VOLUME 29 NUMBER 1 WINTER

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1 connect with the Foundation Journal o f E q u i p m e n t L e a s e F i n a n c i n g Articles in the Journal of Equipment Lease Financing are intended to offer responsible, timely, in-depth analysis of market segments, finance sourcing, marketing and sales opportunities, liability management, tax laws regulatory issues, and current research in the field. Controversy is not shunned. If you have something important to say and would like to be published in the industry s most valuable educational journal, call The Equipment Leasing & Finance Foundation 1825 K Street NW Suite 900 Washington, DC VOLUME 29 NUMBER 1 WINTER 2011 Nominal Additional Consideration: Only Nominally Helpful in Making the True Lease/Security Interest Distinction By Robert W. Ihne With respect to the critically important legal characterization of a transaction as either a true lease or a security interest, the statutory phrase nominal additional consideration has played a major role in analyzing transactions with purchase options. This phrase, however, has proven to be remarkably ambiguous unless accompanied by the application of more fundamental underlying principles for making the distinction. Lease Accounting: New Rules and Realities By Shawn D. Halladay Although the primary motivation for replacing Financial Accounting Standard No. 13 is the capitalization of all lease obligations, the proposals will change the accounting for both lessees and lessors. This article will examine not only the provisions of the August 2010 Exposure Draft for Leases but also the potential market ramifications. The Effect of New Accounting Rules on Capital Leases By James M. Johnson, PhD, and Natalie Tatiana Churyk, PhD Where are lessee firms recording capital leases on the balance sheet: as capital leases or as long-term liabilities or long-term debt? Current reporting practices can shed light on the effects of the new FASB exposure draft. Social Networking for the Equipment Finance Industry: Divine or a Distraction? By Suzanne E. Henry Does engagement in the social media make sense for leasing companies? A recent Foundation study of 1,000 equipment finance professionals suggests that some are participating, but many are waiting for clearer direction and guidance for ROI and development strategies. Copyright 2010 by the Equipment Leasing & Finance Foundation ISSN X

2 Lease Accounting: New Rules and Realities By Shawn D. Halladay The new lease accounting proposals represent a major change in direction for the leasing industry. Although the primary motivation for replacing Financial Accounting Standard No. 13 (FAS 13) is the capitalization of all lease obligations, the proposals will change the accounting for both lessees and lessors. This article will examine not only the provisions of the August 2010 Exposure Draft for Leases (ED) but also the potential market ramifications of the proposed rules. General provisions The underlying structure of the exposure draft is that lessees and lessors will apply a right-of-use model to account for all leases. Under this model, the lessor transfers to the lessee the right to use the lessor s asset. By granting the lessee the right to use its asset, the lessor creates a right to receive payments from the lessee while, at the same time, the lessee incurs an obligation to make those payments to the lessor. The ED applies to leases of property, plant, and equipment. Leases that represent financed purchases (i.e., agreements that transfer all but a trivial amount of the risks and benefits of the Although the primary motivation for replacing Financial Accounting Standard No. 13 is the capitalization of all lease obligations, the proposals will change the accounting for both lessees and lessors. This article will examine not only the provisions of the August 2010 Exposure Draft for Leases but also the potential market ramifications. leased asset) are no longer considered leases for accounting purposes under the proposed standard and, therefore, are not subject to its provisions. One of the criticisms of the existing lease accounting model is the use of FAS 13 s bright-line tests to classify leases. It is interesting to note that, in spite of this opposition, lessees and lessors must use two of those criteria (automatic title transfer and bargain purchase option) to determine if the transaction even qualifies for lease accounting under the new rules. Additionally, lessors must apply versions of the 75% and 90% tests when classifying leases as either derecognition or performance obligation leases on their balance sheet. Figure 1 (next page) shows how these tests are used in the new rules. The service components of bundled leases also are not subject to the lease accounting rules, and, therefore, not capitalized, as long as the service component is distinct. 1 If it is not, however, the entire payment is subject to the leasing rules and will be capitalized by the lessee as an obligation to make payments to the lessor. The exposure draft introduces several new lease accounting concepts: Editor s note: This article is based on the Foundation study of the proposed lease accounting changes, Changes to Lease Accounting: Rules, Reactions and Realities (the Foundation Study) prepared by The Alta Group. This report can be accessed at

3 one is the requirement that lessors and lessees must incorporate the most likely lease term to occur when booking a lease. The expected amount of contingent rents also must be considered when booking the lease. Although not stated in the ED, the effective date of the new rules is expected to be around 2014 and will be known when the final standard is issued in mid Lessees The implications to the lessee of the proposed rules fall into two broad categories. These categories include the financial reporting aspects of the changes and the operational impact they will have on lessees. Financial Reporting The proposals require all leases to be capitalized on the lessee s balance sheet. This capitalization consists of a right-of-use asset (representing the lessee s right to use the leased asset) and a corresponding liability (representing its obligation to pay rents). The right-of-use asset is considered an intangible asset. Automatic transfer of No title? Yes Loan Figure 1 Classification Tests Lease Derecognition Lease No No No No Lessee/Lessor Bargain purchase option? Yes Source: The Alta Group, Economic life test? The new capitalization rules will increase the size of the balance sheets for those lessees that have operating leases. The expenses on these leases will be front-loaded since the cost of the lease is measured as amortization No and interest expense. Residual risk test? Yes Yes Performance Obligation Lease Lessor The liability, or obligation to pay rents, is recorded at the present value of the lease payments over the most likely term. The rents, which also include expected contingent rents, are discounted at the lessee s incremental borrowing rate or the rate the lessor charges the lessee, if it can be determined. This process is similar to booking 2 a capital lease under FAS 13. The right-of-use asset is booked at the amount of the liability to make lease payments, plus any initial direct costs. Once the right-of-use asset and obligation are capitalized, the lessee must amortize the asset and obligation over the estimated term of the lease, which, again, is very similar to the capital lease treatment of FAS 13. Since the right-of-use asset is considered an intangible asset, however, it will be amortized rather than depreciated. The obligation is amortized to interest and principal over the estimated term, using the interest method. The new capitalization rules will increase the size of the balance sheets for those lessees that have operating leases. The expenses on these leases will be front-loaded since the cost of the lease is measured as amortization and interest expense, rather than as rent expense. Figure 2 illustrates the differences between the cash rents paid, FAS 13 operating lease expense recognition, and the ED expense recognition for a representative five-year forklift lease with a low-high payment structure. The combination of increased assets and frontloaded expenses will result in the deterioration in lessees key leverage and performance ratios. On the flip side, however, EBITDA (earnings before interest, taxes, depreciation, and amortization) improves under the proposed rules due to the reclassification of the lease cost from Expense 60,000 50,000 40,000 30,000 20,000 10,000 0 Figure 2 Lease Expense Comparison Cash ED FAS Years Source: Changes to Lease Accounting study, Figure 6, page 25.

4 rent expense to amortization and interest expense. Since EBITDA is a key valuation ratio for many companies, leasing will be viewed more favorably by this portion of the lessee market. These reporting and measurement changes will occur even though the cash flows and business attributes of the transactions have not changed. In addition to affecting overall company performance measures, the changes in these metrics also will impact bonding and loan covenants, government reimbursement policies, bonus calculations, company ratings, and regulatory requirements. The financial reporting consequences of the new lease accounting rules will result in a reduction of equipment leasing volume, the extent of which is not yet known. Various surveys, including the one conducted for the Equipment Leasing & Finance Foundation study, however, indicate that the loss of off balance sheet financing is not a significant concern for most lessees. For example, 68% of the respondents in a recent Grant Thornton survey said that a requirement to capitalize lease obligations would not cause them to change the way in which they finance their operations. 2 Increased Effort Another consequence of the new proposals is the increased effort associated with leasing. While the loss of off balance sheet financing applies to a very specific set of customers, the additional administrative burden of using leasing will apply across the board and may cause lessees to consider other products such as loans. This additional effort primarily is related to estimating the longest lease term most likely to occur and calculating the expected amount of additional payments, such as contingent rents. For example, when recording and measuring a lease, both lessors and lessees must determine the longest lease term most likely to occur. This is accomplished by estimating the probability of occurrence for each possible term, based on any options to extend or renew the lease, such as month-to-month renewal provisions. Contractual and noncontractual factors must be considered as part of this process. Any expected payments, in addition to those payments over the most likely lease term, also must be calculated under the proposed rules. 3 The longest possible term more likely than not to occur is the point at which the cumulative probability of the possible terms occurring exceeds 51%. This longest possible term more likely than not to occur, which may not equal the contractual obligation, is what is used to book the lease. Any expected payments, in addition to those payments over the most likely lease term, also must be calculated under the proposed rules. These payments generally will consist of contingent rents, but a lessee may have other potential obligations such as term option penalties, restocking fees, and residual value guarantees. These expected payments represent the probability-weighted average of the cash flows for a reasonable number of outcomes (i.e., not every outcome must be considered). Table 1 is an example of a hypothetical analysis of the expected outcome of payments. Third-party residual value guarantees are not considered lease payments, nor are the exercise prices of purchase options. Other areas of additional effort include: behavioral data capture associated processes and accounting policies increased asset and liability tracking lease management system upgrades and implementations service component distinctions additional internal controls tax compliance Table 1 Expected Outcome Analysis Outcome Uses Cost Probability Weighted outcome 1 5,000 $ % , % , % , % , % 225 Expected payment 788 Source: Changes to Lease Accounting study, Table 1, page 8.

5 The responses were mixed to The Alta Group s survey questions about the impact on lessee financing decisions of the extra effort required to estimate the lease term. Some lessees stated that they monitored their leases closely and currently did not pay renewal or evergreen rents beyond the base lease term, making this requirement moot. Others said that it would cause them to reconsider, although not necessarily avoid, using equipment leasing. The shift to the proposed standard also will have other consequences on lessee market behavior. According to the Foundation study, 69% of the lessees surveyed indicated that the new rules will change how they analyze and approve equipment leases. These changes will include shifts in the level of decision-making and approval, decreased end-of-term options, shortened lease terms, modified lease documentation, and changes in sale-leaseback activity. The transition to the proposed standards also will create additional work, again for both lessees and lessors, when the new rules become effective. Since there are no grandfathering provisions in the exposure draft, both lessees and lessors must apply the new standard to their leases existing at the date of initial application. This effort, for many lessees, will be significant, as leases oftentimes are tracked on spreadsheets across many different locations. The transition for lessors with leveraged leases on their books will be particularly arduous. Lessors The lessor implications of the proposed rules fall into three, rather than two, broad categories. These categories include the financial reporting aspects of the changes, their operational impact, and how lessors will approach their customers under the new rules. Financial Reporting 4 The proposed changes replace FAS 13 s lessor accounting products with two new designations performance obligation leases and derecognition leases. The distinction between the two leases is based on whether the lessor retains exposure to significant risks or benefits in the leased asset. Table 2 provides a general correlation between these new lease types and those of FAS 13. Table 2 Lessor Product Correlation Exposure Draft product Performance obligation lease Derecognition lease Short-term lease Not retained The shift to the proposed standard also will have other consequences on lessee market behavior. According to the Foundation study, 69% of the lessees surveyed indicated that the new rules will change how they analyze and approve equipment leases. FAS 13 product Blend of: direct financing lease operating lease Direct financing lease Sales-type lease Operating lease Leveraged lease Source: Changes to Lease Accounting study, Table 4, page 12. A performance obligation lease is one in which the lessor retains significant risk and rewards associated with the asset. As pointed out earlier, the lessor considers the following factors when determining its exposure to significant risks and benefits associated with the asset: Whether the lease term is significant in relation to the remaining useful life of the asset (economic life test) Whether there is significant risk and reward from the leased asset at the end of the term (present value test) Under performance obligation accounting, the lessor records a right to receive payments equal to the present value of the lease payments, discounted at the rate the lessor charges the lessee. The underlying leased asset remains on the balance sheet, so there is no separate residual value. The lessor also records a liability equal to the right to receive payments. This liability, which is another new lease accounting concept, represents the lessor s obligation to perform under the lease. Although not specifically addressed, it is assumed that any gross margin in manufacturer and

6 dealer performance obligation leases will be spread over the expected term of the lease. The lessor recognizes the following items in the income statement: interest income on the right to receive lease payments lease income as the performance obligation is satisfied depreciation on the leased asset The lessor applies the derecognition approach, on the other hand, if it does not retain significant risks and benefits associated with the leased asset. A derecognition lease records a right to receive payments, equal to the present value of the lease payments, discounted at the rate the lessor charges the lessee. The lessor offsets, or nets, its right to receive payments against the leased asset in what is called derecognition. There is no residual value in a derecognition lease, at least not in its form under FAS 13. The difference between (1) the lessor s right to receive payments (the amount derecognized) and (2) the book value of the leased asset is considered the allocated residual asset. The income recognized over the term in a derecognition lease is the interest income on the right to receive lease payments. Residual income is not accreted over the lease term in a derecognition lease, which represents a significant departure from the current accounting rules. The income recognized over the term in a derecognition lease is the interest income on the right to receive lease payments. Residual income is not accreted over the lease term in a derecognition lease, which represents a significant departure from the current accounting rules. Sales-type revenue recognition, however, is available in the derecognition lease. Lease income under the new rules will be either more uneven, volatile, front-loaded, or back-loaded than under the current rules, depending on the lease type and nature of the transaction. Table 3 compares the income allocation over the term for a lease under the performance obligation, derecognition lease, and direct financing lease approaches. This example is based on payments of $1,361, in arrears, over an expected term of six years. The equipment has a fair value of $7,000, and the rate of interest implicit in the lease is 8%. Operations The operational burden faced by lessors will increase substantially, as the increased effort associated with the new proposals is not limited solely to lessees. When recording and measuring a lease, lessors must determine the longest lease term most likely to occur by estimating the probability of occurrence for each possible term. Lessors also must calculate the expected amount of additional payments, such as contingent rents. Furthermore, these estimates must be reassessed each year during the lease term. The exposure draft also creates a disconnect between the accounting and economics of the transaction, as illustrated in Table 4, which compares the pretax, eco- Table 3 Lease Income Comparison Year Performance obligation Derecognition Direct financing Total 2,290 2,290 2,290 Source: Changes to Lease Accounting study, Table 9, page 18. Table 4 Pretax Yield Comparison Year Economic Direct financing Performance obligation Derecognition % 8.00% 8.18% 7.40% % 8.00% 8.11% 7.32% % 8.00% 8.03% 7.19% % 8.00% 7.91% 6.99% % 8.00% 7.72% 6.62% % 8.00% 7.35% 29.26% Source: Changes to Lease Accounting study, Table 16, page 34. 5

7 nomic yield to the accounting yields of the performance obligation, derecognition, and direct financing leases. This comparison is based on the previous six-year example, which illustrated the performance obligation and derecognition lease income. The required, incremental processes and procedures will alter the internal control environment and potentially increase audit costs. Other potential increases in the operational burden for lessors include: changes in how sales taxes are remitted increases in deferred tax tracking when estimated terms do not represent contractual or tax flows renegotiations and revisions of debt covenants amendments to treasury management processes and models changes to regulatory requirements and reporting adjustments to regulatory capital alterations to reporting and budgeting processes modifications to buy/sell strategies Implementing the proposed changes presents challenges to lessors on several different levels, including financial/ management reporting, operations, and systems support. Lessors must establish an implementation plan that addresses these issues. The implementation plan should include, among other things, a product analysis, process development, and systems gap analysis. Lessors need to establish a transition plan, in addition to an implementation plan, some aspects of which will overlap. In addition to creating new accounting products, the new rules will require additional data tracking and analytical capabilities. These new requirements emphasize the importance of the lessor s software applications and the system provider s ability to support and implement the necessary changes. Some lessors may choose to stay with their current application and update its functionality to support the new regulations, while others 6 may decide to use the changes to migrate to a different application with functionality that supports the new proposals. Market Response In addition to creating new accounting products, the new rules will require additional data tracking and analytical capabilities. These new requirements emphasize the importance of the lessor s software applications and the system provider s ability to support and implement the necessary changes. The loss of off balance sheet financing for lessees will result in market shifts for lessors, as the lease capitalization requirements will have a negative effect on overall leasing volumes. However, as has been pointed out, the off balance sheet aspect of operating leases is only one of the many benefits of leasing, and, based on past surveys, not even the most important benefit. On the positive side, partial off balance sheet financing opportunities still remain for leases of equipment with high residuals, and the new rules will open up heretofore closed markets, such as with EBITDA players and those customers concerned with transparency. Product differentiation (e.g., through residual or structure), knowledge of the customer, and a value-added approach will become even more important under the new accounting rules than in the past. Lessors may have to alter their product mix, as several lessees indicated that shorter lease terms may become more attractive as a way to minimize liabilities on the balance sheet. More transaction structuring also may be required. These phenomena, however, create opportunities for lessors that are willing to take on the role of true asset managers. Conclusion There is no denying that the proposed lease accounting rules will have an effect on leasing volumes. When the other benefits of leasing are considered with the Foundation study results, however, it can be inferred that the lease accounting changes do not represent a catastrophic event for the leasing industry. This conclusion also is supported by history, which has shown that the partial elimination of one customer motivation does not mean the rest of the industry will go away.

8 Lessors must act proactively, however. They must continue to emphasize the many other benefits of leasing, such as cash flow, asset utilization, tax issues, and flexibility, since these key lessee motivations still remain as significant volume drivers. It also is imperative that the lessor educate its sales force on the accounting changes so it can communicate these attributes to customers and identify opportunities. Customer-focused lessors are viewing these changes as an opportunity to become more intimate with their customers. These lessors and those that create product differentiation through residual-based leases will prosper in this new environment, whereas others may falter. Where will you land? Endnotes 1. The International Accounting Standards Board s version of the exposure draft requires the service component to be split from the lease payment. 2. Of the 68% of respondents in the Grant Thornton study that indicated they would continue to utilize lease financing, 51% would continue to use leases more or less in the same manner, and 17% would continue to use leases but, possibly, with significant changes in the provisions of the agreements. Shawn D. Halladay shalladay@thealtagroup.com Shawn D. Halladay is a principal of The Alta Group in Salt Lake City, Utah, and is the managing principal of its professional development division. He began his career in the audit division of Arthur Andersen & Co., and over the past 25 years, he has developed significant expertise in all areas of leasing, including accounting, pricing, tax, funding, and operations. Mr. Halladay has international teaching and consulting experience on leasing practices and policies, having conducted consulting assignments or taught classes in more than 25 different countries. He has written eight books on various aspects of equipment leasing, served as managing editor and co-author of the Handbook of Equipment Leasing, and regularly contributes to various industry trade journals. He is a member of ELFA s Financial Accounting Committee and serves on this journal s editorial review board. A certified public accountant, he received his BS in accounting and MBA in finance from the University of Utah, Salt Lake City. 7