IT/Office Equipment and Vehicles Update
It should be noted that there have been changes that are favorable to the IT impact analysis I previously reported on. Specifically, the threshold for including estimated renewals has been raised to where current GAAP is, so lessee behavior in terms of renewal history will not be a factor in determining whether renewals should be considered minimum lease payments. Only bargain or economically compelling renewals need be included in the capitalization calculation. Also the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) now favor allowing lessees to recognize straight line P&L cost for leases that are operating leases under IAS 17-like classification criteria to be defined. This means that most IT/office equipment operating leases should make the cut. It also means that FMV vehicle leases (previously reported on) should make the cut, but split-TRACS and synthetic leases would likely not make the cut (this would mean the lessee would use capital lease accounting for the P&L cost recognition for synthetics and split-TRACs).

Summary of the Proposed Changes (Per the Exposure Draft Issued 8/17/10)
Lessee
Where we are now (although still subject to change) is that all operating leases will be capitalized as an asset (the right of use (ROU) of the leased asset) and a liability (capitalized lease obligation) measured by the present value of the estimated lease payments based on the current GAAP definition of the lease term (a major favorable change versus what was proposed in the ED). They are still trying to finish and issue the rule this year, but they have moved the expected effective date to 2015 (the delayed implementation is good news). I personally think they will have a hard time finishing in 2011, and I think they should push the implementation date out past 2015 because of the need for complex systems particularly for lessees.

Variable payments based on an index or a rate (like LIBOR) must be estimated and included in minimum lease payments. Variable payments based on usage, such as cost per use or excess mileage charges, will only be considered a minimum lease payment if they are “reasonably assured/certain”(still to be defined but a higher threshold than per the ED). If the lease payment includes service/executory cost elements, as in a bundled full-service lease, the lessee and lessor must separate the executory costs from the lease payment. But, if the lessee has no observable market information to estimate the breakdown, it would have to capitalize the whole bundled payment.

The lessee will consider the lease term to be the contractual lease term plus renewals where the lessee has a “clear economic incentive” to exercise the options (in other words, current GAAP). Minimum lease payments will include interim payments, contractual payments, renewal payments, estimated payments under residual guarantees (the amount by which they are in the money) and estimated contingent rent payments (like excess mileage charges/cost per use and floating lease payments based on an index or a rate like LIBOR) occurring during the estimated lease term. Purchase options will be ignored unless they are bargains (in which case the lease is considered a loan/capital lease).

Lessees will use their incremental borrowing rate or the implicit rate in the lease, if known, to calculate the PV of the payments to determine the amount to capitalize. Lessees have to review and adjust estimated variable payments whenever they report financial results and use the original incremental borrowing rate to calculate any adjustment. If the lease is a floating rate lease, the spot LIBOR rate is used to estimate the payments but details on what rate to use and how to calculate subsequent accounting and adjustments have not been determined.

Leases of 12-month terms or less will be accounted for under the current operating lease method. The P&L lease cost will be like, if not the same as, the straight-line average rent as we have in current GAAP if the lease is classified as an operating lease using IAS 17-like criteria. Leases that are not operating leases will use capital lease accounting with P&L comprised of straight-line amortization of the ROU asset and imputed interest on the liability.

Lessor
The ED proposed three accounting methods for equipment lessors (Derecognition, Performance Obligation and Operating Lease), but the FASB/IASB now are considering dropping or modifying the Performance Obligation (PO) method. Lessors are also required to estimate lease payments in the same manner as lessees. It is difficult to report on status of the lessor methods as less has been decided since the focus of the project is on getting operating leases capitalized by lessees. They are taking up lessor accounting last but still making comments where their lessee decisions impact where they may come out on lessor accounting.

The boards have said that they want to use concepts being developed by the revenue recognition project to guide lessor accounting. This is likely to mean that where the lessee controls the right to use the asset, the lessor will derecognize the value transferred in the form of booking the PV of the rents and residual and derecognizing the leased asset. Lease revenue will be finance income as the rents are collected and the residual is accreted (although the ED proposed to not allow residual accretion, there are indications that they will reverse that decision).

They are also talking about using IAS 17-like criteria to classify leases as either derecognition or operating (so some form of PO method), but I am hopeful that this will not occur. It is not logical to have a lessee capitalize payments yet not allow a lessor to record a receivable using a derecognition model. It would also be bad news for the industry to still have an operating lease model or PO model for other than short-term leases, but being bad news for the industry is not a good excuse that the FASB would accept.

Focus on the Municipal/Not-for-Profit Business
The good news here is the muni business segment will not be seriously impacted by the proposed lease rules. The customer base in the muni business segment are either state and local governmental entities that use the “dollar out” lease product or non-governmental entities such as not-for-profit (501c3) hospitals that use either loans or synthetic leases in complex structures where working through a state agency they get the benefit of tax exempt financing. Another big product used by not-for-profit hospitals is FMV leases of QTE equipment with pricing being particularly good now because of 100% bonus MACRS.

Impact to Lessees

Impact to Lessors

Where Might We Be In The End?
What I reported above is still subject to change, but it seems that the muni segment will see little impact. As long as the GASB does not adopt the new rules, dollar out lease accounting will be the same as today. Synthetic leases and FMV QTE leases are capitalized but at much lower amounts than the leased asset cost. As long as they drop the PO model and treat all but short-term leases as derecognition leases with residual accretion, lessors will see an improvement. Sales-type lease accounting will be the same for dollar outs, and partial gains will be allowed for synthetic leases FMV, which is not a terrible outcome. We still have to watch the GASB agenda and watch progress of the FASB/IASB project as other segments of the industry still have issues that need to be fixed.

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Bill Bosco is president of Leasing 101, a lease consulting and training company. He has more than 35 years experience in the leasing industry, with expertise in accounting, tax, structuring and pricing. He has product development and strategic marketing experience as well. He has been on the ELA accounting committee since 1988 and was chairman for ten years. He is a frequent speaker and author of articles on leasing issues. Bosco was selected by the FASB/IASB to be a member of the Lease Accounting Project Working Group. He can be reached at 914-522-3233, or by e-mail at [email protected]. For more information on the company, visit www.leasing-101.com.