New FASB/IASB Lease Accounting Rules to Be Issued Soon

The FASB retained the current classification rules with minor changes. This is very good news ' the 75% of useful life and 90% PV of asset cost/value bright lines will remain as guidance to determine lease classification. It will still be important that leases be classified as operating leases by lessees for reasons stated below.

The FASB capitalizes operating leases with terms greater 12 months with the liability not presented as debt, rather as an “operating” liability like accrued expenses (as an example) and P&L cost is the straight-line average rent expense (same as current GAAP). The capitalized operating lease asset (right of use or “ROU” asset) is also presented separately from finance lease assets. The impact of presenting the operating lease liability as an operating liability is that it will not cause debt limit covenant breaches and will not impact debt to equity ratios. The impact of maintaining the straight line rent expense is it closely matches the IRS tax treatment so there will not be any new deferred tax assets and it will not erode equity and earnings. The impact of reporting the capitalized operating lease assets separate from other assets is that allows tax compliance, regulatory capital calculations and lenders' analysis of collateral to be done as easily as is done under current GAAP.

Finance leases are treated the same as current GAAP for capital leases, as discussed below.

IASB Version: Lessee Accounting

There are no classification tests for lessees as they treat all leases as capital/finance leases.

All leases (except for short term ' < 12 months and except for small value (< $5,000) items) are capitalized using the model for current capital leases ' the liability is presented as debt, the asset is commingled with finance lease assets and the lease cost is front-ended, that is, the expense is a combination of straight-line depreciation of asset and imputed interest on the liability, each reported separately on the P&L statement. The impacts of the IASB one-lease model will be severe. Debt covenants will be broken, large deferred tax assets will be created, earnings and equity will be eroded, most financial ratios and measures will be worse, banks will have to raise more capital (to make up for the front ended lease costs, to apply to the operating lease ROU asset that is not separately reported and to cover the deferred tax asset created by the front-ended costs), and lessees will see the need to keep records under existing GAAP to provide information for reporting for tax, regulatory capital and lenders' needs.

FASB/IASB Comparison of Ratios/Measures Changes

Some financial ratios and measures will change for the worse and the results for U.S. companies vs IASB companies will be different as follows:

[IMGCAP(1)]

Lessor Accounting

The IASB and FASB are substantially converged ' keeping current GAAP with some exceptions:

1. The FASB drops leveraged lease accounting, grandfathering existing leases on the transition date. The implication here is that there is still a window to do leveraged leases and they will be grandfathered. They will be able to be traded after the transition date.
2. The FASB changes sales type lease accounting for those leases where third-party insurance/guarantees are needed to pass the 90% test ' in that case the gross profit is amortized with lease revenue as opposed to allowing for up-front gross profit recognition as per current GAAP. To my knowledge, this will not impact many manufacturers and dealers. They still will be able to get more accelerated recognition than if they did not purchase third-party insurance as operating lease treatment forces a straight line recognition of gross profit on sale.
3. Both require guaranteed residuals to be considered in lease classification but they recorded as a residual (physical asset) rather than a lease payment (financial asset). The implication is that it will be difficult to securitize the guaranteed residual ' it may end up being an on balance sheet financing.

We are not sure if ITC/tax grants will be expressly treated as revenue in a finance lease. The implication of not treating it as revenue is that the economic yield and reported revenue of a lease with ITC/tax grants will be distorted, appearing to be well below market and the benefit of the ITC/tax grant will be buried in tax expense. We have to wait to see the final words in the rules.

Other Items

Variable rents based on an index or rate are lease payments subject to capitalization at the spot rate ' IASB requires rebooking when rents change ' FASB requires rebooking only when another event causes the lease to be rebooked.

Residual guarantees in TRAC/Synthetic leases are capitalized at their expected value (what the lessee is likely to pay) ' the amount is usually zero. This outcome should make TRAC-like structures with lessee residual guarantees more popular, as the capitalized amount is only the present value of the rents and the present value (likely zero) of the amount expected to be paid under the residual guarantee.

Sale leasebacks with fixed purchase options are not sales unless the lessee is acting as an agent, not a principal, or when the lessee does not control the asset at the time of the sale leaseback. The resulting accounting for a failed sale leaseback leaves the asset on the books of the lessee and the leaseback is accounted for as debt. The lessor also accounts for the transaction as a financing. This outcome will cause lessors that use sale leasebacks to fund their portfolio to take steps to insure they do get lease treatment. This outcome will also cause lessees and lessors to add steps to the process of leasing new assets where a sale leaseback is used to insure lease treatment.

Initial direct costs definition is changed to include only third-party costs. The implication is that more costs will be charged to current earnings than under current GAAP and there is a different treatment for loan vs lease IDC ' many think this is not logical.

The lessee and lessor must bifurcate non-lease components of gross or bundled billed payments (leases with a service component). Gross billed leases are common in real estate and full-service truck and rail car leases. The lessee must use observable market pricing of one of the components to estimate the bifurcated amounts unless the lessor divulges the breakdown. The lessee capitalizes the present value of the lease component only, although the lessee can elect to capitalize the full payment. Lessees will demand a breakdown of the lease and service components because observable market evidence is generally not available. Lessors generally view the details of their pricing as proprietary and will not divulge the breakdown. The alternative of capitalizing the full payment is not acceptable to lessees, as it would cause the lessee to capitalize amounts significantly in excess of the cost of the asset.

Conclusion

The U.S. market should see little change in new business volumes, as the FASB chose an approach that allows the lessee financial statements to reflect the economic substance and legal and tax reality of operating and finance leases. The reasons for leasing still remain strong, especially because accounting is not the major reason that companies decide to lease.

A summary of the general reasons why customers lease and how those reasons fare under the FASB's version of the proposed new rules is contained in the chart below.

[IMGCAP(2)]

Bill Bosco, a member of this newsletter's Board of Editors, is the Principal of Leasing 101, a lease consulting company. He has been on the EFLA accounting committee since 1988 and was chairman for 10 years. He is a frequent author and speaker on leasing topics and has been selected to the FASB/IASB Lease Project working group as the ELFA representative. He can be reached at [email protected],'www.leasing-101.com or 914-522-3233.

The International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) have completed decision-making meetings and the respective staffs are drafting the final rules, which will be signed and issued this month. The IASB and FASB will issue separate rules as they have chosen two different models for lessee accounting. They both have adopted the same lessor model with a few minor differences.

The transition year for public companies will be 2019 (fiscal years beginning after Dec. 15, 2018) with SEC-required comparative balance sheets for 2018 & 2019, and comparative P&L for 2017, 2018 and 2019. For U.S. private companies, the transition year will be 2020 (fiscal years beginning after Dec. 15, 2019) with two years' recommended comparative balance sheet and P&L, although not required.

FASB Version: Lessee Accounting

The FASB retained the current classification rules with minor changes. This is very good news ' the 75% of useful life and 90% PV of asset cost/value bright lines will remain as guidance to determine lease classification. It will still be important that leases be classified as operating leases by lessees for reasons stated below.

The FASB capitalizes operating leases with terms greater 12 months with the liability not presented as debt, rather as an “operating” liability like accrued expenses (as an example) and P&L cost is the straight-line average rent expense (same as current GAAP). The capitalized operating lease asset (right of use or “ROU” asset) is also presented separately from finance lease assets. The impact of presenting the operating lease liability as an operating liability is that it will not cause debt limit covenant breaches and will not impact debt to equity ratios. The impact of maintaining the straight line rent expense is it closely matches the IRS tax treatment so there will not be any new deferred tax assets and it will not erode equity and earnings. The impact of reporting the capitalized operating lease assets separate from other assets is that allows tax compliance, regulatory capital calculations and lenders' analysis of collateral to be done as easily as is done under current GAAP.

Finance leases are treated the same as current GAAP for capital leases, as discussed below.

IASB Version: Lessee Accounting

There are no classification tests for lessees as they treat all leases as capital/finance leases.

All leases (except for short term ' < 12 months and except for small value (< $5,000) items) are capitalized using the model for current capital leases ' the liability is presented as debt, the asset is commingled with finance lease assets and the lease cost is front-ended, that is, the expense is a combination of straight-line depreciation of asset and imputed interest on the liability, each reported separately on the P&L statement. The impacts of the IASB one-lease model will be severe. Debt covenants will be broken, large deferred tax assets will be created, earnings and equity will be eroded, most financial ratios and measures will be worse, banks will have to raise more capital (to make up for the front ended lease costs, to apply to the operating lease ROU asset that is not separately reported and to cover the deferred tax asset created by the front-ended costs), and lessees will see the need to keep records under existing GAAP to provide information for reporting for tax, regulatory capital and lenders' needs.

FASB/IASB Comparison of Ratios/Measures Changes

Some financial ratios and measures will change for the worse and the results for U.S. companies vs IASB companies will be different as follows:

[IMGCAP(1)]

Lessor Accounting

The IASB and FASB are substantially converged ' keeping current GAAP with some exceptions:

1. The FASB drops leveraged lease accounting, grandfathering existing leases on the transition date. The implication here is that there is still a window to do leveraged leases and they will be grandfathered. They will be able to be traded after the transition date.
2. The FASB changes sales type lease accounting for those leases where third-party insurance/guarantees are needed to pass the 90% test ' in that case the gross profit is amortized with lease revenue as opposed to allowing for up-front gross profit recognition as per current GAAP. To my knowledge, this will not impact many manufacturers and dealers. They still will be able to get more accelerated recognition than if they did not purchase third-party insurance as operating lease treatment forces a straight line recognition of gross profit on sale.
3. Both require guaranteed residuals to be considered in lease classification but they recorded as a residual (physical asset) rather than a lease payment (financial asset). The implication is that it will be difficult to securitize the guaranteed residual ' it may end up being an on balance sheet financing.

We are not sure if ITC/tax grants will be expressly treated as revenue in a finance lease. The implication of not treating it as revenue is that the economic yield and reported revenue of a lease with ITC/tax grants will be distorted, appearing to be well below market and the benefit of the ITC/tax grant will be buried in tax expense. We have to wait to see the final words in the rules.

Other Items

Variable rents based on an index or rate are lease payments subject to capitalization at the spot rate ' IASB requires rebooking when rents change ' FASB requires rebooking only when another event causes the lease to be rebooked.

Residual guarantees in TRAC/Synthetic leases are capitalized at their expected value (what the lessee is likely to pay) ' the amount is usually zero. This outcome should make TRAC-like structures with lessee residual guarantees more popular, as the capitalized amount is only the present value of the rents and the present value (likely zero) of the amount expected to be paid under the residual guarantee.

Sale leasebacks with fixed purchase options are not sales unless the lessee is acting as an agent, not a principal, or when the lessee does not control the asset at the time of the sale leaseback. The resulting accounting for a failed sale leaseback leaves the asset on the books of the lessee and the leaseback is accounted for as debt. The lessor also accounts for the transaction as a financing. This outcome will cause lessors that use sale leasebacks to fund their portfolio to take steps to insure they do get lease treatment. This outcome will also cause lessees and lessors to add steps to the process of leasing new assets where a sale leaseback is used to insure lease treatment.

Initial direct costs definition is changed to include only third-party costs. The implication is that more costs will be charged to current earnings than under current GAAP and there is a different treatment for loan vs lease IDC ' many think this is not logical.

The lessee and lessor must bifurcate non-lease components of gross or bundled billed payments (leases with a service component). Gross billed leases are common in real estate and full-service truck and rail car leases. The lessee must use observable market pricing of one of the components to estimate the bifurcated amounts unless the lessor divulges the breakdown. The lessee capitalizes the present value of the lease component only, although the lessee can elect to capitalize the full payment. Lessees will demand a breakdown of the lease and service components because observable market evidence is generally not available. Lessors generally view the details of their pricing as proprietary and will not divulge the breakdown. The alternative of capitalizing the full payment is not acceptable to lessees, as it would cause the lessee to capitalize amounts significantly in excess of the cost of the asset.

Conclusion

The U.S. market should see little change in new business volumes, as the FASB chose an approach that allows the lessee financial statements to reflect the economic substance and legal and tax reality of operating and finance leases. The reasons for leasing still remain strong, especially because accounting is not the major reason that companies decide to lease.

A summary of the general reasons why customers lease and how those reasons fare under the FASB's version of the proposed new rules is contained in the chart below.

[IMGCAP(2)]

Bill Bosco, a member of this newsletter's Board of Editors, is the Principal of Leasing 101, a lease consulting company. He has been on the EFLA accounting committee since 1988 and was chairman for 10 years. He is a frequent author and speaker on leasing topics and has been selected to the FASB/IASB Lease Project working group as the ELFA representative. He can be reached at [email protected],'www.leasing-101.com or 914-522-3233.