U.S. Banks as Lessees & Lessors

by Bill Bosco Jul/Aug 2014
As the FASB and IASB continue their work on the lease accounting project — and are most likely issuing separate lease accounting rules with key differences — Monitor contributor Bill Bosco notes that recent developments are good news for U.S. bank lessors, but not so for IFRS bank lessors.

Bank lessors are the major players in the leasing industry both in the U.S. and in IFRS countries. They are both lessors and lessees. The news out of the lease project is very good for U.S. bank lessors but not so good for IFRS bank lessors. The FASB and IASB are most likely issuing separate lease accounting rules with key differences. They are targeting the first half of 2015 for completion. The transition date is still to be decided but will not be any earlier than 2017, with 2018 the more likely date when both lessees and lessors must report under the new standard.

Banks as Lessors

Both the FASB and IASB have agreed that lessor accounting rules do not need major changes. That means that there will still be two accounting methods — direct finance lease (DFL) accounting and operating lease accounting — indicating that bank lessors will not have to make major system adjustments. The lease classification tests to determine if a lease is a DFL or operating lease will be changed to be in line with the current IAS 17 tests. That means no “bright lines” — the 75% of useful life and 90% present value versus the fair value. There will be minor changes like the definition of the lease term and lease payments, but these will be more in the nature of tweaks.

Sales type lease accounting will change too, but banks normally don’t qualify for sales-type lease accounting. Leveraged lease accounting is likely to be dropped from the U.S. rules, although there is a good chance that existing leveraged leases will be grandfathered.

Most importantly, new business for U.S. bank lessors and lessors in general should be robust as ever as the boards have made some key decisions that will simplify the lessee accounting rules. They loosened the definition of a short-term lease (they are exempt from capitalization) so that it includes only renewals that represent a significant economic incentive to exercise. They minimized instances requiring rebooking leases for changes in variable payments. These changes will significantly ease the compliance burden that had concerned lessees.

The FASB in particular has decided that IAS 17-like classification tests should be used for U.S. lessee accounting as well. These rules are well-understood by lessees and lessors and auditors and result in accounting for leases according to their substance. The proposed wording of the classification tests are:
A lessee would effectively obtain control of the underlying asset (resulting in direct finance lease accounting for lessors and for FASB lessees, Type A treatment) — when any one of the following three criteria is met at lease commencement:

(a) The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
(b) The lessee has a significant economic incentive to exercise an option to purchase the underlying asset (Note: If the boards decide to revise the notion of significant economic incentive, the staff would propose to revise this criterion accordingly.).
(c) The lessee otherwise has the ability to obtain substantially all of the remaining benefits of the underlying asset as a result of the lease. Situations that individually or in combination would normally indicate that the lessee has the ability to obtain substantially all of the remaining benefits of the underlying asset as a result of the lease include:

  1. The lease term is for a major part of the remaining economic life of the underlying asset.
  2. The sum of the present value of the lease payments and any residual value guaranteed by the lessee amounts to substantially all of the fair value of the leased asset.
  3. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

The FASB decided current lessee accounting should be retained for operating leases except for the capitalization of the lease. So lessees will continue to report straight line average rent as the reported cost in the income statement. The board has also said that the lease asset and liability arising from operating leases be separately reported from capital lease assets and liabilities on the balance sheet. The key benefits here are that operating lease liabilities will not be labeled as debt so lessee debt limit covenants will not be impacted. This was a huge concern for small and medium-sized and non-publicly traded companies that often lease equipment as they have limited sources of capital. It is true that lessees will have to capitalize operating leases but only at the present value of the lease payments, so one could say that operating leases will only be partially on balance sheet while all the other aspects of operating lease accounting remain in place.

This all means that the U.S. market should see little change in lessee behavior. The structuring of operating leases will be different due to changes to the IAS 17 judgment rather than bright lines approach. I think this will mean that transactions with a present value of lease payments of 89.9% will be challenged so the lessor will have to take more residual risk. Also the use of interim rents in structuring will be evident to lessees and the interim rent will be a payment that will be capitalized and included in the present value test.

Banks as Lessees: The Capital Issues

Banks are heavy users of operating leases, primarily real estate leases, due to their branch network and office buildings. The accounting treatment for the capitalized operating leases under the proposed standards will impact IFRS banks adversely while U.S. banks will fare much better. The key is the IASB decision to treat all leases the same versus the FASB decision to retain current GAAP two-lease regime, accounting for the capitalized operating leases as they are today except for the fact that they are capitalized on balance sheet.

In my opinion the IASB is fixated on the fact that lease payments are made over time so they must be a part of a financing. The board does not seem to care that some leases are rentals and should reflect that substance on the income statement and balance sheet. The substance defines when capital is needed to support an asset and when a liability impacts leverage.

The one-lease lessee model means that IFRS banks will have front-loaded costs that reduce equity capital and create deferred tax assets that are generally deducted from regulatory capital. The loss of capital and new deferred tax assets are permanent capital problems, as they will never reverse until a bank stops all leasing, which is not a realistic scenario. At the same time U.S. banks will see no changes to regulatory capital, as the P&L cost will be the straight line average rent as under current GAAP.

On the balance sheet IFRS banks will report the combined capital and operating lease assets and liabilities as one number. The new capitalized operating lease asset will attract capital for banks at the new Basel III requirement of as high as 10.5%. Under current rules, operating leases need no capital, as the leased asset is returned to the lessor in a bank liquidation, therefore any so-called lease assets and liabilities cease to exist for capital consideration. The IFRS banks will have a difficult time getting regulatory relief without unwinding the accounting and re-doing the classification tests and accounting on all leases to determine which have no capital impact in a bankruptcy liquidation.

The capitalization of operating leases will impact Basel III liquidity standards and leverage ratios for IFRS banks. U.S. banks should see no such issues. The capitalized operating lease asset will be reported separately so that regulators can give relief on that asset for capital and liquidity measures. The operating lease liability will not be classified as debt so it will not impact leverage ratios. I think the U.S. regulators will allow regulatory capital relief for all aspects of the new operating lease accounting rules.

It’s Good to be a U.S. Lessor & Lessee

The best conclusion I can think of is that it is good to be a U.S. lessor and/or lessee. The FASB has listened to our feedback and retained the most sound parts of current lease accounting GAAP while the IASB is back to its one-lease lessee model. The IASB should see significant backlash from banks and lessees in general.

Bill Bosco is the principal of Leasing 101, a lease consulting company. Bill has over 37 years of experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. Bosco has been on the ELFA accounting committee since 1988 and was chairman for 10 years. He is a frequent author and speaker on leasing topics. He has been selected to the FASB/IASB Lease Project working group. He can be reached at [email protected], www.leasing-101.com or 914-522-3233.

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