SEC Takes Aim at Lease Accounting

SEC Takes Aim at Lease Accounting

October 01, 2005

Many US companies use lease financing rather than borrow from a bank to buy new equipment. The equipment must be returned to the lessor at the end of the lease term, unless the lessee exercises a purchase option to retain it. There are various reasons why a company might prefer lease financing. One is that it lacks the tax base to use the tax depreciation and any tax credits to which it would be entitled as the owner of the equipment. In a lease, the lessor claims these benefits and shares the value with the lessee in the rent it charges for use of the equipment. Another reason is that companies would rather not have to show more debt on their balance sheets. A lease can be a form of off-balance-sheet financing.

The staff of the US Securities and Exchange Commission said in a report in June that the accounting rules that allow this off-balance-sheet treatment for leases should be rewritten. The rules are in the hands of the Financial Accounting Standards Board. The SEC staff called on the accounting board to act.

The following is a conversation with Henry Phillips, an expert on leasing with the accounting giant Deloitte, about what is likely to come out of the SEC report. Phillips is the professional practice director of the national mergers and acquisitions practice for Deloitte. He also heads the subject matter team at Deloitte on leasing, and is part of a team at Deloitte that fields questions about entity consolidation. The questioner is Keith Martin.

MR. MARTIN: The Securities and Exchange Commission staff said lease accounting lets publicly-traded companies keep $1.25 trillion in future cash obligations off their balance sheets. The staff thinks this makes the financial statements of these companies misleading. Are you familiar with the report?

MR. PHILLIPS: I am. This is a report that the SEC was required by the Sarbanes-Oxley Act to write. It looks broadly at the use of off-balance sheet accounting.

The SEC staff identifies four goals in the report for those involved in financial reporting. One is to discourage companies from structuring transactions with the aim of producing favorable accounting rather than real economics. Another goal is to prod the Financial Accounting Standards Board to adopt more principle-based standards rather than hard-and-fast objective tests around which it is easy to plan. Another goal is to make financial statement disclosures more relevant to investors. The last goal is to focus financial reporting on communication with investors rather than rote compliance with the rules.

The staff made a number of recommendations. It urged the Financial Accounting Standards Board to reconsider its accounting guidance for leasing transactions. That is not a new SEC position. The report also urges the accounting board to reconsider how companies are required to account for defined benefit retirement plans. It wants FASB to require companies to report all financial instruments at fair value and abolish the notion of hedging and deferring costs on the balance sheet.

Finally, the SEC wants the accounting board to improve or redo FIN 46, which addresses when companies must consolidate special-purpose entities. FIN 46 was adopted in the wake of the Enron debacle. It has proven too easy for companies to structure around and, as a consequence, it has not had the desired effect.

MR. MARTIN: Come back to lease accounting. What is lease accounting?

MR. PHILLIPS: Accountants consider a transaction a “lease” if someone has been given the right to use a specified asset for a stated period of time. How that transaction is reported on a company’s books depends on whether you are talking about the lessor or the lessee and what type of lease is involved.

Lessors

MR. MARTIN: Let’s start with the lessor side of the transaction. If the transaction is reported using lease accounting, then the lessor would show itself as the owner of the asset and any debt used to acquire it would appear in the lessor’s balance sheet. Is that correct?

MR. PHILLIPS: That’s true when lessors account for leases as “operating leases.” You will often find that the lessor and lessee use asymmetrical accounting. In many cases, the lessee will report a transaction as an operating lease, and the lessor will treat it as a “capital lease.”

MR. MARTIN: A capital lease means the lessor views himself merely as financing a purchase of the equipment by the lessee?

MR. PHILLIPS: That’s right. An example of an operating lease is where a business traveler rents a car at the airport. In an operating lease, the lessor has a hard asset — the car — on its books. It is the owner. The lessor reports the rental income on a straight-line basis over the lease.

However, in most big-ticket lease transactions — especially where a financial institution is the lessor — the lessor prefers to account for the lease as a capital lease. The most common subcategory of capital lease is a “direct finance lease.” The lessor does not treat itself as owning the hard asset. Rather, what it shows on its books is ownership of a lease receivable.

MR. MARTIN: A note?

MR. PHILLIPS: A note receivable. The best of all worlds for a financial institution is a “leveraged lease.” In a leveraged lease, the lessor collapses the transaction and reports it on a net basis. The only thing it shows on its books is its equity investment in the deal. The nonrecourse debt at the lessor level and the lease receivable are a wash to the extent rents will be used to pay off the lease debt.

MR. MARTIN: Back up one step. You said there are two types of leases, broadly speaking — capital leases and operating leases, and within the capital lease classification, there are subcategories of capital leases. There are a direct finance lease, a leveraged lease and — are there others?

MR. PHILLIPS: There are three types of capital leases from the standpoint of lessors.

The first is a sales-type lease. These are most common where the lessor is the manufacturer of the equipment being leased. It is really a form of sale. The lessor reports immediately the same profit that it would have had from a direct sale. The lessor also has lease income over the lease term, but a sales-type lease is really a financing and the only further income that the lessor reports from the transaction — after the profit is reported up front — is the interest income that it earns from financing the purchase.

The next type of capital lease is a direct finance lease. An example is where a financial institution acquires an asset directly from the manufacturer and immediately leases it to the lessee. It is merely a financing transaction. The lessor recognizes interest income over the term of the lease.

MR. MARTIN: And then there is a leveraged lease where the lessor shows just the equity investment it has after netting out the amount it borrows and the amount it is viewed as on lending?

MR. PHILLIPS: Right. A leveraged lease must first meet the requirements to be classified as a direct finance lease, and then there are some additional tests. First, there must be three parties to the transaction — the lessor, a lessee and a lender. Second, there must be substantial leverage in the transaction, meaning more than 50% nonrecourse financing from a third party. There are a couple other tests. The bottom line is the only thing a lessor shows on its books is its net equity investment.

MR. MARTIN: Why is that the best result for the lessor?

MR. PHILLIPS: Because the lessor does not have to show the debt. Contrast a leveraged lease with a direct finance lease, where the lessor has an interest-bearing asset on its books in the form of a lease receivable, but it also has the related borrowing on its books.

A leveraged lease also gives the lessor special accounting for when income is reported from the deal. Income is front loaded in a leveraged lease. The lessor reports his entire profit in year one and then only financing — or interest — income in later years. These are entirely form-driven standards.

Actually, what I just said on timing is an oversimplification. The reporting of income from a leveraged lease gets quite complicated. You need to determine the interest rate over the life of the investment that will yield a constant rate of return. In the early years of the deal when the lessor still has a positive net investment — after taking into account the tax benefits it is receiving — the constant yield is applied each year to that positive net investment. The net investment declines over time and, in some deals, actually goes into a negative position, and the lessor ceases to recognize any income for a period of time. There may be some additional income in the out years. The point is that most of the book income is usually recognized in the first several years under leveraged lease accounting.

MR. MARTIN: What is the timing of the income with a single investor lease or direct finance lease where there is no leverage?

MR. PHILLIPS: It is like the income that a lender reports when it makes a loan. The income each year is the rate of return times the outstanding principal balance. A portion of each lease payment will go to reduce principal and the rest is interest. The payments are more interest in the early years when a large principal balance is outstanding and then in later years, the situation reverses and each payment is considered more principal.

MR. MARTIN: So you have a natural acceleration, but you do not have the pattern in a leveraged lease where there is extreme acceleration followed by ...

MR. PHILLIPS: In some periods, the lessor in a leveraged lease may have no income.

Lessees

MR. MARTIN: Let’s turn to the lessee side of the equation. With an operating lease, a lessee does not have to show any future financial obligation on its books, right? It just pays rent and deducts it each year?

MR. PHILLIPS: Right. There are disclosure requirements under the accounting standards that require the lessee to show in a table in the footnotes to its financial statement how much rent it expects to have to pay in the next five years. If the lessee has guaranteed the lessor a minimum residual value for the equipment at the end of the lease term, that must also be included in the footnotes.

In deals where there is a residual value guarantee, the guarantee shows up as a future liability offset by prepaid rent. The lessee is treated as having given something of value to the lessor at inception. That value is prepaid rent. That value is also the measure of the future liability the lessee must show on its books.

Residual value guarantees are more common in “synthetic leases”— transactions that the parties report as a loan even though they are set up as leases in form — than in “true leases.” The trouble with residual value guarantees in true leases is they may make it harder for the lessor to claim that it is the tax owner of the asset. The guarantee puts the risk on the lessee that the asset will be worth less than expected at the end of the lease term. This is normally a risk that comes with owning the asset.

MR. MARTIN: The choices for the lessee are whether to report the transaction as an operating lease or a capital lease. A lessee likes an operating lease because he shows five years worth of rent in a footnote as a future obligation, but otherwise just deducts his rent each year as it is paid. The lessee is not viewed for financial reporting purposes as having a long-term obligation like a debt owed to someone. Contrast that with a capital lease. With a capital lease, the lessee is viewed as if he bought the asset. He has an asset on his books, but he also must show the full stream of rents that he must pay as an obligation. Is that right?

MR. PHILLIPS: Yes. An operating leases gives a lessee two things. One is the asset and liability are off the books from an accounting standpoint. I think the rating agencies are well aware of this. They tend to add back the future obligations, so I am not sure how much benefit lessees get today from operating leases.

The other point about operating leases is there is an income statement pickup. In an operating lease, rents are deducted from book income on a straight-line basis over the term of the lease. In a capital lease, the lessee has an asset on its books that it must depreciate. Each rental payment is treated as part interest and part principal. The part interest is deducted immediately. The lessee also has to depreciate the asset for book purposes. The combination of an interest and depreciation deduction each year is dilutive. Earnings are reduced more in the early years with a capital lease than with an operating lease. The expenses in a capital lease tend to be more front loaded.

MR. MARTIN: In the early years of a capital lease, more of each payment is considered interest than principal. So you get a large interest expense and a straight-line depreciation deduction. That is why the expenses are front loaded. In an operating lease, the expenses are reported on a straight-line basis? There is no acceleration?

MR. PHILLIPS: That’s right.

MR. MARTIN: What is the key to treatment as an operating lease versus a capital lease if you are a lessee? Are there a series of bright-line tests to pass and, if you pass them, you are home free? No further analysis is required?

MR. PHILLIPS: This is where the criticism of lease accounting takes hold. I am not sure anyone would disagree with the SEC’s charge that it is absurd that whether a transaction is an operating lease or a capital lease can turn simply on the identity of the lessee. The two transactions can be otherwise economically similar.

A lessee will have a capital lease if one of four things is true about the transaction. First, title will transfer automatically from the lessor to the lessee by the end of the lease term. Second, the lessee has an option to purchase the asset from the lessor at a bargain price. Third, the lessee has the right to use the asset for more than 75% of its expected economic life. Fourth, the present value of the minimum lease payments that the lessee is obligated to make exceed 90% of the estimated fair market value of the asset at inception of the lease.

Any one of these attributes will make the transaction a capital lease. This is where the regulators chafe at the form-driven nature of the rules. Two lessees may use different discount rates with the result that one has an operating lease because the present value of his minimum lease obligations is 89.9% of the value of the asset, and the other lessee has a capital lease because his slightly lower discount rate gives his rents a present value of 90.1%.

MR. MARTIN: What discount rate does FASB require lessees to use?

MR. PHILLIPS: If known, the lessee must use the implicit interest rate in the lease. You determine that rate by solving for the discount rate to set the expected rent payments equal to the lessor’s estimate of the residual value the asset will have when the lease ends. In most leases, the lessee cannot compute the implicit interest rate because it does not know what estimate the lessor has made of residual value.

In such cases, FASB requires the lessee to use its incremental borrowing rate — or the rate it would have to pay to borrow from a third party on similar terms — as the discount rate for applying the 90% present-value test. Lessees’ borrowing rates vary.

MR. MARTIN: So you could have an identical transaction that would be booked as an operating lease by one company and a capital lease by another just because the two lessees’ borrowing rates are different.

MR. PHILLIPS: Exactly.

Outlook

MR. MARTIN: Come back to what the SEC staff said. Did the SEC staff recommend to FASB that it get rid of lease accounting?

MR. PHILLIPS: I wouldn’t put it that strongly. The staff recommended that the Financial Accounting Standards Board reconsider the accounting for leases. This is not a new position for the SEC. The SEC has urged the board for several years to take on leasing as a project. FASB has had it on the agenda to take on, but it has put off opening such a project for at least the past 10 years because other matters always seemed more pressing. Leasing has never been a priority. I think that is partly because FASB is moving toward greater harmonization of US and international accounting standards, and it has been waiting for the International Accounting Standards Board to address leasing, but the IASB has also viewed leasing as a second-tier priority.

MR. MARTIN: Do you think FASB is likely to take action on leases in the next couple years?

MR. PHILLIPS: The SEC report could be just the spark that moves leasing up on the FASB agenda, but I think FASB is constrained by its desire to make this a joint project with the IASB. I think you could see FASB open a project on this in the next couple years. In the next five years, we could see a new standard.

The process of coming up with a new standard is a long one. FASB has a healthy deliberative process with release of exposure drafts and plenty of opportunity for comment. The leasing industry is a very large industry. It is an effective lobbyist for its interests.

Most people are on board that lease accounting needs to change. It will take time for people to get comfortable with whatever FASB proposes and to assess the impact on their businesses.

MR. MARTIN: Let me just insert this background. FASB Chairman Robert Herz said three years ago: “My personal view is that lease accounting rules provide the ability to make sure no leases go on the balance sheet, even though you have the asset and an obligation to pay money that you can’t get out off.” He said that if companies don’t capitalize leased assets on their balance sheets, something is wrong. David Tweedie, who is the International Accounting Standards Board chairman, said during Senate testimony in the wake of the Enron scandal, “A balance sheet that presents an airline without any aircraft is clearly not a faithful representation of economic reality.”

It seems that those two gentlemen are interested in changing lease accounting, although — for reasons you point out — it may not happen very quickly. What is the International Accounting Standards Board treatment of leases? Does it mirror the FASB treatment?

MR. PHILLIPS: It is similar to the US standards, but there is a bit more substance. IAS-17 is the leasing standard. You should not have a situation, under the IAS rules, where characterization turns on whether the present value of the minimum required lease payments is 89.9% or 90.1% of the estimated value of the leased asset. However, the IAS rules are based generally on the same tests as in the United States. It is just that the tests are not applied as rigidly.

MR. MARTIN: In a case where you have a cross-border lease, say, between a European country and the United States, do both IAS and FASB standards come into play? Is the US party regulated by FASB, and would the European party be looking to IAS standards?

MR. PHILLIPS: Possibly yes, but some European companies ultimately reconcile to US GAAP because they are SEC reporting entities.

MR. MARTIN: If someone is in the midst of doing a large deal and relying on lease accounting, is there anything he or she should do in anticipation of possible changes in the accounting standards while structuring the transaction?

MR. PHILLIPS: My advice, given the current reporting and regulatory environments, is to structure the deal so that it aligns with the economics. When you apply the form-driven standards to get to operating lease or capital lease treatment, be reasonable in your judgments around those tests. Don’t push the envelope.

For example, I don’t think it makes sense for public companies with independent audit committees to move forward with a transaction as an operating lease if the present value of the minimum lease payments is close to the 90% line. In the current environment, I would be very conservative and stop at 80 or 85%. Give yourself a margin for error because there are judgments in applying the standards, and you don’t want to end up losing if someone challenges your judgment. You don’t want, as a lessee, to have to have change the reporting later on transactions that you thought were operating leases to capital leases.

My second bit of advice is that accurate disclosure is critical in these transactions because it can be material to investors, rating agencies and others who rely on the company’s financial statements. Be sure accurately to disclose the obligations and risks and rewards associated with the transactions.

MR. MARTIN: If you had to guess at what new standards might come out of any FASB or IASB reworking of lease rules, in what direction do you think those boards will move?

MR. PHILLIPS: I think that there is a lot of support for an older accounting model called the G4+1 McGregor report. What that report said is that a lessee should put the present value of its lease obligations on the books as both an asset and a liability if the lease term exceeds one year. If you had a three-year lease, you would show three years of rentals as an obligation and an offsetting leasehold interest in the asset for a term of three years. If you had a 15-year lease, you would show 15 years of rentals.

MR. MARTIN: So no more off-balance sheet?

MR. PHILLIPS: That’s right, but I think most people are reconciled to that result. It raises a number of other complex issues in terms of both recognition of assets and liabilities as well as de-recognition of assets and liabilities for both lessors and lessees. Some people struggle with having the same asset on both parties’ books. Some of these finer points will have to be worked out as the accounting boards develop the new standard.

MR. MARTIN: I was going to ask you for an example of a complication. That is the main complication — the possibility of the asset being on two companies’ books at the same time?

MR. PHILLIPS: That’s right.

MR. MARTIN: What would happen, if the accounting boards move in the direction you suspect, to existing operating leases that lessees have in place when the new rules take effect? Will lessees have to make an immediate financial statement adjustment?

MR. PHILLIPS: The transition is always interesting when you have a new standard. FASB could mandate a number of things. It could require companies to apply the standard retroactively to existing leases, which might require restating earnings in prior years. It could require a cumulative catch up in the current period. It could “grandfather” existing leases. I suspect it will require a retroactive restatement because, otherwise, financial statement periods would not be comparable. Comparability is one of the things with which the accounting boards always struggle when adopting a new standard.

MR. MARTIN: Let me ask two other questions based on things you said earlier. You said it is not uncommon for the lessor to report a lease one way — for example, as a capital lease — and for the lessee to report it a different way — for example, as an operating lease. What percentage of big-ticket leasing transactions have this bifurcated treatment?

MR. PHILLIPS: This is only a guess, but I would venture to say in the majority of transactions where the lessee is accounting for them as operating leases, the lessor is accounting for them as capital leases or direct finance leases. One reason this happens is the lessee is using its incremental borrowing rate to apply the 90% present-value test, and this rate is usually higher than the rate the lessor uses as the implicit rate in the lease. That’s because the lessor can usually borrow at lower rates than the lessee. Thus, the lessor may discount the minimum lease payments at a 4% rate and find they exceed 90% of the value of the equipment, while the lessee uses 6% and gets a different result. People are not playing games. It is just how the current rules work.

MR. MARTIN: The SEC report estimated that only about 22% of public companies report the lessee position as a capital lease while 63% book their transactions as operating leases.

The other question is you said rating agencies are focused on the off-balance sheet aspects of operating leases and are not really giving lessees full off-balance sheet treatment. Is there some way to quantify how much off-balance sheet benefit someone gets today from an operating lease?

MR. PHILLIPS: I am probably not the best person to speak to that, but I have heard that the rating agencies discount back the lease payments and treat the lessee as if he had a debt on his balance sheet equal to the present-value amount. So perhaps lessee gets about 10% off-balance-sheet treatment. I am just not sure.