by Shawn Halladay
Exposure Draft on Accounting for Leases
It has been a long and painful process getting here, but the Financial Accounting Standards Board (FASB) finally has issued its highly anticipated Exposure Draft on how to account for leases. There were no big surprises, as most of its provisions have been discussed and expected. The Exposure Draft does, however, clear up some issues and allow us to get a clearer view of its impact on the equipment leasing industry. This article will highlight the major provisions of the Exposure Draft and postulate some potential business consequences.
The Exposure Draft applies to leases of property, plant and equipment. Under the proposals, lessors and lessees are to apply a right-of-use model to account for their leases. Leases that represent financed purchases are excluded from the scope which means that, although the four criteria of “FAS 13” are gone, you still will have to run tests to determine if the deal qualifies for lease accounting.
Lessees will initially recognize an asset representing their right to use the leased asset and a liability for the obligation to pay rentals. These amounts will be recorded at the present value of the estimated lease payments discounted using the lessee's incremental borrowing rate. As a result, lessors that are willing to offer residual-based products will be able to create product differentiation through some form of off balance sheet financing.
The major change for lessees is the requirement to measure the lease term and estimated payments based on a probability-weighted methodology. This means that all options must be considered and evaluated as to their likelihood of occurrence – the more options, the more work. Payments for this purpose also will include contingent rents and residual value guarantees. Lessors also must perform this analysis. Fortunately, purchase options are not required to be capitalized.
Once the right-to-use asset and obligation are capitalized, the lessee will amortize the asset and obligation over the life of the lease, which is similar to capital lease treatment under “FAS 13.” The kicker here is that the lessee must reassess its estimate of the lease term and payments if it perceives there has been a significant change to its liability to pay rents. Again, more work associated with lease financing option.
Although an effective date has not yet been established, all leases on the lessee’s books will have to be converted to the right-to-use model as of the transition date. This will have minimal effect on capital leases but will prove burdensome for customers that have operating leases with multiple options.
The requirements to measure the lease term and estimated payments based on a probability-weighted methodology and periodically reassess these assumptions also apply to lessors. Lessor accounting, however, will change significantly, and not just due to the elimination of leveraged lease accounting.
The Exposure Draft requires lessors, once they have determined that a transaction qualifies as a lease, to account for the lease under either a Performance Obligation Approach (POA) or a Derecognition Approach (DA). The POA is required for leases in which the lessor retains significant risks or benefits associated with the underlying asset.
When the lessor uses the Performance Obligation Approach, it records the present value of the payments as a right to receive payments and an obligation to perform under the lease. The physical asset remains on the books. Over the term of the lease, the lessor recognizes interest income, income from the performance obligation, and depreciation expense. Needless to say, this methodology creates some interesting income patterns, even though all amounts will be netted. There is no separate residual value under the Performance Obligation Approach, as it is captured in the net book value of the physical asset.
The Derecogniaton Approach requires the lessor to record the present value of the payments as a right to receive payments and then offset this amount against the book value of the physical asset. This approach is somewhat similar to direct financing lease accounting under FAS 13. Again, there is no separate residual, as it is represented by the net of the lessor’s right to receive payments and the book value of the physical asset. Income under this method will be recognized as interest income but the residual income only will be recognized based on the lessor’s activities at the end of the lease, not over the lease term as currently is the case.
There is no doubt that these new rules will create a diminution in volume for that certain set of customers that actively seek off balance sheet financing. The additional evaluation and assessment requirements of the Exposure Draft also are a factor that will cause lessees to revaluate their usage of leases. The primary reasons for leasing, such as cash flow, tax reasons, and asset management, still exist, however, and will continue to drive leasing volumes. For example, a recent survey of CFOs suggested that more than 60% would not alter their lease financing strategies based on these new rules.
The partial off balance sheet benefit that remains will most likely truncate lease terms for customers attempting to minimize the present value of the lease payments on their balance sheets. This phenomenon will create opportunities for lessors who are willing to take on the role of true asset managers.
From the lessor’s perspective, we will have to create systematic approaches to evaluating and reassessing the lease term, along with modifications to front and backend systems. Some lessors also will have to reassess their pricing strategies and performance metrics. Of major importance, of course, will be the sales effort required to educate the customers and continue to promote the many benefits of leasing. On the bright side, these changes create a chance to become more intimate with your customers as you dive into what really is driving their financing decisions.
We have seen major changes occur within the leasing industry before and we always have adjusted. The same holds true for the effect of the Exposure Draft – we will adjust. Plus, these changes will bring opportunities for lessors, not just create a downside, as some unintended consequences become more apparent. The new rules, when applied in a certain manner, for instance, will allow lessors to accelerate residual income. We just have to dig in and do that which we do best – find the opportunities!
Shawn is managing principal of The Alta Group's Professional Development Division and has authored or co-authored eight books on equipment leasing, including A Guide to Equipment Leasing, An Introduction to Leasing and The Handbook of Equipment Leasing.
Disclosure: no position