Intermediate Accounting Presenters: Amy Nelson, SVP, De Lage Landen Financial Services Theo Schuldt, Assistant Controller, GATX Corporation
Agenda Lease Classification Issues Items included/excluded in Minimum Lease Payments Economic Penalties Residual Value Guarantees Impact of lease classification on future transactions Asset Transfers Impairment Disclosure Requirements Accounting for Sale-Leasebacks Introduction to Leveraged Leases
Lease Classification Issues
Minimum Lease Payments - Lessee Exclude: Executory costs paid by lessee (insurance, maintenance & taxes) Contingent rentals directly related to usage (cost per hour, cost per copy) Include: Minimum rentals required over lease term (bargain renewals) Bargain purchase option amount Cost of economic penalties Lessee guarantee of lessor debt obligation at lease termination date (considered a residual guarantee)
Minimum Lease Payments - Lessee Include (cont): Payment required to make upon failure to renew, extend or locate replacement lessee. Contingent rentals NOT related to usage (indexed to CPI) Contingent rentals related to unrealistic excess wear and tear clause
Minimum Lease Payments - Lessor Include same items as for Lessee, plus Any guarantee of residual value or of rental payments beyond the lease term by an unrelated third party, provided the third party is financially capable of discharging the obligations that may arise from the guarantee.
Economic Penalties Factors to Consider Economic Compulsion Existence of an economic penalty resulting from factors external to the lease must be known at the inception of the lease. The nature and estimated amount of the penalty at the inception of the lease must be such that renewal of the lease by the lessee would appear to be reasonably assured. Loss is economically similar to a requirement to make a payment to the lessor or a third party at the end of a lease.
Economic Penalties Examples Lessee leases office space for a short period with option to renew for relatively long period. Logistics of moving personnel requires long period to plan and execute. Lessee has invested substantial amount in installing equipment. Lease of equipment is for a short period with relatively long renewal periods. Removing the equipment would be costly and inconvenient. Judgment required to assess if renewal/purchase is reasonably assured. Conclusion: Accountants will examine reasonableness of assumptions.
Residual Value Guarantees Lessee Lessee agrees to make up any deficiency below a stated amount in the lessor s realization of the residual value. The guarantee is included in the minimum lease payments to the contractual maximum stated amount, not an estimate of the deficiency to be made up. Third Parties If the guarantee of the residual value is obtained by the lessee from an unrelated third party for the benefit of the lessor, it does not reduce the amount of the lessee s minimum lease payments unless the lessor explicitly releases the lessee from all obligations.
Residual Value Guarantees Types Residual Value Insurance purchased from third party Unreasonable wear & tear or usage standards. Purchase Option: if economic penalty is created Remarketing arrangement: seller must secure a lessee or a buyer for property Lessee guarantee of lessor debt when guarantee extends beyond lease term
RVG Accounting Impact Lessee provided both lessee and lessor include as minimum lease payments for 90% test Third Party provided Lessor includes as minimum lease payment for 90% test, lessee does not.
Impact of Lease Classification
Impact on Future Transactions Lease classification affects accounting for Future sales or transfers of leased assets Determining whether lease investments are impaired
Impact on Future Transactions Financial / non-financial assets - Assets on operating lease are not financial assets Direct financing lease receivables are financial assets. The unguaranteed residual component of a direct financing lease investment is not a financial asset. As a result, lease classification affects accounting for future sales or transfers of lease investments
Impact on Future Transactions Sales or transfers of assets on operating lease Governed by FAS13 (para. 21) Risk / reward model Sale not considered a sale if the seller retains substantial risks of ownership
Impact on Future Transactions Sales or transfers of direct financing lease receivables Governed by FAS140 Legal and substance model
Impact on Future Transactions Sales or transfers of direct financing lease receivables (cont d) Sale not considered a sale if 1. the receivable is not isolated from the seller, even in the event of the seller s bankruptcy; 2. the purchaser does not have the ability to pledge or exchange the lease receivables; and 3. the seller has not surrendered effective control over the lease receivables
Impact on Future Transactions Sales or transfers of direct financing lease unguaranteed residual Similar to sale of assets on operating lease Sale not considered a sale if the seller retains substantial risks of ownership See example in FAS140, para. 90
Impact on Future Transactions Determining whether lease investments are impaired Assets on operating lease subject to FAS144 Direct financing lease investments subject to FAS13 (residual) and FAS5 (receivables)
Impact on Future Transactions Determining whether assets on operating lease are impaired Impaired if the carrying amount of the asset is not expected to be recovered by cash flows to be generated by the use and disposition of the asset If impaired, write asset down to its fair value
Impact on Future Transactions Determining whether assets on operating lease are impaired Expected cash flows should not be discounted for purposes of this analysis Accounting rules do not require a return on long-lived assets only require the asset to be recoverable
Impact on Future Transactions Determining whether direct financing lease investments are impaired Direct financing lease receivables Covered under FAS5 Loss/impairment recorded when 1) Information indicates it is probable a loss has been incurred and 2) The amount of the loss can be reasonably estimated
Impact on Future Transactions Determining whether direct financing lease investments are impaired Direct financing lease unguaranteed residual Covered under FAS13 Required to be reviewed annually Impaired if new estimate of residual value is lower than original and decline is believed to be other than temporary
Accounting For Sale-Leasebacks
Definition of Sale-Leaseback Sale-leaseback transactions involve the sale of property by the owner and a lease of the property back to the seller. The seller-lessee records the sale and removes the asset from its balance sheet. The leaseback is classified in accordance with SFAS #13. Note: specifically excludes the use of sales-type lease classification in a sale-leaseback transaction. Gains or losses MAY be recorded depending on several factors. Real estate (including integral equipment) is treated differently than equipment not covered in this presentation.
Accounting Guidance If the asset is equipment, the leaseback is subject to SFAS #28 (amendment to #13). If the asset is real estate or integral equipment (as defined by EITF #00-13), the leaseback is subject to SFAS #98 (amendment to #13).
What is Integral Equipment Integral equipment is any physical structure or equipment attached to real estate, or other parts and cannot be removed and used separately without incurring significant cost. EITF Issue 00-13 defined significant cost as 10% of the equipment s fair value as of the date of the sale-leaseback. Significant costs include: Cost of removal The diminution in value The cost to ship to a new location for reinstallation, and The cost to reinstall the asset at it s new location. Integral equipment is treated as if it were real estate subject to SFAS #98.
Sale-Leasebacks If the seller-lessee relinquishes right to substantially all (greater than 90% on a PV basis of the FMV of the asset) of the remaining use of the property sold; Treat the sale and lease as separate transactions. Record any profit or loss as if a sale occurred.
Sale-Leasebacks If the seller-lessee retains more than a minor part (greater than 10%) but less than substantially all (less than 90%) of the use of the property through the leaseback and realized a profit on the sale: If the leaseback is an operating lease, profit is recognized to the extent the profit exceeds the present value of the minimum lease payments (including any residual guarantee). If the leaseback is a capital lease, profit is recognized to the extent the profit exceeds the recorded amount of the leased asset of the capital lease. Any unrecognized profit is recorded over the lease term to offset either rental expense (operating lease) or amortization (capital lease). Rationale: profits in excess of continuing obligation may be recorded
Sale-Leasebacks If the fair value of the property at the time of the transaction is less than its undepreciated cost, a loss is recognized immediately up to the amount of the difference between undepreciated cost and fair value.
Sale-Leasebacks - Example Assumptions: Asset Net Book Value $ 4,395 Sale Price $20,000 Lessee Residual Guarantee $ 4,000 Rentals $ 756.90 /QTR Lease Term 5 years
Sale-Leasebacks - Example Lease Classification Gross Present Value Base Rents $15,138.00 $10,788.00 ($756.9 x 20) Lessee Guarantee of residual 4,000.00 2,022.50 Total $19,138.00 $12,810.50 90% of fair value (90% x $20,000) $18,000.00 Since PV MLP is less than 90%, resulting leaseback is classified as an Operating Lease.
Sale-Leasebacks - Example Amount and Timing of Gain Recognition Sales Price $20,000 Cost 4,395 Gain on Sale 15,605 Lessee Guarantee 4,000* Net Gain 11,605 PV of MLP excluding residual guarantee 10,788 Gain Recognized at time of sale 817** * Gain related to gross residual will be recognized at the end of the lease term to extent unexercised ** Remaining gain to be amortized in proportion to rentals (operating lease)
Basic Leveraged Leasing
Leveraged Leases Unique accounting model created to capture the unique economic effect of this type of transaction Unique economic effect produced by combination of: nonrecourse financing and cash flow pattern that allows lessor to recover its investment in the early years and thereafter have temporary use of funds from which additional income can be derived Only from lessor s perspective
Leveraged Leases Unique accounting model (cont d) Separate phases method First phase lessor s investment not yet recovered Second phase lessor s initial investment fully recovered and lease generates excess cash to lessor (investment becomes negative) Third phase lessor reinvests in the lease (investment becomes positive again)
Leveraged Leases Separate phases method 1000 800 600 400 200 0-200 -400 1 2 3 4 5 Aver. AT investment Aver. PT investment PT income
Leveraged Leases Unique accounting model (cont d) Characteristics of accounting model Nonrecourse debt netted from lease receivables on asset side of balance sheet Lease income is only recognized during periods when the after-tax investment is positive Income is front ended If total income changes during lease, lease balances must be recalculated from inception and adjusted Change due to residual estimate, tax rate etc. Gain or loss recognized in period of revision
Leveraged Leases Unique accounting model (cont d) Accounting model increasingly controversial FAS13 issued in November 1976: a lot of accounting changes have happened since then, but the leveraged lease model has remained intact Transparency is reduced by reporting the lease receivable balance net of nonrecourse debt Income each period depends on timing of cash flows, but FAS13 originally only required recalculation of lease balances when total income changes, not when the timing of cash flows change Changed by new FASB Staff Position (FAS13-2) issued 7/13/06
Leveraged Leases To qualify for this unique accounting treatment, a lease must: Meet direct financing lease definition Asset must be new to lessor (fair value = carrying value) Involve at least three parties: a lessee, a longterm creditor, and a lessor
Leveraged Leases To qualify for this unique accounting treatment, a lease must (cont d): Be financed with nonrecourse debt and the amount of the debt must provide the lessor with substantial leverage At least 50% of asset value Debt must have a substantial average life compared to lease term (interpretation to qualify as long-term creditor) Have a net investment balance that declines during the early years of the lease and rises during the later years Usually caused by taxes, but not required to be
Leveraged Leases Detailed example assumptions Asset cost - $3,000 Nonrecourse debt - $2,400 Debt service payments - $633 annually Rentals - $633 annually Residual value - $1,000 Tax rate 50% Lease term 5 years
Leveraged Leases Step 1: Calculate after-tax cash flows Cash inflow (cash outflow) Debt service Year Cost Debt Principal Interest Total Rents Residual Depreciation Taxable income Tax Net cash flows 0 (3,000) 2,400 (600) 1 - (393) (240) (633) 633 - (2,000) (1,607) 804 804 2 - (432) (201) (633) 633 - (1,000) (568) 284 284 3 - (475) (158) (633) 633-475 (238) (238) 4 - (523) (110) (633) 633-523 (262) (262) 5 - (577) (56) (633) 633 1,000 1,577 (789) 212 (3,000) 2,400 (2,400) (765) (3,165) 3,165 1,000 (3,000) 400 (200) 200
Leveraged Leases Step 2: Determine how to allocate after-tax cash flows between after-tax income and return of investment Have to keep trying different rates until we find the rate which, when applied to the net investment in the years that it is positive, will distribute net income to those years, and the investment will be reduced to zero by the end of the lease. Year Cash flows CF alloc to income CF alloc to invest AT Net Investment 0 600 1 804 156 648 (48) 2 284-284 (332) 3 (238) - (238) (94) 4 (262) - (262) 168 5 212 44 168 (0) Rate: 26% Note: the accounting rate used to allocate income is different from the rate of return generated by the cash flows
Leveraged Leases Step 3: Gross up AT income to a pre-tax equivalent Year CF alloc to AT income Divided by tax rate Pre-tax income Tax expense from lease 0 1 156 50% 312 156 2-50% - - 3-50% - - 4-50% - - 5 44 50% 87 44
Leveraged Leases Step 4: Determine components of leveraged lease and taxes as they will appear on the balance sheet throughout the lease term Year Deferred taxes (pay)/rec Cumulative total taxes payable Receivable Debt service Unguaranteed residual Unearned income Investment Current taxes (pay)/rec 0 3,165 (3,165) 1,000 (400) 600 - - - 1 2,532 (2,532) 1,000 (88) 912 804 (960) (156) 2 1,899 (1,899) 1,000 (88) 912 1,088 (1,244) (156) 3 1,266 (1,266) 1,000 (88) 912 850 (1,006) (156) 4 633 (633) 1,000 (88) 912 589 (745) (156) 5 - - - (1) (1) (200) 0 (200)
Leveraged Leases Step 5: Note - investment combined with deferred taxes is the same as the AT investment balance Year Investment Deferred taxes AT investment 0 600-600 1 912 (960) (48) 2 912 (1,244) (332) 3 912 (1,006) (94) 4 912 (745) 168 5 (1) 0 (0)
Leveraged Leases Step 6: Additional information - numbers used in investment and income graph Year Beginning AT investment Beginning PT investment Ending AT investment Aver AT inv Ending PT investment Aver PT inv 0 600 300 600 300 1 600 (48) 276 600 912 756 2 (48) (332) (190) 912 912 912 3 (332) (94) (213) 912 912 912 4 (94) 168 37 912 912 912 5 168 (0) 84 912 (1) 456