions and true leases are affected by accounting standards and in many cases, attempts have been made by tax laws to bodily import the accounting definition into tax laws. India’s Central Board of Direct Taxes proposed, in Nov 1995 to incorporate the IAS-17 definition for tax purposes. It took stiff resistance from the industry to thwart the move. History further suggests that such attempts have been disastrous for the leasing industry, because of the inherent subjectivity in accounting definition. For example, since introducing IAS-17 based tax rules, Singapore has registered negative growth of leasing.
Finally, without intending to, the 8 tests given in paragraph 9 may become the basis for the tax auditors to question the lessor’s eligibility to capital allowances; the leasing industry is little prepared for the ramifications of such a possibility.
Old problems stay:
While redrafting the standard, there was every opportunity to review the weaknesses in the earlier standard, which were evident after years of its application. But IASC seems to have been obsessed with the additional disclosure requirements: it did not try building upon experience of years of working of IAS-17 to remove its present infirmities.
Take, for instance, the definition of “minimum lease payments.” The current definition is problematic in that the value of the asset, not guaranteed by the lessee but guaranteed by an independent third party, is also taken along with the minimum lease payments. It is unclear how a value which is guaranteed by an independent third party can be grouped with the payment the lessee is supposed to make. Is the essence of the definition the risk that the lessor does not take, or the risk that the lessee takes? If the lessee does not take a risk in the asset, but the lessor shelters his own risk, how can the asset be regarded as a financing transaction for the lessee? Or, for that matter, if the lessor eliminates risk by guarantee, but stands to be rewarded by the excess realization, how can such lease be regarded as a financing transaction for the lessor? To take the argument to some extreme, any one may insure his own assets, and such insurance may cover values designed to eliminate owner’s asset-risk. Will all such assets disappear from balance-sheet?
Likewise, Para 12 of ED-56 (which corresponds to Paragraph 9 of IAS-17) provide a circular meaning to interest rate implicit in the lease. The rate, commonly called IRR, by definition equates the minimum lease payments to the fair value of the asset. Though mechanical in theory, the working of the IRR is shrouded in subjectivity in regard to the definition clause, which requires the unguaranteed value of the asset also to be captured as a cashflow. Cashflows relevant for IRR computation are certain, but unguaranteed asset value is surely contingent. Therefore, the entire computation becomes subjective. Further, this definition also provides ample room for manipulation, as one may arbitrarily use a higher unguaranteed value, thus inflating the IRR, and thereby both inflating the lessor’s profits and bringing down the capitalised value of the lease liabilities in the lessee’ balance sheet. Reliance on unguaranteed value in IRR computation has the effect of bringing unrealised profits in the profit and loss a/c, and in practice, no accountant has even been able to convince his auditor on capturing such value.
In conclusion, this author strongly feels that ED-56 has missed the experience gathered so far in the difficulties in implementing IAS-17, and has focused merely on enhancing its requirements.