Although ASC 842 and IFRS 16 were released several years ago, many lessees will only first notice how the changes affect financial reporting in the first reporting period for 2019. Many lessees will not be subject to the new standards until a future date because either they are not required to provide publicly-issued financial statements or they have different fiscal years with a different implementation schedule.
For the most part, both ASC 842 and IFRS 16 require the capitalization of virtually all leases greater than 12-months by lessees. This is the most pervasive change as a result of the implementation of the new standards. Since capitalization of leases is now unavoidable, prospective lessees may seek other means to eliminate capitalization or minimize the amount capitalized. The most material value of leases that will be capitalized may actually be real estate leases, an issue not addressed in this article.
ELIMINATING OR MINIMIZING THE BALANCE SHEET EFFECT
As stated previously, virtually all leases will be capitalized and there is no easy way to avoid capitalizing a lease. Some possible approaches include, but may not be limited to, 1) substituting the lease with a contract that is outside the scope of ASC 842, 2) providing for a lease term that is under 12-months or 3) providing for payments that are fully contingent. Absent avoiding capitalization, lessees may seek structures to minimize, to the extent possible, the amount of asset and liability capitalized.
Contracts outside the scope of ASC 842. As discussed in the past, changing the fundamental business model from a lease with firm minimum payments to a contract to sell the output from an asset is often very difficult and usually limited to the type of asset and nature of business. For instance, one could sell energy generated by a solar facility or a wind farm because 1) mother nature usually ensures the fuel (sun or wind) is available and 2) the generating assets generally operate with nominal intervention. Contrast that with a truck, which requires a driver (at least for now), or an MRI that requires a radiology technician to be operated. It may be a challenge to identify other assets with properties similar to the solar facility or wind farm, so the prospect of an alternative contractual structure is difficult.
Leases under 12 months. Providing a lease term of less than 12 months can, in theory, be achieved, but it requires placing a large reliance on 1) the residual value of the asset at the end of 12 months or 2) an assumption of multiple renewal periods. Both of those assumptions are a risky proposition for the lessor and can also result in a very high rental rate that may not be acceptable to the lessee. This approach however may be achieved if the lessee provides some level of residual value guarantee which is discussed in more detail below.
Contingent Rent Payments Structures. To provide for 100% contingent payments, again the business model would need to be changed dramatically. In the case of solar or wind, the payments are typically 100% contingent on power being produced. So while the contract may be construed to be a lease under ASC 842, the lessee’s payments are fully contingent and thus the lessee has nothing to capitalize. However, in the case of solar or wind, the probability of the sun shining or wind blowing is very high, so investors are able to place a high level of certainty that contingent payments will arise. Again, whether lessors can morph this model to other assets is yet to be determined.
Minimizing the Amount Capitalized. One approach that may be acceptable would be to share some of the risk associated with the asset’s residual value with the lessee. This approach was previously found under ASC 840 in synthetic lease structures and split or modified TRAC leases which were structured to achieve off-balance sheet operating lease treatment for the lessee. In both structures the lessee was willing to guarantee the first-loss portion of the residual value of the asset, but only just enough such that operating lease treatment was still achieved. Assuming the first loss risk mitigated much of the risk of the residual value otherwise held by the lessor enabled the lease pricing to be more favorable.
The synthetic lease structure had grown out of favor for some time because 1) it was believed that the new leasing standard would somehow eliminate it and 2) it was also viewed as “financial engineering”. Leasing industry participants generally believed that the synthetic lease structure may come back as a product because it has now been ‘legitimized’ by ASC 842 in the sense that even with a guarantee the lease will be capitalized.
The split TRAC lease never lost favor because the motivation of the TRAC (Terminal Rent Adjustment Clause) portion of the structure was principally for specific tax reasons. The off- balance sheet nature of the split TRAC was an added benefit but not the primary motivation of the structure.
In both structures under ASC 842, the lessee capitalizes the firm payments plus the amount of the residual value guarantee they reasonably expect to pay. Since the amount of residual value guarantee expected to paid could be substantially less than the full amount of the guarantee, the lessee can capitalize a smaller amount while the lessor could have a guarantee A variation of this that previously existed was a relatively short-term lease (i.e. 12 months) with a partial residual value guarantee structured to achieve operating lease treatment under ASC 840. The lease would include a series of future renewal opportunities each structured in a similar fashion so as to keep the asset off balance sheet through each renewal period and thus was referred to as an ‘evergreen’ structure. This structure was acceptable from an accounting perspective for equipment, generally because equipment is leased for a shorter period and can be easily returned and replaced. However the Big 4 accounting firms required that when the asset being leased was real estate, the base lease term had to be five-years or more, otherwise the lessee would be compelled to renew the lease. Perhaps this evergreen form of synthetic lease structure will return again, refined to satisfy the requirements of ASC 842.
The synthetic lease is viewed as a loan for tax purposes because the lessee usually assumes a major portion of the residual value risk. The split or modified TRAC lease is treated as a tax lease because of an exception in the tax code pertaining to over-the-road vehicles. To date no lease structure has yet been devised that would allow for a partial lessee residual value guarantee and still be treated as a tax lease for federal income tax purposes. For example, assume a lease is for 24-months with a 60% residual value and with the lessee guaranteeing the first 25% of any loss of the residual value. In this scenario, the lease may satisfy the requirements of the tax code to allow the lessor to claim the tax depreciation. However, the industry may need this approach to be vetted through the tax laws before it can be adopted.
MOTIVATIONS FOR LEASING REMAIN
The motivations for leasing are largely unrelated to off-balance sheet reporting regardless of the fact that leases must now be capitalized. We believe that the primary motivation behind most leasing transactions is related to the true economic benefits provided, namely that:
Perhaps the only lease structure largely driven by off-balance sheet treatment was the aforementioned synthetic operating lease, which ironically may now see an increased demand because of the favorable way residual guarantees are reported.
Nonetheless, the new standards now require lessees to capitalize all leases and to track the accounting of the ROU asset and the lease liability as well provide for several different forms of income statement recognition under ASC 842. These new lease reporting requirements have probably eliminated or substantially reduced the “ease of administration” reason for leasing indicated above, as such lessors must focus on the other benefits of leasing.
2019 will start to see changes in the leasing market. Lessors must watch closely to see what lessees’ objectives are and also continuingly stress the benefits of leasing to remind lessees that the leasing industry remains a vital source of capital that can suite a lessee’s needs. The sky is not falling; rather, the sky is raining new opportunities for financing structures. As usual, the leasing industry must respond to those changes and stress its strengths and value-added benefits.