Key Lessee and Lessor Decisions Made in the Lease Project

The two lessee approaches (with an exception for short-term leases to use the existing operating lease model) are:

1. The Right of Use (“ROU”) approach (now called Approach 1) where the lease is capitalized and the asset is amortized straight line and interest is imputed on the liability. The result is a front-ended expense pattern.
2. The Whole Contract approach (now called Approach 2) where the asset and liability are capitalized, then adjusted each month to equal the PV of the remaining payments. The P&L is straight line as the average rent is accrued each month and the actual rent paid is charged to the accrued rent payable account.

The two lessor approaches (with an exception for short-term leases) are:

1. The Receivable and Residual (“R&R”) method.
2. The Operating Lease method (same as current GAAP in FAS 13).

The dividing line will be a newly created idea where real estate and equipment leases are treated drastically different.

Equipment Leases

For equipment leases it is presumed that the lease is an ROU lease for lessees and an R&R lease for lessors unless the lease term is an insignificant portion of the economic life of the underlying asset, or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

This new line is vastly different than under existing GAAP, and for legal and tax purposes causing more equipment leases to have front-ended costs and causing equipment lessees to still keep records under the existing rules. Equipment lessors should be aware that the fact that there is symmetry with lessee accounting is good now that there will be more R&R leases, but if the “line” is moved the result will be the opposite.

Real Estate Leases

For real estate leases it is presumed the lease is a Whole Contract lease for lessees and operating lease for lessors unless the lease term is for the major part of the economic life of the underlying asset, or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

This line is virtually the same as the line under existing GAAP; therefore, the real estate industry and its lessees should be pleased.

Financed Purchases

It should also be noted that leases that are viewed as financed purchases by the Revenue Recognition Project will not be considered leases. Control of the underlying asset is the principle employed, so leases with automatic transfer of title or bargain purchase options will be considered financings ' not leases. This means that, for those transactions, capital lease accounting will be used by lessees, and lessors will use sale and loan accounting. The ELFA and I support the view that the Revenue Recognition standard should be used to define which lease contracts are financed purchases versus which leases are merely a transfer of the right of use. Then the leases standard would deal with just lease accounting and the financed purchases would be accounted for as a purchase and a loan.

Analysis

It is good that the Boards decided on a two-lease model for lessees, as it should be closer to the economics of leases in that some leases transfer ownership rights while others merely transfer a right of use. Those that only transfer a right of use are executory contracts that should result in cost pattern that is level, and the liability is not classified as debt in bankruptcy. The big problem for equipment leases is that the new line to classify leases is vastly different than under current GAAP and will not reflect the economics of most equipment leases.

Equipment lessees will not support the idea of a different dividing line than the existing FAS 13/IAS 17, as that line is baked into our IRS, property tax and legal systems. The current lease classification GAAP process is closer to the widely accepted “risks and rewards” approach that will survive as the legal and tax conceptual framework. Lessees will have to keep two sets of records to do their tax returns and to show potential lenders which leases survive bankruptcy as assets and debt using existing capital leases accounting concepts that will remain in the tax and bankruptcy rules.

Lessees will have a more difficult task of classifying leases under the proposed “line,” as there is more judgment required than under FAS 13. The proposed “line” is now based on a judgment as to whether the lease term or PV of the rents is insignificant, whereas the current FAS 13 tests are the opposite. That is, is the lease term or the present value of lease payments significant compared with the useful life and fair value of the underlying leased asset? More equipment leases will have front-ended costs. The difference in the outcomes may not likely be significant in terms of the cost patterns, which begs the question of why change the “line” when the current classification process is well understood, requires less judgment and is baked into many aspects of the fabric of business and regulations in the United States.

U.S. lessors advocate a two-lease model based on a business model with financial lessors using the R&R methods and operating lessors using the operating lease method. Symmetry is not appropriate, as lessees and lessors have different views of the lease transaction. U.S. equipment lessors who are financial lessors will generally view the current decision as an improvement over current GAAP (except for the loss of leveraged lease accounting, excluding ITC from revenue recognition in non-leveraged leases and changes to sales-type profit recognition) only for the reason that there will be fewer operating leases, but if the “line” changes then there will be more operating leases. Real estate and full-service and short/medium term equipment lessors also favor the decision only for the reason that they can keep using the operating lease method.

The devil is in the details, so we have to wait to see what unfolds and how the ED reads.

William Bosco, a member of this newsletter's Board of Editors, is the president of Leasing 101, a lease consulting company. He is a member of the Equipment Leasing and Finance Association (“ELFA”) Financial Accounting Committee and a member of the Lease Project Working Group representing the ELFA. He can be reached at [email protected] or 914-522-3233. His website is www.leasing-101.com.

The FASB and IASB Boards met on June 13, 2012 in London and made key decisions on lessee and lessor accounting in their Lease Project. Although they finally decided all leases are not alike, they made a split decision as to how to classify them based on type of asset leased. The decision is bad news for most equipment lessees and possibly bad for lessors, with the only good news being for real estate lessees.

This was the last major decision-making meeting (there was one more meeting in July 2012) that was holding up drafting of the new Exposure Draft (“ED”). The timeline for the project is:

• Last decision-making meeting regarding remaining small issues in July 2012,
• Draft ED in third quarter 2012,
• Issue ED year end 2012 with 120-day comment period,
• Review comments letters and revise ED if necessary 2013,
• Issue final standard 2014,
• Effective date 2017 to allow lessees and lessors time to develop systems, extract lease data and prepare comparative financials under the new models.

Although the Boards were split with the FASB favoring a two-lease model and the IASB favoring a one-lease model, they took a second vote on whether compromise was possible to get a converged standard. In the second vote the majority agreed they could compromise on a two-lease model approach for both lessees and lessors with the same dividing line to determine which accounting approach to use. The ELFA and I have been advocating a two-lease approach since the outset of the Lease Project in 2006. It is a bit ironic that after six years they are virtually back to using current GAAP with operating leases capitalized, but with a set of new complex classification tests that are different for real estate and equipment. It appears that there is a lack of consistent treatment that should not be if the standard is principles based. Both equipment and real estate leases have the same legal treatment ' they are not considered loans from a legal perspective.

The Approaches

The two lessee approaches (with an exception for short-term leases to use the existing operating lease model) are:

1. The Right of Use (“ROU”) approach (now called Approach 1) where the lease is capitalized and the asset is amortized straight line and interest is imputed on the liability. The result is a front-ended expense pattern.
2. The Whole Contract approach (now called Approach 2) where the asset and liability are capitalized, then adjusted each month to equal the PV of the remaining payments. The P&L is straight line as the average rent is accrued each month and the actual rent paid is charged to the accrued rent payable account.

The two lessor approaches (with an exception for short-term leases) are:

1. The Receivable and Residual (“R&R”) method.
2. The Operating Lease method (same as current GAAP in FAS 13).

The dividing line will be a newly created idea where real estate and equipment leases are treated drastically different.

Equipment Leases

For equipment leases it is presumed that the lease is an ROU lease for lessees and an R&R lease for lessors unless the lease term is an insignificant portion of the economic life of the underlying asset, or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

This new line is vastly different than under existing GAAP, and for legal and tax purposes causing more equipment leases to have front-ended costs and causing equipment lessees to still keep records under the existing rules. Equipment lessors should be aware that the fact that there is symmetry with lessee accounting is good now that there will be more R&R leases, but if the “line” is moved the result will be the opposite.

Real Estate Leases

For real estate leases it is presumed the lease is a Whole Contract lease for lessees and operating lease for lessors unless the lease term is for the major part of the economic life of the underlying asset, or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

This line is virtually the same as the line under existing GAAP; therefore, the real estate industry and its lessees should be pleased.

Financed Purchases

It should also be noted that leases that are viewed as financed purchases by the Revenue Recognition Project will not be considered leases. Control of the underlying asset is the principle employed, so leases with automatic transfer of title or bargain purchase options will be considered financings ' not leases. This means that, for those transactions, capital lease accounting will be used by lessees, and lessors will use sale and loan accounting. The ELFA and I support the view that the Revenue Recognition standard should be used to define which lease contracts are financed purchases versus which leases are merely a transfer of the right of use. Then the leases standard would deal with just lease accounting and the financed purchases would be accounted for as a purchase and a loan.

Analysis

It is good that the Boards decided on a two-lease model for lessees, as it should be closer to the economics of leases in that some leases transfer ownership rights while others merely transfer a right of use. Those that only transfer a right of use are executory contracts that should result in cost pattern that is level, and the liability is not classified as debt in bankruptcy. The big problem for equipment leases is that the new line to classify leases is vastly different than under current GAAP and will not reflect the economics of most equipment leases.

Equipment lessees will not support the idea of a different dividing line than the existing FAS 13/IAS 17, as that line is baked into our IRS, property tax and legal systems. The current lease classification GAAP process is closer to the widely accepted “risks and rewards” approach that will survive as the legal and tax conceptual framework. Lessees will have to keep two sets of records to do their tax returns and to show potential lenders which leases survive bankruptcy as assets and debt using existing capital leases accounting concepts that will remain in the tax and bankruptcy rules.

Lessees will have a more difficult task of classifying leases under the proposed “line,” as there is more judgment required than under FAS 13. The proposed “line” is now based on a judgment as to whether the lease term or PV of the rents is insignificant, whereas the current FAS 13 tests are the opposite. That is, is the lease term or the present value of lease payments significant compared with the useful life and fair value of the underlying leased asset? More equipment leases will have front-ended costs. The difference in the outcomes may not likely be significant in terms of the cost patterns, which begs the question of why change the “line” when the current classification process is well understood, requires less judgment and is baked into many aspects of the fabric of business and regulations in the United States.

U.S. lessors advocate a two-lease model based on a business model with financial lessors using the R&R methods and operating lessors using the operating lease method. Symmetry is not appropriate, as lessees and lessors have different views of the lease transaction. U.S. equipment lessors who are financial lessors will generally view the current decision as an improvement over current GAAP (except for the loss of leveraged lease accounting, excluding ITC from revenue recognition in non-leveraged leases and changes to sales-type profit recognition) only for the reason that there will be fewer operating leases, but if the “line” changes then there will be more operating leases. Real estate and full-service and short/medium term equipment lessors also favor the decision only for the reason that they can keep using the operating lease method.

The devil is in the details, so we have to wait to see what unfolds and how the ED reads.

William Bosco, a member of this newsletter's Board of Editors, is the president of Leasing 101, a lease consulting company. He is a member of the Equipment Leasing and Finance Association (“ELFA”) Financial Accounting Committee and a member of the Lease Project Working Group representing the ELFA. He can be reached at [email protected] or 914-522-3233. His website is www.leasing-101.com.