Summary of the Proposed Changes
Lessee
All operating leases will be capitalized as an asset and a liability at the present value of the estimated lease payments. If the lease payment includes service/executory cost elements, the lessee must separate them from the lease payment or else it would have to capitalize the whole payment. The lessee will consider the lease term to be the longest possible lease term that is more likely than not to occur and include interim payments, contractual payments, renewal payments and estimated contingent rent payments occurring during the estimated lease term. History of month-to-month renewals will be considered as a guide to estimating renewal payments to be capitalized. Lessees have to review and adjust estimated payments whenever they report financial results. Leases of 12-month terms or less will be capitalized at the sum of the estimated lease payments. Leases with terms in excess of one year will be capitalized at the present value of the estimated payments using the lessee’s incremental borrowing rate or the implicit rate in the lease, if known. The P&L cost will not be the straight-line average rent but will be front-ended with the reported lease cost comprised of straight-line amortization of the asset and imputed interest on the liability.

Lessor
There will be three accounting methods for lessors. Lessors are also required to estimate lease payments in the same manner as lessees. The Derecognition method replaces the current direct finance lease method, and has the lessor recording a receivable and residual at their present value. Although it is similar in concept to the direct finance lease method, it will allow only partial sales type profit recognition, but won’t allow accreting the residual (residual income will be accounted for on a cash basis). The Performance Obligation (PO) method replaces operating lease accounting, but will include recognizing a rent receivable, allowing an accelerated income pattern, but most importantly will not allow for sales type lease accounting. The classification criteria to determine whether the Derecognition or PO method should be used are based on risks and rewards, so the more risks a lessor keeps, the more likely the PO method would have to be used. The operating lease method will be used for leases with an original term of one year or less including estimated renewals.

Status of Proposed Changes
It is likely that the more onerous provisions will be changed as the FASB has received 697 comment letters as of year-end 2010, many of which cite the need to simplify the proposed changes and keep some of the current GAAP rules, like definitions of lease terms and minimum lease payments, while still capitalizing lessee operating leases. At this point we do not know the outcome.

Impact to Lessees
Lessees will capitalize far more that the rating agencies do today. The increased amounts capitalized will primarily come from interim rents and likely renewals. As an example, a current operating lease of a $1,000 PC with 2.76% rent factor where there is a 15-day interim rent and the likelihood of four continue to bill renewals would PV to $1,001.70 using a 7% incremental borrowing rate. Thus, over 100% of cost may be capitalized.

Lessees will be more aware of the true cost of leasing.

The lease versus buy decision will be more than just an economic analysis as the accounting results of lease capitalization and the compliance burden will be added negative factors.

Reported lease cost will not be the straight-line average rent but will be front ended. In a three-year lease, the first year impact is 7% higher costs. For a five-year lease term, the first year increase in lease cost is 12%. The longer the lease term, the greater the acceleration. This acceleration is temporary as lease costs in the second half of the lease term will be equally lower than straight line.

A trade up has good and bad issues. On the good side, when the existing lease is closed out there will be a gain recorded due to the front ending of lease costs. On the down side, there will be more scrutiny by the lessee’s accounting department as the existing lease is closed out and the trade up is booked at its capitalized amount.

Leases will not be part of the operating budget. A higher level of internal approval will be needed on new business and trade ups as leases will eat into the lessee’s capital budget.

Lease accounting will be more complex and burdensome than ownership due to the need to review and adjust estimates.

Lessees will ask lessors to bifurcate service costs/executory costs from bundled payments.

Although most reasons for leasing will survive, customers that have the option to pay cash or borrow from other sources may decide not to lease.

Impact to Lessors
Except for short-term leases, there will be no operating leases, so earnings patterns will improve for those lessors whose leases were classified as operating leases.

The Derecognition method creates slightly less accelerated earnings than the current direct finance lease method as the residual is recorded at its present vale but it is not accreted into earnings. This means that the earnings from the residual are recorded when the asset is sold or released.

The PO method is an improvement over operating lease accounting as the earnings pattern more closely matches the economic yield on the declining investment. Also, since the receivable would be on balance sheet as a financial asset, it may be financed off-balance sheet via a FAS 166 transfer of financial assets. There will not likely be a need for “FASB” residual insurance to convert an operating lease to a finance lease.

For manufacturers/dealers, the upfront sales type lease profits will be lower as partial profit will be recognized and the portion related to the residual will be deferred. Also, some current direct finance leases may not qualify as Derecognition leases as the proposed risk and rewards “tests” are judgmental. Much will depend on the final wording of the classification criteria and the Big Four interpretations. If the leases do not qualify as Derecognition leases, the gross profit will be recognized over the lease term.

Where Might We Be in the End?
The major reasons why customers lease (100% low cost fixed-rate financing, tax benefit transfer, residual risk transfer, service and convenience) will continue to exist. Off-balance sheet benefits will be limited to how much real residual risk is taken by the lessor. I do think the FASB/IASB will have to eliminate several of the more onerous lessee provisions regarding estimating the lease term and contingent rents. If they do change the proposed rules, then current operating leases with interim rents will capitalize at around 90% to 92% of equipment cost, meaning there would be some level of off-balance sheet benefit. I am less confident that they will retain lease cost as the straight lined average rent, but for this industry segment with three-to-five-year lease terms the acceleration is not material and turns very quickly. I do think for lessors they will eliminate the PO method and allow accretion of residuals so the Derecognition method will be the same as direct finance accounting. More leases will be sales type leases but with partial gross profit recognition. All this will come from the pressure imposed by comment letters that pointed out the errors in the logic of the proposed rules. There may be opportunities to structure leases as service contracts (which would remain off-balance sheet) depending on the wording of the definition of a lease versus a service contract. There also may be opportunities to lease software if the scope is expanded to include intangibles. We will know more about the status of the project in the second quarter of 2011.

In the end, I predict the office equipment leasing segment will lose some lease volume, pick up some loan volume, do less business with investment grade customers and lose some upside from residuals and renewals.

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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.