Captive and Vendor Leasing Equipment Leasing Association Lease Accountants Conference September 18, 2006 Deborah Brady James S. Brzoska Alan L. Moose Key Equipment Finance IBM Global Financing John Deere Credit Inc.
The views expressed today are our own and do not necessarily reflect those of our organizations or their staff.
Captive And Vendor Leasing Agenda Purposes for Captive Finance Companies Captive revenue recognition issues Sales-type versus operating leases Multiple element arrangements Vendor revenue recognition issues Lease arrangements Impact of FIN 45
Definitions Captive: a subsidiary or division of a parent manufacturer with over 50% of the asset base generated through financing products of the parent Vendor Leasing: Lease financing offered to an equipment end-user in conjunction with the sale of equipment. Vendor leases can be provided by a manufacturer, dealer, or a third-party leasing company with a close working relationship with the equipment vendor.
Business Issues - Captive Benefits of a captive Provide integrated sales and financing solutions Use equipment pricing and financing to tailor transactions to customer needs Source of additional income Issues raised by a captive Significant additional capital requirement Added organizational expertise Tension between sales and credit organization
Revenue Recognition - Captive Parent s focus, generally, is on revenue recognition on sales to: End users Dealers and intermediaries Type of financing provided by Captive can impact Parent s revenue recognition, i.e. operating lease or sales-type lease
Revenue Recognition - Captive Sales-type versus operating leases Parent revenue recognition example Assumptions Fair market value: 100 Cost: 40 Payments: 4 @30 Residual value: 20 Present value of residual: 10 Sale price at maturity: 20
Revenue Recognition - Captive Cash sale Sales revenue 100 Cost of goods sold (40) Margin 60 Sales-type lease * Sales revenue 90 Cost of goods sold (30) Margin 60 * - An additional $40 of net finance income would be recognized over the lease term
Revenue Recognition - Captive Revenue recognition from an operating lease 1 2 3 4 Total Captive Net operating lease revenue 10 10 10 10 40 Elimination Company Depreciation elimination 15 15 15 15 60 Consolidated Parent Total Net Margin 25 25 25 25 100
Accounting Guidance - Revenue Recognition Staff Accounting Bulletin 104 SAB 104 applies to all accounting rules that provide guidance on revenue recognition. The Bulletin does not change existing revenue recognition rules. Revenue is generally realized or realizable and earned when all of the following conditions are met: Persuasive evidence of an arrangement exists, Delivery has occurred or services have been rendered, The seller's price to the buyer is fixed or determinable, and Collectibility is reasonably assured.
Accounting Guidance - Revenue Recognition FASB 48 Revenue Recognition When Right of Return Exists Revenue Recognized at time of sale if all of the following are met: The seller s s price to the buyer is substantially fixed or determinable at the date of sale The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product The buyer s s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product The buyer acquiring the product for resale has economic substance apart from that provided by the seller The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer The amount of future returns can be reasonably estimated
Accounting Guidance - Revenue Recognition EITF 95-1 Revenue Recognition on Sales with a Guaranteed Minimum Resale Value Manufacturer sells equipment and contractually agrees to reacquire the equipment at a guaranteed price at specified time periods or pay the purchaser for any deficiency between the sales proceeds received for the equipment and the guaranteed minimum resale value. The manufacturer should not record a sale because the risk of loss on the asset was not transferred. The manufacturer should account for the transaction as either an operating or sales-type lease. Sale treatment is precluded if any combination of residual and/or credit risk is equal to or exceeds 10% of the equipment cost, on a present value basis. EITF 03-12 Impact of FIN 45 No change to EITF 95-1
Accounting Guidance - Revenue Recognition EITF 95-4 Revenue Recognition on Equipment Sold and Subsequently Repurchased Subject to an Operating Lease A manufacturer recognizes a sale at the time the product is transferred to the dealer if all of the following conditions exist: The dealer is independent and transacts business separately with the manufacturer and customers, The manufacturer delivered the product to the dealer and the dealer has responsibility for the ultimate sale. A customer's failure to lease with the finance affiliate would not allow the dealer to return the product to the manufacturer. The finance affiliate has no legal obligation to provide a lease arrangement to a customer of the dealer at the time the product is delivered to the dealer. The customer has other financing alternatives and is in control of the selection of the financing alternatives.
Accounting Guidance - Revenue Recognition EITF 00-21 Revenue Arrangements with Multiple Deliverables Many companies offer solutions to meet their customers needs that involve the delivery or performance of multiple products, services or rights to use assets. EITF 00-21 applies to all deliverables within contractually binding arrangements under which a vendor will perform multiple revenue generating activities Determine whether these arrangements contain more than one unit of accounting standalone value to the customer? objective and reliable fair value? Applicable revenue recognition criteria should be considered separately for separate units of accounting
Accounting Guidance - Revenue Recognition EITF 00-21 (continued) Allocation of arrangement consideration The arrangement consideration should be allocated to each identified unit of a transaction based on the unit's relative fair value Under this method, any discount is shared proportionately among each unit of the transaction based on its relative fair value The SEC view is that the range of product fair values in a population of cash transactions should be the same as the range of the same product fair values in a financed transaction Issues Using artificial equipment values to decrease the implicit interest rate, in order to pass the 7d sales-type lease test Allocating monthly payment stream (e.g., services) to equipment to accelerate up-front revenue recognition Adjusting residual values to manipulate revenue recognition
Accounting Guidance Statement of Cash Flow SEC Accounting Position Issued March 4, 2005 Classification of receipts in the statement of cash flows from inventory sales SEC s view is that Paragraph 22 of Statement 95 requires cash receipts from sales of goods or services to be reflected as operating cash flows. This classification is required regardless of whether those cash flows stem from collection of the receivable from the customer or the sale of the customer receivable to others; regardless of whether those receivables are on account or stem from the issuance of a note; and regardless of whether they are collected in the short-term or the long-term. Generally impacts the consolidated statements and not the captive finance subsidiary s separate company statements.
Vendor Leasing Guidance FASB Statement No. 13, Accounting for Leases Paragraph 21 states that The sale of property subject to an operating lease, or of property that is leased by or intended to be leased by the third-party purchaser to another party, shall not be treated as a sale if the seller or any party related to the seller retains substantial risks of ownership in the leased property. This paragraph also specifically identifies a commitment by the seller to acquire the property upon lessee default or lease termination as an example of the seller retaining substantial risks of ownership in the leased property.
Revenue Recognition FASB 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities FASB 140 for transfers of sales-type/direct financing lease receivables and guaranteed residual values (at inception) Is transfer of financial assets sale or collateralized borrowing? Transferor has surrendered control over assets, sale recorded if all the following are met: Legal Isolation transferred assets are isolated from transferor Right to Pledge or Exchange each transferee has right to pledge or exchange assets Effective Control transferor has given up effective control over transferred assets The FASB project ongoing. Focus on isolation criteria and permitted activities of a QSPE. Final guidance expected second quarter of 2007
Revenue Recognition Operating Leases Vendor achieves sale treatment if equipment is subject to capital lease because substantial risks & rewards of ownership transferred to lessee Typical transaction: 3 rd party intermediary finances sale of manufacturer s product through an operating lease to the end-user lessee Substantial risks of ownership/continued involvement -upon default or termination of lease, the seller committed to Acquire the lease or the property Substitute an existing lease Secure a replacement lessee or buyer for the property under a remarketing agreement Direct or indirect guarantee of lease payments, such as credit or residual guarantee, is another form of risk of ownership (SEC 1999) Substantial risk: equals or exceeds 10% on a PV basis of the equipment s fair value at the time of transfer
Revenue Recognition Remarketing Agreements FAS 13: A remarketing agreement by itself does not disqualify sale accounting for the transaction if the seller A. Will receive a reasonable fee commensurate with the effort involved at the time of securing a replacement lessee or buyer for the property and B. Is not required to give priority to the re-leasing or disposition of the property owned by the third-party purchaser over similar property owned or produced by the seller
Revenue Recognition Recourse Pooling Special considerations when selling equipment subject to operating leases or when buyer s lease classification is not known When PV of vendors risk on a transaction with recourse is >10% of fair value of equipment, no sale recorded; profit deferred Risk of loss measured on a transaction by transaction basis Risk of loss measured on a pool level for homogeneous pools of transactions Sale of assets occur over a short period The assets have similar residual values The leases are for similar terms/periods Lessees with the same credit risk
EITF D-107 Guidance Criteria for pooling more restrictive over time (i.e. only for similar equipment sold over a short period of time with similar residual curves, lessee credit risk and comparable lease terms.) Pooling now being challenged under EITF D-107: Lessor Consideration of Third Party Residual Value Guarantees. D-107 states that RV guarantees of a portfolio of leased assets preclude lessor from determining amount of guarantee of any individual leased asset in portfolio, therefore no such amounts should be included in minimum lease payments. Rule is now being applied to vendor guarantees of residual and credit risk. Accounting firms are reconsidering their prior view that under a homogeneous concept, similar assets could be treated as one. Vendor may not receive sale treatment.
EITF 01-08 Determining Whether an Arrangement Contains a Lease Whether a service contract or similar arrangement is or includes a lease. Does the purchaser have operational control of the property take substantially all of its output? Arrangement may contain a lease. If the lease is deemed to be capital, the end user would need to put the transaction on its balance sheet. Revenues formerly reported from sales of products or services may have to be treated as rental lease income.
FIN 45 Overview Guarantor s s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others Expanded disclosure and recognition of guarantees in financial statements Disclosure: financial statements issued after 12/15/02 Disclose the maximum potential undiscounted future payments under guarantee Recognition: guarantees issued or modified after 12/31/02 Fair value of obligation reported as a liability on the guarantor s financial statements
Vendor Leasing Implications FIN 45 - Continued Manufacturer guarantees Residual and credit support Guarantees whose existence prevents the guarantor from recognizing a sale or the earnings from a sale are not included in scope All events indemnifications Indemnify for adverse judgment in a lawsuit or adverse tax law changes or interpretations Indemnities related solely to the lessee s future performance are not included in FIN 45 acts and omissions
FIN 45 Measurement of Liability Determination of Fair Value Market-based Fair Value If a market for similar guarantees does not exist then use Probability Weighted Cash Flows
Fair Value Calculation Example Lease example $500,000 computer lease 12% expected FMV Vendor provides $40,000 residual support to lessor 8% vendor guarantee Vendor takes sales treatment
Fair Value Calculation Example Possible Asset Values 17% 12% 7% 0% Total Guaranteed Payment 0 0 5% 8% Probability of Occurrence 20% 50% 20% 10% Weighted Expected Value 0 0 1.00.80 1.80 Discount at risk free rate of 4.70 (5 yr Ts) = 1.42%
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