By Shawn D. Halladay
The Alta Group has been tracking the proposed changes to the lease accounting rules since they reared their (dare we say, ugly?) head back in 1996. Over the years, these proposals have morphed considerably, undergone numerous revisions, and generated their fair share of heartburn in the equipment leasing industry. With the release of the International Accounting Standards Board’s (IASB) version of the lease accounting standard on January 12th of this year, it is now only a short matter of time until the Financial Accounting Standards Board (FASB) does the same.
The following discussion is intended to assist our clients in identifying how their companies will be affected and what strategies need to be implemented. Naturally, any lease accounting changes that impact how lessees account for their leases also impacts lessors. Nonetheless, the lessee impact, which primarily is sales-oriented, is discussed separately from the lessor impact, which is operational.
Of course, the greatest and most visible impact of the accounting changes is that all leases, with few exceptions, will now be on balance sheet. In a win for the industry, ELFA was able to get FASB to recognize that there are two different types of leases: financing arrangements, which are capital leases, and usage agreements, which are operating leases.
Consequently, the new standard will make a distinction between capital leases and operating leases. This distinction will be based on the current classification rules of FASB 13 (Topic 840), with minor tweaks that align them more closely with the current international lease accounting standard. Capital leases will continue to be accounted for in the same manner as they currently are, although operating leases now will be capitalized.
The impact of this capitalization is that lessees now not only must track their leases more closely, but also maintain amortization schedules for both capital and operating leased assets and liabilities. This will require additional investment in processes and operational capabilities, although nothing beyond that already required for loans. Since there now will be a balance sheet distinction between leases and service contracts, lessees also will need to make operational distinctions between lease payments and other elements in the transaction for proper classification.
One of the benefits of retaining the distinction between finance and operating leases is that lessees will continue to recognize the expense associated with operating leases on a straight-line basis, a result that retains a financial reporting advantage for the lease over comparable loans. Another benefit of straight-line expense recognition for operating leases is that it continues to match up with the tax treatment of the leases, thereby removing the need to create and track deferred tax balances.
The new provisions also contain other aspects that mitigate the commercial impact of putting all leases on balance sheet. The lease liability, for instance, is not presented as debt but, instead, is shown as an operating liability. This balance sheet presentation means, in theory, that lease capitalization will not create covenant issues or impact the debt-to-equity ratios. Lastly, the partial off balance sheet treatment still available on the residual portion of the lease is enhanced for TRAC-type residual guarantees, as the lessee in these arrangements only has to book the expected residual payment, not the full potential liability.
We don’t see these changes as creating deleterious results for the equipment leasing industry overall, although it is important for lessors to proactively address the impacts that do exist. As Alta has maintained from the outset, the best advice is to communicate with lessees about the changes and reassure them that the many benefits of leasing remain untouched, including the partial off balance sheet benefits in FMV leases. This message has to be conveyed consistently and on a timely basis by the sales force.
There are no significant accounting changes for lessors, in general, although there may be necessary changes to product approaches due to lessee impacts. The new rules do preclude lessors from recognizing sales-type profit at the commencement of the lease, however, for direct financing leases that use third-party insurance or residual guarantees to meet the 90% test. Instead, this profit will be recognized as financing income over the term of the lease.
Another provision related to residuals requires lessors to record guaranteed residuals as a nonfinancial (physical) asset, as opposed to a financial asset such as a lease payment. In another change, the definition of initial direct costs now only includes third-party costs, which means that fewer costs will be deferred, adversely affecting income in the near term.
The recently issued FASB statement on revenue recognition has impacted the sale-leaseback rules, in addition to sales-type lease accounting. For example, whenthe leaseback contains a purchase option, it will be more difficult to achieve sale and operating leaseback treatment. Lastly, leveraged lease accounting has been eliminated but existing leveraged leases as of the transition date are grandfathered, meaning that leveraged leases still may be originated until the effective date of the new standard.
The operational impact will be negligible for lessors as their systems will need minimal change. For lessors this will require minor tweaks to lease management systems but not a major cost as most lease software companies see this as a maintenance fix. Since lessees are facing a lot more work related to lease capitalization, and most do not have robust tracking systems, they may turn to lessors for help. One way for lessors to do this is by providing data feeds through existing Lease Management System (LMS) portals.
The effective date of the new rules for public companies will be fiscal years beginning after Dec. 15, 2018, which makes 2019 the transition year. Companies cannot wait until then to begin their transition efforts, however, as the U.S. Securities and Exchange Commission (SEC) requires two-year comparative balance sheets and three-year comparative income statements from public companies. In a slight nod to private companies, FASB has extended the transition to the new rules for private companies by an additional year, until 2020.