FASB has issued a proposed accounting standards update intended to improve three areas of the leases guidance. How will this update affect equipment lessors?

O’Sullivan: There are three proposed amendments in the Exposure Draft that the FASB has asked the public to comment on by December 4, 2020. One item impacts only lessors, another item impacts only lessees and the third item impacts both lessors and lessees.

One of the proposals would impact equipment lessors with sales-type leases when the rental payment structure is made up primarily of variable lease payments that are not based on a rate or index. An example is an equipment lease in which the lease payments are based on usage activity (e.g., rate per hour of use) that can vary from period to period. For a sales-type lease, upon commencement a lessor derecognizes the underlying leased asset and records a lease receivable, which represents the present value of future lease payments. Under current guidance, the lessor does not include variable payments that are not based on a rate or index in the calculation of the lease receivable.

When a lessor has a sales-type lease that is made up primarily of variable lease payments that are not based on a rate or index, they could face a situation in which the carrying value of the underlying asset that is derecognized is greater than the calculated lease receivable amount, resulting in recognizing a Day 1 loss at commencement. The FASB proposal would require lessors to classify leases that are made up predominantly of variable lease payments that are not based on a rate or index as operating leases. As lessors do not derecognize the underlying leased asset in an operating lease, no loss would be incurred at commencement.  The recognition of a Day 1 loss when the payment terms are primarily variable in nature has been an area of frustration for many lessors, as they have indicated the accounting does not represent the economics of the transaction.  Therefore, this amendment to the standard should be well received.

The other amendment proposed in this Exposure Draft that impacts equipment lessors relates to changes in lease modification accounting. Under current guidance, when a contract that includes multiple lease components (e.g., a master lease agreement that governs the terms for multiple leased assets) is modified to terminate some (but not all) lease components early, both the lessor and lessee are required to apply lease modification accounting to the remaining lease components that were not terminated.

Modification accounting requires the lessor and lessee to reassess the classification of the lease and remeasure the lease liability, which can be burdensome given the need to reassess the discount rate, and determine the asset fair value and asset economic life for multiple lease components. The proposal in this Exposure Draft would exempt both lessors and lessees from the requirement to apply modification accounting to the remaining lease components if they have not been economically affected.

2) How will the proposed changes impact the customers of equipment lessors?

O’Sullivan: The proposed amendment discussed above regarding modification accounting is also applicable for lessees. Therefore, customers of equipment lessors, i.e. equipment lessees, would also be exempt from applying lease modification accounting if a contract that includes multiple lease components is modified to only terminate a portion of those lease components early and the remaining lease components have not been economically affected. This exemption would allow lessees (i.e., customers) to continue accounting for the remaining lease components as originally set up at commencement, saving the costs and complexity of having to perform a full remeasurement and reclassification during the lease term.

The final amendment proposed in the Exposure Draft, which applies only to lessees, could impact customers of equipment lessors. Current guidance requires lessees to include variable payments that are based on an index or rate (e.g., payments that fluctuate based on inflation rate indices) in the calculation of the lease liability balance using the rate in effect at the commencement date. ASC 842 does not allow lessees to remeasure the lease liability when the only change to their lease is due to subsequent changes to the index/rate, and instead a lessee recognizes these changes through variable payments.

However, IFRS 16 requires lessees to remeasure the lease liability each time there is a change in the index or rate (rather than account for these as variable payments). That means that lessees that report under both US GAAP and IFRS have to apply different accounting treatment to the same lease, which can be costly and time consuming. In the Exposure Draft, the FASB proposes giving lessees the option to mimic the IFRS requirements and remeasure their lease liabilities at the time of a change in the index/rate they are based on. This option is likely to be welcomed by companies that report under both US GAAP and IFRS as it should bring efficiencies to companies who report under both standards.

In your opinion, will the proposed changes impact the equipment finance industry in a positive or negative manner?

Stevenson: I wouldn’t characterize the impact of the proposed changes on the equipment finance industry as “positive” or “negative” since they’re unlikely to affect the majority of companies in this sector. This ASU discusses a change for lessors whose lease payments are predominantly (more than 50%) variable, and historically, most equipment finance companies do not typically use this type of payment structure. However, those that do would now be required to apply operating instead of sales-type lease accounting, thereby recognizing Day 1 sales-type losses. The FASB proposed the changes with the intent to ease the accounting process for organizations as well as reduce or eliminate the recording of Day 1 losses. Day 1 losses could occur when a large portion of the lease payments were variable and consequently, unable to be included in the Day 1 calculations of gain or loss on a sale.

Trying to structure the lease arrangements whereby the leases will be required to be accounted for as operating leases could ultimately prove to be a simpler method and has the potential to help companies recognize their cash flows on a more predictable pattern, absent large fluctuations in expected amounts derived from variable lease payments. This may present an opportunity for lessors to structure their lease payments for the results they want to have in terms of earning profit based solely on a fixed basis.

4) What should equipment finance companies do to prepare for this proposed ASU?

Stevenson: From a lessor perspective, to prepare for this proposed ASU, it is important that equipment finance companies first assess what population of their leases would fall into this category impacted by the proposed ASU. Lessors should establish a team to consider if the proposed change impacts the organization to begin with. If there is no impact, there is not much to think about. If there is, decision-makers should determine if the company wants to take a different approach to structuring lease arrangements to achieve a different result.