The leasing industry is driven by frequently changing forces. The key factors influencing leasing are accounting rules, tax law, funding availability, interest rates, commercial law, regulations, technology and economic cycles. The industry has always been nimble, adapting to each new challenge while continuing to grow.

When the Monitor 100 began, the industry was using FAS 13 accounting rules and was ruled by the 1986 tax act with MACRS depreciation and ITC eliminated. Regulations were fairly stable, but technology was rapidly changing. The U.S. economy had just taken a hit with the savings and loan crisis.

Accounting Environment — Then and Now

Financial Accounting Standard 13 (now known as ASC Topic 840, soon to be replaced by Topic 842) created a great environment for both lessees and lessors. For the lessee, the lease classification rules were clear and easy to understand. Operating lease treatment was the main lessee objective, as that resulted in off balance sheet treatment and straight-line lease cost equal to the average rent paid over the lease term. That combination created the best Return on Assets (ROA) result for lessees, which is an important measure for investors.

The “present value” classification test was the key to achieving operating lease classification, and the present value of the rents had to be less than 90% of the asset’s cost or fair value. This was easy enough to achieve with assets that held their values because, if the lessor could assume a residual that is high enough to present value to 10.1% or more of the asset’s cost/value, that lease was an operating lease. In the late 1970s, some creative minds created the synthetic lease structure for equipment leases of common, easy to replace equipment (like auto and truck fleets), which included a minimum short term with the right to renew or cancel. The lessee guaranteed a portion of the residual, just enough to ensure that the present value of the guarantee and lease payments was less than 90%. The structure was also applied to TRAC leases in the form of a split-TRAC with a partial residual guarantee. The structure spread to other equipment types too. The product was even applied, on a leveraged basis, to real estate leases.

The market for synthetic real estate and equipment leases continued to grow, as it was low-cost off-balance sheet financing where the lessee could keep the tax benefits. The FASB issued rules targeting large synthetic leases with thinly capitalized SPEs as the lessor, but the market responded by quickly adopting a structure with the lessor being a “normal” leasing company.

The Enron bankruptcy, caused in part by off-balance sheet SPEs “sold” by Enron while it guaranteed the equity and debt, prompted Congress to pass the Sarbanes-Oxley act in 2005. This legislation directed the SEC to look for other off-balance sheet transactions, and Congress found that operating leases were a large off-balance sheet item. The Enron bankruptcy and subsequent scandal was the result of failure to account for the SPEs. In turn, operating leases came to the attention of the FASB and IASB. Those setting the accounting standards had been questioning whether operating leases should be capitalized formally.

A study written by the G4+1 (a group of standard setters) in 1995 and 1999 recommended a “right of use” approach. The 2005 SEC report gave the accounting groups the impetus to put a joint lease accounting change project on their agendas. It took 11 years to finish the project, and they split on lessee accounting with the result that IASB and FASB issued separate standards. The FASB version is the superior version, in my opinion, as it retains the concept from a commercial law perspective of a two-lease model that acknowledges some leases are financed purchases while operating leases are clearly not. That is an important distinction for lenders and credit rating agencies, as operating leases are not debt (the lessor gets its asset back and has no claim for the remaining obligation to pay rent).

Twenty-five years later, where we do stand with the new rules, which must be implemented by public companies in 2019 and private companies that issue audited statements in 2020? In my opinion, we will see little impact. Operating leases will be capitalized only to the extent of the present value of the lease payments, the obligation will not be presented as a debt on the balance sheet and the lease cost will remain as the straight-line average rent. The accounting benefit is partial off-balance sheet, and the result is better ROA than borrowing to buy. The other reasons for leasing remain unchanged. The favorable outlook is due to the ELFA and other industry participants tracking and actively commenting on the project as it evolved. The initial approach would have been disastrous, as the operating leases would have been treated as capital leases, that is, as debt on the balance sheet and a front-ended cost pattern.

Tax Environment – Then and Now

Tax rules and tax benefits have been key to the benefits of leasing. The 1986 tax act took away ITC and generally lengthened depreciation lives by watering down tax benefits. In addition, Treasury note rates have dropped from about 8% 25 years ago to about 2% now, further hurting tax lease pricing as tax benefits are based on the time value of money. Economic cycles, including the saving and loan crisis, the internet bubble, the Enron/WorldCom bankruptcies and the sub-prime mortgage crisis, all hit the tax base of potential investors in tax leases, creating cycles, which lacked lessors with tax capacity. The early news on the FASB lease accounting project was that leveraged leases would be eliminated as a structure with no grandfathering, which basically killed that market. We now know existing leveraged leases will be grandfathered.

Lilos and Silos had a brief heyday with about 400 very large ticket deals done. They were creative and complex structures that took advantage of tax laws to “create” tax benefits in transactions with tax-exempt lessees (government or foreign entities not subject to U.S. income tax). The transactions created large fees and present value savings for lessees. The IRS cracked down on these transactions, claiming they lacked economic substance. Settlements were offered that many lessors accepted, but some sued the IRS. Virtually all the lessors lost the suits.

I must include the TRAC lease, which was officially created by Congress in 1983 (the structure had been offered since the 1940s) as the only lease structure that has a first loss lessee residual guarantee while it remains a true lease. TRAC leases apply only to licensed over-the-road vehicles and are the primary structure (usually in a split TRAC form) used to finance autos, trucks and trailers used by businesses in the U.S. Volumes have continued to grow, and it may be the best lease product because the lessee gets operating lease treatment and the lessor has negligible residual risk while still taking the tax benefits. I think it was allowed by the IRS to support the vehicle business in the U.S., which is such a large part of our economy.

One piece of good tax news is that ITC is available for certain alternate energy assets and those assets are leasable. Since current GAAP is silent regarding the treatment of ITC, other than in a leveraged lease, lessors have been leery. “Flowing through” the ITC as a credit to tax expense distorts the accounting yield on these transactions. Though amortizing the ITC as revenue is the desirable method, and most often used in practice, it always took some renegotiating with the auditors to get them to agree. Fortunately, the new accounting rules will allow amortizing the “grossed up” ITC as revenue. This is a major win and can be attributed to the ELFA lobbying and a few lessors who chose to comment.

Securitization

The non-bank lessors, like captives, finance companies and independent lessors, got a major lift when securitization of lease receivables began in the late 1980s. This created a huge new source of cheap financing. Formerly those companies got their funding from banks, their own equity or by issuing bonds if they could get a credit rating. In 1983, the FASB issued FAS 77 that codified the rules on securitizing/participating out-lease receivables so that the securitization was offbalance sheet. The rule even allowed the “seller” to give some recourse. One huge benefit was allowing certain special purpose entities called Qualified SPEs to not be consolidated for accounting purposes yet still be consolidated for U.S. income taxes. SPEs are used in structuring securitization. The use of a QSPE allowed lessors to keep the lease tax benefits while funding the lease receivable “off-balance” sheet. The FASB revised the securitization rules several times, eliminating the use of QSPEs, among other changes. Currently some transfers of financial assets/securitizations are still off-balance sheet, but many are not. The low cost remains a big benefit.

Other Issues

I have seen the results of over-regulation in several areas. The increased required regulatory capital has had the biggest impact. Twenty-five years ago, banks carried 4% capital but the various iterations of the Basel rules have upped that to more than 10%. It is hard to get an attractive ROA/ROE for investors with the high capital requirements. PCs, software, systems and communications advances have enabled the industry to reduce costs, improve productivity and meet customer needs. I am old enough to remember when our lessor lease management system could not handle a floating rate lease. I can also remember using a home-grown leveraged lease pricing system. I priced an acquisition on a “portable” PC the size of an old sewing machine using Lotus 123 and each iteration took five minutes to run, giving me time to pour a drink, sit back and relax.

Conclusion

I have been around long enough to see huge changes in the industry — almost all positive. The Monitor is one of those positive changes. I started in the industry in 1974 reading the newsprint version of the Monitor. The Monitor magazine publication and online version have matured to be an important source of hard information for the industry. I am honored to be a part of it.