Recent & Proposed Changes in
Accounting Rules and Their Impact
2004 ELA Equipment
Management Conf.
William Bosco
CitiCapital Managing Director
914-899-7803
Matt Kentner
Deloitte Audit Manager
203-761-3102
Agenda
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Recent Accounting Changes
What is Coming Next?
Impact on Strategy & Products
The Future
Q&A
Recent Accounting Changes
• FIN 46 – provides a new consolidation model that affects many
business ventures including special purpose entities such as
those used by lessors in big-ticket leases
• FIN 45 - requires guarantees to be accounted for on balance
sheet at their “fair value” & disclosed in footnotes
• SEC D 107 - eliminates pooling of guarantees for purposes of
lease classification & vendor sales treatment
• EITF 01-08 - requires most contracts that involve the use of
equipment to be bifurcated and accounted for as a lease and
an executory contract
• SEC off balance sheet disclosures - requires companies to
disclose off- balance sheet arrangements prominently in MD&A
section of annual report.
FASB Interpretation No. 46
Consolidation of Variable Interest Entities (Revised December 2003):
• Objective is to force consolidation of Variable Interest Entities (VIEs), by the
VIE’s Primary Beneficiary, the party that has the majority of the variable
interests (risks and rewards) in the entity
• Changed the criteria for consolidation from majority of voting interest to a
control model based on economic variability - principles based so judgement is
required
• VIE is an entity that has some or all of the following characteristics:
– activities are limited by charter (lacks decision making authority)
– not actively managed by the equity holders
– equity not greater than the entity’s expected economic variability
– equity does not have majority of upside and downside risks
– can’t finance itself without third party support
– is controlled by parties other than those that have voting ownership
FIN 46 - Impact on Leasing Industry
– Large ticket real estate synthetic lease market dried up
– Mid ticket real estate deals still being done without SPEs
– Big 4 ask for info in confirmation letters re synthetic leases to determine if
lessor is VIE
- Confidentiality issues
- Difficult process
– Big 4 have asked for lease terms to restrict/control sale or assignment
– Securitization costs increased
– Vehicle lease deals with titling trusts dried up
FASB Interpretation No. 45
Guarantor’s Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others (issued November
25, 2002):
• Objective is to account for the fair value of guarantees and to increase
disclosure of the guarantees
• Fair value will equal the PV of the estimated payments that might be made
under the guarantee, plus a risk premium
• For lessee residual guarantees in operating leases, entry is a debit to Prepaid
Expenses (amortized), credit to FIN 45 Liability (amortized only if the payment
is NOT probable)
Types of guarantees covered will include:
• Lessee residual guarantees in operating leases
• Vendor/dealer guarantees of residual and of credit to support financing
of their equipment sales
• Performance guarantees
• Indemnities
• Indirect guarantees of indebtedness of others
FIN 45 Impact on the Leasing Industry
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Lessees in synthetic leases have to book the “fair value” of their residual
guarantee
– Calculations are difficult for assets with no secondary markets
– Fair value calculation includes a risk premium that has no market reference
points
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Implementation issues still are with us
– Calculation of fair value of other guarantees like tax indemnities are very
difficult
– SEC has stated however that all guarantees have a fair value
– Subsequent accounting choices were listed but guidance not given
FIN 45 Impact on the Leasing Industry
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Synthetic leases have been restructured to minimize the FIN 45 liability
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Scrutiny of synthetic leases has increased.
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Harder to structure leases with assets that don’t retain value, e.g. PCs
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Volume of synthetic leases has decreased
EITF Topic D 107
In May 2003, EITF issued Topic D 107 - Lessor Consideration of Third Party
Residual Value Guarantees
• Eliminates pooled residual guarantees in the determination of minimum lease
payments for lease classification purposes
• Residual guarantees must be applied on a lease by lease basis
• If a pool can be drawn on for any amount to cover a deficiency such that in effect
the whole amount for that lease is guaranteed, one cannot determine how much
of any one lease is guaranteed.
Subsequent Interpretations:
•Rule is being applied to :
• Lessee residual guarantees in master leases
• Vendor guarantees of residuals in all leases & credit risk in operating leases
•Overturned the interpretation by the Big 4 that allowed pooled guarantees in leases
if the pool was homogeneous
•Does not apply to pooled credit guarantees of loans or direct finance lease
receivables as that is covered and allowed by FAS 140
EITF Topic D 107
Impact to the Leasing Industry:
• Lessor lease classification - Residual insurance policies that had pooled risk
have to be restructured in this quarter to maintain direct finance lease treatment
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Lessee lease classification - Lessee pooled residual guarantees of
homogeneous assets in master leases result in capital lease classification
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Vendor sale treatment - Ultimate Net Loss (UNL) pools or other first loss pool
arrangements re: operating leases & residuals in direct finance leases will
negate sale treatment
EITF Issue 01-08
In May 2003, EITF issued Rule EITF 01-08 - Determining Whether an
Arrangement Contains a Lease:
• Requires companies to separate any lease component in a multipleelement arrangement, e.g. service contract, full service lease, take or pay
contract:
– Contracts involving use of equipment may have to be bifurcated &
accounted for as a lease & an executory contract
– Bad news is the lease may be a capital lease to the customer
– Rule clarifies FAS 13 and enforces identification of disguised lease
agreements for both provider and recipient
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Implications to the Leasing Industry:
– Contracts may have to be restructured to lower rents & assume higher
residuals
– Big 4 & customers are slow in reacting to this new rule so major market
impacts have not been seen
SEC Off-Balance Sheet Transactions
Disclosure
The SEC added new operating lease disclosure requirements in its release
(ER61) dated January 22, 2002:
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Off balance sheet disclosures must be in one location - in the MD&A section
of the annual report
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Amounts of any and all guarantees and contractual off-balance sheet
obligations displayed in a tabular format
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Disclose:
– Nature & business purpose of material off-balance sheet arrangements
– Importance to the business
– Describe the events that would trigger the payment under the
arrangements, the likelihood of occurrence and the course of action if
the arrangement was no longer available
SEC Off Balance Sheet Transactions Disclosure
•The impact of this is hard to measure
– It has contributed to the synthetic lease market problems
– The big ticket real estate market is dead
– There has been a reduction in the mid ticket real estate
deals
– Equipment deals volumes are down
• CFO’s have to consider how they explain any off balance
sheet arrangement, so they may be more reluctant to do such
deals
BASEL II - What is it?
•Basel I - Basel Accord was an agreement reached in 1988 in Basel Switzerland
among the OECD country bank on minimum capital requirements
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Risk differentiated by product - OECD Gov’t (0% risk weighted), home
mortgages (20% RW), commercial loans/leases (100% RW), etc
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100% RW = 8% capital
•Basel II - Next step in refining rules to be finalized in 2004 and implemented
2006
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Aligns economic & regulatory capital
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Obligor & structure will be risk rated, capital required can be as low as
4% or as high as 12% depending on the risks
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Residual may be RW 100% even if obligor & structure carry a lower RW
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There will be four leasing company types:
– (1) Basel I- Standardized+, (2) Basel II-Foundation, (3) Basel IIAdvanced IRB and (4) non-regulated.
BASEL II Impact on the Equipment Leasing Industry
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Capital, the most important element for financial institutions, will change
dramatically under Basel II- could be good or bad
– Good if:
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Lessor is non-regulated, good credit & can issue debt to the
public without bank support
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Lessor has historical portfolio data with good performance
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Lessor targets investment grade customers
– Bad if:
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Lessor is non-regulated, needs to borrow from banks or
supported by banks & credit carries a high RW
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Lessor lacks good historical portfolio data and or data shows poor
credit performance
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Lessor target market is below investment grade
Future Changes to Lessor Accounting
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Lessor Accounting
– FASB has added a Revenue Recognition project to its agenda
– It is a joint project with the IASB
– Lessor accounting is likely to be in its scope
– There is a chance leasing will be out of the scope if it is viewed as too
complex/special
– The time table assumes issuing an exposure draft in 2005 and that could lead
to a rules change in 2005
Future Changes to Lessor Accounting
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What is the nature of the likely rules change?
– The model is a component model similar to what has been talked about in the
“New Approach” asset & liability model
– Components of a lease that result in revenue are rents, residual, purchase
options, other minimum lease payments and tax benefits
– Most of the components would be considered assets & would be capitalized
like a direct finance lease and that would be good news for the industry
Future Changes to Lessor Accounting
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What are our concerns?
– Income recognition is a question - after-tax or pre-tax yield for amortization
– Leveraged lease accounting may be lost
- netting of non-recourse debt
- MISF yield amortization of income
– How will contingent rents & purchase options/residual guarantees be
accounted for?
Future Changes to Lessee Accounting
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Lessee Accounting
– UK ASB has been working on the “New Approach” to lease accounting, now
focused on lessee accounting, with the IASB following its progress
– Although it is not officially on its agenda, the IASB regularly discusses progress
and issues at its board meetings
– The FASB will be actively involved as well so we expect any new rule to be
adopted in the US
– The progress has not been rapid so the likely timing of any new rule is 2006 or
later
Future Changes to Lessee Accounting
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What is the nature of the likely rules change?
– The model is a component model that will require the lessee to record the
assets & liabilities in the lease contract
– The right to use the asset and any options are the assets inherent in the lease
– The obligations to make minimum lease payments plus options or guarantees
issued are the liabilities
– The model will require that the lease be capitalized by the lessee at the present
value of the liabilities
Future Changes to Lessee Accounting
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What are our concerns?
– Operating lease classification is a major reason for leasing & it will be lost
– The complexities & cost to implement may cause customers to borrow rather
than lease
– How will contingent rents & purchase options/residual guarantees be
accounted for
New Approach Impact
• Reasons Why Customers Lease:
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Raise capital
Reduce cost of capital*
Manage taxes
Manage accounting*
Manage assets
Manage regulatory issues*
Gain convenience/service
* Benefit achieved via operating lease treatment
The Future
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No off-balance sheet accounting for assets
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No “virtual” companies
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Sale treatment difficult to achieve
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Whoever bears the risk books the transaction
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Capital costs rise as debt is on balance sheet
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Current thinking on measures, ratios, ratings, etc. will be adjusted
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The Future
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Despite the pressure on off balance sheet accounting for assets,
leasing will continue to provide multiple benefits
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The value added lessor will:
– Have a strong balance sheet
– Provide low cost capital
– Provide service and be relationship minded
– Take credit & equipment risk
– Price tax benefits
– Provide customer focused creative solutions