Leasing has grown tremendously in popularity. Today it is the fastest growing form of capital investment. Why? Here's an example. Krispy Kreme, a chain of doughnut shops, had been showing good growth and profitability using a relatively small bit of capital. That's an impressive feat if you care about return on capital. But there's a hole in this doughnut! The company explained it was building a $30 Million new mixing plant and warehouse in Effingham, Illinois but its financial statements did not disclose the investment or obligation associated with that $30 Million.

How did Krispy Kreme manage that? By financing through a "synthetic" lease, Krispy Kreme kept the investment and obligation off its books. In a synthetic lease a financial institution structures a loan using lease documents in a manner that meets current U.S. Generally Accepted Accounting Principles ("U.S. GAAP") accounting requirements for non-capitalization (or off balance sheet treatment) for financial reporting purposes while the lessee retains tax benefits and ownership. While future obligations are disclosed in footnotes to the financial statements no asset or corresponding liability shows on the firm's balance sheet.

The leasing industry is a significant and growing business which contributes to economic growth by providing lower cost capital, flexibility and 100% financing. Yet current lease U.S. GAAP accounting and reporting has been identified by Securities Exchange Commission ("SEC"), the International Accounting Standards Board ("IASB"), and the U.S. Financial Accounting Standards Board ("FASB") as requiring standard setting attention.

Why is this important? Financial reporting requirements ultimately affect your access to liquidity.

What is the Industry Doing?

Leasing is a global business. The Equipment Leasing and Finance Association ("ELFA") estimates the equipment leasing market is a $700 Billion business, with the U.S. accounting for about one third of that global market. These statistics are just for equipment; add real estate leasing, which is larger, and we have a very large and growing business. One that is at least partly driven by accounting. Here's a sampling of current issues:

1. Lessee Accounting The first exposure draft proposed a "right of use" asset approach requiring lessee capitalization of leases. From a book reporting standpoint this results in replacing rent expense with amortization and imputed interest. Because of user community (lessees and financial analysts) feedback that this "front-ending" of "book" expense (a non-cash expense) would have real economic cost this whole area is now actively under reconsideration. The FASB appears to favor "interest based" amortization which would more closely match the cash rents being paid; the IASB favors amortization of the right of use asset to the residual value of the underlying leased asset (giving longer lived assets a less front loaded lease cost pattern). Both methods are being tested by users and preparers. It is likely there will be changes.
2. Lessor Accounting The Boards have decided that there will be one lessor accounting method for all leases called the "receivable residual" ("R&R") method. There will be three exceptions: short term leases can be accounted for under the current GAAP operating lease method, real estate leases can be accounted for at fair value using the investment properties method if the lessor is a real estate investment company, and, leases of investment property assets (multi lessee leases of commercial real estate) may be accounted for under the current operating lease method.
3. Leveraged Lease Accounting Leveraged lease accounting is eliminated with no grandfathering. This is a FASB issue only. New leveraged leases may be allowed offsetting of the rent & debt service (to be determined) under the "Balance Sheet Offsetting" project that the Boards are separately working on. The Boards are not allowing tax affected revenue recognition for any lease.
4. Lessee & Lessor Transition For lessees capital leases are grandfathered. Lessee operating lease "obligations" would be booked at the PV of remaining rents with the "right of use" asset booked but adjusted by the ratio of remaining rent to total rents at inception. For lessors direct finance leases and sales type leases are grandfathered. For operating leases book the PV of the rents as an asset, de-recognize the operating lease asset and the difference is the residual.
5. Scope New reporting rules are to cover all leases of a "specified" asset, which includes leases of explicitly or implicitly identifiable property, plant, and equipment as under current GAAP. Also included will be "inventory items" such as spare parts. Guidance will not be provided in the leases standard for distinguishing a lease of an underlying asset from a purchase or a sale (installment contract).
6. Rates for Lessee and Lessor Accounting Lessees will use their incremental borrowing rate unless the implicit rate in the lease is known. Lessors will use the implicit rate in the lease to calculate the present value of their receivable and to accrue revenue.
7. Sale Lease Backs If the transaction is considered a sale under the revenue recognition standard, account for the transaction as a sale leaseback, otherwise, consider it a financing/loan. When the sales price and leaseback rents are at fair value, gains or losses arising from the transaction are recognized immediately. When sales price and rents are not at fair value, the assets, liabilities, gains and losses should be adjusted to reflect the current market.
8. Residual Guarantees The Boards reiterated their conclusions that a third party residual guarantee is not a minimum lease payment for the lessor. For lessors a residual guarantee will not be recorded until the residual is resolved. Guarantees will not convert the residual asset to a financial asset (it will not affect gross profit recognition).
9. Timeline for Re-Exposure A new exposure draft may be issued later this year with a 120 day comment period. If so, mid-2013 is the earliest a new standard may expected to be issued. The effective date? Most likely 2016 due to the current slippage. The transition date also depends on the progress of the Boards' Revenue Recognition project as they would like both to have the same transition date.
10. Conclusions The Boards are currently split with regard to Lessee accounting: the FASB favoring one lessee view while the IASB favors another. Project timing will depend on resolution of this issue.

If the new rules seem complicated, that's because they are. Rule makers perceive abuse by companies that structure around the 90% ownership test that currently determines whether a contract is an operating lease and therefore is not on the balance sheet. Most stakeholders however are not convinced that the intended benefits will be worth the additional cost and effort.

Lease finance is an area where lessors may choose to deliver lower lease payments by assuming a higher residual. For the lessee this is truly a cash-flow issue.

Being proactive includes participating in the "outreach" meetings currently being held by the FASB/IASB. Make your business issues known by presenting the impacts these proposed rules will have on your access to liquidity. Regardless of the outcome, one thing is sure, lease structuring will continue, so plan accordingly.

Some say the future cannot be predicted. Others say the only way to predict the future is to create it!

Lechner Law Office, P.C.
Law and Professional Center
Orland Hills, Illinois 60487-4623
708-460-6686
Paul Lechner, Esq., CPA
paul@lechnerlaw.com