WLN Columns

Through the Looking Glass: The Lease Product Continuum under the Proposed Leases Project

The joint FASB/IASB (“Boards”) Leases project is entering the final redeliberations phase, with the goal of issuing a revised Exposure Draft (ED) in November 2011 for a 120-day comment period. At this time, it appears the Boards will likely issue their new standards in mid-2012 with an effective date in 2016. For comparability purposes, the new standard will generally require restating the accounting for outstanding leases in all prior periods presented. As of the date of this article, the Boards have not yet redeliberated on the method(s) to use in restating outstanding leases. The Boards had previously proposed partial restatement, an approach which generally only considers remaining future cash flows. In the context of comment letters and subsequent analysis, the Boards will likely consider allowing full restatement.

With the FASB’s decision to eliminate leveraged lease accounting, the new ED will likely propose no grandfathering of leases for lessors (other than short term leases). For lessees, the proposed ED will likely limit grandfathering to capital leases that do not have options, contingent rentals, term option penalties or residual guarantees and short term leases.
This article examines the likely effect on the proposed accounting for newly originated triple net equipment leases across the main part of the lease product continuum based on the tentative decisions reached by the Boards as of July 2011.
$1-out leases and leases intended as security. These leases convey eventual ownership from the lessor to the lessee by the end of the lease term and, under US commercial law, constitute secured transactions. Such leases are currently within the scope of FASB 13 and are generally capitalized based on the transfer of ownership (title) or the bargain purchase option criterion. As intended, the current accounting for such lease is the same as the purchase/sale of an asset for a note or as a loan.

The original ED proposed to exclude such leases from the scope of the new standard under an “in-substance purchase/sale” provision. This provision specifically proposed that leases which automatically transfer ownership (title) by the end of the lease term or extend a bargain purchase option to the lessee and transfer all but a trivial amount of the risks and benefits associated with the underlying lease should fall outside the scope of the new standard. This scope exclusion would not have changed the lessee’s or lessor’s accounting for the arrangement – the amounts reflected on the balance sheet and in income over the lease term would be the same whether the arrangement was within the scope of the leases standard or treated as a purchase by the lessee and a sale by the lessor.

By removing such leases from the scope as initially proposed, it would allow the lessor and lessee to elect the fair value option for the lease receivable and the lease obligation, respectively. From the author’s point of view maintaining this scope exclusion would have properly placed the focus of the new standard on leases that meaningfully allocate the risks and rewards of ownership between the lessee and lessor (e.g., true leases).

In redeliberations, the Boards tentatively decided to eliminate the scope exclusion. Given that the Boards have also tentatively decided to generally apply a single financing method of accounting to all leases from the standpoint of either party (the “right-of-use” model for lessees and the “receivable and residual” model for lessors), a scope exception no longer appears necessary. These proposed financing methods would produce the same accounting and reporting results as the existing GAAP for both parties, including ineligibility for the fair value option. Moreover, it would result in a new standard covering the entire continuum of leases, although the pending revenue recognition standard could bring “in substance purchase/sale” leases under its scope in the final analysis.

Full TRAC leases. These leases contain a terminal rental adjustment clause under which the lessee is contingently liable if the lessee returns the property to the lessor and the proceeds of sale of the subject equipment is not sufficient to fully satisfy the stipulated termination amount. Since the strike price of the stipulated amount is generally set at the estimated fair value of the residual, such leases today are generally capitalized based on the present value of the minimum lease payments, including the residual guarantee, not to exceed fair value of the leased property.

FASB 13 currently displays the full amount of the guarantee, measured on a present value basis at lease commencement which accretes thereafter to the full nominal amount by lease end. It also displays the interest each party has in the estimated residual value in relation to the strike price. If the lessor has the right to any excess above the strike price, it considers such interest in determining its estimated residual value. If the lessee has the right to the amount above the strike price, it will depreciate the capitalized leased asset down to the estimated residual value.

To illustrate, FASB 13 contains an example of a full TRAC lease originated by a third party lessor, initially capitalized at the fair value of leased property ($5,000) and scheduled to terminate on the basis of a strike price set at estimated residual value ($2,000) with the lessee having the right to receive any amount above the strike price. Assuming no adverse change to the estimated residual value, the lessee would depreciate the leased asset to its estimated residual value ($2,000) and apply the effective interest method to the capital lease obligation in such a way that it is left with the residual value guarantee ($2,000) as a balloon payment at the end of the lease. This accounting reports the lessee’s interest in the estimated residual value at the end of lease, with which it will use to satisfy the residual value guarantee. In the FASB 13 example, the sale proceeds ($2,100) exceed the strike price, resulting in the lessee netting off the then leased asset and obligation ($2,000 each) and recording $100 gain on disposal of the leased property.

Assuming full TRAC leases do not qualify as sales under the Boards proposed revenue recognition standards, under the proposed new accounting, the lessee and lessor would only capitalize the amount expected to be payable under the residual value guarantee. Hence, if the residual value guarantee were set at estimated residual value, the lessee would only record the present value of the lease payments ($3,517 assuming the lessor’s implicit is used as the discount rate) and the lessor would record this same present value as its receivable and the balance of its investment in the lease as an accretable (earning) estimated residual interest ($1,483). As a result, the TRAC lessee would record only about 70% of the amount it currently does under FASB 13, and its interest and guarantee in the estimated residual value would be reported “off balance sheet.” The lessor would end up reporting about 30% of its initial investment as its estimated residual value (a non financial asset) and commensurately reduce the amount subject to credit risk analysis. In such a shifting the lessor would have significantly less of its investment eligible for accounting monetization (i.e., transfers of financial assets).

With respect to split TRACs and synthetic leases where the strike price is set at fair value, unless the subject transaction contains a purchase option with a “significant economic incentive to exercise,” the lessee and lessor would only capitalize the present value of the rental payments. The lessee would similarly report its residual value interest and guarantee “off balance sheet,” while the lessor would report an economically disproportionate amount of its investment as non financial. Again, the outcome of the revenue recognition project may affect the ultimate accounting treatment.

Tax leases. With the proposed elimination of leveraged lease accounting, no leases will report the time value benefits of deferred taxes as part of the lessor’s yield. By accounting for the pre-tax economics separate from the tax benefits in all circumstances, tax leases will exhibit significant variability in their investment performance relative to the priced (cash on cash) performance. The greater the lessor’s reliance on available tax benefits, the greater the variance will be. For single investor leases, the lessor’s accounting will likely remain unchanged. The reported spread and returns generally will trend from significantly less than the priced spread and returns in the early years and significantly greater in the later years. This variability reflects the building up of deferred taxes (an interest free loan) over time, which implicitly serves to lower the lessor’s cost of carrying the lease. For leveraged leases, where the tax benefits drive the pre-tax rate near the risk-free rate, lessors generally will report pre-tax losses through the majority of the life of the investment.

Since tax leases are generally longer dated to achieve deferred tax benefits and generally contain limited or no residual value guarantees, the lessees in such transactions would generally capitalize close to 90% of the fair value of the leased property. Based on initial simulations undertaken by the major software vendors, assuming the Boards respond to preparer comments and allow for full retrospective restatement, third party lessors with mature portfolios who generally account for such leases as direct financing leases should see little or no change to the accounting. These simulations raise a threshold issue if the benefits of lessor rebooking exceed the cost.

The proposed accounting views all leases across the continuum as financing transactions. However, as discussed below, independent scope decisions have created anomalies in the application of this view with respect to debt-like leases, such as $1-out leases and leases containing a bargain purchase option, full TRACs, and synthetics. The Boards have not sought to change the accounting as the magnitude of the consideration exchanged between the parties increasingly involves residual value and tax benefits. Accordingly, the proposed accounting only brings the resulting pre-tax economics into clear view.

The proposed accounting for debt-like leases remains similar to, but not identical, to equipment loans. Unlike such loans, fair value accounting would neither be permitted nor required f even when the rights and obligations are essentially identical as, for example, under US commercial law. Today, no leases are eligible for the fair value option. In the future, assuming debt-like leases remain outside the scope of the financial instruments project, the lending side of a financial institution will need to affirmatively support its accounting for loans (fair value vs. amortizing cost) based on its business strategy, while the leasing side will not have a symmetrical requirement. Some commentators believe this asymmetry may be resolved through the revenue recognition project.

The proposed accounting, based on expected payments, views all or a significant portion of a guaranteed residual value s supported by a terminal rental adjustment or similar provision as properly reported “off balance sheet” from the standpoint of the lessee and as properly reported as an unguaranteed residual position from the standpoint of the lessor (at least on the face of the balance sheet). The author believes the current GAAP view, which presents each party’s interest in the residual and its relationship to the guarantee, to be a more representational faithful view of the economics.
With respect to tax leases, the proposed accounting would continue the practice of not bringing the exchange of residual value and tax benefits for lower pre-tax rentals into view as an integral part of tax leasing. From the author’s view, the elimination of leveraged lease instead of the extension of the method of recognizing lease income based on the pattern of after-tax cash flows leaves the accounting for tax leases distorted.

From a big picture perspective, the author believes the proposed accounting will be only understandable to those who view the product spectrum through an accounting lens, instead of anticipating the accounting conventions will mirror the economics. The Boards’ decision to issue a new ED gives interested parties another opportunity to comment in the interest of better aligning the accounting and economic viewpoints.