The Times They are a Changin’
The FASB and IASB put the Leasing Project on their Agendas
By Bill Bosco, Principal of Leasing 101
This article appears in the October 2006 issue of the Monitor
On July 19, 2006, a day that may live in infamy in the leasing industry, both
the Financial Accounting Standards Board (“FASB”) and the International
Accounting Standards Board (“IASB”) put the project to re-write the lease
accounting rules on their agendas. The project will be a joint project so we
can expect the outcome to be one leasing standard applied world wide. Will
this be good news or bad news for the industry? Well, you don't need a
weather man to know which way the wind blows.
Background
This story started back in 1995 with the issuance of the first report by the
G4+1, (a group made up of representatives from the accounting standards
boards of the US, The UK, Canada, Australia, New Zealand and a
representative of the IASB) on the asset and liability approach to lease
accounting. Since the issuance of FAS 13 in 1976, the thinking on lease
accounting in the accounting world has changed from the risk and rewards
approach to the asset and liability or financial components approach. The
risks and rewards approach deals with the leased asset as the asset that is
either capitalized or not depending on the risks and rewards analysis. The
asset and liability approach considers the financial components in the lease
contract like lessee’s rights and obligations and puts them – not the leased
asset – on balance sheet.
The asset and liability method became known as the New Approach to lease
accounting in the issuance of the second, much more detailed G4+1 report
issued in 2000. Nothing of note happened with lease accounting until the
Enron scandal caused off-balance sheet transactions to be put in the
spotlight. In recent years the IASB and FASB advisory committees ranked
leasing high on the potential projects list but they had too many other
projects underway to free up time. The SEC issued its report on off-balance
sheet arrangements which was highly critical of FAS 13 citing the all-ornothing capitalization method, the rules rather than principles based
approach, the bright line tests, which contribute to the financial engineering
of lease transactions to be off-balance sheet. All the regulatory bodies feel
that material operating lease obligations (the SEC estimates an undiscounted
figure of $1.25 trillion in operating lease payments reported in the footnotes
of public companies, per my analysis 70% is from real estate leases) must be
capitalized. This all culminated in the addition of the joint project to the two
standards boards’ agendas.
The Timetable
The joint project will take a long time, much to the chagrin of the SEC and
the FASB. This is due to the complexity of the issues, the due diligence
process of the FASB and the fact that the current Board and staff were not
around when the G4+1 reports were issued. They publicly announced that
they will examine at all the issues and alternative accounting methods. Their
action plan is as follows:

Research phase – remainder of 2006
The FASB/IASB staff of five and a half people assigned to the project
will research lease products, lease contracts, alternative lease
accounting approaches and other issues. The staff will compare
decisions made on things like conceptual framework, definitions of
assets and liabilities, and on other accounting topics to the research on
lease accounting alternatives.

Board deliberation – 2007
The staff will present their work to the Board as they progress with
their research and the Board will make decisions that will guide the
work. A Working Group will be organized to help with the work by
providing technical input and resources. The Working Group will
made up of people from various interest groups like preparers of
financials, investors, lenders, rating agencies, accounting firms,
subject matter experts and industry groups like the ELA. The Boards
are accepting nominations through September 30, 2006 for individuals
to serve on this working group.

Preliminary views document – 2008
This document will be issued for public comment. It will detail
preliminary views on the new lease accounting rules. Comments will
be used to help develop the final rule.

Issuing final rule – 2009
An exposure draft will be issued for public comment. This is a draft
of the final rule. Comments will be reviewed and processed and
changes made. They may need to issue additional exposure drafts if
changes are significant. When deliberations are complete the new
rules will be issued
The Alternative Methods
The Staff and Board have mentioned several alternative lease accounting
methods that they will examine and they are:
 The New Approach (AKA asset and liability or financial components
approach) - This approach causes the lessee to capitalize all material
leases at value of the lessee’s rights and obligations under the lease.
The amount capitalized will typically be the PV of minimum lease
payments using the lessee’s incremental borrowing rate as the
discount rate as it will be difficult to figure any other value. The
lessee’s costs that flow through P&L would be depreciation and
imputed interest cost on the capitalized lease obligation. In my
opinion this approach is the leading contender and has been fleshed
out quite well in the G4+1 reports, although there points in the reports
that have alternative views presented with no conclusions. This
approach offers some hope in that the amount capitalized by the lessee
can, in some cases, be significantly less that the economic value of the
leased asset. Some key points in the asset and liability approach from
a lessee perspective are:
o The “TRAC” like end position in a synthetic or split-TRAC
lease may be treated as an option. This means that its initial
value is zero if the TRAC is set at expected fair market value.
There is another view that says the TRAC amount should be
treated as minimum lease payment as the lessee bears much of
the risks and rewards in the leased asset. We should beware as
the latter view is the UK GAAP view and Sir David Tweedie,
the current IASB head, was the head of the UK Accounting
Standards Board when they adopted that view.
o Contingent rents based on usage will continue to be off-balance
sheet. Contingent rents based on factors other that usage would
be capitalized at their estimated amounts.
o Material lease has not been defined and may still allow for
some leases to be accounted for as operating leases.
From a lessor’s perspective all leases would be direct finance leases
which is good as the earnings pattern is attractive and easier to
securitize. There is a good possibility that the after tax yield will be
allowed for single investor leases, also a good thing, but it is likely
that leveraged lease accounting will be lost.
 The Whole Asset Approach – This approach was championed by
Dennis W. Monson, a KPMG partner, in a paper written in 2001
entitled The Conceptual Framework and Accounting for Leases.
This approach would have the lessee record the leased asset’s fair
value as the asset and records two liabilities, one being the PV of the
minimum payments discounted at the lessee’s incremental borrowing
rate (same as in the asset and liability method) and the other being the
obligation to return the asset (a plug to make the entry balance), which
is like a residual. This approach is also a leading contender. It appears
to be the worst case approach for the industry as the lessee would
have to capitalize the fair value of the asset (the amount the lessee
would pay to buy the leased asset). Less is written on this approach,
but, in my opinion, many of the concepts in the G4+1 paper would
seem to apply. As above, materiality would still be a concern and
may provide a benefit to the leasing industry if the FASB defines it
and the materiality threshold is high enough so it encompasses a
significant number of equipment types. The lessor accounting would
likely be the same as with the asset and liability approach as explained
above.
 The Risk and Rewards approach – This is the current model and I will
not waste words to comment as we all know the regulators think it is
not an acceptable approach.
 The Executory Contract approach – This method considers the legal
and commercial aspects of contracts, meaning that most true leases
would be operating leases. I will not analyze this as the FASB’s
current thinking for leases is that although a lease may be an
executory contract, the execution on the lessor’s part is completed
when the asset is delivered. Also any method that would allow
material leases to be off –balance sheet, as this method would, is not a
serious possibility.
 The Variable Interest approach – This method is the method used in
FIN 46 where the concepts of control and risk of loss determine who
records the asset. I also chose not to analyze this approach as it would
still allow off-balance sheet accounting for material leases with
significant residual interest retained by the lessor. That would not fit
the objective of capitalizing all material leases.
Despite assurances by the FASB that they will consider all approaches
to lease accounting, the FASB and SEC continue to talk only of the
objective of capitalizing all leases.
What Might the Numbers Look Like?
Assuming a Split TRAC or open end vehicle lease with the following terms:
Vehicle cost
$20,000
Lease term
3 years
Delivery date
June
TRAC amount
50% or $10,000
Pre-tax MISF Yield
7.50%
Monthly rent in arrears 1.82% or $364
Lessee incremental
borrowing rate
7.50%
Under the asset and liability method there are 2 likely outcomes that would
result in the following entries:
If the TRAC is considered an option with zero value, the capitalized amount
is $10,527, calculated by present valuing the rents at the lessee’s incremental
borrowing rate. The entry is:
Leased Asset
Capitalized Lease Obligation
$10,527
$10,527
If the TRAC is considered as the equivalent of putting the lessee in the
ownership risks and reward position (in my opinion it will be treated as
such), the capitalized amount would be the sum of the present values of the
rents and the TRAC amount at the lessee’s incremental borrowing rate. The
entry is as follows:
Leased Asset
Capitalized Lease Obligation
$19,693
$19,593
Under the whole asset method the capitalized asset is the vehicle cost of
$20,000 and the capitalized lease obligation is the present value of the
minimum lease payments (see above) of $10,527 or $19,593 depending on
the view of the TRAC amount. There is also a credit or liability for the
obligation to return the leased asset that is calculated as the difference
between the asset cost and the capitalized lease obligation.
Assuming a zero value for the TRAC, the entry would be:
Leased Asset
Capitalized Lease Obligation
Obligati0n to Return Asset
$20,000
$10,527
$9,473
Assuming the TRAC amount is considered the equivalent of a minimum
lease payment, the entry would be:
Leased Asset
Capitalized Lease Obligation
Obligati0n to Return Asset
$20,000
$19,593
$407
Assuming a closed end or fair market value option vehicle lease with the
following terms:
Vehicle cost
$20,000
Lease term
3 years
Delivery date
June
FMV residual assumed 40% or $8,000
Pre-tax MISF yield
7.50%
Monthly rent in arrears 2.08% or $416
Lessee incremental
borrowing rate
7.50%
Under the asset and liability method, the capitalized amount in the FMV
lease is $13,374, calculated by present valuing the rents at the lessee’s
incremental borrowing rate. The entry is:
Leased Asset
Capitalized Lease Obligation
$13,374
$13,374
Under the whole asset method the capitalized asset in the FMV lease s the
vehicle cost of $20,000 and the capitalized lease obligation is the present
value of the minimum lease payments (see above) of $13,374. There is also
a credit or liability for the obligation to return the leased asset that is
calculated as the difference between the asset cost and the capitalized lease
obligation. The entry would be:
Leased Asset
Capitalized Lease Obligation
Obligation to Return Asset
$20,000
$13,374
$6,626
Business Impact
I will only analyze the business impact of the asset and liability and whole
asset approaches as I feel strongly that the other alternatives will be rejected.
The impact on lessees and lessors will vary by business segment. There is
the potential for some good news besides the expected bad news.
Small Ticket – The definition of materiality is the driver for the possibility
of good news under both the asset and liability and whole asset approaches.
Small ticket items may be immaterial to lessees, even if the individual assets
are lease schedules subject to a large master lease, as each schedule is a lease
unto itself. Each schedule can have its unique rent factor. This is due to
differences in lease rates based on delivery month of each asset and changes
in lessee incremental borrowing rates due to general interest rate changes.
As a result each leased asset can have its unique capitalized asset and
liability. Also small ticket true leases would require deferred tax accounting.
It sounds complex and it is. Fortunately several FASB members are
sympathetic to the complexity and cost/benefit issue. If all small ticket
leases are immaterial there should be no negative impact to lessees as
immaterial leases presumably will be accounted for as operating leases.
Under both likely approaches to lease accounting small ticket lessors will
have all leases recorded as finance leases or sales type leases, which is
favorable.
Middle Market – The ticket size in this market segment is usually material.
The lease type is usually either a true lease with minimum payments with a
present value in the mid to high 80% range, a conditional sale that is
capitalized under any accounting method or a synthetic lease with a present
value of the minimum payments of about 30- 50% (depends on the treatment
of and/or valuation of “TRAC” options). Those present value amounts
would be capitalized under the asset and liability approach while the fair
value of the asset at inception would be capitalized under the whole asset
approach. As a result, under both approaches, lessees will capitalize more
assets and that may reduce lease volume. Even if a lease is capitalized, there
should still be a cost of capital advantage as long as the present value of the
payments is less than the economic value of the asset and the imputed
interest is lower than the interest paid on a debt financed purchase. Under
both approaches, lessors will record all leases as finance or sales type leases,
which is favorable.
Big Ticket – The ticket size in this market segment would always be
material. The lease type is either a true lease or synthetic lease, which will
be capitalized at amounts in the 80-90% (for equipment leases) and 25-30%
(for real estate leases) (assuming the TRAC is valued at zero) ranges
respectively under the asset and liability approach. Under the whole asset
approach the capitalization is 100% of the leased asset’s value at inception.
Lessees may be indifferent, as the rating agencies capitalize leases in much
the same way already and the cost of capital advantage may remain to a
certain extent. If not, there will be a reduction in leasing volume except
where the reason for leasing is to transfer tax benefits. Lessors may lose
leveraged lease accounting benefits in true leases, causing lease rates to
increase, perhaps prohibitively. Using a FAS 140 sale of the rents may be
the structure that replaces the leveraged lease, but it will not produce the
same beneficial earnings pattern. All leases would be accounted for as
finance leases by lessors, eliminating the need for residual value insurance,
which, of course, is favorable.
“True” Operating Leases – In this market, material assets and leases with
material lease terms will be capitalized. The amount capitalized will directly
relate to the residual assumed by the lessor in the case of the asset and
liability approach. For instance, a five-year rail car lease may have a present
value of minimum lease payments of 50% of the value of the equipment.
Lessees may be indifferent, as the driver is transfer of residual risk and the
right to return equipment after a short lease term. Of course, under the
whole asset approach 100% of the asset is capitalized, but the imputed
interest cost is only applied to the asset cost less the residual, providing
some P&L benefit. Lessors will benefit from the finance lease accounting as
described above.
Conclusion
The overall concern of course is that the volume of lease business will
decline with users of equipment switching to debt financing. The reasons
for leasing that will remain are to raise capital for lesser credits, to transfer
residual risk to the lessor, to reduce the after tax financing cost for lessees
who are non-full taxpayers, and for services and convenience. Some reasons
for leasing will be less popular or disappear for large ticket items, such as,
CAPEX limits, and off-balance sheet treatment.
There will continue to be a benefit in minimizing the capitalized value of the
minimum lease payments under either approach to lease accounting. This
can be achieved through tax benefits, making rents contingent based on
usage and assuming residual risk. There may be an opportunity to supply
the lessee with the accounting compliance information (book and tax entries
and disclosures) to ease the compliance burden that may drive them from
using the lease product.
Do not think that the rules will not change or that they will be delayed
beyond 2009 as the FASB is committed to seeing the changes through and
feels time is of the essence. The SEC will pressure them for completion on a
timely basis. My prediction is this is not the beginning of the end of the
leasing industry but it will be a major blow to mid and large ticket segments.
The rules will change, but there will still be business opportunities, as a
matter of fact certain provisions may be beneficial. We’ve seen tax and
accounting change before and the industry has more than survived, it has
thrived. It is important that you recognize what will be viable under the new
rules and that you start the process to adapt your business model right now.
Lessees know the project is underway. On sales calls they will be asking
you how your proposed new deal might be accounted for in the future. Be
ready to respond.
Figure 1: Comparative analysis of lease accounting alternatives
The
Assets
and
Liabilities
approach
Description Capitalizes
all leases
at value of
the
lessee’s
rights and
obligations
under the
lease,
typically
the PV of
minimum
lease
payments.
Likelihood
of
acceptance
Synthetic
and Split
TRAC
lease
treatment
The
Whole
Asset
approach
The Risk
and
Rewards
approach
The
Executory
Contract
approach
The
Variable
Interest
approach
Capitalizes
the FMV
of the
leased
asset with
offsetting
credits: a
liability to
return the
asset and
the PV of
the
minimum
lease
payments
The
economic
significance
of the
lessor’s
retained
interest
would
determine
the nature
of the
transaction
The nature
of the
contract
under
commercial
law and a
substantive
analysis of
economic
performance
would
determine
the nature of
the
transaction
The
concepts of
control and
risk of loss
determines
who records
the asset
Most
likely
High
No chance
Low
Low
PV of
minimum
lease
payments
capitalized
and TRAC
will either
be treated
as an
option or
as a
Fair
Off balance
market
sheet
value of
the asset
capitalized
Lease
capitalized
at Fair
market
value of
leased asset
Lease
capitalized
at fair
market
value of
leased asset
FMV
operating
lease
treatment
minimum
lease
payment
PV of
minimum
lease
payments
capitalized
Fair
Off balance Off balance
market
sheet
sheet
value of
the asset
capitalized
Result
based on
analysis of
lessee/lessor
risks in the
asset