Corporate Finance & Restructuring Lease Accounting Changes: Pain or Gain for Equipment Lessors? By Pablo Wangermann Alison Mason Bill Trent In August 2010, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) (the Boards ) together published an Exposure Draft that proposes significant changes to the current standards for lease accounting. The primary goal of the proposed changes is to increase transparency by requiring that lessees bring on balance sheet their obligations to make payments under operating leases. The Exposure Draft however also includes material changes to lessor accounting for both balance sheet and income statements simply as a consequence of lessors being on the other side of the lease transaction, rather than to address any perceived deficiency in lessor accounting transparency. A review of a sample of the more than 300 comment papers provided in 2009 to the IASB/FASB in response to a Discussion Paper on Lease Accounting indicates there is substantial disagreement on the need to include lessor accounting at this juncture, and whether the complexity of the proposed changes is warranted. Nevertheless, the IASB estimates that $640 billion of annual lease payment obligations are not reflected on lessee balance sheets, and the Boards have determined that this problem cannot be addressed in a vacuum. The Boards primary concern is commercial real estate leases (e.g., retail, hotel, office space), which account for 75 80 percent of operating leases. Equipment leasing is only a small part of the market, 1 but will be held to the same new standards if they are implemented. Given that comments on the Exposure Draft are due by mid-december, with Final Rules to be issued mid-2011, it would be prudent for lessors of core operating assets to begin planning their potential responses to these changes now. 1 Equipment leasing includes leases of non-core assets such as copiers, company cars, and computers/software.
What s New in the Exposure Draft Elimination of Operating/Finance Lease Distinction The crucial proposed change has to do with how a lease is defined. Broadly, a contract that is essentially a sale financed over time will not be considered a lease, whether it provides for automatic title transfer at termination or offers a bargain purchase option exercisable at any point. A lease will be defined as the right to use a specified asset for a period of time in exchange for consideration. Specification is the important term here: a Master Lease Agreement governing the provision of 100 railcars for example, where the assets are not specified and the lessor has the right of substitution, will not be considered a lease. 2 Additionally, true leases that contain a distinct service component (i.e., the service can be bought separate from the asset, either from the lessor or on the general market, such as a full-service railcar lease) will need to allocate receipts between lease payments and service contract payments, even if not delineated in that manner in the contract. Balance Sheet Accounting Changes For equipment leases that satisfy the new definition, lessors will be required to include on their balance sheets an asset representing their right to receive lease payments, as opposed to simply booking receivables as invoiced. They have two options for doing this: derecognition and performance obligation. Derecognition reflects a de facto sale and requires the replacement of the physical asset with a receivable and a residual value on the balance sheet. Performance obligation requires the physical asset to be shown on the balance sheet, as well as both a lease receivable and a corresponding obligation to provide the asset. To determine which of the two methods to use, the lessor must assess whether it will retain the risks and benefits of ownership of the asset at the termination of the lease. 3 If the lessor will not retain economic ownership, then the derecognition approach is required. If the lessor retains economic ownership, then it must apply the performance obligation method. Although the choice of accounting method will not always be clear cut, the most straightforward indicator of which to use will likely be the remaining useful life test. A performance obligation approach generally would be called for if the lease period is less than the effective useful life of the asset; if the lease period is equal to the asset s remaining useful life, a derecognition approach would be used. Changes to P&L Accounting Instead of simply accruing contractual payments when due, the Exposure Draft proposes that lease revenues in lessor accounts will include both income related to the use of the equipment and imputed interest (Exhibit 1). These amounts combined will not equate to the contractual payment and will vary over the lease term, increasing the volatility of reported income. This effect will be enhanced to the extent that estimates for contingent payments are included in the lease receivable, along with any adjustments to those estimates over the lease term. For the derecognition method, lessors will recognize a gain or loss at the time of lease inception, based on the difference between the net book value and the fair value of the asset. Going forward, lessors will recognize both lease income and imputed interest income related to the discount of the lease receivable until the receivable is amortized and the lease terminated. Lessors will then recognize a gain or loss on disposal of the residual. 2 It appears these will be considered Service Contracts, subject to separate Board rules that may result in more limited accounting changes. 3 Assuming that the lessee performs under the lease; no consideration may be given to lessee credit and the possibility of early termination for non-performance. 2
Exhibit 1 Example of Impact of Proposed Changes on Lease Revenue P&L Accounting Total lease revenue $6,000, 5 year lease, $1,200 payment in arrears, PV at 12% p.a. $1,500 $1,400 $1,300 $1,200 $1,100 $1,000 $900 $800 Under Current GAAP Under Proposed GAAP Year 1 Year 2 Year 3 Year 4 Year 5 Difference 184 103 11 (91) (206) Lease Income 865 865 Total 4,326 Imputed Interest 519 437 437 346 346 243 243 129 1,674 Total Lease Recv.. 3,645 2,882 2,028 2,028 1,071 1,071 0 6,000 For the performance obligation method, lessors will also recognize both lease income and imputed interest, as well as continuing to expense depreciation. Lessors will recognize a gain or loss on the asset when sold, and a similar gain or loss on the net lease receivable if the asset is sold with a lease attached. Should a lessor retain the equipment and re-lease it until the end of its useful life, the final lease will require using the derecognition method, possibly generating a gain or loss (which could be reversed when the asset is actually sold or scrapped). To Be Decided: Controversial Issues in the Draft Renewal, Extension, and Early Termination Options A renewal, extension, or early termination option conveys an asset to the benefit of the lessee, but does not create (or shorten, in the case of an ETO) a non-cancellable obligation until it is exercised. How these options should be treated in determining the lease term for calculating the present value (PV) of lease payments, whether as an asset for lessors or a liability for lessees, is likely to be the subject of much debate and we expect clarification of these points in the Final Rules. Estimating the probability of lease renewal, extension, or early termination for transportation equipment is not an easy task and historical data show that many factors contribute to high variability. The Exposure Draft implicitly acknowledges this by stating that it is likely that a lessor and a lessee will account for the same lease in a different manner on their respective books, reflecting the asymmetry of expectations that these options will be exercised. Contingent Lease Payments, Residual Guarantees, and Purchase Options Contingent payments may take the form of payments based on usage (typical for transportation equipment), sales (for retailers), or another index, which may or may not be within the lessee s control. There is therefore a concern that minimum lease payments may be disguised as contingent payments to game the system (e.g., if the sun rises, the contingent payment is due ). 3
For these reasons, the Exposure Draft includes a requirement that contingent payments over the life of the lease be estimated and included in the PV of lease payments. The ability to accurately estimate these at inception and then adjust them over time is likely to be one of the most controversial elements of the accounting standard. Residual guarantees and purchase options are flip sides of the same coin the former creates a contingent payment obligation that can be quantified, the latter is an option that may be exercised to create an obligation, both relative to expected future values. Estimating the probability of either occurrence in order to put a value on contingent payments will be complex, as future value evolution is difficult to predict. This is another non-trivial challenge and any estimate could be readily disputed. Moreover, these estimates will have different effects for lessors and lessees, so getting agreement on key valuation parameters will be tough. We therefore expect further clarification of these points in the Final Rules. Short-Term Leases vs. De Minimis Leases In the Exposure Draft, leases of less than 12 months duration at inception (including all extensions or renewal options) are excluded from these changes. Concerns have been raised about the lack of a materiality test and the ability to engineer leases to avoid the new rules. We expect that this provision will attract significant comment and may be subject to change in the Final Rules. Lessening the Pain: Strategies for Lessors The Final Rules will not be issued until mid-2011 and publication likely will be followed by a transition period for implementation. Although there may be some changes to details in the Final Rules vis-à-vis the Exposure Draft, lessors should take advantage of this interim period to start looking at ways to mitigate the effects of the changes. Oliver Wyman believes some potential options could include: Submitting comments to the Boards describing concerns about the effects on lessor financial statements, the additional effort that will be required to prepare them, and the ways in which normal operations may be affected, such as pricing and structuring of leases or collection practices. (Comment letters may be submitted individually or through industry associations.) Reviewing operating leases to determine if there may be opportunities to work with your clients to amend terms in a way that is beneficial to the lessor and lessee. For example, options for extensions, early terminations, or FMV purchases were previously without cost but may now confer complexity that outweighs their value to both parties. Utilizing the transition as an opportunity for a strategic review of your entire equipment and lease portfolio to ensure that it is optimized for future growth prospects. This could include reviewing asset residual values to evaluate ownership tenor and portfolio mix in light of the new rules. In summary, although changes with respect to lessee accounting may be a good thing, the proposed rules as they stand will impose a significant burden on equipment lessors. Leasing companies would do well to make a concerted effort to understand and comment on the implications for their businesses and to begin making plans for dealing with the financial, operational, and customer challenges presented by the new rules. 4
Oliver Wyman Support for Equipment Lessors Oliver Wyman s Asset Leasing and Valuation Practice provides support for transportation asset owners, operators, managers, and financiers. Assistance that Oliver Wyman can provide to equipment lessors includes long-range strategic planning, with a focus on projected equipment requirements; portfolio cash flow modeling and risk analysis; and assessment of the economics of equipment replacement/investment programs. In the past decade, Oliver Wyman has provided valuations in support of more than $9 billion in transportation assets. Oliver Wyman has worked with both lessees and lessors in restructuring lease obligations and financial restructuring of portfolios. Oliver Wyman s expertise is regularly sought by industry associations in all transportation modes. For more information on Oliver Wyman s perspectives on the impacts of lease accounting changes and strategies for optimizing lease portfolios, please contact your Oliver Wyman account partner or one of the following: Pablo Wangermann +1-214-721-1510 (Dallas) pablo.wangermann@oliverwyman.com Alison Mason +1-646-649-4404 (New York) alison.mason@affiliate.oliverwyman.com Bill Trent +44-20-4852-7424 (London) bill.trent@oliverwyman.com Also contributing to this perspective: Bill Rennicke, Partner, Boston. About Oliver Wyman Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation, and leadership development. The firm works with clients to deliver sustained shareholder value growth. We help managers to anticipate changes in customer priorities and the competitive environment, and then design their businesses, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. We have more than 35 years experience serving Global 1000 clients. Our staff of 2,900 operates from offices in more than 40 cities in 16 countries. Our Corporate Finance & Restructuring Practice offers in-depth market and industry expertise across a wide range of industries, with more than 300 projects conducted for investors annually. Our capabilities include support for M&A, project finance, restructuring/workouts, privatization/ppp and concessioning, and litigation support. www.oliverwyman.com Copyright Oliver Wyman. All rights reserved.