Monitor - November/December 2011

LESSOR

Lessor accounting has been decided with two proposed methods for equipment lessors. Short-term leases, where the term including possible renewals is 12 months or less, can still use the current GAAP operating lease method. All other equipment leases will be accounted for much like current GAAP direct finance leases. This is good news compared to what was proposed under the ED and, thankfully, compared to current GAAP where many leases in this segment were operating leases for the lessor. They call the new lessor accounting method the “receivable and residual” (R&R) method.

Under this method, a PV receivable and a “plugged” residual would be recorded and the leased asset is removed from the lessor’s balance sheet. The residual asset is accreted over the term so that the sum of the finance income on the lease rents as collected and the residual accretion will be the same as the amortization of unearned income under current direct finance lease accounting. The rate used to discount the rents and accrete the residual would be the implicit rate in the lease. Lessors are also required to estimate lease payments in the same manner as lessees. In leases with bundled lease payments, lessors must bifurcate the payment and account for the lease portion using the R&R method and account for the service portion as revenue when the payment is due for services rendered (basically the cash basis).

Sales-type lease accounting for gross profits of manufacturers/ dealers will be allowed for all but short-term leases, but the portion of the gross profit related to the residual must be deferred until the asset is sold or released. This is good news as more leases will be subject to sales-type gross profit recognition, but the downside is the deferral of the portion of the gross profit associated with the residual.

Leveraged lease accounting is a U.S.-only issue (not a product offered in the healthcare segment) and will be eliminated with no grandfathering of existing deals. The boards will not allow the “MISF” yield or a tax-affected yield to be used for revenue recognition for tax leases.

For real estate lessors there are three methods. For leases of a whole building use the R&R method as above. For those lessors who qualify as investment companies use investment property accounting which is like the current operating lease accounting but where the residual asset is adjusted to its fair value (up or down as the values fluctuate). For all other real estate leases use the current operating lease method.

TIMING AND TRANSITION

The boards will issue a new exposure draft in the first quarter of 2012 with a 120-day comment period. I urge all readers to submit a comment letter. The boars will read the comment letters and re-deliberate and make adjustments if they see fit. This means it will not be until the last quarter of 2012 that they will issue the new lease accounting rules. The transition date is likely to be 2016 when lessees and lessors have to convert all existing leases and begin accounting under the new rules.

The lessee transition will be as follows:

• • For all capital leases no adjustment will be required. This is good news because it simplifies transition.

• • For operating leases the lessee will record a liability equal to the present value of the remaining payments using the lessee’s incremental borrowing rate at the transition date. The right to use asset value recorded will be the present value of the remaining payments adjusted based on the ratio of remaining rents to total rents from inception with the difference charged to equity and deferred tax assets. This added complexity is an attempt to lessen the impact of the front loaded leases cost pattern that results from the ROU accounting method.

• • Lessees will have the option of using the full retrospective method where each lease is recorded at inception. This will lessen the impact of the front loaded lease cost pattern but will result in a larger charge to equity and deferred tax assets.

The lessor transition will be as follows:

• • For all existing direct finance and sales-type leases no adjustment is necessary.

• • For all operating leases and leveraged leases, the R&R method is used at the earliest period presented in the financials treating the remaining term as the lease term. The boards do not provide details regarding existing leases that have a manufacturer or dealer profit, but, although it will be difficult to calculate, presumably some portion of the remaining gross profit will be recognized and the portion associated with the residual will be deferred.

• • Lessors will have the option of using the full retrospective method where each lease is booked at inception. I see little benefit to electing this option.

FOCUS ON HEALTHCARE EQUIPMENT BUSINESS SEGMENT

In my opinion the overall impact to the industry will not be great.

IMPACT TO LESSEES

The healthcare market is broad and many of the product offerings are loans. Those that are leases are generally of high-tech equipment like MRIs and CT scanners with good residuals and attractive tax benefits (100% bonus MACRS), so the resent values (capitalized amounts) are significantly less than cost.

• • Doctor and dentist financings are generally start-up financings and are loans. For any equipment acquisitions for doctors and dentists, the liberal tax write offs under §179 would favor CSA or dollar out transactions.

• • In the hospital business segment, there have been a great
deal of acquisition financings that are loans. Hospitals do use
FMV leases to acquire imaging equipment and the capitalized
amounts should be low enough to keep the lease product
popular. The bigger the PV benefit, the lower the amount
capitalized. Stand-alone imaging centers have traditionally
used the FMV product as well to acquire high tech imaging
equipment.

• • The traditional reasons for leasing (raising capital, low financing cost, fixed rates, level payments, transfer of tax benefits, managing equipment needs, transfer of residual risk, convenience and service) will continue to exist. The off-balance sheet accounting reason for leasing will be reduced but not eliminated as long as the amount capitalized is less than the cost of the equipment.

• • Dollar out leases will be treated the same as under current GAAP capital lease accounting — the lease will be capitalized at 100% of the asset’s price.