Structuring Leases Under Topic 842: Two Vital Issues to Consider

by Bill Bosco September/October 2017

Bill Bosco raises two Topic 842 issues to consider prior to implementation — the impact of financial measures and ratios and the new rules regarding sale-leaseback accounting. He discusses several challenging situations and offers potential solutions.

Bill Bosco,
Principal,
Leasing 101

Topic 842 brings two new considerations to keep in mind when structuring leases: 1) the impact on financial measures and ratios and 2) the changed rules regarding sale-leaseback accounting. While some elements of lessee accounting will change, many will stay the same, including the income tax aspects of lease structuring.

The accounting reasons for using an operating lease will still exist, but operating leases will no longer be off balance sheet. Operating leases will be partially off balance sheet with important financial reporting presentation benefits over borrowing to buy. The definition of a “sale” will change to align with the revenue recognition rules with major implications for sale-leasebacks with fixed price purchase options.

Traditional Structuring Process

Understanding and meeting customers’ tax and accounting needs will continue to be the key to structuring leases. The allure of an operating lease for most customers is its off balance sheet treatment. Customers will continue to expect this treatment for the non-debt liability classification and the straight line P&L cost, which lessens the negative impact of capitalization on ROA. The operating lease will remain partially off balance sheet.

A few rare customers want finance (capital) lease treatment, as it is more favorable to the EBITDA calculation, which subtracts interest and depreciation.

When it comes to tax benefits, the best structure for customers who want to pass tax benefits to the lessor would be a tax lease, and a synthetic lease is best for customers who want to keep tax benefits.

Figure 1 illustrates the thought process for determining the best structure for customers based on their accounting and tax objectives:

In my experience, most leases fall into the top two boxes where the customer desires operating lease treatment with either a true lease or a synthetic lease depending on the lessee’s tax position. Leases structured to fall into the lower two boxes are best for lessees concerned with EBITDA impact since finance/capital leases and conditional sales have depreciation and interest as their P&L cost and are subtracted from EBITDA costs.

Operating Lease Classification Importance

The lease classification tests are the same under Topic 842 as under FAS 13/Topic 840, consisting of four tests, with structuring to meet the present value test being the most important. The lease payments, as defined, must be less than 90% of the asset’s value. Although operating leases will be capitalized under the new rules, this will still be an important objective for most customers. As with a finance lease, the amount capitalized as an operating lease right of use (ROU) asset is the present value of the rents so the amount capitalized is less than borrowing to buy, which must be less than 90% of the asset’s value to pass the lease classification tests.

The operating lease liability will be classified as an other operating liability instead of debt, which will not affect debt limit covenants and should have a minimal effect on other financial ratios and measures. The cost pattern of an operating lease is better than a financed purchase because it is level. In a financed purchase, the cost pattern is front-loaded.The difference in cost is in the timing, but it is important. The first year difference is greater the longer the lease term (see Figure 2).

The Capitalization Calculation

To perform the capitalization calculation to book the lease, present value the lease payments as defined using the implicit rate in the lease, if known, or the lessee’s incremental borrowing rate. The booking/commencement date is the day the lessee takes possession of the leased asset. This new definition is important because the payments will clearly include any interim rents. Payments will also include charges a lessee can be required to pay, like a restocking fee for returned assets. The new rules will implore the lessee’s CFO and auditor to focus on lease classification and lease capitalization considering the payments that must be included since operating leases will be on balance sheet instead of merely a footnote disclosure.

The focus of auditors and CFOs may cause problems for lessors that use interim rents and restocking fees to reduce the stated rents to achieve operating lease classification. Previously, auditors only reviewed rents in the lease contract draft, which did not enumerate interim rent as it was unknown until the asset was delivered for the lessee’s use. Similarly, auditors often overlooked restocking fees buried in the clauses regarding end-of-term issues.

Possible Solutions

If lessors cannot reduce the contractual rents and payments using interim rent and restocking fee tactics, they must find other solutions to ensure the lease payments are less than 90% of the asset’s value. One solution is to add a CPI escalator clause to increase rents annually at the rate of change in CPI and reduce quoted rents by the amount the lessor conservatively expects to receive when CPI changes. The CPI clause is considered a variable rent and is not included in the classification tests or in the initial lease capitalization (meaning the amount capitalized will be lower).

The benefit of assuming a 3% CPI increase every year in a three-year PC lease is a benefit of 119 basis points that can be used to reduce quoted rents. This involves taking some risk, but my research indicates over the last 15 years CPI increased an average of 4.3% with the highest year being 7.9% and the lowest a decrease of 2.7%. I suggest assuming 3% and using an “earnings-at-risk approach” that limits the amount of CPI deals to minimize any aberrations. The CPI deal portfolio performance would be monitored to ensure the assumptions are working.

Another solution is to ask lessees to provide a partial residual guarantee that is a “band” set at a strike price below expected fair market value at expiry but higher than the assumption of residual value used in the pricing. Many lessors have pricing policies that set residuals at a percentage of expected FMV, such as 70%, so I suggest the lessee guaranteed residual band set at 10%, covering the residual band from 70% to 80% of expected FMV. This allows the lessor to assume 80% of FMV residual in its pricing, counting on the lessee guarantee. The rents quoted to the customer could be reduced, keeping the desired pricing yield. I estimate the benefit to be 104 basis points in a five-year CAT scanner lease. The residual guarantee is considered for classification so the PV of payments including the residual guarantee must be less than 90% of cost. The guarantee is not considered a lease payment for a capitalization except to the extent there is an expectation of payment. There would be no expectation of payment if the strike price is set at an amount below the expected FMV.

Sale-Leasebacks

The new rules change the view of equipment sale-leasebacks with purchase options. If the leaseback contains a fixed purchase option, even if it is a non-bargain purchase option, there would be no sale under the revenue recognition standard’s theory that the lessee/customer “controls” the asset through the option to buy it back so the lessee is deemed to have never sold the asset. This is a big change, and many equipment leases are sale-leasebacks. The rules will allow sale treatment for fair market value purchase options where the equipment is not specialized, but a FMV purchase option is not as attractive as a fixed purchase option. Any sale-leaseback that fails sale treatment is accounted for by leaving the asset on the seller/lessee’s books and recording the leaseback as though it was a loan/debt. Clearly, lessors and lessees need to avoid this outcome.

Two methods, both involving working with your customers in advance of a contemplated transaction, will avoid the undesired outcome. The first approach is for the lessee to identify the lessor before committing to buy the asset and before making any down payments or progress payments on the transaction. This avoids a sale-leaseback all together. The second method is for the lessee to sign an agency agreement with prospective lessors stating the lessee is acting as an agent of the lessor and not a principal. An agent is not responsible for providing the asset to be sold and leased back, takes no inventory risk and does not set the price (the price would be the asset cost) or have a profit element other than a fee, if any, for services.

Conclusion

The new lease accounting rules must be studied and adjustments must be made to ensure the pitfalls of sale-leaseback rules and the increased audit focus do not cause a lessor’s offering to disqualify for operating lease treatment. By 2019 it will be essential to make sure your products continue to provide lessees with the best accounting outcome. The ideas of the residual band and CPI escalator could be implemented now and the benefits would carry over for lessee customers when they transition to the new rules. The benefit would be booking a lower amount of new ROU assets. This could be a selling point to differentiate your offering from the competition.

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