Exposure Draft Accounting

It is not news that the proposed new lessor and lessee accounting rules as laid out in the recent exposure draft present a variety of challenges to equipment lessors and lessees. In our experience so far, the bulk of attention has been paid to the implications of the new rules on financial reporting, capital requirements and market acceptance of equipment leasing as a product. This emphasis is understandable ' both lessors and lessees want to know what their books are going to look like, and what effect that new look will have on their need for and ability to raise capital. Further, especially among equipment lessors, there are varying degrees of anxiety over the degree to which equipment leasing will continue to be viable.

Since August, the large lessors with whom we work have concluded that the proposed reporting requirements and the resulting capital issues are not, for the most part, intolerable, and that leasing will remain a viable product. While the proposed rules will exact a price in increased operating costs and marketing uncertainty as lessees reassess their equipment financing decisions, business will not cease, the sky will not fall. On the lessee side, the new rules add some economic friction costs to leasing. Whether such costs are sufficient to drive business away from leasing as a finance option to borrowing or cash remains to be seen, but the emerging consensus among large equipment lessors is that leasing will remain a viable product.

Second-Tier Issues

With those primary, corporate life-or-death issues at least contingently resolved for now, companies can turn their attention more to second-tier issues. Among these secondary issues are several key operational issues. The exposure draft's movement away from “bright line” accounting will, at least in the short- and mid-term, require lessors to create new classification rules specific to their businesses and products. For example, in order to properly forecast and budget, a company creates financial products that fit a certain accounting profile. Historically, that meant that a firm would define offerings as Operating Leases, Direct Finance Leases or Loans ' every product had to fit one and only one of these classifications, forecasts for which then flowed through from quoting to pricing to credit to booking and on through to the financial statements, which then feed into Treasury's borrowing plans. Ultimately, a lessor's ability to forecast profits, taxes and funding needs hinges to a large extent on knowing what characteristics its various financial product offerings will have once they reach the books. Then, when real transactions do hit the books, they must be processed correctly according to how they are classified. “Bright lines,” whatever their theoretical drawbacks, provide certainty to the operational task of classifying each transaction correctly.

Under the proposed new rules, there are no bright lines. Lessors can classify a lease transaction as either a Performance Obligation or a Partial Derecognition lease. These two products perform very differently on the balance sheet, in a way similar to the different performance of Operating leases and Direct Finance leases. Keep in mind also that the huge bulk of equipment finance transactions are smaller “cookie-cutter” deals ' the amount of profit associated with them precludes the possibility of having an accountant make a classification ruling on each deal individually. The classification process must be automated. IT Systems must be able to accommodate classification rules automatically.

Each lessor is faced with creating and defending principle-based classifications that are unique to that lessor. This requirement has two parts. First, management must decide what the rules will be: Is 10% residual risk “insignificant”? Fifteen percent? Five percent? For this line of business only, or for all lines of business? And so on. Then, whatever the decision, IT systems must embody it. For example, whenever my sales force quotes lease financing to a prospective lessee, the system must know that the quote is for a Partial Derecognition lease, and that classification information must flow through to the accounting system. The accounting system must then be able to generate accounting streams according to the new rules for Partial Derecognition leases, and allow for rebooking to account for any mid-term changes, again under the new rules.

While life is to some extent simpler for lessees insofar as they do not need to classify the lease and do not need to track its sales process, they still must now account for it under the proposed new rules, which it is safe to say are at least an order of magnitude more complex than existing rules. Many lessees are used to the utter simplicity of accounting for an operating lease under the old rules ' those days are numbered.

The First Challenge

So the first IT systems challenge is: Can my systems handle the new accounting? The accounting system itself is rightly the biggest concern, but, for lessors, the origination system that handles the flow of potential business from quoting to pricing to credit to documentation and booking must also be able to accommodate the new rules to at least some extent. The major players in lessor accounting are, of course, working to make sure their systems can perform under the new rules. It behooves lessors to make sure their providers can, in fact, meet their requirements.

We have heard much less about how lessee accounting systems are planning to accommodate the proposed rules. It is not safe to assume the new requirements will be met on the lessee side. They are extensive and, to a large extent, dissimilar from other lessee accounting processes ' the expected term, present value calculations and rebooking requirements are all very different from what an off-the-shelf lessee accounting system is required to provide today. Lessees need to make sure their providers are on top of these requirements, and to be specific about them ' do not accept vague promises that it will be there when you need it. Trust, but verify.

No Grandfathering

Next, the proposed rules do not allow for grandfathering. Lessors and lessees are expected to retrospectively rebook all lease transactions on their books under the new rules in a “Big Bang.” Companies must make sure their systems can provide this function.

As hinted at above, a number of other, less obvious systems will be affected by the proposed rules. Are company executives compensated on book returns? If so, the compensation committee and HR will very much want to see how the new rules affect ROA. Our preliminary review of pro forma portfolios shows that, depending on classification, the new rules can add or subtract as much as 10 basis points to an ongoing portfolio's quarterly yield over that same portfolio under current accounting rules. Portfolios less homogenous and well-behaved than our test cases might yield larger variances.

Syndication and Securitization

Another systems area likely to be affected is syndication and securitization. Some lessors, especially captives, will need to take a much closer look at the portfolio they are holding in order to find and benefit from syndication opportunities. For example, the proposed rules do not generally allow the manufacturer to recognize a sale if the captive provides lease financing. However, if the captive is able to creatively syndicate such transactions, it can potentially recognize full sales income for the manufacturer while potentially retaining some of the servicing and residual upside potential revenue. To do this, IT systems must be able to handle such syndications routinely, including pricing sales and purchases of portfolios.

Budgeting, Forecasting and Funding

Finally, the budgeting, forecasting and funding processes will be affected. Especially in the early years, the ability to “what-if” various product mixes and sales levels will be critical, as no one knows or can know how the mix and level of sales will pan out under the proposed rules.

Key Points

The key points we've gathered working with our large lessors and industry experts: Do not take system compliance with the new rules for granted ' verify with your suppliers. Second, don't think only of accounting systems. Investigate implications for other systems as well, including origination, pricing, portfolio management, syndication, funding and compensation. Indications are that we all have about two- to three-years to get this right ' enough time, but not by much.

Joseph Moore is Director of Sales & Marketing at Ivory Consulting Corporation. Over the last 13 years, Moore has worked with large lessors around the world on pricing and portfolio issues, and trained hundreds of equipment finance professionals in the intricacies of equipment finance pricing. He has given a number of presentations at ELFA events, most recently on the Portfolio and Marketing implications of the Exposure Draft Accounting.

It is not news that the proposed new lessor and lessee accounting rules as laid out in the recent exposure draft present a variety of challenges to equipment lessors and lessees. In our experience so far, the bulk of attention has been paid to the implications of the new rules on financial reporting, capital requirements and market acceptance of equipment leasing as a product. This emphasis is understandable ' both lessors and lessees want to know what their books are going to look like, and what effect that new look will have on their need for and ability to raise capital. Further, especially among equipment lessors, there are varying degrees of anxiety over the degree to which equipment leasing will continue to be viable.

Since August, the large lessors with whom we work have concluded that the proposed reporting requirements and the resulting capital issues are not, for the most part, intolerable, and that leasing will remain a viable product. While the proposed rules will exact a price in increased operating costs and marketing uncertainty as lessees reassess their equipment financing decisions, business will not cease, the sky will not fall. On the lessee side, the new rules add some economic friction costs to leasing. Whether such costs are sufficient to drive business away from leasing as a finance option to borrowing or cash remains to be seen, but the emerging consensus among large equipment lessors is that leasing will remain a viable product.

Second-Tier Issues

With those primary, corporate life-or-death issues at least contingently resolved for now, companies can turn their attention more to second-tier issues. Among these secondary issues are several key operational issues. The exposure draft's movement away from “bright line” accounting will, at least in the short- and mid-term, require lessors to create new classification rules specific to their businesses and products. For example, in order to properly forecast and budget, a company creates financial products that fit a certain accounting profile. Historically, that meant that a firm would define offerings as Operating Leases, Direct Finance Leases or Loans ' every product had to fit one and only one of these classifications, forecasts for which then flowed through from quoting to pricing to credit to booking and on through to the financial statements, which then feed into Treasury's borrowing plans. Ultimately, a lessor's ability to forecast profits, taxes and funding needs hinges to a large extent on knowing what characteristics its various financial product offerings will have once they reach the books. Then, when real transactions do hit the books, they must be processed correctly according to how they are classified. “Bright lines,” whatever their theoretical drawbacks, provide certainty to the operational task of classifying each transaction correctly.

Under the proposed new rules, there are no bright lines. Lessors can classify a lease transaction as either a Performance Obligation or a Partial Derecognition lease. These two products perform very differently on the balance sheet, in a way similar to the different performance of Operating leases and Direct Finance leases. Keep in mind also that the huge bulk of equipment finance transactions are smaller “cookie-cutter” deals ' the amount of profit associated with them precludes the possibility of having an accountant make a classification ruling on each deal individually. The classification process must be automated. IT Systems must be able to accommodate classification rules automatically.

Each lessor is faced with creating and defending principle-based classifications that are unique to that lessor. This requirement has two parts. First, management must decide what the rules will be: Is 10% residual risk “insignificant”? Fifteen percent? Five percent? For this line of business only, or for all lines of business? And so on. Then, whatever the decision, IT systems must embody it. For example, whenever my sales force quotes lease financing to a prospective lessee, the system must know that the quote is for a Partial Derecognition lease, and that classification information must flow through to the accounting system. The accounting system must then be able to generate accounting streams according to the new rules for Partial Derecognition leases, and allow for rebooking to account for any mid-term changes, again under the new rules.

While life is to some extent simpler for lessees insofar as they do not need to classify the lease and do not need to track its sales process, they still must now account for it under the proposed new rules, which it is safe to say are at least an order of magnitude more complex than existing rules. Many lessees are used to the utter simplicity of accounting for an operating lease under the old rules ' those days are numbered.

The First Challenge

So the first IT systems challenge is: Can my systems handle the new accounting? The accounting system itself is rightly the biggest concern, but, for lessors, the origination system that handles the flow of potential business from quoting to pricing to credit to documentation and booking must also be able to accommodate the new rules to at least some extent. The major players in lessor accounting are, of course, working to make sure their systems can perform under the new rules. It behooves lessors to make sure their providers can, in fact, meet their requirements.

We have heard much less about how lessee accounting systems are planning to accommodate the proposed rules. It is not safe to assume the new requirements will be met on the lessee side. They are extensive and, to a large extent, dissimilar from other lessee accounting processes ' the expected term, present value calculations and rebooking requirements are all very different from what an off-the-shelf lessee accounting system is required to provide today. Lessees need to make sure their providers are on top of these requirements, and to be specific about them ' do not accept vague promises that it will be there when you need it. Trust, but verify.

No Grandfathering

Next, the proposed rules do not allow for grandfathering. Lessors and lessees are expected to retrospectively rebook all lease transactions on their books under the new rules in a “Big Bang.” Companies must make sure their systems can provide this function.

As hinted at above, a number of other, less obvious systems will be affected by the proposed rules. Are company executives compensated on book returns? If so, the compensation committee and HR will very much want to see how the new rules affect ROA. Our preliminary review of pro forma portfolios shows that, depending on classification, the new rules can add or subtract as much as 10 basis points to an ongoing portfolio's quarterly yield over that same portfolio under current accounting rules. Portfolios less homogenous and well-behaved than our test cases might yield larger variances.

Syndication and Securitization

Another systems area likely to be affected is syndication and securitization. Some lessors, especially captives, will need to take a much closer look at the portfolio they are holding in order to find and benefit from syndication opportunities. For example, the proposed rules do not generally allow the manufacturer to recognize a sale if the captive provides lease financing. However, if the captive is able to creatively syndicate such transactions, it can potentially recognize full sales income for the manufacturer while potentially retaining some of the servicing and residual upside potential revenue. To do this, IT systems must be able to handle such syndications routinely, including pricing sales and purchases of portfolios.

Budgeting, Forecasting and Funding

Finally, the budgeting, forecasting and funding processes will be affected. Especially in the early years, the ability to “what-if” various product mixes and sales levels will be critical, as no one knows or can know how the mix and level of sales will pan out under the proposed rules.

Key Points

The key points we've gathered working with our large lessors and industry experts: Do not take system compliance with the new rules for granted ' verify with your suppliers. Second, don't think only of accounting systems. Investigate implications for other systems as well, including origination, pricing, portfolio management, syndication, funding and compensation. Indications are that we all have about two- to three-years to get this right ' enough time, but not by much.

Joseph Moore is Director of Sales & Marketing at Ivory Consulting Corporation. Over the last 13 years, Moore has worked with large lessors around the world on pricing and portfolio issues, and trained hundreds of equipment finance professionals in the intricacies of equipment finance pricing. He has given a number of presentations at ELFA events, most recently on the Portfolio and Marketing implications of the Exposure Draft Accounting.