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ELFA Annual Convention

October 2011

Lease Accounting Changes—Understanding the Lessee Impact and

Strengthening Your Lessee Relationship

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Agenda

• Project Timeline• Overview: Proposed Lessee

Models• Potential Impacts• Strategic Considerations• Remaining Advocacy Issues

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Project Timeline

ED Issue

dAugus

t 2010

Redeliberations Jan 2011 - Ongoing

Comment LettersDec 2011

Timeline in not fixed• Dependent upon progress made and changes to new ED• Effective date uncertain, tied to revenue recognition –

likely to be 2015 or 2016

Outreach

Final Standard

2013

Comment

LettersT+120 Days

New ED Issued

2 QTR 2012

Draft New ED1 QTR 2012

Re-deliberate3/4 QTR 2012

44Proposed Accounting Models – Lessee and Lessor

LessorModels

LesseeRight-of-

Use Model

Recognize “right-of-use”

asset

Recognize liability to

make estimated

future lease payments

“Right to use” leased property

Lease payments

Recognize right to receive

estimated future lease payments +

residual asset Recognize

partial sales-type gross

profit

Derecognize leased

property

R&R Model

Operating Lease Model(Short term leases only)

• Leveraged lease eliminated

• PV estimated rents including interim rents, bargain renewals, value of RVGs

• P&L cost front ended = amortization of ROU asset + imputed interest

• No rent expense• Bifurcate or capitalize bundled

rents

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Redeliberations

The Boards received nearly 800 comment letters, held public outreach meetings, and met several times with the Leasing Working Group. Main issues considered during redeliberations include:– Definition of a lease – fewer contracts will be leases– Lease term - simplified and moved back to current GAAP– Variable lease payments – simplified and limited capitalization– Options - simplified and moved back to current GAAP– Lessor accounting models – one basic DFL-like model plus short term lease

model• Eliminates leveraged leases• Eliminates operating lease accounting for all but short term leases• Sales-type gross profit accounting for all leases/residual portion

deferred– Bundled full service leases – bifurcate service portion to avoid

capitalization– Lease modifications, reassessments – Lessee cost allocation – front ends lease costs

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Lessee People & Change Impacts Due to persuasive organizational change there is a need for a strong

project management office with an effective governance structure and communication protocols

Impacted departments will need appropriate communication and training to understand their role, the impact to their job responsibilities and their level of involvement in the ongoing support of the conversion project and ongoing accounting

Departments impacted outside of General Accounting and Financial Reporting will likely include Business Segment Management, CFO, Legal, Real Estate, Treasury, Internal Audit, IT, Tax, Budgeting, Regulatory, Contract Management, and Forecasting

Broad Impact on Lessees of Proposed Lease Accounting Standards Changes

Lessee Systems & Processes Impacts Existing systems likely do not have sufficient functionality to handle

new requirements of calculating right-of-use assets & lease obligations

Transition will require an inventorying of all leases across an organization, potentially including contracts not previously accounted for as leases (e.g., contract manufacturing, IT outsourcing arrangements)

Once leases are inventoried, physical documents will be needed to collect lease terms for every lease for input to a lease accounting system

Expanded data needs may necessitate a need for forecasting and other systems

Increased management judgment will elevate financial reporting risk, and will require changes to process documentation and SOX 404 testing

Lessee Business Impacts Significant financial statement changes for lessees:

– Increase in ROU & deferred tax assets impacts ROA calculations– Increase in liabilities impacts capitalization & debt to equity

calculations– Inclusion of additional contingent rents will accelerate expense

recognition– Rent expense replaced by amortization & interest increases

EBITDA – Front ended expense pattern = earnings ,capital issues & cost

reimbursement issues– Loan covenant breaches due to changes in GAAP treatment

Management may choose to review buy versus lease decisions Management may choose to evaluate the need to renegotiate

current lease terms

Lessee Accounting and Reporting Impacts Transition will be a major project Increased management judgment (e.g., lease term, options,

contingent rent, service components,, etc.) Increased level of effort & financial reporting volatility due to

ongoing remeasurement New “right of use” asset subject to impairment Added complexity in calculating book vs. tax differences – new def

tax asset Need to significantly amend accounting policies and procedures Increased disclosure requirements Initial valuation of opening balance sheet and preparation

comparative periods Need to support transition and ongoing external audit requirements

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Lessor People & Change Impacts Accounting staff has to learn the new rules and transition rules Sales staff needs to know the new rules to respond to customer

objections and questions Products need to be reviewed for changes to maintain their viability

under the new rules (e.g. bifurcating service portion of full service leases, interim rent policies)

Existing target markets need to be reviewed New products need to be developed Strategies to deal with existing leveraged lease portfolio

Broad Impact on Lessors of Proposed Lease Accounting Standards Changes

Lessor Systems & Processes Impacts Existing systems likely do not have sufficient functionality to handle

new requirements of calculating PV receivable, residual and revenue recognition

Transition will require data collection for all leases for input to a lease accounting system

Lessor Business Impacts Significant financial statement changes for lessors:

– Leveraged leases grossed up, earnings flatter, ROAs reduced, capital hit for accounting change adjustment

– Operating leases, sales-type lease rebooked and new sales-type leases create new revenue recognition patterns

– Inclusion of additional contingent rents will mean remeasurement and adjustment

– Review residual insurance needs– Review existing securitizations for changes in presentation (e.g.,

residual guaranteed residuals are not financial assets)

Lessor Accounting & Reporting Impacts Transition will be a major project especially for leveraged leases Transition will impact capital, the balance sheet and forecasts –

leveraged leases, former operating leases and sales-type leases Increased management judgment (e.g., lease term, options,

contingent rent, service components,, etc.) Increased level of effort & financial reporting volatility due to

ongoing remeasurement Need to amend accounting policies and procedures New disclosure requirements Need to support transition and ongoing external audit requirements

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Business Reasons for Leasing

Reason for Leasing

Details Status After Proposed New Rules

Raise Capital Additional capital source, 100% financing, fixed rate, level payments, longer terms

Still a major benefit versus a bank loan especially for SME & non-investment grade lessees with limited sources of capital

Low cost capital Low payments/rate due to tax benefits, residual & lessor low cost of funds

Still a benefit versus a bank loan

Tax benefits Lessee can’t use tax benefits & lease vs. buy shows lease option has lowest after tax PV cost

Still a benefit

Manage assets/residual risk transfer

Lessee has flexibility to return asset

Still a benefit

Service Outsource servicing of the leased assets.

Still a benefit

Convenience Quick & easy financing process often available at point-of-sale

Still a benefit

Regulatory Capital issues Partial benefit if the PV < cost of the asset, S/B true for hi residual assets w tax benefits

Accounting Off balance sheet Partial benefit if the PV < cost of the asset, S/B true for hi residual assets w tax benefits

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Impact by Lessee Type

Lessee type Potential impact

Investment grade/large companies

Some negative impact as leases often accounting focused, have more sources of capital, more analytical staff, loss of leveraged lease product increases lease costs

Non-investment grade/small & medium sized

Less impact as source of capital is prime reason for leasing, fewer sources of capital, level payments & 100% financing conserves cash, less concerned about balance sheet optics, less staff to analyze lease and less analytical

Municipal/tax exempt No change in municipal market as GASB, not FASB, issues rules and operating leasing appears to be retained by GASB, tax exempt leasing offers lowest cost, leasing avoids issuing debt with all its constraints

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Impact by Asset Type

Asset type Potential impact

High residual – vehicles, aircraft, rail, construction, agriculture, medical, material handling

PV of rents (capitalized amount) significantly lower than cost of equipment = still some accounting benefit

Low residual – computers, copiers, faxes, office furniture and equipment

PV of rents (capitalized amount) closer to cost of equipment = little accounting benefit, interim rents (common in this segment) capitalized revealing a formerly ignored cost, when lease renewed must be rebooked raising attention to renewals which currently often occur without detection, trade ups (on books) get higher scrutiny

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Impact by Lessee Lease Type

Lessee lease type Potential impactCapital leases – Bargain PO/Auto title transfer

No change but now accounted for as a purchase and a loan.Use ROU method – capitalize PV of rents

Capital leases – Useful life/PV test

Use ROU method – capitalize PV of rents

Operating leases Use ROU method – capitalize PV of rents, Short term lease election to still use operating lease accounting

Synthetic/split-TRAC/fleet leases

Use ROU method – capitalize PV of rents and the likely payment under residual guarantee

Bundled full service lease

Bifurcate the bundled payment or capitalize full value

Muni lease Still an operating lease

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P&L Impact by Lessee Lease Term

Lease Term First Year Increase in Lease Cost – Proposed vs. Current GAAP

3 Years 7%

5 Years 12%

10 Years 21%

15 Years 26%

20 Years 28%

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Capitalized Value by Lease Type

Lease Type Terms Estimated Capitalized Value

PC lease 36 mos, 2.76% pmt, FMV with 15 day interim rent

91%

Fleet lease 12 mos, 2.5% pmt, 76% RVG (split TRAC)

29%

Construction equipment lease

36 mos, 1.6% pmt, FMV, 50% residual

52%

Cat Scanner lease

60 mos, 1.5% pmt, FMV, 20% residual

77%

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Impact by Lessor Lease Type

Lessor lease type

Potential impact

Leveraged leases

Eliminated. Existing leases grossed up on balance sheet, negative earnings adjustment charged to equity, future earnings “flatter”, ROAs/ROEs sub-standard. Alternative partnerships structures more costly to lessee and may be too complex for smaller deals and certain asset types.

Direct finance leases

No change but now called “receivable & residual” (R&R) method. Has same income pattern as current direct finance lease method. Guaranteed residual guarantee is not a financial asset.

Operating leases N/A except for short term leases. Good news for lessors as all but short term leases are R&R leases. Better earnings pattern. No need for residual insurance to turn operating leases into direct finance leases. Guaranteed residual guarantee is not a financial asset.

Sales-type leases

All but short term leases get gross profit up-front as in current sales-type lease accounting except the portion of gross profit related to the residual is deferred. Those lessors with high residual assets that were not direct finance leases under the old rules will get some up-front gross profit. On the downside lessors with low residual assets will have some up-front profits deferred. No need for residual insurance for accounting reasons.

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Strategic Considerations

• New products• Revise products• Markets – emphasize/de-emphasize• Customer service

• Disclose service components of full bundled lease payments

• Provide lessee accounting information• Sales training

• Understand proposed rules• Talking points• Dealing with objections

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Remaining Advocacy Issues

• Please be sure to comment when new ED is issued• For details see www.elfaonline.org

Issue Desired outcome Basis for request

Lessee cost pattern Maintain current straight line average rent expense for operating leases

•Reflects economic effects of an executory contract•Matches revenue with costs in rent reimbursement scenarios•Matches tax and legal view•Avoids bank capital adequacy issues

Leveraged leases •Grandfather existing deals•Retain some form of leveraged lease accounting

•Reflects economics of the transaction•Avoids capital adequacy issues•Reduces lease rates

Sales type gross profits deferred in proportion to residual risk retained

Allow residual guarantees and insurance to be considered in the profit calculation

A guarantee/insurance changes the residual’s nature to a financial asset

Sale leasebacks with a non bargain purchase option are considered a financing

The presence of a non bargain purchase option should not negate sale treatment

All the risks and most of the rewards in the asset’s residual value have transferred to the buyer indicating that a sale has taken place

The definition of the lease term for lessees is not clear

The term should include only renewals that are bargains or are a compulsion issue

Non bargain or non compulsory renewals are not obligations at lease inception.

Equipment lessors in medium term leases where the equipment is leased several more times must use the Receivable & Residual method

Lessors in the “operating lease” business should get investment property treatment as real estate lessors do

•Except for the fact that their leased assets are not real estate they otherwise meet the definition of investment property•Operating lease accounting best reflects the economics of their business

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Q&A

Questions?

Answers???