1 Amsterdam Business School
Faculty of Economics and Business
Master of Science in Accountancy and Control 2014 – 2015 Accountancy Track
Divergence in financial standard setting – A quest for legitimacy?
Yatin Sharma, 10085122 Master Thesis, MSc ACC
Date: 19 August 2015 (Final Version) First Supervisor: Dr. Sanjay W. Bissessur Second Supervisor: Dr. Ir. Sander Van Triest
2 Statement of Originality
This document is written by student Yatin Sharma who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
3 Abstract
The topic of this paper is to examine the lobbying behaviours of firms on the revised Exposure Draft of the Lease project by the IASB and FASB. The accounting for lease transactions is fundamentally being changed by introducing a new dual approach whereby all assets and obligations will be capitalized on the balance sheet. This expected change caused a lot of parties to respond to the Boards by submitting comment letters. After the period of public consultation, the IASB and FASB diverged in their jointly Lease project on the topic of lessee accounting. The objective of this paper is two-fold. Firstly, the analysis of the comment letters aids to increase our understanding of how the firms exert pressure on the Boards. By identifying patterns we are able to build a basic framework for analyzing future lobbying behaviour for other standards. Secondly, by means of logistic regression we aim to test whether the IASB and FASB diverged due to the quest for legitimacy in their respective fields. The analysis of the comment letters show that there are eight emerging themes. Two of those were primarily linked to the occurred divergence in the Lease project. Results of the empirical tests indicate that firms reporting under respectively IFRS (IASB) or US GAAP (FASB) lobbied differently. Thus their lobbying behaviour shaped different social expectations for their Boards. This caused the IASB to diverge rather than remain converged with the US GAAP.
Key words: Institutional theory, Leases, Standard setting, Lease project, IASB, FASB, Convergence project, Divergence, Comment Letters, Lobbying.
Contents
Abstract ... 3
1 Introduction ... 5
2 Institutional theory and Convergence project ... 8
2.1 Institutional Theory ... 8
2.2 The Convergence project ... 10
2.2.1 FASB, IASB and the convergence project ... 10
2.2.2 The standard-setting process and involved parties ... 11
2.2.3 The Lease project ... 13
2.3 Institutional Theory applied ... 15
3 Comment Letter Analysis ... 16
3.1 Data collection ... 16
3.2 Data analysis ... 16
3.3 Emerging themes ... 18
4 Interpretation of emerging themes ... 19
5 Hypothesis and Methodology ... 33
5.1 Hypothesis development ... 33
5.2 Research methodology ... 34
6 Results ... 36
6.1 Descriptive statistics ... 36
6.2 Results ... 36
7 Conclusion ... 39
References ... 41
Appendix A Stages of the standard Setting process ... 45
Appendix B Template data collection CLs – Masterfile ... 46
Appendix C Frequency and identification of second order categories ... 47
5 1 Introduction
For the past nine years the Financial Accounting Standard Board (hereafter “FASB”) and the International Accounting Standards Boards (hereafter “IASB”) have been working on the convergence of accounting standards US GAAP and IFRS for lease transactions. In the meeting of July 2006 (IASB, Agenda Proposal - Leasing Paper 9A, 2006) the Boards agreed that to significantly improve the accounting for lease contracts mere adjustments to the current leasing standard would not suffice.
The current standard for leases is criticized for a lack of transparency in providing information about obligations that arise due to engaging in lease transactions. Specifically, the model as it is today contains two lease classifications, financial or operational lease. The obligations arising from the latter one are not required to be capitalized on the balance sheet at all, while this is the case for leases classified as financial. The major critique is that the current standard creates an incentive to structure lease contracts in such a manner, that they would fit the operational lease classification (Levitt, 2003). Consequently resulting organizations to only mention the obligations in the footnotes and not capitalizing these on the balance sheet.
The SEC (2005) reported that undiscounted operational non-cancellable lease payments for US public listed companies amounted to 1,25 trillion dollars. This amount indicates how important the leasing industry itself is for many organizations and the Boards argued that the current balance sheet of lessees provides a misleading picture about obligations and assets arising from lease transactions (IASB, Snapshot Leases RED, 2013).
The Boards proposed that the rights and obligations that arise due to lease contracts should be fundamentally reviewed. Subsequently in the standard setting process (hereafter “due-process”) of developing the new Leases standard, the Boards first published the Discussion paper (2009), then the Exposure Draft (2010) and as of now the most recent paper the revised Exposure Draft (hereafter “RED”) (2013). The due-process (IASB, Due process) in developing the drafts and the final standard constitutes out of multiple stages whereby the Boards interact with multiple parties and individuals whose interest are at stake. The Boards themselves are finally the deciding and responsible party, but to be portrayed as legitimate, concerns and opinions of organizations and individuals are taken into consideration. After each draft has been published, parties are given the possibility to comment and provide the Boards with feedback about the content. This public consultation (IASB, Comment letters) takes the form of comment letters (CLs), and the standard-setter takes the points into account in the development of the final standard. The standard-setter publically gives an overview of the responses and reacts by conveying its position on the concerns raised by its stakeholders. These CLs are a form of lobbying, whereby the parties exert pressure on the Boards about the content of the final standard. Lobbying attempts from parties can be seen as similar or different, this mainly depends on the parties’ intention and priorities.
The FASB and IASB however have to deal with these pressures consistently if they want to maintain convergence. Recently, however both the Boards diverged in the lessee accounting model,
splitting up a crucial element in the leases project (IASB, Project Update Leases, 2014). The IASB opted for a single Type A lessee model whereby the FASB remained steadfast to the dual approach presented in the RED (2013). Academic literature has not yet investigated this divergence and as this phenomenon has occurred before in the joint Financial instruments standard and Insurance standard it is important to understand if lobbying parties are a driving force in this decision. This paper will try to do this by focusing on the lobbying behaviour of preparers in response to the RED (2013) of the Lease project as these responses drove the Boards towards divergence.
The aim of this study is twofold. Firstly, the study will aim to increase our understanding of how preparers lobbied in the standard-setting process with the Boards by examining which themes emerge consistently throughout the CLs. Secondly, the study aims to understand if the recent divergence in the Lease project can be explained by the lobbying behaviour of the preparers that participated in the public commenting process based on the preparers’ reporting regime, thus splitting the prepares up respectively to either the FASB (US GAAP) or IASB (IFRS).
The two research questions that I will address are: “How do preparers exert pressure on the Boards in the in the public consultation period for the Revised Exposure Draft (2013)?” and “Has the lobbying behaviour of the preparers in response to the Revised Exposure Draft (2013) driven the divergence in the lessee model?”.
Our inductive approach showed that the lobbying behaviour of preparers is focused on primarily eight themes. These themes can be further divided into concerns related to accounting, costs and benefit and international convergence. Most of the comments present were directed towards the dual approach and the costs and benefits of the new standard. Specifically, firms commented regularly about the need to align the accounting model with the business model to reflect economic reality and that the costs incurred (implementing the new systems and software and ongoing compliance) would far outweigh the benefits incurred by the users.
The results of the regression indicate that the preparers who commented in response to the RED (2013) lobbied differently depended on their reporting regime. Specifically, results indicate that the pressures exerted by preparers reporting under IFRS are significantly more focused on the dual approach than preparers reporting under US-GAAP. For these preparers there were no significantly different economic characteristics, indicating altogether that the lobbying behaviour of US-GAAP and IFRS firms was different for the RED Leases and resulted in heterogeneous pressure on the board that highlights an explanation for the current divergence in the lessee model. These findings shows us that in the institutional realm, despite aiming for convergence, the divergence of the lessee model is a reflection of the quest for maintaining legitimacy for both the IASB and FASB as their reflective stakeholders had different demands.
The societal contribution of this paper is related to understanding how the standard setters operate and to increase transparency by examining the responses of the preparers independently. Furthermore, as convergence is highly praised and supported by influential international organizations as the G20, World Bank, IMF, Basel Committee and the International Organization of Securities
7 Commissions (IOSCO) it is important to understand how divergence takes place. Multiple regulators and associations support both Boards due to this endeavour, understanding this phenomenon will aid in solving future divergence issues.
The academic contribution of this paper lies primarily in the research method. In contrast to prior research that applied the lens of positivistic theories (e.g. positive accounting theory and agency theory), in this study the process of standard setting is interpreted through institutional theory. This theory is applied from an social constructivism point of view, meaning that society and its activities are not seen as distinct from each other, rather the world is socially constructed by the parties themselves and value is given based upon their interpretations and social norms. This interpretive approach increases our knowledge about how parties in the (social) standard setting environment interact. Previous research focused most primarily only on the outcomes of the standard setting process, in this paper emphasis is firstly on the process itself and afterwards on understanding how the pressures exerted during the process resulted in the outcome (e.g. divergence).
Secondly, this paper will help in developing a framework in analyzing CLs lobbying. To understand how the preparers influenced the boards, the CLs in response to the RED will be analyzed in-depth. Once emerging themes are identified, institutional theory will be applied to understand and explain the pressures the Boards had to deal with. Illustrating the concerns that are prevalent in response to the RED (2013) can act as a starting point in understanding which dimensions are addressed by preparers. This framework can be used as a stepping-stone to increase our knowledge of how the standard setter is influenced over time in the development of multiple standards.
The final academic contribution lies in examining whether the pressures exerted by the firms actually “work”. On basis of rationality (costs and benefits), convergence is most likely to occur and be prevalent. However, this divergence nevertheless occurred. Using the earlier developed framework of pressures, we will examine whether these pressures steered the Boards towards divergence. This will be done by means of a empirical analysis where preparers will be differentiated based upon their reporting regime, IFRS (IASB) or US GAAP (FASB).
The remainder of this paper is structured as follows. The next section discusses the institutional theory, the convergence project of the boards and briefly the Lease standard and its changes over time. In section 3 and 4 the focus will be on understanding how the preparers influenced the Boards. Section 3 therefore elaborates the methodology used for analyzing the CLs and identifying emerging themes. In section 4 the themes are explained and interpreted following the institutional theory. In section 5 and 6 the emphasis will be on testing whether the lobbying behaviour of preparers drove the divergence in the lessee model. Specifically, section 5 outlines the development of hypotheses and method used for examining the probability of pressures driving the divergence between the Boards. Results of these tests are discussed in section 6. Finally, the last section concludes by discussing the overall findings, its implications, attached limitations and suggestions for future research.
2 Institutional theory and Convergence project
In the first section institutional theory is explained. This theory forms the basis for understanding how convergence or divergence occurs in organizational fields. In the second section the convergence and lease project is discussed. Finally, the institutional setting of standard setting is interpreted through institutional theory.
2.1 Institutional Theory
Firstly, the quest for legitimacy will be discussed. Secondly, isomorphism and the organizational field will be explained. Finally, the pressures that drive this process will be discussed and illustrated to understand the theoretical framework for analysis..
2.1.1 Quest for social legitimacy and isomorphism
Institutional theory helps in understanding how organizations are depended on their contextual field and are thereto influenced by the constituents active in that field. Organizations are not seen as rational decision-makers, rather they are pressured and urged to follow rational myths projected towards them by their institutional setting to be seen as legitimate (Meyer et al., 1977). Neglecting this myth would cause these organizations to lose their social legitimacy. What would result in losing support from their stakeholders and access to resources for further existence (Meyer et al., 1977; Deegan, 2006).
In this organizational field, after innovations have reached their thresholds, isomorphism (hereafter convergence) between institutions is expected to take place. This definition exactly stands for organizations becoming more alike in their organizational quest for legitimacy. DiMaggio et al.(1983) formed a clear basis for analysis by defining the organizational field and the dimensions that drive the convergence process. For an organizational field to exist four criteria have to be satisfied. Firstly, there must be an increased extent of interaction between the parties. Secondly, a clear emergence of interorganizational structures of domination and patterns occur. Thirdly, an increase of information in which the organizations operate occur. Finally, they mention that there should be a sense of awareness of a common goal between the organizations (DiMaggio et al., 1983). All these four criteria are fulfilled for the Boards. Besides the converging institutions, the organizational field thus also exists out of organizations and individuals that interact with the converging institutions. These interacting organizations and individuals exert pressure towards the converging institutions. The converging institutions themselves follow and adapt to the pressure that they seem to be legitimate.
2.1.2 Pressures
There are three types of pressures that can drive institutions towards convergence (DiMaggio et al., 1983; Zucker, 1987). These are coercive, mimetic and normative pressures. Legal institutions, regulators or stakeholders with whom the organization interacts and is dependent on for future existence cause coercive pressure. Mimetic pressure takes place due to the success of organizations in uncertain times.
9 Organizations that have dealt successfully with uncertainties also seem to be more legitimate. This causes other organization to copy them all with the quest to seem more legitimate. Normative pressure is characterized by pressure exerted by professionals that operate across associations (educational, professional) in the field. All these pressures create rational myths that seem to constitute legitimacy for the converging institutions in the organizational field (DiMaggio et al., 1983). This convergence of the Boards thus resulted from the quest for legitimacy within the financial reporting environment.
DiMaggio et al. (1991) hints at the fact that it is important to understand that isomorphism is not always expected to take place. In organizational fields, institutions are often complex due to their association with different parties that do not have similar demands. Due to this diversity, heterogeneity (hereafter “divergence”) instead of homogeneity might appear and the organizations will diverge on these dimensions. Convergence or divergence is a result of the stakeholders’ pressures exerted on fundamental dimensions that drive the creation of rational myths in the organizational field for the converging institutions (Greenwood et al., 2008). For the IASB and FASB, this means that convergence/divergence is a result of the stakeholders’ pressure on elements of the new accounting standards. Heterogeneity (homogeneity) between the demands of stakeholders from respective the IASB or FASB thus drives divergence (convergence).
2.2 The convergence project
In this section a brief background is given about the FASB, IASB and their joint convergence project. Then the manner in how this convergence was to take place is discussed by highlighting the standard-setting process and the involved parties. Finally, the lease project and the recently occurred divergence is discussed.
2.2.1 FASB, IASB and the convergence project
The Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) are both standard setter bodies. The FASB operates in the US and is since 1973 responsible for establishing the United States Generally Accepted Accounting Principles, in short US GAAP. These standards have as goal to guide nongovernmental organizations in the preparation of their financial reports. US GAAP are recognized standards by the Securities and Exchange Commission (“SEC”) and are mandatory for publically listed firms in the US (FASB, Mission Statement, 2015).
The IASB replaced the IASC (founded in 1973) in 2001 and is situated in London, UK. In contrast, to the jurisdiction of the FASB, the IASB operates internationally and has as goal to “to develop IFRS that brings transparency, accountability and efficiency to financial markets around the world” (IASB, Mission statement, 2015). According to the IASB, 114 out of 138 (84%) jurisdictions already require public listed companies to use IFRS in preparing financial information and 130 out of 138 (94%) have publically committed to use this single set of standards in the future (IASB, IFRS Pocket Guide, 2015).
On the 18th of September 2002, the Boards decided and announced their commitment to develop high-quality and compatible international accounting standards (Memorandum of Understanding, The Norwalk Agreement, 2002). The Boards at that meeting mentioned that they will try to align existing standards as soon as possible and that they will cooperate in future projects to make sure that once convergence is achieved, it will also be maintained.
Since then the Boards have issued multiple papers and drafts of new accounting standards. The Boards published in 2013 an update stating: “since 2002 we have made remarkable progress in improving and converging major global accounting standards” (Meeting of G20, 2013). This is however questionable as convergence on major topics has only occurred for four standards (see table 2.2). The Boards have discontinued or diverged for 9 out of 13 major joint projects. How could this have occurred and why is it not possible for the Boards to converge on a consistent basis? Quite some research has focused on institutional factors related to national government and law-setting to understand the differences that cause the boards to diverge. However, there is no evidence of how parties itself influence the Boards and in which manner this impacts the projects towards either convergence or divergence. To examine how parties influence the Boards it is important to understand the standard setting process of the Boards. This is discussed in the next paragraph.
11 2.2.2 The standard-setting process and involved parties
In the past 10 years there is an increased interest in research that tries to examine the process of how financial standards are established (Allen & Ramanna, 2013; Georgiou, 2004; Ramanna, 2008; Deakin, 1989; Kelly, 1985; Watts & Zimmerman, 1978; Gipper et al., 2013;). The standard setting process (hereafter “due-process”) mostly consists out of multiple stages where different papers (e.g. discussion paper, exposure draft) are published by the Boards1. After each stage parties (e.g. firms, investors, debt holders, regulators, individuals) are invited to comment. The standard setter takes the concerns addressed in these letters into account for drafting the new draft/final version as long as they are conceived to be in line with the objective of the standard. The standard setter has to take into account complementing but also conflicting points of view.
Prior research examined this process primarily through a positivistic lens (Kelly, 1985; Kothari, 2010; Watts & Zimmerman, 1978) and examined mostly only the determinants for lobbying behaviour of firms (Koh, 2011; Ramanna, 2008). In this study, the focus will be specifically on how the preparers of financial statements (firms) influence the Boards through their CLs. Examining this will help us in understanding more about the social pressure the preparers exert on the Boards. In international context there is there is little evidence of how the Boards are affected and influenced by the lobbying behaviour of (international) firms (Khadaroo, 2005). The reason for focusing mainly on the influence of the preparers is twofold. Firstly, the largest impact in terms of costs is on the firms that have to prepare their financial reports in accordance with these standards.
12
Status Project Description
Converged Business combinations Converged standards issued in 2008
Converged Consolidation Converged standards issued in 2011
Converged Fair value measurement Converged standards issued in 2011
Converged Revenue recognition IFRS 15 Revenue from Contracts with Customers was issued In May 2014. The standard is fully converged with ASU 2014-09 Revenue from Contracts with Customers.
Discontinued Conceptual Framework This project has been partially completed. Work on further phases was discontinued and the IASB undertook an IASB-only comprehensive project.
Discontinued Financial statement presentation Joint work on this comprehensive project has been discontinued. Some amendments to existing requirements have been made in relation to the presentation of the statement of comprehensive income.
Discontinued Insurance contracts Joint work on this overall project has been discontinued, although the IASB and FASB continue to liaise on some issues.
Discontinued Intangible assets The IASB and FASB decided in 2007 not to add this project to their joint agenda. Discontinued Liabilities and equity Joint work on this project has been discontinued.
Discontinued Post-employment benefits Joint work on this project has been discontinued.
Divergence Derecognition The IASB and FASB could not reach a converged solution and instead additional disclosures were implemented.
Divergence Financial instruments
This is a high-priority project of both boards and work is currently under way. This project compromises a number of projects, some completed and some under way. In some areas, divergent outcomes have been developed, and timing of the issuance of pronouncements is no longer aligned. The IASB has completed work on IFRS 9 Financial Instruments.
Divergence Leases This is a high-priority project of both boards and work is currently under way, although divergence has occurred regarding some aspects. Table 2.2: Major joint projects of IASB-FASB (IASplus)
13 These costs are made out of the initial switching/implementation costs and ongoing compliance cost (Ramanna, 2008) These costs can go up in the billions for large corporations and are an enormous burden for Small Enterprises as well (Allen, 2013; Deakin, 1989; Francis, 1987; Kelly, 1985). Secondly, for existence the IASB and FASB both need resources. These resources are primarily provided by firms (FASB, Funding; IASB, Funding) and thus future existence for the Boards is depended on the relationship they maintain with them. Preparers also submit the most CLs in comparison to other parties in the standard setting process2.
2.2.3 The Lease project
The Lease project was initially placed on the agenda in 2006. The completion date itself has been extended several times due to the complexity of this joint project. The main objective of the standard setters was to improve the quality and comparability of financial reporting by providing greater transparency of entities entering into lease transactions by capitalizing the resulting assets and the obligations an entity is exposed to.
In 2009 the Boards issued a discussion draft regarding a new standard for leases. The main reason for this new standard was due to weaknesses in the current leasing standard in properly distinguishing the type of leases in the financial report, financial or operational. The Boards had concerns that firms manipulate leasing contracts in a manner to fit the classification of an operational lease, so that the resulting assets and liabilities do not have to be incorporated on the balance sheet (Biondi et al., 2011). Besides the incentive to structure lease transactions, the following three reasons are often mentioned (Snapshot Leases RED, 2013):
1. Information provided today is insufficient as the balance sheet of firms that prepare these (hereafter “preparers”) have to be adjusted by users themselves. These adjustments are different between users, while users attempt to measure the obligations of the same transactions.
2. Some firms even provide non-GAAP numbers to incorporate off-balance sheet lease liabilities. Some firms indicated that they see this form as an important way of financing and thus this information is relevant for users.
3. Enhancing the disclosures in the notes of the standard is not sufficient for improvement. The misleading picture portrait by the operating lease classification can only be fixed by capitalizing the assets and liabilities resulting from a lease transaction.
Recent reports (SEC, 2005; PwC, 2009) and studies (Franzen et al., 2009) show an increase of classifying leases as operational. Franzen et al. (2009) noted that in the period of 27 years (1980 – 2007) the fraction of operational leases in relation to total debt increased by 745 percent. They further show that incorporating this off-balance sheet liability on the balance sheets of firm would affect their financial
ratios, specifically the average debt-to-capital ratio would increase between 50 to 75 percentage. The Boards argues that this form of accounting for lease transactions creates a false impression of the firms’ liabilities. Thus in the new proposal the classification requirement (e.g. financial or operational) is removed and all leases longer than a period of 12 months are capitalized. The standard-setter sees this as an improvement in the quality of financial statements, as investors and other parties will have more complete information regarding the resulting liabilities derived from engaging in lease contracts.
Due process and divergence
Throughout the due process multiple changes occur in concepts presented in the lease papers. From the offset of the drafting process the Boards had the goal to capitalize all lease obligations arising from lease contracts in a single model, eliminating the dual classifications. This was clearly stated in the first Discussion Paper as “the lessee should recognise: (a) a single right-of-use asset […] and (b) a single obligation” (Discussion Paper Leases, 2009). The concept of capitalizing all lease obligations remained intact over the three draft papers, however the single lessee model took the form of a dual model in the RED (Snapshot Leases RED, 2013). The Boards themselves attribute this change in model due to the input from parties in a response to the Exposure Draft released in 2010. In the comment letters (hereafter “CLs”) received from parties the Boards mention that the respondents had mixed views and noted that many in their view did not found that the single lessee model would represent the economics of all leases. After receiving this feedback, the Boards followed up extensively and held meetings to discuss this matter with different stakeholders. From the CLs and meetings the Boards argue that different views exist regarding the economics of leases, some see leases as a financing transaction while others see it mere as a rental of equipment. This led the boards to propose the dual approach in the RED, reasoning that the model is better in reflecting the different economics of leases in the financial statements (2013). After the public consultation period for the RED the Boards were again impacted by the CLs. This time it caused the IASB to revert back to the single approach, while the FASB kept the dual approach. The main reason for the IASB was that the information for users and investors is higher for a single model (Project Update Leases, 2014). This change thus caused the divergence. Our focus will be on the comment letters of the RED as that steered the IASB in making this decision.
15 2.3 Institutional Theory applied
In this section institutional theory as defined in the first section of paragraph two is applied to the standard setting environment. The goal of this paragraph is to highlight how institutional theory helps us in understanding reality.
Convergence or divergence between the IASB and FASB depends on the pressures that are exerted in the organizational field. These pressure appear in three forms; coercive, mimetic and normative. Combined these pressures formulate the rational myths whom the IASB or FASB will try to attain in quest for legitimacy. In our case, the focus is on the coercive pressure exerted by the firms that prepare financial statements. Firms that report in accordance to IFRS (Board is thus IASB) are the stakeholders of the IASB, and firms that solely report in accordance with US GAAP are stakeholders of the FASB. Institutional theory thus explains that based upon the similarity (differences) between the pressures exerted by these two types of preparers, convergence (divergence) will occur due to the quest of legitimacy for the Boards in their respective organizational field.
Pressure: Coercive Normative Mimetic
Party Preparers, Regulators, Users, Industry
organizations, Individuals
Industry organizations, Individuals, Auditors, Consultants, Academics, Standard Setter Bodies
Standard Setter Bodies
3 Comment Letter Analysis
In this chapter first the process of data collection is described. Afterwards the process of analysing the CLs is explained and in the last section the emerging themes are reported.
3.1 Data collection
In accordance with an interpretive approach for understanding the lobbying behaviour of the preparers, the methodological basis for analysis is mainly constituted by a meaning-oriented analysis of the comment letters submitted by the preparers to the RED Leases. The aim for conducting this analysis is to identify emerging themes that portray the lobbying behaviour of the preparers on key elements of the new standard.
The Boards published the RED on May 16th 2013 and invited parties to comment till September the 13th of that year. In total 641 CLs were submitted in response to the RED. These CLs were collected from the website of the FASB3 and consequently identified to the criteria of being a preparer or not. Preparers submitted 381 CLs and these have been analysed for this study.
3.2 Data analysis
The approach to analyse and derive themes from the CLs is called inductive analysis (Gioia et al., 2013). This entails that from a qualitative set of data (e.g. text) patterns are identified by systematically analysing the content. The process entails the following five steps, during these steps all data is stored in a Masterfile4;
1. Target sample is identified6 and all CLs are obtained.
2. CLs are read and identified as a preparer of financial statements if CL is written and submitted by a firm.
3. A CL is read and marked according to the four classifications of responses (issue, reason, effect and/or suggested solution). For this keywords were essential in identifying the responses (see table 3.1). The marked section(s) of the CLs are then stored according to their classification in the Masterfile7. Responses are stored based upon the meaning of the response (e.g. transition requirements, implementation costs, definition of a lease). This data represents the 1st order concepts (Gioia et al., 2013).
4. After completing step 2 and 3 for all the CLs the initial coding of categories is started. The reader starts to identify and code categories emerging in the data (e.g. transition requirements is G1). Consequently, categories identified are further screened and evaluated upon possible matching.
3 Comment Letters RED Leases, reference number 2013-270:
http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=1218220137090&project_id=2013 -270
17 Similar categories are merged and brought together to derive the second order categories (Gioia et al., 2013).
5. The final step of this analysis is to crunch the categories obtained in step five towards a set of emerging themes. This is done by assessing the frequency of the second order categories identified in step 4.
Table 3.1 gives an overview of the total unique responses per classification. A systematic approach was applied to conduct this analysis consistently. Responses were systematically classified based on issue, reason, effect or solution in respect to matching with certain keywords and the meaning of passages. An issue was an overall identification of point raised in the CL. Responses that specifically backed up an issue were identified as a reason(s). Effect points out at the expected (mostly tangible) outcome of implementing the RED due to the issue and/or reason raised earlier. Suggested solution tells us how the preparer thinks the issue can be solved or effect can be lightened. The topics throughout the whole dataset reoccur in a consistent manner. Analysing the CLs based on keywords, meaning and triangulation of researchers aided in reaching theoretical saturation (Glaser et al., 1968) of the CLs. The concerns raised in the CLs were not similar in sense of richness (e.g. issues, reasons, effects and solutions were not consistently mentioned). Some firms only mentioned some points, while others broadly elaborated the issue, their reasons, the effects and their suggested solutions. Furthermore, four preparers have sent in multiple CLs (CL33-33A; CL45-45A; CL47-47H; CL397-C397A). These have also been analysed separately.
In extend to prevent confirmation bias, the readers themselves had no in-depth knowledge of the issues presented in the project Leases upfront and no research question or aim was specifically formulated. Basic knowledge of the accounting for leases was present, as this was necessary to understand what preparers were pointing out in the CLs, especially for the identification of categories and emerging themes. To derive the second order categories the question was asked to as what does the preparer want
CL A S S I F I C A T I O N OB S E R V A T I O N S KE Y W O R D S
Issue 2728 We do (not) agree with ...
... is a problem
Reason 2308 It concerns me to think that ...
We (do not) believe that ....
Effect 1632 This will create ..
The proposal will lead to ...
Solution 1613 We suggest that ....
Our recommendation would be..
Total 8281
to convey? This resulted in 52, 55, 42 and 49 categories5 for respectively issues, reasons, effects and solutions. After analyzing the frequency of the second order categories the emerging themes were identified. An illustration of this process is given in figure 3.1.
3.3 Emerging themes
An overview of the eight emerging themes is given below in table 3.2. These themes will be discussed and interpreted in chapter 4.
Emerging themes
1. Structuring opportunities remain
2. Dual approach is complex, does not (reflect economics)(increase quality information) 3. Measurement and reassessment of Lease term and Variable lease payments
4. Ambiguous definitions, room for subjectivity 5. Transition and disclosure requirements are excessive 6. Impact on current debt covenants and access to capital 7. Costs and benefits
8. International convergence and interaction with existing standards Table 3.2 Emerging themes
5 See appendix C for an overview of the identified categories
Step 3: 1st order concepts
Step 4: 2nd order categories 1. Classifying the lessee into Type A and Type B does not give
users of financial statements more relevant information. K4
No increase in financial reporting quality
2. Result in cost of implementation and compliance that far
outweigh the benefits K1
Costs are higher than benefits received 3. Estimates would have to be reviewed and adjusted at each
reporting date within the lease period. This would increase workloads significantly with little perceived benefit.
K3 Re-measurement is costly
4. Additionally companies would need to evaluate their existing lease processes to determine where lease information is maintained and the level of completeness and accuracy of the information.
K5
Cost of changing software and systems
19 4 Interpretation of emerging themes
In this section the concerns present in the emerging themes from the CLs of the preparers will be outlined and discussed to increase our understanding of how prepares exert pressure on the Boards.
4.1 The Emerging themes
Before the emerging themes are discussed two points inherent to the analysis have to be mentioned. Firstly, it is important to understand that in the interpretation and following discussion of the emerging themes the subjectivity of the researcher is deeply involved. These themes were inductively deduced while the researcher was categorizing the 1st order concepts (see chapter 3.2). To solidify trustworthiness and consistency of the interpretations, the researcher initially coded his interpretations separately and afterwards compared and recoded the total dataset with the interpretations of the other two students. The second order categories identified among the three students were similar and reaffirmed the consistency in the systematic approach used in analysing the CLs (See appendix C for second order categories).
Secondly, the themes are not totally distinct from each other as the subtopics present in the themes are interlinked with each other. For example, classification problem of dual approach in theme 1 Structuring opportunities remain, can also be interpreted in theme 6 Divergence in application due to room for subjectivity and broad interpretation of terms. It is up to the reader to judge the consistency of the researcher in the analysis and understand that these eight themes reflect the lobbying behaviour of the preparers collectively. From the analysis I identified eight emerging themes. A summarizing overview of these themes is given in table 3.2.
4.1.1 Structuring opportunities remain
One of the main critics for the current lease standard is that the current model creates an incentive for firms to structure lease transactions to the operating lease classification. This classification does not require the preparer to capitalize the resulting obligation on the balance sheet. The standard-setter themselves mention this critic in their released documents (ED Snapshot Leases, 2013). Removing this incentive is in line with the standard setters’ goal to improve quality and comparability of financial reporting by providing greater transparency about entities engaging in lease transactions. Especially, comparability is increased if all the firms engaging in leasing activities have to capitalize the resulting lease liability on the balance sheet. However, as in the RED the dual approach is introduced, there still remains an incentive to structure lease contracts as Type A or B as these types of leases are treated differently in their income statement. Preparers have mentioned this incentive to structure leases due to the dual model throughout the CLs (CL73, CL75, CL91, CL95, CL97, CL133, CL 143, CL 161, CL 175, CL177, CL194, CL196, CL213, CL471). Management is expected to have discretion in managing the manner in how lease transactions are accounted for:
“The distinction between Type A and Type B leases continues to allow opportunities to manage accounting results through structuring lease transactions (CL75, Koch Industries)”.
“Significant leeway in determining what constitutes a Type A lease versus a Type B lease. This does nothing to curb the potential for management to structure the underlying lease terms in such a way to achieve a desired accounting result (CL 73, Trinity Industries)”.
Some preparers mention that this is partly due to the criteria of property/non-property in the RED and its “bright-line” nature:
“The classification of an asset as property or non-property can be discretionary (CL194, Siemens AG)”.
Interesting is that preparers also mention that the model in the RED will influence the way contracts are structured to fit the service arrangements classification and so prevent capitalization of leases (CL91, CL161):
“Given the significant difference in the accounting treatment of contracts with similar characteristics between classifications as a service contract or lease there remains a risk that arrangements will be structured to achieve particular accounting outcomes without changing the underlying economics of the transaction (CL91, Wesfarmers Limited).”
Acknowledging that the incentive to structure lease arrangements, either as Type A /B or service contracts is present, preparers further mention that the benefits of replacing the current model with the dual approach eliminates the expected benefits of creating a new standard:
“They will also nullify the benefits of eliminating the current distinction between operating and finance leases by replacing them with the need to determine the distinction between two new types of leases (CL90, Shell International B.V.)”.
21 Furthermore, preparers mention that complexity in financial information is increased and that comparability is actually reduced and not increased by introducing a dual approach (CL90, CL133, 140, CL175, CL194, CL175):
“Classification system is not an improvement, but adds greater complexity for preparers, users and auditors, reduces the comparability for the stakeholder and creates new opportunities to structure transactions (CL 194, Siemens AG)”.
“The proposal, at significant cost, does not improve the quality or comparability of financial reporting (CL91, Wesfarmers Limited).”
Overall, this theme shows us the disagreement towards the dual classification in Type A or B. To solve this problem, prepares argued to switch towards Type A only, Type B only or a single approach (no preference given) for accounting. The type A only and single approach solutions both fit and represent the action the IASB afterwards took.
Type A: “The Type A model has the advantage of being largely familiar to all constituents and should, in our view, be retained as the only model for leases (CL90, Shell International B.V.)”.
Type B: “All leases would be accounted for consistent with Type B leases (CL97, Vantage Drilling Company).” No preference, but single: “We encourage that IASB make utmost efforts to provide a single/unified accounting model for all leases (i.e. no classification needed at all) (CL180, Minsheng Financial Leasing Company)”.
4.1.2 Dual approach is complex, does not (reflect economics)(increase quality information)
This theme is most present throughout the CLs as it is directly focused upon the change in accounting treatment., namely the dual approach used by lessees and lessors to account for lease transactions. From the total of 8281 observations identified 3116 (38%) observations are coded under this theme. The three major concerns raised consistently under this theme are the definition of a lease, the ability to reflect economic reality and the complexity of the accounting model. The responses related to these concerns will be subsequently discussed. Concerns related to measurement of specific lease term liability and ambiguity of accounting terms are in separate themes. This theme specifically focuses on the accounting of lease transaction itself, thus focusing on a conceptual level.
4.1.2.1 Definition of a lease
With regard to the definition of a lease, preparers either disagreed or requested some specific adjustment to the definition itself. The reasons for this were the following:
1. Ability to direct the use of an asset – This point is mentioned for certain industries (drilling industry especially) as the ability to direct the use of an asset is done in collaboration with the client, however the operational responsibility remains with the party providing it. This however in the opinion of several preparers does not mean that such assets (e.g. drilling platforms) should be classified as a lease. The
definition of a lease in the RED does present that such transactions should be classified as a lease as the ability to direct the use of this assets is done in collaboration with the customer (e.g. lessee). Preparers rather opt and argue that for their business model, they keep control of the asset and in providing these assets (e.g. drilling platform) they actually provide a service. This is further clear due to the extra involvement of trained personnel for operating the asset for the duration of the contract-term. Following responses highlight that:
“While our customers may be involved in the design of certain new build rigs or upgrade/suitability projects, this involvement does not transfer our ability to direct the use of the rig throughout the term of the contract (CL60, Noble Corporation)”.
“The drilling company will retain the control over basic operations of the rig such as drilling personnel, rig safety and remains responsible for the physical condition of the rig. The additional guidance provided in paragraphs 842-10-15-9 through 15-16 is ambiguous as to the definition of lease in respect of a drilling contract (CL97, Vantage Drilling Company)”.
“A supplier providing a service to the customer, where both the customer and the supplier have involvement in, or the ability to make, significant decisions regarding providing the service, or situations where an identified asset used to provide the service is a significant component of the service being delivered (CL156, The Williams Companies Inc.)”
“Joint or Mutual Involvement of Customer (Terms & Condition of Industry) in design but not operational decisions (CL222, Encana Corporation)”.
Besides disagreement with wording in the definition of a lease, preparers also demanded clarification to which type of asset categorization the Right-of-Use asset fits, tangible or intangible.
“No indication if the asset is tangible or intangible (CL397A, Crowe Horwarth LLP)”.
“The proposed requirements for right-of-use assets recognised by the lessee are defined without resolving what the right-of-use asset is: an underlying tangible asset, an intangible asset, a unique asset subject to lease, or perhaps a service provided over the lease period (CL164, Deutsche Telekom AG)”.
Especially, financial institutions demanded this clarification as their regulatory capital requirements will be drastically effected if the Right-of-Use asset is classified as intangible:
“Banks often act as lessee in significant lease contracts, particularly of property e.g. bank branch networks and office buildings. Under IAS 17 banks are not required to hold any regulatory capital for such leases which are classified as operating leases, however there is concern that the new assets should be treated as intangible assets, potentially resulting in a 100% deduction from regulatory capital (CL508, Nordea Bank AB)”.
23 “Classification of the right-of-use asset as an intangible asset would affect the calculation of risk-weighted assets, as intangible assets result in a 100% regulatory capital deduction (CL177, ANZ)”
Multiple preparers thus requested clarification:
“Recommend that the Boards clearly comment on their evaluation regarding the classification of the right of use asset (CL95, Wells Fargo & Company)”.
4.1.2.3 Ability to reflect economic reality
In this theme the concerns were related to the ability of the RED to reflect economic reality of leasing transactions. Different views exist and these have been mentioned throughout the CLs. Three concerns refer to this theme:
1. Frontloading pattern of costs (revenue) for lessee (lessor) in the income statement is not reflective of economic consumption.
“Front load costs as finance costs are accelerated (CL35, Africa Express Line LTD)”.
“front loaded expense pattern does not reflect the true economic activity from the lessee perspective and the expense pattern should not be solely determined because the lease is for real estate or equipment (CL52, Med One Capital Funding)”
“The front loading of interest does not reflect the economic reality of a level lease payment (CL185, De Lage Landen)”.
“Front loading of revenue does not reflect the economic consumption pattern of aircraft and inconsistent with risk profile of aircraft lease transaction (CL405, Air Lease Corporation)”.
4.1.2.4
The business model of lessorsPreparers responded differently regarding this topic. Lessors themselves mentioned that the RED should take the two6 different types of business models into account, namely one of providing finance or managing assets:
“Lease classification for the lessor should be based on the business model of the lessor (CL94, Cigna Corporation)”.
6In the current standard leases are accounted for as capital if it is expected that the majority of the assets’ risks are transferred to
the lessee over the contract-term. This arrangement in substance reflects a purchase of the asset through a lease contract, the lessor thus acts partly as a provider of finance.
An operating lease reflects a rental service. The lessee uses the asset for operational reasons and never has the intention to own the asset itself. The lessee has no asset related risks. After the contract term the lessor takes the asset back and will continue to lease the asset if possible. The lessor in this arrangement has to face residual value risk. That is the value of the asset after the lease arrangement is over. The risk the lessor has is that the asset value after the contract-term is lower than expected.
“Providers of finance and asset managers have different business models and manage their business from a different point of view (CL195, VTG)”.
“We are convinced that an approach to classify leases according to the business model will reduce complexity and will help preparers, auditors and investors to reflect and to understand what a company is doing (providing finance or managing assets) (CL195, VTG)”.
“Derecognizing the PP&E asset does not reflect the nature of the operations and as discussed above, is a significantly different accounting treatment from the current real estate guidance. In our view, this type of transaction is a fee for service rather than a sale and disposition and therefore, the receivable and residual method does not reflect the economics of the transaction (CL208, Enbridge Inc.)”.
While some lessees mentioned that they prefer all transactions to be accounted for as a financing arrangement:
“We disagree with the idea that Type A leases and Type B leases are substantially different from the economic perspective of a lessee. Both types of leases represent a financing for the use of the specified asset (CL73, Trinity Industries Inc.)”.
“There are no meaningful economic differences between Type A and Type B leases that would support treating them differently as proposed under the Exposure Draft. We have observed that both types of assets (property and non-property) are routinely purchased and financed in practice by a wide variety of companies and industries. As such, we do not see the conceptual rationale for basing the determination of the accounting treatment on the type of asset leased. We have observed in practice that both types of arrangements result in the economic right to use an asset that is paid for over time, so we do not see an economic basis for the different accounting models (CL132, Time Warner Cable Inc.)”.
4.1.2.5
. Property criteria for classifying leases is misleadingThe property criteria is misleading as preparers state that equipment (property) leases also display characteristics of a Type B (Type A) lease. Solely introducing the criteria to classify based on property criteria does not reflect true economics:
“The case of type B leases, leasing is not a form of financing assets. There are many other business and operational reasons why companies use leasing arrangements, such as to mitigate risk or have flexibility in their operational plans [….] We therefore do not agree that the grossing up of property assets on the balance sheet is reflective of the commercial undertaking of property leases (CL198, Marks and Spencer PLC)”.
“The nature of underlying asset being property or not is not always representative of underlying consumption of the asset or the economic effects of the lease transaction (CL466, Cenovus Energy Inc.)”.
The solutions proposed by the preparers for the above concerns were to simplify the classification criteria by focusing on the business model.
25 4.1.2.6 Complexity of applying and understanding
The last major concern that was present in this theme was the level of complexity in the new accounting model for preparers to apply and users to understand the new financial statements. This complexity is mainly present due to the classification and reassessment requirements.
“Due to judgement of various lease classification models, the reassessment criteria and recognition models the ED is overly complex (CL443, Bank of America corporation)”.
“Complex due to, users have to look at add multiple line items, including understanding the new unconventional type B accounting in order to gain a complete picture of the leasing arrangements of an organization (CL513, Tesco PLC)”.
“For users of financial statements the increased complexity of financial information will lead to financial statements being less understandable and transparent than they are under existing standards (CL191, Northgate PLC)”.
Specific references were made with regard to the Type B expenditure:
“We expect problems in the accounting application (tracing depreciation in sub ledger for fixed assets to the general ledger “rent expense”) in the case of Type B leases (bundling the expenses in a line “rent expense” within the P+L)(CL70, The Linde Group)”.
“Adds tremendous complexity to lease accounting due to the amortization method on Type B assets (CL186, Air Canada)”.
“It may prove difficult to apply the concept in practice due to the difficulty in drawing a clear dividing line between those leases that do involve consumption of a more than an insignificant part of the underlying asset and those that do not (CL138, RBS)”.
Preparers hinted at the detrimental effects on comparability of financial statements due to this complexity:
“It will significantly reduce the comparability and reliability of the financial statements to our key stakeholders (CL97, Vantage Drilling Company)”.
“The fact that Type A and Type B leases for lessees are initially presented similarly in the financial statement but subsequently measured differently may affect users’ ability to understand how the right-of-use assets are measured [...] Transactions which are economically similar can be accounted for differently which reduces comparability for users of financial statements (CL194, Siemens AG)”.
Preparers suggested multiple solutions, primarily the focus was on keeping the current standard and only improving the footnote disclosure. Besides that preparers suggested a single approach (Type A or Type B) or simplification of subsequent measurement (e.g. straight line expensing).
“Following the existing IAS 17 lease classification guidance as it is both principles-based and already used in practice. We believe any other deficiencies perceived in information provided under the current framework could be addressed by enhancing the existing disclosure requirements for leasing transactions (CL152, Viacom Inc)”.
“It is our opinion that the current accounting is appropriate and should be retained. Where the need for additional information is required, supplementary disclosures can be provided in the footnotes to the financial statements (CL205, New York Community Bancorp Inc.)”.
“Propose a reversion to a single accounting model where all leases are accounted for in a consistent manner (CL169, Altria Group INC)”.
“Suggest to just add additional disclosure is the better route to take on the project (CL484, Liberty Mutual Holding Company Inc.)”.
4.1.3 Measurement and reassessment of Lease term and Variable lease payments
In this theme the concerns addressed were pointed at the requirement to reassess the lease liability. As the proposal included the requirement to assess if a significant economic incentive exist in use an option for extending the contract, preparers responded heavily stating that this requirement introduces significant extra judgement and in practice is not operational.
“No conceptual basis for the proposed recognition and inclusion of option periods based on a "significant economic incentive" threshold and represents a judgemental area where considerable range of differing evaluations may emerge (CL482, Statoil ASA)”.
“Significant economic incentive is a new concept which will require considerable judgement (CL436, Lloyds Banking Group)”.
“More professional judgment is needed to determine whether a "significant economic incentive" exist” (CL466, Cenovus Energy Inc.)”.
As a solution preparers opted to only account for the term stated in the contract as that term is the only enforceable fact.
“To simplify the process, our recommendation is for the lease term to be defined simply as the non-cancellable term of the lease, with no adjustment for renewal or termination options (CL124, Swift Energy Company”.
“Limiting lease term to the period for which an entity is contractually obligated would represent a practical expedient that is consistent with the accounting for other types of contractual arrangements (CL129, Dollar General Corporation)”.
27 Preparers also mentioned that the reassessment requirements are burdensome and not practical, as any change in relevant fact can trigger the requirement while this may not be even relevant information.
“Measurement of assets and liabilities recognized for leases is not operational for companies with a significant number of leases. Estimates extend beyond a company’s long range forecast plans (CL107, TW Telecom Inc.)”. “Requirements are confusing and meaningless due to the amount of judgment needed to estimate future events (CL173, Principal Financial Group)”.
As a solution preparers requested the Boards to introduce materiality threshold that will act as a trigger for reassessing.
“Reassessment should be done with triggers like exercise of options, cancellation or extensions (CL324, Canadian Pacific)”.
4.1.4 Ambiguous definitions, room for subjectivity
This theme is related to accounting terms needed for classification as insignificant, major part and substantially all, measurement of the lease liability incorporating significant economic incentive, the process of determining the discount rate and splitting of contracts that contain lease and non-lease components.
Major reasons for these concerns to be mentioned was due to the unclarity of how these terms have to be applied in practice. The wordings itself were seen as ambiguous and difficult to interpret. Others clearly indicated that inconsistent accounting will take place and will cause diversity in practice among firms.
“It is likely that divergence in practice would arise countering the improved quality and comparability of financial reporting envisaged under the proposals (CL91, Wesfarmers Limited)”.
We believe the distinction between a lease and a service contract in the ED proposals is unclear (CL177, ANZ)”.
Further preparers also hinted at the increased subjectivity due to the terms that incorporates additional management judgment.
“Because there is no quantity criteria of “insignificant” in the draft, how to assess “insignificant” remains a problem (CL182, Air China Limited)”.
“It is not clear how "insignificant" or "major part" should be interpreted and there is no further application guidance provided in the ED (CL 537, BT Group PLC)”.
Solutions were majorly hinted at redefining the principles needed for classification. Preparers mostly focused on the definition of a lease (concept of control, substantially all, right to use), the classification criteria’s (insignificant, major part, substantially all), the measurement of the lease term (significant economic incentive and assessing the discount rate), the bifurcation of lease and non-lease components and intercompany transactions.
“Clarification on what constitutes an 'insignificant part' of the total economic life of an underlying asset as we see no further guidance on this other than by inference of example 12 that it is less than 17% of the total economic life (CL191, Northgate PLC)”.
“We believe that clarifying what a right-of-use asset actually is, is vital (CL164, Deutsche Telekom AG)” “We believe that the right-of-use asset should be treated as a tangible asset on the basis that conceptually a tangible asset reflects the economics of a leasing transaction more than an intangible asset (CL177, ANZ)”.
“Provide additional guidance for the definition of property as well as specific guidance for lease classification applicable to integral equipment (CL208, Enbridge Inc.)”.
4.1.5 Transition and disclosure requirements are excessive
This theme highlights the concerns related to the transition requirements and disclosure requirements. For transition the major points raised were for requesting the grandfathering of existing leases, a long lead time for implementing the standard and preparing forehand and requesting other methods for transition, especially prospective application, rather than full or modified retrospective application.
“Existing leases from initial application date till effective date should be grandfathered (CL358, Tyco International LTD)”.
“A prospective application with appropriate disclosure may be more cost justified (CL72, Keycorp)”. “Prospective transition with supplementary disclosure should be permitted (CL291, Apple Inc.)”.
Responses related to disclosure focused mainly on the increased requirements for reporting. As in contrast to the current standard, the preparers did not expect to see a rise in requirements as now all the leases are capitalized. However, in the RED the Boards drafted the requirement to present additional disclosures (e.g. roll forward of lease liability, reconciliations of open/end balance). This was the main argument for requesting the Boards to remove or reduce requirements.
“With the objective being to capitalise operating lease then additional disclosures are not necessary (CL414, Telstra Corporation Limited)”.
“I think the reconciliation of the lease liability is excessive (CL17, TEC)”.
“If the new accounting model is providing the information that users need, then one might expect to a decrease in disclosures (CL39, Petrochina Company LTD)”.
