The new rules have some implications for the vendor, dealer and captive finance segments of the leasing industry. This article will identify the issues and implications and provide commentary on strategies to deal with them. Some issues affect all the segments while others only affect one.
Lessee Operating Lease Accounting
This issue affects all three segments where the asset leased does not have strong residual values. Operating lease classification has always been important to lessees under current GAAP to keep the assets off balance sheet. Operating lease treatment will still be important under the new rules (Topic 842) as only the present value of the asset goes on balance sheet, which lessens the negative impact on ROA. The lease liability is not considered debt, which reduces the impact on debt covenants and financial ratios, all compared to a financed purchase of the asset. The lease cost also remains the straight-line average rent expense, which reduces the negative impact on ROA versus a financed purchase. Lessors must structure leases so the present value of the lease payments is less than 90% of the leased asset’s cost to achieve operating lease treatment. This may be difficult from a risk perspective if the expected residual at lease expiry is not equal to or greater than 10.1% future valued at the lessee’s incremental borrowing rate. As an example, in a 36-month PC lease, assuming a 5% discount rate, the residual assumed needs to be 11.73% for the lease payments (2.683% in advance) to present value to 89.9%.
Often tactics to reduce lessor risk, like charging interim rent and/or a restocking fee, are used as those payments were often erroneously ignored when leases were tested for classification. Interim rent is a stub period rent charged by lessors with systems that start billing periods on the first of the month, so if the asset is delivered on the 15th in a 36-month lease the lease term is really 36.5 months. In those cases, the lease classification decision typically is made by reviewing a lease document that states the term is 36 months while the actual delivery date is unknown. Restocking fees are often ignored as an oversight as they are “buried” in the redelivery provisions of the lease document. The new environment under Topic 842 will raise the bar of CFO and audit oversight. Operating leases must be capitalized at the present value of the lease payments as newly defined — interim rents are fixed payments and restocking fees are payments a lessee can’t avoid — and the lease is recorded on its commencement date, which is the delivery date of the asset to the lessee. Since the lease will be on the balance sheet instead of being merely disclosed in a footnote, this will cause both CFOs and auditors to more closely review the accounting and classification of the lease.
How do we deal with these issues? The simple answer is to take more residual risk, but that is often not prudent. Another choice is to use a synthetic lease structure or residual guarantee structure, but that is also problematic — and maybe mathematically impossible — because of the low asset residual values. Another solution is to add a CPI clause to the lease while reducing the lease rents commensurate to estimated CPI increases. The reduced rents would have to PV to less than 90% of the asset cost. This works as variable rents based on an index are not capitalized or considered in lease classification. The downside to this solution is it involves a new risk for the lessor. Can or will your organization step up to that risk?
Sale Leaseback Accounting
There will be a major change in equipment sale leaseback accounting under the new rules if the leaseback contains a fixed purchase option. This issue affects the dealer segment and, in some cases, captives, full service lessors and daily rental companies that often use sale leasebacks as a lease portfolio funding mechanism. Heavy equipment is typically involved, such as transportation, construction, material handling and agricultural. Often, dealers/lessors have used sale leasebacks done with large bank-owned leasing companies to fund their operating lease portfolios. The process under current GAAP has been simple and straightforward. The dealer/lessor company buys the assets and leases them to customers. The lessor company then puts out an RFP to large funding source lessors asking for a quote on a sale leaseback with early buyout provisions. Under current GAAP, as long as the leaseback purchase option provisions are not bargain options and the leaseback rents present value to less than 90% of the assets’ values, the transaction is accounted for as a sale and the leaseback is off balance sheet. These transactions can be structured as true leases or synthetic leases.
Under the new rules, the presence of a fixed price purchase option in the sale leaseback negates sale treatment. The asset stays on the seller’s books, and the leaseback is booked as a loan/debt — a bad outcome. Although the new rules allow for FMV purchase option as long as the asset is non-specialized and available in the market, which is doable with certain assets, it is not as attractive as a fixed non-bargain option. A sale and operating leaseback will still be attractive under the new rules as, although it will be capitalized, it will be at less than 100% of the asset cost and the liability will not be debt. In addition, the lease cost will be straight line, matching the straight-line rent from the end-user leases.
How do we deal with these issues? This should be a concern for both the seller/lessors and the large lessor funding sources. I see three approaches. The simplest is to sell the operating lease portfolio to the funding source but continue to bill, collect and manage the end of lease asset disposition for a fee/share of the profits. Another approach is for the seller/lessor to identify the funding source before acquiring the equipment and have the funding source fund the purchase and execute a lease, which can contain non-bargain purchase options and be classified as an operating lease. The last option is for the seller/lessor to sign an agency agreement with the lessor/funding source so the seller/lessee is not considered to be in the chain of ownership in the transaction. Under the new rules, if the seller/lessee is merely acting as an agent arranging the transaction, there is no sale leaseback. Since there are more elements of judgment in the new rules, and we have no experience regarding interpretations yet, it is best to get the customer’s auditors to opine on any structure before you spend any time on it.
Sales-Type Lease Accounting
This issue only affects captives that need to buy residual insurance to convert operating leases done with their customers to sales-type leases. The objective is to record a gross profit on sale up front. The new rules will not allow upfront profit recognition because the leasing rules have been conformed to the new revenue recognition rules, which state a sale can only take place in the lease contract between the lessor and lessee and there cannot be a third party in the sale decision. If the lessor does still buy residual insurance, the lease will be considered a direct finance lease, and the gross profit will be included in the lease revenue but recognized over time as interest income assuming an implicit rate that is high. It assumes the PV is the manufacturer’s cost in calculating the implicit rate for earnings recognition. Earnings are deferred and reported on the interest income line instead of as a gross profit on sales. If the captive does not buy residual insurance, the lease is an operating lease and the gross profit is recognized straight line over the lease term as reduced depreciation expense since the basis in the asset is the manufacturer’s cost. This is also a negative outcome due to timing of earnings and presentation.
What can be done? I see several approaches. One is to petition the FASB to allow the gross profit portion of the interest income reported on the gross profit line — there is still time before the transition in 2019. I would base my argument on the fact that each lease payment is a sale of the right of use, and the portion of the gross profit should not be classified as interest income because it is not, which distorts comparative results among captives. This is a long shot. Another approach is for the captive to use a third-party vendor lessor to buy its leases, allowing for the gain on sale to be reported up front. To maintain the relationship with the end-user customer, the arrangement can involve the captive to remain as servicer and manager of end-of-lease dispositions for a fee and share of profits. Another approach is to buy the residual insurance and sell the direct finance lease receivables to trigger a gain. The problem with this is the gain will be shown as other income instead of as gross profit on sales.
We still have time until the transition year of 2019, but lessors’ management and sales staff have to understand the new rules in detail, including how they may affect their offerings to customers and how they manage their own internal funding strategies and financial reporting planning.