Equipment Leasing Association

Transcription

1 Equipment Leasing Association INTERMEDIATE LEASE ACCOUNTING Joe Sebik, VP - Global Originations & Structuring J. P. Morgan Leasing, Inc. (212) joseph.p..p.sebik@jpmorgan.com Howard Thompson, Director - Pricing & Economics Key Equipment Finance (518) howard.k..k.thompson@key.com

2 Topics Lease Classification Issues - Items included/excluded in Minimum Lease Payments - Economic Penalties - Residual Value Guarantees Accounting for Sale-Leasebacks - Equipment - Real Estate & Integral Equipment Leveraged Leases Other Relevant Topics & Areas

3 Lease Classification Issues

4 Minimum Lease Payments - Lessee Exclude: Executory costs paid by lessee i.e. insurance, maintenance & taxes Contingent rentals directly related to usage (i.e. machine hours) Include: Minimum rentals required over lease term (bargain renewals) Bargain purchase option amount Cost of economic penalties Lessee guarantee of lessor debt obligation at lease termination date (considered a residual guarantee) Payment required to make upon failure to renew, extend or locate replacement lessee. Contingent rentals NOT related to usage ( i.e. indexed to CPI) Contingent rentals related to unrealistic excess wear and tear clausec

5 Minimum Lease Payments - Lessor Include same items as for Lessee, plus Any guarantee of residual value or of rental payments beyond the lease term by an unrelated third party, provided the third party is financially capable of discharging the obligations that may arise from the guarantee.

6 Economic Penalties - Factors to Consider ECONOMIC COMPULSION Existence of an economic penalty resulting from factors external to the lease must be known at the inception of the lease. The nature and estimated amount of the penalty at the inception of the lease must be such that renewal of the lease by the lessee would appear to be reasonably assured. Loss is economically similar to a requirement to make a payment to the lessor or a third party at the end of a lease.

7 Examples of Economic Penalties Energy provider leases power facility for shorter term than sales contracts Lessee leases office space for a short period with option to renew for relatively long period. Logistics of moving personnel requires long l period to plan and execute. Lessee has invested substantial amount in installing equipment. Lease of equipment is for a short period with relatively long renewal periods. Removing the equipment would be costly and inconvenient. Short initial lease when facility was built to suit to lessee specifications. Judgement required to access if renewal/purchase is reasonably assured. CONCLUSIONS: Accountants will examine reasonableness of assumptions.

8 Residual Value Guarantees Lessee Lessee agrees to make up any deficiency below a stated amount in the lessor s realization of the residual value. The guarantee is included in the minimum lease payments at the contractual maximum stated amount, not an estimate of the deficiency to be made up. Third parties If guarantee of the residual value is obtained by the lessee from m an unrelated third party for the benefit of the lessor, it does not reduce the amount of the lessee s minimum lease payments unless the lessor explicitly releases the lessee from all obligations.

9 Forms of Residual Value Guarantees Residual Value Insurance ( accounting RVI ) Unreasonable wear & tear or usage standards. Purchase Option: (if Economic Penalty is created) Remarketing arrangement: Seller must secure a lessee or a buyer for property. Lessee guarantee of lessor debt when guarantee extends beyond lease term.

10 Residual Value Guarantees Accounting Impact - Lease Classification Lessee provided - both lessee and lessor include as minimum lease payment for 90% test Third party provided Lessor includes as minimum lease payment for 90% test; Lessee does not

11 Accounting for Sale-Leasebacks

12 Sale-Leaseback Accounting Literature SFAS 13, Accounting for Leases SFAS 28, Accounting for Sales with Leasebacks SFAS 98, Accounting for Leases - Sale-Leasebacks of Real Estate EITF Issues (examples:) Issue No Sale-Leaseback Transactions with Repurchase Option Issue No Leveraged Leases: Real Estate Leases and Sale- Leaseback Transactions; and Delayed Equity Contributions Issue No Deferred Profit on Sale Leaseback Transaction with Lessee Guarantee of Residual Value Issue No Consideration of Executory Cost in Sale-Leasebacks Issue No Unsecured Guarantee by Parent of Subsidiary's Lease Payments in a Sale-Leaseback Transaction

13 Sale-Leaseback Accounting Literature- (cont d) Issue No Impact of an Uncollateralized Irrevocable Letter of Credit on a Real Estate Sale-Leaseback Transaction Issue No Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions Issue No Accounting for the Sale and Leaseback of an Asset That Is Leased to Another Party Issue No Revenue Recognition on Equipment Sold and Subsequently Repurchased Subject to an Operating Lease Issue No The Effect of Lessee Involvement in Asset Construction Issue No Determining When Equipment Is "Integral Equipment" and Subject to FASB Statements No. 66 and No. 98 Topic D-14 D Transactions Involving Special-Purpose Entities Topic D-24 D Sale-Leaseback Transactions with Continuing Involvement

14 Definition of Sale-Leaseback Sale-leaseback leaseback transactions involve the sale of property by the owner and a lease of the property back to the seller. The seller-lessee lessee records the sale and removes the asset from its balance sheet. The leaseback is classified in accordance with SFAS #13. Gains or losses MAY be recorded depending on several factors. Real estate (including( integral equipment) ) is treated differently than equipment.

15 Real Estate or Equipment? Is the asset equipment or real estate? If the asset is equipment,, the leaseback is subject to SFAS # 28 (amendment to #13). If the asset is real estate or integral equipment (as defined by EITF #00-13), the leaseback is subject to SFAS #98 (amendment to #13).

16 What is Integral Equipment Integral equipment is any physical structure or equipment attached to real estate, or other parts and cannot be removed and used separately without incurring significant cost.. (i.e. Chemical refinery, oil refinery). EITF Issue defines significant cost as 10% of the equipment's fair value as of the date of the sale-leaseback. leaseback. Significant costs include: (i) cost of removal (including cost repairing damage to existing g location) (ii) the diminution in value (significant loss in value or utility ty of property) (iii) the cost to ship to a new location for reinstallation, and (iv) the cost to reinstall the asset at it s new location. Integral equipment is treated as if it were real estate subject to SFAS #98. See copy of article

17 Sale-Leasebacks Involving Real Estate) SFAS #98 - Sale-Leaseback Transactions Involving Real Estate was meant to make; Make SFAS #13 consistent with SFAS #66 Accounting for Sales of Real Estate and eliminate loopholes which allowed sellers-lessees lessees to sell real estate, take it off their balance sheet and record profits, while leasing g it back, retaining risks and rewards.

18 Sale-Leasebacks (Involving Real Estate) - (cont d) Sale-leaseback leaseback accounting is acceptable if: A normal leaseback relationship exists between lessee and lessor. The buyer-lessor has an initial and continuing investment in the property. Terms and provisions transfer all of the other risks and rewards of ownership as demonstrated by the absence of any continuing involvement by the seller-lessee. lessee. If sale-leaseback leaseback accounting is not applicable, use the deposit method or treat it as a financing.

19 Sale-Leasebacks (Involving Real Estate ) (cont d) Continuing involvement that indicate the risks and rewards of ownership may not have been transferred: Seller-lessee lessee has an obligation to repurchase or has a fixed price purchase option. Seller-lessee lessee guarantees the buyer s investment or the return on the investment. Seller-lessee lessee is required to pay buyer for any decline in the fair value below the estimated residual value. Seller-lessee lessee provides non-recourse debt to buyer. Buyer is obligated to share any appreciation in the asset value. Leaseback does not include the underlying land. Conclusion: Only open ended FMV leases are permissible.

20 Sale-Leasebacks (Not Involving Real Estate) (cont d) IF the seller-lessee lessee relinquishes right to substantially all (greater than 90% on a PV basis of the FMV of the asset) of the remaining use of the property sold; Treat the sale and lease as separate transactions. Record any profit or loss as if a sale occurred.

21 Sale-Leasebacks (Not Involving Real Estate) (cont d) IF the seller-lessee lessee retains more than a minor part (greater than 10%) but less than substantially all (less than 90%) of the use of the property through the leaseback and realizes a profit on the sale: If the leaseback is an Operating lease, profit is recognized to the extent the profit exceeds the present value of the minimum lease payments (including any residual guarantee). If the leaseback is a Capital lease, profit is recognized to the extent the profit exceeds the capitalized value of the capital lease. Any unrecognized profit is recorded over the lease term to offset t either rental expense (operating lease) or amortization (capital lease). Rationale: Profits in excess of continuing obligation may be recorded.

22 Sale Leaseback - Example (Equipment) Assumptions: Asset Net Book Value $ 4,395 Sales Price $20,000 Lessee Residual Guarantee $ 4,000 Rentals $ / quarterly Lease Term 5 years

23 Sale Leaseback - Example Lease Classification Base Rent (quarterly payments Gross Present Value of $756.9 for five years) $ 15, $ 10, Lessee Guarantee of Residual 4, , $ 19, $ 12, % of Fair Value (90% X $20,000) $ 18, Since PV MLP is less than 90%, resulting leaseback is classified as an Operating Lease.

24 Sale Leaseback - Example Amount and Timing of Gain Recognition Sales Price $ 20,000 Cost 4,395 Gain on Sale 15,605 Lessee Guarantee 4,000 11,605 PV of MLP excluding residual guarantee 10,788 Gain Recognized at time of sale 817 Gain related to gross residual will be recognized at the end of the lease term to extent unexercised Remaining gain to be amortized in proportion to rentals

25 Leveraged Leasing Lessee Lessor Long-Term Creditor

26 Leveraged Leasing Lessor(s) EQUITY INVESTMENT(S) 15% TO 20% OF PURCHASE PRICE Lessee FREE CASH TAX BENEFITS LEASE PAYMENTS REPAYMENT OF NON-RECOURSE DEBT Owner Trust 100% OF PURCHASE PRICE ASSETS Lenders 80% TO 85% OF PURCHASE PRICE RECOURSE TO LESSEE Manufacturer/ Developer

27 Criteria for Leveraged Lease Classification - Lessee From the standpoint of the lessee, leveraged leases shall be classified and accounted for in the same manner as non-leveraged lease, as a: Capital Lease or Operating Lease

28 Criteria for Leveraged Lease Classification - Lessor 1. Meets definition of direct financing lease: Capital lease (meets one of four criteria of paragraph 7 of SFAS 13) No manufacturer s /dealer s profit 2. Involves three parties Lessee Lessor (equity participant) Long-term creditor 3. Financing is non-recourse to lessor s general credit and leveraged is substantial 4. The net investment in leveraged lease declines during early years and then increases in subsequent years Usually caused by tax impact Decrease/increases may occur more than once during term

29 Leveraged Lease - Classification Considerations Must meet direct financing definition: - Cannot be constructed by lessor/affiliate - Lessor/affiliate services during construction cannot affect fair value of property - Asset cannot be existing asset of lessor Leveraged lease permitted for real estate and sale-leasebacks. leasebacks. Substantial leverage; non-recourse debt at least 50% of asset value Investment pattern requirement is strict; Non-taxable lessors - difficult to meet criteria (tax benefits not received by lessor) Synthetic leveraged operating leases (no -taxes) is possible!

30 Leveraged Lease - Lessor Accounting Investment in lease shown net of nonrecourse debt. Investment in leveraged lease: - Rentals receivables, net of non-recourse debt (principal and interest) - Estimated unguaranteed residual value of leased asset - Unearned/deferred income comprised of estimated pretax income (loss) allocable to future periods less initial direct costs Net investment in leveraged lease: - Rentals receivables is equal to Investment in leveraged lease less l deferred taxes and - is used as basis for income allocation and investment pattern testt

31 Leveraged Lease - Income Recognition At the inception of the lease, the lessor prepares a schedule of after-tax tax cash flows for the entire lease term. Schedule defines the lessor s net investment in the leveraged lease at the end of each accounting period during the lease. Total after-tax tax income generated during entire lease is allocated to those periods during which the lessor s net investment in leveraged lease is positive. This results in a constant after-tax tax rate of return on the net investment during the years net investment is positive. Rate of return is distinct from accounting implicit rate.

32 Leveraged Lease - Income Recognition (cont d) No income is allocated to periods when the net investment is negative (typically middle years; when deferred taxes exceed investors net investment (after non-recourse debt) balance Net income is comprised of three elements: - Pretax lease income - Income tax expense (tax effect of pretax income)

33 Leveraged Lease - Example Assumptions: Asset Cost $3,000 Non-recourse Debt $2,400 Debt Service Payments $633/annual Rentals $633/annual Residual Value $1,000 Tax Rate 50% Lease Term 5 years

34 Leveraged Lease - Example Estimated Cash Flow Schedule Asset Debt Service Taxable Cash Year Cost Debt Principal Interest Total Rents Residual Deprec. Income Tax Flow Totals

35 Leveraged Lease - Example Cash Flow Beginning Investment Ending Year Investment (Recovery) (Income) Total Investment 1 $ 600 $ (648) $ (156) $ 804 $ (48) 2 (48) (284) (332) 3 (332) (238) (94) 4 (94) (262) (168) (44) $ (600) $ (200) $ 800 The rate of return necessary to distribute the net income (after tax) from the lease to those years in which the net investment is positive is 26%.

36 Leveraged Lease - Accounting During Lease Term Lessor required to review key assumptions and estimates that affect amount of income to be recognized at least annually Changes in residual value (upward revision not permitted) Changes in income tax laws or rates (EITF 86-43) Amount and timing of tax benefits and charges Delayed equity contributions (EITF 85-16)

37 Leveraged Lease - Accounting During Lease Term If any assumptions or estimates are changed Lessor must recompute the rate of return from the inception of the t lease Accounts making up net investment are adjusted to the balances that would have resulted from applying net rate of return from inception Any gain or loss recognized in period of revision

38 Other Relevant Topics and Areas Exposure Draft - Consolidation of Certain Special Purpose Entities; an interpretation of ARB # 51 Makes structures used for isolating and syndicating larger synthetic leases (non-tax operating leases) very difficult Guarantor s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others Requires inclusion in financial statements of the fair value of such guarantees FAS #140 - Transfers of Receivables Provides strict guidelines as to when a financial asset may be removed r from a transferor s balance sheet

39 Questions???????

40 Joseph Joe Sebik Vice President - Global Originations and Syndications J.P. Morgan Leasing, Inc Avenue of the Americas, 16th floor, New York, New York Joe is a member of the ELA Accounting Committee and is a Vice President with J.P. Morgan Leasing. Joe has over 20 years of leasing industry experience in various marketing, structuring, pricing, finance, syndication and accounting positions. Joe has prior experience with Citicorp s Global Equipment Finance leasing group, Jacom Computer Leasing, IBM Credit Corp. and Price Waterhouse. Joe received his undergraduate in Accounting from Queens College of the City University of New York and attended graduate school at St. John s University School l of Business. He has been a CPA in NYS since J.P. Morgan Leasing, Inc. is a subsidiary of JPMorganChase.. Its leasing business includes vendor leasing programs, tax leasing, TRAC leasing, synthetic leasing, real estate structured finance and leasing, and lease advisory and syndication services. Tel (212) , Fax (212) joseph.p..p.sebik@jpmorgan.com

41 Howard Thompson Director - Pricing and Economics Key Equipment Finance 66 South Pearl Street 7 th Floor Albany, New York Howard Thompson is a member of the ELA Federal Tax Committee and is a Director of Pricing and Economics for Key Equipment Finance. Howard has 15 years of financial services experience at Key, including 8 years of leasing industry experience in various pricing, finance, and product development positions, working with small ticket, middle market and large ticket transactions. Howard holds a bachelor s degree in communications from Syracuse University, and a master s degree in Business Administration, from Rensselaer Polytechnic Institute. I Key Equipment Finance oversees a $10 billion equipment portfolio with annual originations exceeding $3 billion. The company, which operates in 25 countries and employs more than 600 people worldwide, has been in the equipment financing business ss for nearly 30 years. Tel (518) , Fax: (518) howard.k..k.thompson@key.com