As we celebrate 40 years of great industry reporting by the Monitor, let’s look back at what was happening in the lease accounting world in the winter of 1973. One maybe not so major event for all of you, but important to me, was that I was interviewing for a job in the accounting department of Citibank’s leasing division. At the time I had no leasing experience — I did not even know how to spell ITC.

More importantly, the FASB and staff were about to issue a Discussion Memorandum requesting public comment on their thoughts behind a new set of accounting rules for leases that would ultimately result in the issuance of FAS 13, so important to the development of our industry. The prevailing accounting for all leases for lessees was off balance sheet accounting with disclosures required for long-term leases under Accounting Research Bulletin (ARB) No. 38, Disclosure of Long-Term Leases in Financial Statements of Lessees issued in 1949. The concern was to disclose long-term operating lease obligations under the theory that they were a debt-like instrument and “are material facts affecting judgments based on the financial statements of a corporation.” There was no concern for accounting for assets created by the lessee, and short-term leases were not included in the rule. In September 1964, the Accounting Principles Board (APB) issued Opinion No. 5, Reporting of Leases in Financial Statements of Lessee, which replaced ARB 38, and required capitalization of leases where the lease was in substance a financed purchase of the leased asset as evidenced by an “equity” position acquired by the lessee. Examples of an equity position are excess rent payments above the fair value of the asset, bargain renewal and purchase options and specialized nature of the property.

In May 1966, the APB issued Opinion No. 7, Accounting for Leases in Financial Statements of Lessors, which was the first standard to deal explicitly with lessor accounting. Opinion 7 adopted a model for finance and operating lease accounting based on an analysis of risks and rewards that has carried through to FAS 13, but with much more detail. The primary focus was to allocate “revenue and expense to accounting periods covered by the lease in a manner that meets the objective of fairly stating the lessor’s net income.”

In November 1972, the APB issued Opinion No. 27, Accounting for Lease Transactions by Manufacturer or Dealer Lessors, to clarify issues regarding when a manufacturer/dealer should recognize sales profits in a lease. Opinion 7 introduced the FAS 13 classification tests, in almost the exact form that survives, to determine when an “in substance sale” has taken place. In that case, the lease is accounted for by the lessor as a financing with a gross profit on sale recognized up front.

In November 1972, the SEC issued ASR No. 132, Reporting of Leases in Financial Statements of Lessees, requiring a lessee to capitalize leases that were in substance financed purchases. The SEC urged the FASB to place lease accounting high on its agenda, thus accelerating the process to develop FAS 13. The SEC also clarified classification tests and lessee accounting and expanded disclosure requirements for lessees in ASR 147, issued in October 1973. The pace of changes to lease accounting was increasing just as the Monitor was being created.

Today

Four months after I started working for Citicorp Leasing, in July 1974, the Financial Accounting Standards Board issued a Discussion Memorandum, An Analysis of Issues Related to Accounting for Leases. After two exposure drafts, ultimately FAS 13 was issued in November 1976. In my opinion it helped our industry greatly as it codified concepts that very closely match the economic substance for both the lessee and lessor (with a few exceptions). It meant that the financial statements of both lessees and lessors very closely reflect what lessors were pricing and structuring, including the transfer and or retention of asset risk and tax benefits and what benefits lessees were receiving and what they were obligated to pay.

The four classification tests for lessees are in line with the U.S. legal and income tax view of leases. Specifically they are designed to determine if the lessee in fact or in effect has received the rights of ownership and is obligated to make payments under the leases as in a debt instrument. Those leases where the rights equate to ownership rights are capitalized as a tangible asset and debt (aka a capital lease). If the lessee is in a position of merely obtaining the temporary right to use the lease asset the transaction is viewed as a “true” lease and not a financed purchase, such that no asset or liability is recognized. In other words, in substance the lessor remains the owner and the obligation to pay rent and receive use are executory — the lessee is merely “renting” the lessor’s asset. Rent is reported as the lease expense. Clear disclosure of future lessee obligations under operating leases are required as a footnote. The footnote is an integral part of the financial statements and is audited information. The analysts and lenders all understand the nature of leases, and they have developed procedures to calculate information to include in or adjust the key metrics upon which to base their lending and ratings decisions. The difference between leases that are rentals and financing is basic to their bankruptcy risk evaluations. This is where the “rubber meets the road” in lease accounting and financial reporting — the practical every day uses of financial information regarding leases.

The U.S. legal view of leases evolved as a subset of the Uniform Commercial Code (UCC) Article 2 rules regarding the legal view of sales and in contrast to UCC Article 9 that deals with secured financing transactions. Article 2a was a 1987 amendment (further amended in 2003 with a reminder to us all that “Leasing is distinctive”) to the UCC rules that addresses leases in response to equipment leasing activities that emerged in the 1950s and grew dramatically in the 1960s and beyond, becoming a large and important industry in the U.S. economy. Its basic framework is a risks and rewards framework similar to FAS 13 to determine when a lease is a sale (financing of the leased asset) or lease where ownership of the leased asset does not transfer via the terms of the lease. These are important distinctions in bankruptcy and liquidation scenarios to determine which assets are owned or leased and which obligations are treated as debt or those that are executory and disappear when the asset is returned to the lessor as a result of the bankruptcy procedures.

The U.S. income tax view also tracked the history of leasing starting in 1955 with revenue ruling 55-540 dealing outlining factors to be used to distinguish true leases from sales (conditional sales and leases that are in substance financings if the purchase of the lease asset) to determine which party to the lease is entitled to benefits of ownership (depreciation and tax credits, if any). In 1975 a revenue procedure 75-21 was issued (amended in 2001) to provide ruling guidelines for leveraged leases that is used as a guide for all true leases by lessors to ensure they structure leases to meet a desired tax treatment. Again the four basic FAS 13 tests are in line with the tax guidelines.

For lessor accounting, leases are either direct finance leases or operating leases based on the classification tests. Direct finance leases are recorded as financings, while operating lease accounting leaves the asset on the books of the lessor and rent and depreciation are the P&L items. Leveraged leases and sales type leases are forms of direct finance leases.

Tomorrow

We are in the throes of the development of a joint FASB/IASB project to change accounting worldwide using a new approach to lease accounting. However, the project was expanded to completely overhaul both lessee and lessor accounting. This not only added a great deal of complexity, but also served to misrepresent the economics of equipment leases on the lessee’s financial statements. In the opinion of many, capitalizing of operating leases is a worthy objective. However, the rest of lease accounting has been working effectively, i.e., reflects the economics of a lease, is simple and well understood. The project is very controversial as evidenced by the 579 comment letters received to date on the second exposure draft with the vast majority being negative.
My predictions on where we will end up are:

• Operating leases will be capitalized but the assets and liabilities of the former operating leases will be separately presented on the balance sheet;
• The P&L cost will be the straight line average rent;
• Sadly, we will likely lose leveraged lease accounting;
• Lessor accounting will be based on business model — operating lease accounting for “operating” lessors and finance lease accounting for “finance” lessors; and
• The accounting and transition rules will be simplified.

I also predict that the “center of the plate” leasing business to small and medium-sized and non-investment grade lessees will be virtually unchanged, as they need the product as a means of acquiring the use of assets without tapping their bank credit or owners’ capital. Leasing to investment grade companies will also flourish where the reasons for leasing are related to the use of the asset, outsourcing services and tax reasons — and even the accounting reasons will survive as the rules capitalize the PV of the payments — not the cost of the asset. Our great industry will do just fine no matter what the regulators throw at us.

The ELFA, the Monitor and leasing industry have been diligent in getting the word out regarding the proposed changes and issues. As an industry, we’ve vigorously responded with our feedback to the FASB. I am an optimist (there is a saying: “the pessimist may be right, but the optimist has a better time on the trip”), so I think we will have done what it takes to fix the big issues we have been fighting for.

Bill Bosco is the principal of Leasing 101, a lease consulting company. Bosco has more than 37 years of experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the EFLA accounting committee since 1988 and was chairman for ten years. He is a frequent author and speaker on leasing topics and 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.