The FASB and the IASB issued exposure drafts August 17, which propose to make this change in the treatment of operating leases.  They also discuss some changes in the accounting for purchase options, conditionals, leases with service contracts, and the accounting for lessors, including the elimination of leveraged leases.  I shall address these topics at a later time; in this essay I wish to concentrate on the more fundamental issue of lessee accounting.

Let’s review the history of accounting for operating leases briefly.  The board issued Statement No. 13 on lease accounting in November 1976.  (The Accounting Principles Board also had pronouncements on lease accounting, but they were simply dreadful.)  For lessees, the statement created two categories, capital leases and operating leases.  The FASB concocted four criteria for the recognition of a lease as a capital lease.  If any one of the following criteria is met, then the business enterprise must account for the lease as a capital lease.  They are: (a) if legal title passes to the lessee; (b) if the lease contains a bargain purchase option; (c) if the lease term (the length of the lease) equals or exceeds 75 percent of the asset’s life; and (d) if the present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property.  If none of the four criteria is met, then the business enterprise treats the lease as an operating lease.

Accounting for these leases differs greatly.  In a capital lease, the firm capitalizes the asset at its present value (not to exceed its fair value), and it capitalizes the lease obligation at the present value of future cash flows.  On the income statement, the business enterprise shows the depreciation of the capitalized asset and displays the interest expense on the lease obligation.  In an operating lease, the entity ignores its property rights and it pretends that it has no debts, and on the income statement, the organization acknowledges a rent expense.  There is, however, no economic justification for this differential treatment.

I think it amazing—maybe even revolutionary—for the board finally to follow its own conceptual framework in the development of lessee accounting standards.  The FASB’s conceptual framework defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”  Further, it defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” 

It doesn’t take an accounting professor, much less Donald Trump, to figure out that leases confer to lessees probable future economic benefits and probable future sacrifices.  Present-day accounting for operating leases contradicts this rational approach of reporting the economics of these business transactions.  If the board only applies its own conceptual framework, as it appears ready to do, then it will achieve a much better accounting.

Let’s also remind ourselves of the significant consequences of these actions.  Billions, maybe trillions, of dollars of lease obligations have been off-balance sheet since time began.  Here is a small sample of firms, with my estimates (details on my estimation scheme in “Hidden Financial Risk”) of the present value of the cash flows of the operating leases (numbers are millions of dollars except for percentages).

Clearly, the capitalization of essentially all leases is an important step to knowing realistically what corporations owe.  Notice that this sample of only six firms has off-balance sheet lease debts of almost $70 billion.  As this amount is material to everybody (except for members of Congress and the White House), business enterprises should supply this information to investors and creditors so they can better understand the firm’s financial leverage.

While this chapter of financial reporting is coming to a close, the most remarkable event in the history of lease accounting occurred in 1960.  That year Arthur Andersen published the booklet “The Postulate of Accounting” and averred that the only postulate of accounting is fairness.  “Financial statements cannot be so prepared as to favor the interests of any one segment without doing injustice to others.”  To add flesh to this argument, Arthur Andersen then gave the example of leases, contending that all leases should be capitalized.  Unfortunately, the AICPA’s Committee on Accounting Procedure and its Accounting Principles Board ignored these comments.