Staying Ahead of the Curve: Preparing for the New Lease Accounting Rules

by Bill Bosco Nov/Dec 2014
Bill Bosco takes a different approach to the lease accounting project discussion by detailing how lessors can best prepare for the new accounting rules and how to apply them to your business planning. Overall, he notes that despite the proposed changes, the prospects for the industry are positive.

The project to change lease accounting has been a painfully long process. Rest assured though, the project will be completed by mid-2015. The project objective to capitalize all operating leases on the balance sheet of lessees has been a scary thought for both the leasing community and its lessee customers. Despite being in the news, I believe many customers do not understand the project’s impact. The project has evolved to where it is not as bad as it once appeared; in fact, some lease structures fare very well. Customers should be educated on the fact that the FASB’s recent decisions will result in little change to the reasons they lease. You should be knowledgeable on the nuances of the proposed rules so you can explain the impact to customers, and you should be reacting to the proposed changes in advance.

Evolution of the Project: The Outset

At the outset of the project the proposed lessee accounting model was to treat all operating leases as though they were capital leases, and to estimate likely renewals and variable rents to dramatically increase the amount capitalized. The impact on the balance sheet would have been a new asset and debt measured at amounts that could approach or, in some cases, possibly exceed the cost of the asset. On the income statement, the lease cost would have been higher, in total, compared to current GAAP due to the inclusion of estimated payments in the initial accounting for the capitalized leases. The pattern of lease cost would have been front loaded — as in capital lease accounting, as the expense elements would have been the sum of straight line depreciation and imputed interest on the lease liability. In the first half of the lease term the pattern of lease cost would have been higher than the straight line average of rents under the current GAAP model. The proposed model would not have portrayed the true economic effects of leases on lessees’ financial statements. Rather, it would have overstated the balance sheet amounts and mismatched the lease cost versus the use benefit in the lease.

The added debt from the capitalized leases would have caused debt limit covenants to be breached. This in and of itself would have caused lessees to delay equipment acquisitions and possibly not lease at all. The front-ended cost pattern would have been a drag on earnings and capital. The cost pattern combined with the increased assets and debt could have also impacted other debt covenants based on financial measures and ratios. The proposed model imposed tremendous complexity on lessee customers. Specifically, they would have to deal with estimating rents, booking the asset and liability, imputing depreciation and interest expense, and then continually adjusting the amounts when the estimates varied from actual results. That was not a pretty picture for new business prospects in the industry. The Equipment Leasing and Finance Foundation sponsored an economic study that predicted the changes would negatively impact the economy and employment in the same manner as would an increase in interest rates on U.S. businesses.

Evolution of the Project: Where We Are

Both the FASB and IASB agreed to simplify the project by eliminating the need to estimate likely renewals and variable rents. Further, the FASB listened to feedback and broke from the above single lease (capital lease accounting for all lease) model and reverted to a two lease model where operating leases would be capitalized but treated differently than capital leases. The former operating would be accounted for virtually the same under current GAAP for P&L cost purposes (i.e., the cost pattern would remain as the straight line average rent).

Additionally the FASB decided that the capitalized operating lease liability is not to be classified as debt; rather, it will be an “other” liability. As a result, debt covenants will be affected minimally, with no impact on debt limit covenants. These changes made by the FASB present the financial impact of operating leases more closely to the true economics of the transaction. The changes also eliminate most of the negative aspects of the proposed changes. The amount capitalized will be less than the equipment cost so there will still be an accounting benefit to leasing over borrowing to buy. The greater the residual assumed and the higher the tax benefits, the lower the capitalized amount. The question is, do customers understand all of this?

What should you do?

First, your sales staff should understand the details of the project. The project is close to completion (the transition is expected to begin in 2018) so we know all the major proposed provisions now. Conduct sales staff training on the details of the project and its impact on customers.

Second, you should be proactive with your customers to show, in an upbeat way, that the impact of the project is minimal. You should develop sales staff talking points on the current state of the project detailing how customers will be impacted. This will help the staff deal with potential customer objections. You should develop educational marketing materials and deliver them to customers. This will allay customers’ fears and may differentiate you from the competition as being a knowledgeable and trusted advisor. You should stress that the traditional reasons why customers lease will remain strong and viable despite the rules changes. The following grid illustrates my points:
Bosco-leasing-table

You should also review your lease structures against the proposed rules to see which products work best and where changes are should be made. You should also look at the impact on asset types and markets so that you focus on the areas where the prospects are best given the details of the proposed rules. There are positive and negative nuances in the proposed rules that need to be understood.

Conclusion

In my opinion, the prospects for the industry are good despite the proposed changes. We should see little impact on new business volumes from the changes. In fact, there could be some opportunities. Stay ahead of the curve on the project.

Bill Bosco is the principal of Leasing 101, a lease consulting company. Bosco has over 39 years experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the ELFA accounting committee since 1988 and was chairman for 10 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], www.leasing-101.com or 914-522-3233.

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