Leveraged Leases Going Out of Style

Companies are using far fewer leveraged lease arrangements to facilitate major capital acquisitions, as the Financial Accounting Standards Board nears completion of its plan to end accommodation for such leasing in U.S. Generally Accepted Accounting Principles.

FASB is inching closer to a comprehensive new standard for how to account for all leases, and so far it does not allow special treatment for leveraged leases. In response to appeals that it allow the treatment under the new standard, the board considered a separate model for leveraged leases, but backed away from the idea. A frustrated Bill Bosco, a public policy consultant with the Equipment Leasing and Finance Association, says FASB acknowledged the current accounting model reflects the economic characteristics of leveraged leases. “Then in the next breath, they killed it,” he says.

A leveraged lease is a three-party transaction where a lessee—a company acquiring a piece of equipment, for example—secures the lease at a reduced cost because the lessor (the company providing the equipment) has taken an investment position in the transaction. The lessor puts up some of the cash necessary to finance the transaction and borrows the rest under a non-recourse lending agreement. The lessee makes lease payments to the lessor, who then makes mortgage payments to the lender.

Current accounting rules contained in Accounting Standards Codification Topic 840, Leases (but written in 1976 in Financial Accounting Standard No. 13: Accounting for Leases) allow lessors to display on their balance sheet only their investment interest in leveraged leases. “The unique accounting allows the lessor to show only the at-risk position as the asset,” Bosco says.

FASB is nearly finished with a new standard that would require all leases to be treated like the financed purchase of a piece of equipment or real estate. That means an asset will appear on the balance sheet reflecting a right to use the asset, along with a liability reflecting the obligation to pay for that right of use over the life of the lease. FASB is still working on exactly how its model for lessees will translate into new rules for lessors as well, but it recently determined that it will stick to its guns on a single model and no longer allow lessors to show leveraged leases on a net-only basis.

The accounting treatment could be a death knell for leveraged leases, but they were already dying off thanks to changes in their tax treatment. John Hepp, a partner at accounting firm Grant Thornton, says the leveraged lease was more common when major equipment purchases more readily qualified for a federal investment tax credit, but that credit evaporated two decades ago. Today, he says, the leveraged lease is more of an “arcane exception” in U.S. GAAP.

“Once upon a time, there were lots of different vehicles like the leveraged lease, and we called them tax shelters,” he says. “I wouldn't call the leveraged lease a tax shelter now, but it has some of the same elements, such as the after-tax cash flows being very important to the transaction.”

Despite the evaporation of the most significant tax advantages, the leveraged lease is still alive in heavy equipment sectors such as airlines, shipping, and utilities, Bosco says. That's because the arrangement still facilitates capitalization in a way that would otherwise be more expensive for buyers. Now that FASB is doing away with the accounting exception, banks are sure to phase out the product entirely. “Now there will be a higher cost of capital,” he says, “which means prices for all of those products will be higher because FASB is killing the product.”

“Once upon a time, there were lots of different vehicles like the leveraged lease, and we called them tax shelters. I wouldn't call the leveraged lease a tax shelter, but it has some of the same elements.”

—John Hepp,

Partner,

Grant Thornton

Indications are that the decision was not easy for FASB to make. During a recent meeting on the subject, FASB member Larry Smith said he struggles with eliminating the leveraged lease accommodation because he believes it accurately reflects the economics of legitimate transactions. “But I also acknowledge that there are a lot of other transactions where there are tax advantages and we do not do special accounting for those,” he said.

The need for convergence with international accounting rules also drove the decision. FASB is weighing its larger objective to make GAAP more like international rules, where no leveraged lease accommodation exists and the International Accounting Standards Board has no interest in creating one.

Grandfather Provision?

FASB also wrestled with the idea of creating a transition period to provide relief for companies already carrying long-lasting leveraged lease positions on their balance sheets, but decided against that as well. FASB Chairman Leslie Seidman, said she was open to the idea of providing some kind of relief.

LEASE ACCOUNTING COMMENTS

Below is an excerpt from the comment letter that was sent to FASB and IASB from 32 organizations—including the Equipment Leasing and Finance Association—that would be affected by changes to lease accounting:

Leases account for hundreds of billions of dollars in transactions annually throughout the global economy. The impacts of financial reporting requirements that may have unintended consequences on business decisions and activities could have adverse impacts upon the economy and cast doubt upon future standard setting activities. A commitment to undertake and publish an economic impact study should be taken before any final action is taken on the proposal. Obviously an economic impact study can identify potential unintended consequences, as well as adverse impacts upon investors.

Similarly, such a comprehensive rewriting of a major accounting standard requires comprehensive field testing to identify any potential unintended consequences. Field-testing should be undertaken before the proposal is finalized, as well as in the pre and post implementation phases of a final standard.

It should be noted that these suggestions are not new and have been proposed before by the Securities and Exchange Commission's Advisory Committee on Improvements to Financial Reporting. The SEC chartered CIFiR to examine the United States financial reporting system in order to make recommendations intended to increase the usefulness of financial information to investors, while reducing the complexity of the financial reporting system to investors, preparers, and auditors.

CIFiR also recommended reforms to the accounting standards setting development, governance processes, the testing of real world implications of standards before they are implemented, as well as the effectiveness of accounting standards post-implementation. Clearly, the tools envisioned by CIFiR should be used on such a controversial and comprehensive standard revision in order to understand the economic impacts and minimize unintended consequences.

Finally, we have also followed the joint public meeting of the European Financial Reporting Advisory Group (EFRAG) and the IASB held on June 14, 2011. We agree with EFRAG that the FASB and IASB still need to explain what leases are and why some types of contracts they currently refer to as leases require capitalization. We share the view that the current proposals do not represent a sufficient improvement over the existing leases standard; consequently, we agree with EFRAG that the FASB and IASB must carry out a “fundamental rethink” of the Leases project. Moreover, like CIFiR, we note that EFRAG has been repeatedly calling for field-testing and further consultation as necessary steps in this project.

Source: ELFA-Led Comment Letter to FASB, IASB, July 8, 2011.

“This exception has existed in GAAP for several decades,” she said. “The effects of reversing this are so dramatic, it almost strikes me as punitive.” Yet FASB member Tom Linsmeier countered that any kind of transition provision would create “a comparative nightmare,” making it difficult for investors to sort out differences between grandfathered leases and new leases.

With no transition provision, such companies are going to face a big balance sheet punch when they can no longer show only the net position in such leases, says Julie Valpey, a partner with BDO USA. “They will have to add all those assets and debt onto their books,” she says.  “It will blow up their balance sheets, and it could really hinder their ability to go out and borrow money. It's going to change their debt ratios.”

Ed Grossman, a partner with accounting firm Crowe Horwath, says he's pleased the board has decided it will re-publish the revised standard for a new round of review and comments. FASB said earlier it would seek new comments on its equally significant standard for revenue recognition, and the changes to the leasing standard are no less extensive or important, he says. Still, he's worried that FASB has a long way to go to determine the lessor accounting. “I'm comfortable talking with clients about the lessee side, but the lessor side is kind of scary,” he says. “They don't have a clear model yet.”

That hasn't stopped companies from making changes in anticipation of the final requirements. Bill Murrell, a partner with Deloitte, says companies are starting to face the inevitability of bringing assets and liabilities onto balance sheets and are starting to get their data in order. The direction of the accounting rules suggests companies need some kind of centralized system for capturing lease information, he says. For decentralized, multinational companies, it's a big job. He says most companies are at a point where they're starting to create such systems, or are at least planning how they will create them.