Benefits Remain Strong for "On Balance Sheet" Operating Leases

For companies leasing equipment, the change means that, for accounting purposes, all leases for plant, property and equipment would be recorded on the balance sheet for some time.

Last September, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) released the "Lease Accounting Exposure Draft," which is a joint public statement about the intended changes to current FASB and IASB lease accounting guidance. The changes, if adopted as currently proposed, will impact the way companies worldwide account for leased equipment and real estate. Given the fast pace of recent FASB/IASB deliberations, many manufacturer-lessees are still in the learning curve in comprehending the details and how on balance sheet reporting for operating leases might impact their individual businesses. Although the proposed changes are significant and complicated, as explained below the benefits to leasing manufacturing equipment remain significant and distinct.

Proposed Changes

For companies leasing equipment, the proposed changes would replace FAS 13 operating and capital lease treatment with a single method called "Right of Use" (ROU). The ROU method determines how much would go on the balance sheet. In effect, this means that, for accounting purposes, all leases for plant, property and equipment would be recorded on the balance sheet for some amount.

This change would have the biggest impact on lessees currently using or considering an operating lease. Currently, FAS 13 says, among other things, that if the present value of payments due under the lease agreement is less than 90% of the original cost of the equipment, the lease should be treated as an operating lease. If the present value is more than 90, the lease should be treated as a capital lease because, at that level, it is deemed to transfer substantially all of the risks and benefits of ownership to the lessee.

Commonly referred to as "off balance sheet" financing, the business simply treats the lease payments as an operating expense, generally recorded on a straight-line basis, on the income statement. By not carrying the leased asset and rental obligation on its balance sheet, businesses can report stronger balance sheets and better return ratios. However, since FAS 13 provides for disclosure of operating lease commitments in the notes of the lessee's audited financial statements, creditors and investors can, and do, adjust the balance sheets and ratios for credit and ratings purposes.

The proposed changes would eliminate this "bright line" 90 percent test. Rather, the proposed ROU model would take several factors into consideration and calculate the value that would go on the balance sheet. In addition, leases that would have formerly been classified as operating leases would no longer record a straight-lined lease expense. The FASB and IASB have tentatively decided to treat all leases as financings and thus require a front-loaded pattern of expensing for all leases, similar to an asset purchased with debt financing. Under this approach, the sum of ROU amortization and interest on the capitalized lease obligation would exceed cash rent in the early years with an inverse relationship in the later years.

Right of Use Method

The ROU determines the present value of the likely payments a manufacturer will make under a lease agreement, discounted using the manufacturer's incremental borrowing rate (which could be the lessor's implicit rate), plus any initial direct costs incurred. Lease payments would include initial term payments, interim rent, contingent rents based on a rate or an index and any portion of residual value guarantees expected to be paid. Additionally, any contingent payments for which the variability lacks economic substance and are reasonably certain of payment (so-called "disguised" lease payments) must be sized and included in the payment stream. The present value amount determines initial cost at which the lessee would record the leased assets and related lease obligation its financial statements.

The FASB/IASB have tentatively agreed not to significantly change the accounting for purchase options. Similar to existing accounting, purchase options would not be included in the estimated lease payments calculation unless the lessee has a "significant economic incentive" to exercise the option, such as a bargain purchase option, or actually exercises the option. The proposed ROU model recognizes that a manufacturer that leases its equipment under an operating lease generally would not have an obligation to pay for 100 percent of the cost of the equipment. Thus, in cases where the lessor invests equity in the equipment, or a third party guarantees the equipment's future value, the manufacturer will only recognize the cost of the equipment that it is obligated and likely to pay for under the lease agreement. The result is that most operating leases will partially shelter the balance sheet from the entire cost of owning equipment, instead reflecting only the costs associated with accessing equipment via a lease agreement. However, if a lessee determines it has a significant economic incentive to exercise the purchase option, the ROU asset would be amortized over the economic life of the asset rather than the lease term.

Given what we know about the proposed changes so far, manufacturers can expect that every equipment acquisition will involve a front-end cost assessment. While this takes time and may involve more internal discussions and approvals, the costs associated with an equipment lease will be more transparent to all parties.

Timing

The initial public statement about the proposed changes was published in September 2010. A three-month public comment period followed, during which the FASB and IASB accepted feedback from the public on the changes proposed. Currently, the Boards and the project team are reviewing that feedback, engaging in outreach and continuing the deliberations.

It is already evident that due to voluminous negative feedback, several aspects of the proposed changes remain in discussion. The board is expected to continue its deliberations and draft the new accounting guidance throughout 2011 and possibly into 2012. While it's not yet clear exactly what the final lease accounting rules will be, the initial proposal is clearly an indication that change is definitely coming.

The FASB and IASB initially proposed an implementation date of January 1, 2013. Due to ongoing deliberations, this date has been taken off the table. Many industry watchers believe a more likely effective date is 2015. This may depend in part on decisions still to be made about how to retroactively adopt the new changes for leases already running at the critical dates.

Benefits Remain Strong

Clearly, the above described lease accounting changes, if adopted as proposed, would have a significant impact on the financial statements of lessee-manufacturers. However, this change in reporting generally would not impact the distinct advantages to leasing manufacturing equipment, particularly when compared to a purchase or loan.. For example:

  • Leasing For Your Customers

    As a manufacturer you know that leasing can be a critical tool to gain access to the equipment your company needs to grow and remain efficient. If your company manufactures finished equipment, then your customers can benefit from leasing too.

    For many manufacturers, offering a point of sale financing option is an important -- and highly profitable -- part of the sales process because it's a proven way for manufacturers to secure sales and other benefits, including:
    • Minimize days sales outstanding -- accelerate the sales cycle by eliminating the question of how the equipment will be paid for.
    • Improve upgrade activity -- end-of-lease disposition provides a natural contact point for next-generation and upgrade sales.
    • Maintain account control -- be the first to propose replacement equipment needs and use regular account servicing contact points to make constant contact with the client.
    • Up-sell -- more affordable payments can mean affording more equipment overall.
    Some manufacturers have a captive finance company -- owned by a common parent. But more often than not, the equipment finance provider is an outside partner. Now more than ever, it's important to make sure manufacturer sales representatives and equipment finance partners who offer your clients a point-of-sale lease option are knowledgeable about leasing and the proposed lease accounting changes. It's also a good idea to speak with your company's equipment finance partner to make sure someone is available to answer questions and provide information for end-user customers quickly and easily.
    Lower on-book debt -- When the present value of the equipment is less than the cost of the asset, manufacturers will continue to see a benefit on the balance sheet. Third party equity and/or re-purchase guarantees should continue to result in a lower present value.
  • Lower after-tax cost -- Regardless of accounting treatment, tax leases can continue to result in the lowest after-tax cost to acquire equipment, especially when the manufacturer is not a full taxpayer. Manufacturers that have prior year tax loss credits to use or those that are Alternative Minimum Taxpayers typically can't use the full benefits of depreciation associated with a new equipment purchase. Leasing can allow the manufacturer to trade in those benefits for an overall lower cost of financing.
  • Managing upgrade/replacement cycles -- Leases allow manufacturers to shift end of lease equipment value risk to the finance company. This eliminates the risk of finding a buyer for obsolete equipment. It also makes it easier to manage equipment upgrade and replacement cycles because manufacturers don't have to wait for proceeds on the sale of old equipment to acquire new equipment.
  • Conserve capital -- Leasing continues to help manufacturers conserve capital lines of credit for short-term needs by allowing 100% financing, including delivery, installation and training.
  • Speed -- Leasing can allow manufacturers to respond quickly to new opportunities with minimal documentation and red tape. Many leasing companies can approve applications within an hour. And, a new equipment finance addendum (sometimes called a schedule) can be quickly added to a master lease without the need for lengthy negotiations.
  • Improved Cash Forecasting -- When businesses lease, they can accurately forecast the cash requirements for equipment since they know the amount and number of lease payments required.

For More Information

As the date for implementing the proposed changes draws nearer, manufacturers can expect to hear more about the issues surrounding these changes from accountants, the media, the company's equipment finance partner, and at industry conferences and groups.

The Equipment Leasing and Finance Association also offers detailed, up to date information on its web site, including recent media coverage about the proposed changes, comment letters from the equipment finance industry and additional research and analysis.

Finally, it is always wise to consult your tax advisers when considering how lease financing might benefit your business.

Kelly Reale is vice president of product and market development for Key Equipment Finance. Key Equipment Finance is a bank-held equipment finance company and affiliate of KeyCorp. The company provides business-to-business equipment financing solutions for organizations of all types and sizes.

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