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All leases aren't created equal.

As the Financial Accounting Standards Board continues nits deliberations on the leasing project, some important issues have been raised about the proposed accounting models for both the lessor and the lessee. A fundamental issue is whether all leases are created equal, from the perspective of the business model of the lessor.

"Business model" is sometimes a term of derision in accounting circles, but it can be a useful means of comparing two transactions to determine whether their economic substance is the same.

The main criticism of current lease accounting is the ease with which it can be abused. The explicit criteria for recognizing a capital lease provide a roadmap for how to structure arrangements so that lessees qualify for operating lease accounting. Some critics, however, object to any distinction at all between capital and operating leases because they believe that all executory contracts should be recognized on the financial statements, preferably at fair value, and that operating leases are an excellent place to start.

How one views the problem will affect how they view the solution. If the issue is abuse, one solution would be to revise the criteria. On the other hand, if the issue is unrecorded executory contracts, there is then no need to have criteria at all. One would simply recognize an obligation for future lease payments and a corresponding contract asset.

For the lessee, FASB and the International Accounting Standards Board (the boards) have proposed a right-of-use model that is a hybrid form of the executory contract model. Future payments that relate to an underlying asset would be capitalized. Future payments for related services would continue to be accounted for as executory contracts. This may not satisfy those who favor recognition of executory contracts because only part of the future payments would be recognized.

A Single Model ... with

Exceptions For the lessor, the proposed solution from FASB and IASB eliminates the distinction between capital and operating leases but does not adopt either approach as the new unified accounting model. The proposed solution is the receivable and residual approach, which reclassifies the underlying asset as two new assets: a receivable for the present value of the future minimum tease payments and a residual, which represents the asset to be returned by the lessee at the end of the lease term.

Leases are accounted for similarly to a partial sale or a sale with a partial right of return (of a future residual interest), instead of as a sale of the underlying asset or as an executory contract. Profit is immediately recognized for that portion of the underlying asset transferred to the lessee. The economic substance of the lease is defined as a sale of the right-of-use asset for the duration of the lease term and a related financing.

The boards did incorporate some exceptions into the proposed model. Short-term leases will continue to be accounted for as executory contracts as a "practical expedient" (because the amounts are immaterial or because the accounting would be unduly burdensome), but not because there is anything different about the economic substance of a short-term lease.

IASB also made an exception under International Financial Reporting Standards for leases of investment property that are accounted for at fair value (an option not yet available under U.S. generally accepted accounting principles). During redeliberations, the boards received feedback arguing that the receivable and residual model would not be practical to implement for many leases of real estate.

The boards therefore decided to extend that exception to all leases of investment property, regardless of whether the leased assets are accounted for at amortized cost or at fair value.

It is the belief of the authors here that the proposed exceptions to the model for investment property and short-term leases are indicators of a difference between the economic substance of certain leases unrelated to the term of the lease, the nature of the property or whether the lessor accounts for the property at amortized cost or at fair value.

Instead, the exceptions reflect different lessor business models.

One Model or Two?

The single-model approach considers all leasing transactions to be financing arrangements. Reality is more complicated. Sometimes the lessor is managing financial assets and ometimes the lessor is managing operating assets.

* Managing Fin irk i Assets

A lessor managing a portfolio of financial assets may engage in financing with varying amounts of exposure to credit risk, interest rate risk and perhaps residual risk, but little or no exposure to other risks associated with ownership, such as obsolescence, price risk or other market risks.

The lessor may or may not retain any residual risk:

* If the lessor is primarily managing financial assets and does not retain the residual risk by, for example, obtaining a residual guarantee from the lessee or a third party, then the lease is in substance a sale and financing. However, the lessor may have an obligation to perform remarketing services at the end of the (ease term, which may be a separate performance obligation. In that case, the lease would be a multiple-element arrangement.

* If the lessor is primarily managing financial assets but retains the residual risk, the lessor engages in two profit-making activities--lease financing of new equipment, and remarketing of used equipment.

These types of business models are commonly employed for many, but not all, equipment leases.

* Managing Operating Assets

A lessor may also be engaged in multiple ongoing business processes in association with a group of operating assets, such as marketing efforts to secure customers and ensure full utilization, inventory management, maintenance and security. Assets may be managed for their entire economic life. Some assets, especially real estate, may be held for appreciation as well as for income.

The question then becomes: Will a single accounting model faithfully represent the economic substance of all leasing arrangements? As tempting as it is to search for a single model that will prevent structuring--or, depending on one's point of view, limit judgment--a single model cannot provide relevant information that faithfully presents the underlying economics of all leasing transactions in the financial statements.

Examples: Extracting Value from Financial Assets

The following are examples of business models in which the lessor is managing a financial asset and may or may not be managing a residual risk.

Equipco Manufacturing engages in leasing transactions for equipment that it manufactures. Typically, leases run for three years. Most customers do not renew the lease or purchase the leased equipment. At the end of the lease term, the equipment is refurbished and sold in the used equipment market where Equipco is a dealer. Pricing of the lease includes estimated proceeds from sales of used equipment.

Leaseco is a lease financing company that offers lease financing options to customers of various manufacturers. Leaseco does not engage in market activities. At the end of the lease, lessees may purchase or remarket the equipment. The lessee typically is responsible for any shortfall in residual value and may participate in any gains. The lease is priced based on prevailing interest rates for similar lessees and collateral.

Customco engages in build-to-suit real estate leases in which Customco purchases designated real estate and constructs buildings such as retail outlets or restaurants to the lessees' specifications. Leases are generally for 20 years or more, with two five-year renewal options. Customco also holds the land (but sometimes not the improvements) for appreciation.

The lease is "triple-net," i.e., the lessee is responsible for all operating costs including maintenance, insurance and taxes. The lease is typically priced based on prevailing interest rates for similar lessees and collateral.

Examples: Extracting Value from Operating Assets

The following are examples of business models in which the lessor is managing operating assets and related processes, as well as residual risk.

Rentco is a car rental facility that typically rents cars for periods of one day up to three months. Rentco actively seeks customers and has facilities in airports, resorts and major urban centers. Rentco also provides maintenance and road service. The cars are refurbished and sold at auction after two years of service. Rental rates are based on factors such as market, competition, duration and season.

Railco leases railcars with an expected life of up to 60 years for periods of three, five and seven years. Some of the leases are full-service leases where Railco provides maintenance and other services. At the end of the lease term, Railco typically refurbishes cars and seeks other lessees. Rates are primarily determined by supply and demand.

Officeco owns office buildings in major urban centers and rents space with leases of five to 10 years, usually renewable at market rates for additional five-year terms. Officeco maintains the exterior of the building, common areas and elevators, and maintains the heating and air-conditioning systems, common plumbing, wiring and other infrastructure.

Officeco holds the buildings for rental income. Officeco plans to hold some of the prime properties indefinitely. Others may be sold if the circumstances are favorable. Rentals are primarily determined by the vacancy rate in the particular market and the desirability of the location.

Telling the Difference

Telling the difference between the two types of leases is an issue that has bedeviled standard setters for generations. Clearly, current GAAP--which tries to draw a distinction based on the transfer of substantially all of the risks and rewards--is not working. The model needs updating; however, we disagree with the boards' proposal to replace the current GAAP model with a single model and somewhat arbitrary exceptions for real estate and leases of one-year or less.

The central issue is not the nature of the underlying asset, but whether the lessor is managing financial assets or managing operating assets and what types of risks are inherent in the lessor's business model.

Our suggestion is to have future research focus on the business model of the lessor to determine the risks retained by the lessor and whether the lessor has retained substantive control over the underlying asset or has transferred that control to the lessee with the right of use.

Significant differences in the business models may warrant different measurement attributes, revenue recognition and, especially, disclosures. How to subsequently measure executory contracts and the appropriate level of disclosure remain open issues of importance to the users of the financial statements.



John Hepp, CPA, is a partner in the Accounting Principles Consultation Group and Mark Scoles, CPA, is partner in charge, Accounting Principles Consultation Group, both for Grant Thornton in the Chicago office. For information visit
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Author:Hepp, John; Scoles, Mark
Publication:Financial Executive
Geographic Code:1USA
Date:May 1, 2012
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