By Shawn D. Halladay
The FASB has issued a Discussion Paper on lessee accounting for leases. As expected, the requirement to classify leases as capital or operating is gone and lessees must capitalize all leases. This one-size-fits-all model, which treats dollar-outs and FMV leases the same, accounts for very different transactions in the same way.
Under the new rules all leases will be treated essentially the same as current capital leases. In a significant departure from FAS 13, though, lessees must assess the impact on the lease term of options to return, renew, or purchase the leased asset.
For example, if the lessee expects to renew the lease, the base term plus the renewal payments now must be capitalized. Furthermore, these assumptions are reassessed each reporting period. Lessees also must estimate and capitalize the amount of any contingent rents and residual guarantees likely to be paid.
The capitalized asset and liability are amortized to depreciation and interest expense whether the lease represents an in-substance financing or a usage agreement. The Equipment Leasing and Finance Association (ELFA), however, is fighting to keep the periodic expense of usage/operating leases under the new model the same as the current FAS 13 rent expense so as to better represent the transactions’ economic substance.
The requirement to capitalize operating leases will, of course, cause a decline in volume due to the loss of off balance financing and the time and cost of estimating lease terms, options, and contingent rents on each lease. Capitalizing operating leases will, of course, impact lessees’ ratios, even though their financial health remains unchanged. Lessees also can expect to incur costs associated with rearranging capital structures and avoiding technical default on outstanding debt.
Off balance sheet leases will not disappear, however, as lessees seeking partial off balance sheet financing will adopt structures that minimize the present value of the lease obligations. Certain asset classes will create significant off balance sheet benefits for lessees due to residuals and/or tax benefits. Lessees also will seek shorter-term leases and leases structured with subjective options and contingencies, allowing lessors to charge a premium for this greater risk and flexibility.
Yes, my friends, the smell of opportunity is in the air for those lessors willing to take residual risk and fine-tune their business model. There will be opportunities to provide accounting-based products, plus, lessees will continue to utilize leasing for its many other benefits. Keep on leasing!
About the author
Shawn D. Halladay is a member of the Leasing News Advisory Board. This is a synopsis of his 4,500 word article to appear in the next edition of the Equipment Leasing and Finance Association "ELT" magazine, available for members.