As reported in the October 2006 issue of the Monitor, on July 19, 2006, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) placed on their agendas a project to re-write the lease accounting rules. Interested readers may want to read that article for background on the project. It is a joint project so we can expect the outcome to be one leasing standard applied worldwide.

The Timetable
The joint project may take a long time due to the complexity of the issues, the due diligence process of the FASB/IASB and the fact that it is a joint venture, which can mean time spent on compromises and reconciliation of differences. The updated action plan is as follows:

Research Phase — 2006
The FASB/IASB staff completed 11 papers in 2006, which were presented at a February 15, 2007 meeting of the working group of 18 leasing industry experts, of which I am a member. The papers covered the definitions of assets and liabilities, presentation of the terms of a simple lease, identification of the assets and liabilities in that simple lease, discussion of when a lease should be booked, a presentation of alternative accounting models and discussion of what the lease term is when there is an option to renew and an option to terminate. The staff presented the issues and asked for input.

Board Deliberation — 2007
The staff will present their work to the board as they progress with their research and meet with the working group. Then the board will make decisions that will guide the work. There have been three meetings so far this year — the working group meeting as well as meetings of the FASB/IASB on March 21st and 22nd respectively where the first decisions were made. For results see Decisions Made. There should be two or three more working group meetings in 2007 to discuss further papers from the staff because there is a long list of topics for discussion and decisions.

Preliminary Views Document — 2008
This document will be issued for public comment, and will detail preliminary views on the new lease accounting rules. Comments will be used to help develop the final rule. It is your company’s opportunity to comment, and I encourage you all to do so.

Issuing of Final Rule — 2009 or Later
An exposure draft will be issued for public comment. Again it is an opportunity for professionals in the industry to be heard, so please comment. This is a draft of the final rule. Comments will be reviewed and processed and changes made. If changes are significant, there may be the need to issue additional exposure drafts. When deliberations are complete, the new rules will be issued. The predictions made by two IASB board members at the meetings in London were that the rule changes are likely to be issued later than 2009 with an effective date likely to be 2012. Although this creates uncertainty, it should be good news for all but the large ticket, long-lived asset segment of the leasing industry. Many have asked if existing leases will be grandfathered, and although it is too early to know, similar accounting rules changes have not allowed for grandfathering.

Decisions Made
Assets and Liabilities in a Simple Lease
For the lessee the assets are the right to use the leased item and rights to renew the lease or purchase the leased item for a fixed price. Presumably FMV options to buy or renew have no value. The liabilities are the obligation to pay minimum lease payments and any guarantees such as residual guarantees.

For the lessor, the assets are the right to receive minimum lease payments and the right to residual proceeds. Presumably there would be no liability as the balancing credit would be to the leased asset to remove it from the lessor’s books. This area will be difficult to deal with when only a part of the item is leased such as space in office buildings or a fractional share of a private jet. (See Figure 1.)

The Lease Term
A simple lease with a fixed option to renew has a lease term equal to the base lease term. The renewal is only considered as part of the lease term when and if the renewal option is exercised. A simple lease with an option to terminate has a lease term equal to the non-cancelable lease term. The FASB/IASB realize that more work has to be done on defining the lease term in cancelable leases to mitigate financial engineering.

The Alternative Lease Accounting Methods
The staff presented several alternative lease accounting methods and the IASB/FASB boards decided which to continue to work on:

The Right-of-Use Method
The Right-of-Use Method (or New Approach, asset and liability or financial components approach) is the chosen method by both the FASB and IASB. This approach causes the lessee to capitalize all material leases at value of the lessee’s rights and obligations under the lease. Although details of debits and credits at inception and subsequent accounting and measurement are still to be worked on, we know the general direction from previous papers and the current discussions.

The amount capitalized as a liability will typically be the PV of minimum lease payments using the lessee’s incremental borrowing rate as the discount rate plus the value of any residual or other guarantees. The lessee’s costs that flow through P&L would be depreciation/amortization of the capitalized value of the right to use the asset and imputed interest cost on the capitalized lease obligation.

The Equipment Leasing and Finance Association (ELFA) is encouraging the FASB to consider straight line recognition of lessee expenses as that would seem logical if we are trying to account for an intangible right of use rather than an owned tangible asset funded with amortizing debt. The assets capitalized are the rights in the lease — the right to use the leased item and any rights to buy the leased item or renew the lease at a fixed price. This approach offers some hope in that the amount capitalized by the lessee at inception can, in some cases, be significantly less then the economic value of the leased asset. The devil is in the subsequent accounting as lessees will likely have to record changes in values of purchase/renewal options and residual guarantees. Some feel it will not be a big deal as we have that fair value concept in FIN 45 now for accounting for residual guarantees in synthetic leases and the market is buying the product. Key points in the right-of-use approach from a lessee perspective include:

From a lessor’s perspective all leases would be in a form similar to direct finance leases, which is good since the earnings pattern is attractive and easier to securitize. There is a good possibility the after-tax yield will be allowed for single investor leases, but it is likely that leveraged lease accounting will be lost.

The Whole Asset Approach
The IASB did not direct the staff to continue work on this (good news for the industry), but one FASB board member feels this method may have merit for certain asset (this is not a widely held view). 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. 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).

The Risk and Rewards Approach
This is the current model and the IASB and FASB rejected it.

The Executory Contract Approach
The FASB directed the staff to continue work on this method as it would be the likely method used to account for lessee accounting for immaterial leases. This method considers the legal and commercial aspects of contracts, meaning that most immaterial true leases would be operating leases for the lessee. Presumably the lessor accounting would be similar to direct finance lease accounting under FAS 13.

Business Impact
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 fully capitalized or a synthetic lease with a present value of the minimum payments of about 30–50% (depending on the treatment of and/or valuation of TRAC options). The present value amounts would be capitalized under the right-of-use approach. Lessees will capitalize more assets and that should 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. Lessors will likely record all leases as finance or sales type leases, which 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. For instance, a five-year railcar 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. Lessors will benefit from the finance lease accounting as described above. The FASB/IASB have also talked about using the after tax yield to amortize earnings as they do in the UK.

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 synthetic real estate leases) — assuming the option to buy and residual guarantee are valued at zero — ranges respectively under the asset and liability approach. 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. All leases would be accounted for as finance leases by lessors, eliminating the need for residual value insurance, which, of course, is favorable to the industry.

Small Ticket
The small ticket business segment is driven by the need for financing, convenience and transfer of asset risk. The ELFA industry statistics show 80% of small ticket deals are capitalized today as they are either conditional sales or low residual true leases. The definition of materiality is the driver for the possibility of good news for situations where off-balance sheet is important. 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. Fortunately several FASB/IASB board 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. Small ticket lessors will likely have all leases recorded as finance leases or sales type leases, which is a favorable outcome.

Conclusion
The first few decisions made are probably the most realistic and best outcome the industry could have hoped for as there will still be a positive accounting differentiation for a lease vs. a loan — that is the right-to-use model offers the ability to minimize capitalization, purchase and renewal options and residual guarantees are not minimum lease payments and there is sympathy for operating lease accounting for immaterial leases. The only downside I see is the fact that lessees may have to use fair value accounting subsequent to booking, which may cause some to reconsider leasing due to complexity and earnings volatility. We cannot avoid the world of fair value accounting forever.

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. 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 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. It is important that you recognize what will be viable under the new rules so I urge you to follow the progress of the project. 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.

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Bill Bosco is the principal of Leasing 101, a lease consulting company. He has more than 30 years experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the ELA accounting committee since 1988 and was chairman for ten years. Bosco 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] or 914-522-3233.