The purpose of Greasing the Wheel is to bring relevant industry issues to the table, keep you informed of current trends and provide suggestions on improving results, both business and personal. With this in mind, I took a market approach in my last article and addressed pricing responses to potential customer-driven product changes. My focus in this installment of the column, on the other hand, will be more operational in nature. Pricing remains the topic, but this time I will discuss the pricing process and then examine how lessors may need to adjust their pricing practices in response to the upcoming changes to lessor accounting. (The lessor accounting model is still under heavy debate by the FASB and IASB, but is not yet finalized. Although the performance obligation approach discussed in this article is one of the potential outcomes of the leasing project, nothing is certain until the final standard is issued.)
The starting point for pricing a transaction is the yield, which, like any other product, can be built by combining various components and adding a profit. Yields can be developed in any number of ways, depending on the lessor’s specific need, but they typically are based on the lessor’s costs of providing the financing. Exhibit One illustrates a sample yield, including its various components.
Funding represents the largest component of the lessor’s yield, although it is return on equity (ROE) that drives profitability. Using the following example, we can develop the pre-tax yield that will achieve the targeted ROE of 13.65%.
In Exhibit Two, the cost of debt, capital structure, tax rate and ROE target are incorporated to establish the base, after-tax hurdle rate of 3.25%. This after-tax yield will recover the money costs of the transaction (debt and equity). It does not, however, address the costs of doing business such as operating expenses and losses. These costs are recovered by adding them to the hurdle rate, along with the taxes to be paid on any taxable income, as shown in Exhibit Three.
The pre-tax yield, or rate to charge the lessee, in this example is 6.5%. If the lessor charges the customer this rate, and the lease performs as expected, the lessor will achieve its targeted ROE of 13.65%, as shown in Exhibit Four. This constant yield is measured in the financial statements over the life of the transaction if it is accounted for as a direct financing lease. The ROA and ROE for this transaction are 1.52% (1,516 ÷ 100,000) and 13.65% (1,516 ÷ 11,110), respectively, and match the targets established in Exhibit Two.
So far, so good, right? The yield data is accurately captured in the financial statements under the direct financing lease model. The next step, therefore, is to correlate the economic yield to the financial statement measurement under the potential lessor accounting changes.
An important aspect of the pricing process is the feedback mechanism provided by portfolio analysis, which, on a macro level, at least, is provided through the financial statements. Most lessors expect the economics of the transactions they price, therefore, to be reflected accurately in the financial statements. Although this is not always the case (as in operating leases and, to a much lesser extent, tax leases), we have come to rely on direct financing lease accounting as being economically representative of what is occurring in the portfolio.
This comfort/reliance may become a thing of the past if some of the current models being considered for lessor accounting are adopted. How will this relationship between economic and book yields change, if at all, under these potential lease accounting rules? First, one must understand the basics of the changes.
The original 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 instead, create a hybrid between operating and direct financing leases. Under one option being considered, known as the performance obligation approach (POA), a portion of the lease 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.
Exhibit Five shows the balance sheet for the following lease under the direct financing lease method. Exhibit Six illustrates the same information for the proposed performance obligation model.
Here is where the problems with the POA become evident. The economic, or pre-tax, cash-on-cash yield in this example is 6.5%. The direct financing lease reflects this constant yield, as can be seen in Figure One, which compares the yields, as derived from the financial statements, under both the current method and the potential POA.
Figure One also illustrates the asymmetry between the actual economic yield and that reported in the financial statements under the POA. As is evident from the example, the financial statement reporting of the transaction does not reflect the lessor’s economics, (i.e., a constant pre-tax return of 6.5% on its investment).
Measuring results based on the POA represents a disruptive paradigm shift in the lessor’s management reporting environment. Furthermore, comparability and benchmarking to past results will no longer be valid. Even if lessors are allowed to net the asset against the performance obligation in the balance sheet (an option being considered) lessors will still have to create and track this additional asset and liability in their internal records. This task also will include tracking the associated deferred taxes that will arise.
Subsequent measurement of the yield is not the only challenge created under the POA. The process of establishing the yield is affected as well, since the components used to develop the yield also are based on information derived from the financial statements. The operating expense component of the yield, for example, is based on costs derived from the income statement and compared to the net investment in leases on the balance sheet. Since the operating expense number does not change under the POA, but the assets almost double, the methodology behind building the yield also must be altered.
Changes to the lessor accounting rules are imminent, although their full extent is not known as of the date of this article. What is known, however, indicates that lessors will have to adjust their operations, processes and reporting to one degree or another. Will you be ready?
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