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 from the lease project is very good for U.S. bank lessors but not great for IFRS bank lessors. The FASB and IASB are going to issue separate lease accounting standards because of key differences in lessee accounting. The differences are serious and the IASB approach is negative for bank lessee customers as well as banks as lessees. The FASB approach more closely reflects the economic reality that operating leases are not financings so the impact on business for U.S. bank lessors will be minor.

The timing of the project is imminent. The new rules should be signed by the end of this year. It is expected all lessees and lessors will have to convert to the new rules in 2018 and report financials reflecting those rules.

The basics of the new rules are known from following the meetings and the posted project outline. Also, there are no major open issues left on the FASB and IASB agendas. Recent meetings have been dealing with minor issues that the staff has found as they continue to finish drafting the new rules. The two boards continue to hold joint meetings where the issues are common to both approaches.

One issue looming for the IASB is that EFRAG — the European Financial Reporting Advisory Group — has formally requested that the IASB expose the new draft for public comment. EFRAG takes the position that the IASB has made a number of significant changes since the last exposure draft, and the public should be allowed to comment. EFRAG was established by the European Commission to provide input into the development of accounting standards issued by the IASB and to provide the European Commission with technical expertise and advice on accounting matters. The European Commission must formally endorse the IASB’s new leasing standard for it to become law. This is contrary to the U.S. process where the SEC has delegated accounting standard setting to the FASB, making it independent of the political process. As a result, the European Union has the power to reject the IASB’s proposed lease accounting standard. It is quite possible that the European Union will reject the IASB standard if it is not re-exposed for public comment.

Banks as Lessors

Both the FASB and IASB have agreed that lessor accounting rules do not need major changes. 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. The decision not to change lessor accounting means that there will still be two accounting methods — direct finance lease (DFL) accounting and operating lease accounting. This means bank lessors will not have to make major systems changes.

The lease classification functions as a test to determine if a lease is a DFL or an operating lease; therefore, lessors will continue to employ a risks and rewards approach. The FASB has tentatively agreed to change the classification tests to be in line with the current IAS 17 tests by eliminating the “bright lines” — the 75% of useful life and 90% present value vs. the fair value. However, as I have been asked for feedback on this, there is reason to believe the current FAS 13/ASC 840 classification tests will be kept. There are reasons for keeping the bright lines: it would be simpler to implement, and it would mean less judgment, which would lead to more assurance that lessee accounting would be consistently applied.

Sales type lease accounting will change too, but banks normally don’t qualify for sales type lease accounting. Leveraged lease accounting has been dropped from the U.S. rules, but the good news is that existing leveraged leases will be grandfathered in transition. This means bank lessors can continue to do new leveraged leases until the transition year, which is expected to be 2018. It should also mean that leveraged leases can continue to be traded after transition and without losing their initial classification as a leveraged lease.

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

Lease business volume should remain robust because the reasons for leasing will continue to remain strong. Even though operating leases will be capitalized, this should still be better than borrowing to buy (for more detailed analysis see “Customer Education is Key During FASB Implementations” in Monitor’s March/April issue), to the extent that lower amounts for the asset and liability will be reported on the balance sheet and the lease costs will be straight lined. Borrowing to buy means the full asset goes on the balance sheet, the borrowing is classified as debt and the combination of depreciation and interest expense front ends lease costs. All this adds up to lower returns on assets and equity for the lessee. Additionally, the lessee may not be able to borrow or might be forced to agree to loan terms that are less favorable than the lease terms, such as less than 100% financing or higher after-tax cost, to name two common issues.

Specifically, the good news for lessee customers is the FASB decided current lessee accounting should be retained for operating leases except for the capitalization of the lease. As a result, lessees will continue to report straight line average rent as the reported cost in the income statement. They also decided that the lease asset and liability arising from operating leases should 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- to medium-sized and non-publicly traded companies that have debt limit covenants in other debt agreements. These companies often lease equipment as they have limited sources of capital. While it is true that lessees will have to capitalize operating leases, it will only be at the present value of the lease payments. One could say that operating leases will only be partially on the balance sheet while all the other aspects of operating lease accounting remain in place.

Banks as Lessees: Capital Issues

Banks are heavy users of operating leases, primarily real estate leases, due to their branch network and office space needs. 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 the current GAAP two lease regime. In my opinion, the IASB is fixated on the fact that lease payments are made over time, so operating leases must be a financing like any other financing. They do not seem to care that some leases are rental contracts — executory contracts — 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 asset 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 lease 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 the event of bank liquidation, so any 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 redoing 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 as the capitalized operating lease asset will be reported separately so that regulators can give relief on that asset for capital and liquidity measures. In my opinion, the U.S. regulators will continue to treat operating leases as they do today despite the accounting rules’ changes.

Little Environmental Change

The FASB approach will reflect economic reality for lessees. The FASB has listened to feedback and retained the best, meaning most sound, parts of current lease accounting GAAP while the IASB is back to its “one lease” lessee model. The IASB still has to deal with the negative aspects of its approach.