Lessors and the Proposed New Accounting Rules

So what must be done? As with any change, there will be opportunities. These include providing accounting-based products for those lessors willing to take residual risk, implement appropriate processes, and adjust their business models. In other words, the creativity and prudent risk-taking that represent the foundation of the equipment leasing industry still will have a role.

Shawn Halladay is a principal with The Alta Group (www.thealtagroup.com) and manages its Professional Development Division, the training and education subsidiary. Halladay also is spearheading Alta's efforts to assist clients to successfully adjust to the upcoming lease accounting changes. The Alta Group provides consulting and advisory services to the equipment leasing and finance industry on a global basis.

The race to overhaul U.S. lease accounting standards is entering the last lap and, although the final results are yet to be determined, the field is becoming clearer. This article examines the proposed lease accounting rules to date and their anticipated impact on lessors and the way they do business. This examination begins with a discussion of the proposed changes and their impact on lessee behavior, then progresses to how those behaviors impact lessors, and finishes with an examination of how lessors potentially will have to adjust to these market and rule changes.

The Proposals

Getting to where we are with the current proposals has been a long and arduous process, one which began with regulators' concerns about off-balance-sheet assets and liabilities under today's lease accounting rules. This process gained momentum with the push to converge U.S. accounting standards with international standards and resulted, in March of 2009, in the joint issuance of a Discussion Paper on lease accounting by the International Accounting Standards Board (“IASB”) and the Financial Accounting Standards Board (“FASB”), referred to collectively, as the Boards. See Discussion Paper, Leases: Preliminary Views, published by the Financial Accounting Standards Board, March 19, 2009.

It is this Discussion Paper that formed the basis for the evolving changes we see being considered today. The final version of the proposals will be published in an Exposure Draft, the contents of which will be open to public comment before they are finalized. The Exposure Draft, at press time, is expected to be issued in late July or early August. [Note: Although lease accounting is a joint project between the FASB and the IASB, the FASB will issue a separate lease accounting standard that will apply to companies in the United States.]

Although the proposed rules establish new requirements that, supposedly, will standardize the lease accounting process, they also will add more complexity to both lessor and lessee accounting. As a starting point, the proposals require that all leases be capitalized in the lessees' books as a right of use asset and a corresponding obligation to pay rent. Other changes include the requirement that lessees record the lease liability based on the present value of the payments over the most likely lease term.

Contingent rents also must be assessed and capitalized under the new rules. Furthermore, these assumptions must be reassessed each reporting period by both the lessee and the lessor. This reassessment is based on any new facts or circumstances that may arise. Any changes will require an adjustment of the lease debt in the lessee's books. Changes to the lease obligation arising from updated expectations about contingent rents or residual value guarantees, however, would flow through profit or loss.

The primary, and very valid, concern for lessors is that requiring lessees to capitalize all leases will negatively affect volumes. Even today, we see reluctance by some lessees to even use operating leases, for fear of the impact of capitalization in the future. The compliance burden associated with reassessing the lease term also will have an adverse effect on lessees' decisions to utilize lease financing. These changes may result in an increase in capital, particularly for banks, as more debt is added to the balance sheet, and more judgment calls related to renewal options and contingent rents. Lessors also can expect lessee behavior to change in regard to renewal and purchase options.

On the flip side, lease volumes may increase in certain customer segments. Lessees with EBITDA concerns, for instance, will now find leasing more attractive, along with those lessees concerned with transparency. [Note, a 2006 study of 25 companies by the Georgia Tech Financial Analysis Lab found that the EBITDA for these companies would rise an average of 17.2%. Alan Rappeport, Lease Accounting: Falling Rents Will Boost EBITDA, CFO.com, Nov. 27, 2007.] Lessees still can achieve partial off-balance-sheet financing on those leases in which the lessor retains residual risk, so it can be expected that lessees will seek shorter-term leases. They also may request more leases with subjective options and contingencies inherent in the structure. In this respect, some lessees may choose to take on the greater risk of adopting shorter-term leases as a trade for taking a portion of the lease obligation off the balance sheet.

This move to shorter-term, more option-oriented leases will shift more residual value risk toward lessors. Lessors should be able to charge a premium for this greater risk and flexibility, however. This trend will create opportunities for those lessors willing to take residual risk and either fine-tune, or adjust, their business model. Consequently, there will be opportunities to provide accounting-based products for those lessors who are willing to take residual risk. And, in spite of dire predictions to the contrary, lessees also will continue to utilize leasing for its many other benefits such as cash flow savings, tax motivations, and flexibility.

Lessor Compliance

The initial thought process of the Boards, which was reflected in the Discussion Paper, was to defer consideration of lessor accounting until after the lessee guidance is in place. This is no longer the case, as the Boards' recent struggles with some rather thorny lessor issues have shown. Although aspects of the lessor accounting model are still under heavy debate by the Boards, the direction of the new requirements is beginning to come into better focus. The concern over leveraged leasing, for example, is now a thing of the past, as this form of lease has been eliminated under the new model.

The original industry expectation for lessor accounting, based on lessee capitalization of all leases, was that lessors would treat leases in their financial statements as either direct financing or sales-type. The new lessor proposals being discussed do not follow this logic, however, and, in some cases, create a mix of operating and direct financing lease attributes.

Rather than staying with an existing model, the Boards tentatively have decided to use a hybrid lessor accounting model. Under this model, the lessor would use the performance obligation approach to lessor accounting for leases that expose the lessor to significant risks and benefits associated with the underlying asset. The derecognition approach would be applied to all other leases that are subject to the new rules.

Based on the most recent decisions (although nothing is certain until the final standard is issued) it appears that lessors will be required to account for four different types of leases. These include:

• Substantive sales in the form of a lease;
• Performance obligation leases;
• Derecognition leases; and
• Short-term leases.

Leases that are, in substance, sales and financings are expected to be excluded from the requirements of the new leasing rules. In a reincarnation of the capital lease tests under FAS 13, substantive sales will be determined by application of four criteria indicating a transfer of ownership from the lessor to the lessee. These criteria are more subjective than the so-called “bright line” tests of FAS 13.

The performance obligation approach (“POA”) being considered is a new way of looking at the lease from the lessor's perspective. Under the POA, the lessor retains the leased equipment as a long-term asset on its books and recognizes a financial asset measured at the present value of the minimum lease payments. This financial asset is supported by a non-debt liability (the performance obligation). This liability represents the lessor's obligation to provide continued use of the asset to the lessee. The performance obligation will be amortized to income over the life of the lease.

The derecognition model, on the other hand, removes the leased asset from the balance sheet and recognizes the receivable (a financial asset) and residual value (a non-financial asset). This model is essentially the same as direct financing lease accounting under FAS 13. The IASB, however, has considered a partial derecognition model in which the residual value would be separated from the receivable and reported as a long-term asset, so this model represents another potential result under the final rules.

Measuring results based on the potential POA represents a shift in the lessor's management reporting environment, as most lessors expect the economics of the transactions they price to be reflected accurately in the financial statements. Although the yield data are accurately captured in the financial statements under the direct financing lease model, this is not the case under the POA. Instead, an asymmetry is created between the economic yield and book yield reported under the POA. This difference is due to the amortization of the performance obligation.

A leased asset is not a pure long-term asset in the traditional accounting sense. The POA does not capture this nuance. For example, when an asset comes off lease under the current rules, it is put into available-for-lease inventory, where it can be monitored from both a market and risk perspective. The leased asset is a current asset at this point, not a long-term asset. A separate shadow accounting process will have to be set up to accomplish this important function under the POA.

Operations

The operational burden faced by lessors will increase substantially under the proposed lease accounting rules as lessors establish new processes and data analytics to accommodate the new requirements. For example, there will be increased customer analysis and tracking necessary to determine the most likely lease term, not only at inception, but also at each reporting period. These incremental processes and procedures will alter the internal control environment and potentially increase audit costs.

Other increases in the operational burden for lessors include:

• Changes in how sales taxes are remitted;
• Increases in deferred tax tracking associated with the performance obligation and inception date assets and liabilities;
• Renegotiation and modification of debt covenants;
• Modification to treasury management processes and models;
• Changes to regulatory requirements and reporting;
• Adaptation of processes to track inception date assets and liabilities, including fair value adjustments;
• Adjustments to regulatory capital; and
• Alterations to reporting and budgeting processes.

Information Systems

Current lease management systems have the capability to track operating leases and finance leases. The POA, however, will require each of these modules to be linked and then integrated. New performance obligation capabilities will have to be created and then linked to the leased asset and receivables.

The POA also will require more asset tracking capabilities than some legacy lease management systems currently possess. Tracking subvention income, blended income, and other subsets of income and deferred charges now will become even more complicated and difficult to implement as the number of components associated with the lease transaction increases under the POA. Additionally, lease origination systems will need to be modified to track and accommodate the performance obligation and inception date assets and liabilities booked at inception.

Affected Constituents

The effect of adopting the POA goes well beyond lessors, as other constituents of the equipment leasing industry also will be impacted. There will be disruption of the regulatory oversight function, for example, as regulatory capital, as measured in the financial statements, will be inadequate under the POA if netting is not allowed. This change will necessitate altering metrics, regulatory guidance collateral, and, potentially, audit approaches, documentation, and focus.

The rating agencies will be forced to adjust their metrics and analysis, not only in their scrutiny and investigation of leasing companies, but also in how they measure and assess lease securitizations. Investors and lenders in the equipment leasing industry also will have to adjust to viewing the industry in a whole new light.

Conclusion

The good news is that, although sweeping in scope, the proposed accounting changes apply to only a portion of the customer population. A large segment of the leasing market, such as lessees with capital leases and those who choose to lease for non-accounting reasons, will not be affected. Changes to the way lessors must approach their customers and account for the subsequent leases are imminent, however, although their full extent is not known as of the date of this article.

So what must be done? As with any change, there will be opportunities. These include providing accounting-based products for those lessors willing to take residual risk, implement appropriate processes, and adjust their business models. In other words, the creativity and prudent risk-taking that represent the foundation of the equipment leasing industry still will have a role.

Shawn Halladay is a principal with The Alta Group (www.thealtagroup.com) and manages its Professional Development Division, the training and education subsidiary. Halladay also is spearheading Alta's efforts to assist clients to successfully adjust to the upcoming lease accounting changes. The Alta Group provides consulting and advisory services to the equipment leasing and finance industry on a global basis.