Thursday, March 26, 2009

International Lease Finance in trouble

The Wall Street Journal reports that the world's biggest lessor of airplanes, International Lease Finance Corp., says in a recent filing that its financing needs could threaten its survival. ILFC is a (profitable) part of AIG, and AIG's woes have been impairing its ability to borrow money to finance its purchases of planes, which it leases to many of the world's airlines. ILFC owns 955 planes worth $50 billion. It had been using commerical paper for a lot of its financing, but with the cut in credit ratings it has suffered as part of AIG, that market is now closed.

The article speculates that ILFC is too big to fail, as it's the largest customer for both Boeing and Airbus (not to mention the prime supplier of airplanes to numerous airlines). AIG is trying to sell ILFC to raise money to repay their borrowings from the feds.

Saturday, March 21, 2009

Discussion paper released

The same day (March 19) as my previous post, wondering when the discussion paper on the proposed new lease accounting standard would be released, it was actually released. It's available now from the FASB or IASB (the copies vary because of the differences between American English and British English, a reminder of George Bernard Shaw's witticism that we're two countries separated by a common language). Anyone is welcome to comment to the boards (they request that you pick one board or the other, not both, to comment to) by July 17, 2009. The FASB permits sending comments to, File Reference No. 1680-100. The IASB has a web form for comments. All comments become part of the public record, available for viewing on the web. The boards also plan to have a live web presentation on the DP in May, with details to come.

The DP is over 100 pages; while the information is generally a restatement of the boards' decisions, it'll take me a day or two to look through the full text and post comments (not least because some big projects are on my plate right now). The FASB has also posted a press release about the DP. Predictably, not everyone is happy: the Equipment Leasing and Finance Association, the main US trade association for equipment lessors, issued a press release expressing concern about the complexity of the proposal and its potential to increase the cost of capital. In other words, they're afraid fewer people will lease equipment if they can't keep the transaction off the balance sheet. No doubt that's true, though I don't know how anyone can realistically estimate the magnitude of the effect.

WebCPA has an article on the DP.

Thursday, March 19, 2009

Discussion Paper, when?

The FASB has released the agenda for its joint meeting with the IASB next week. The agenda does not have an item for leases, so apparently the discussion paper won't be part of the meeting. Whether it will be released without further board involvement, or has been delayed, is unclear at this time. The FASB leases project page still says the DP will be released in Q1 2009, but the page hasn't been updated since the end of January.

Contingent rent, now and future

One of the more confusing aspects of lease accounting is dealing with contingent rents. The FASB defines these as "The increases or decreases in lease payments that result from changes occurring subsequent to the inception of the lease in the factors (other than the passage of time) on which lease payments are based..." [FAS 29, para. 11] Typical causes for contingent rents are inflation adjustments, percentage of sales, a rental amount based on a floating interest rate (like LIBOR), property taxes, and maintenance fees.

Under FAS 13, contingent rents are handled in one of two ways. Both are based on the overall concept of making a one-time estimate at the beginning of the lease, and expensing the difference between the estimate and the actual payment when the payment is made.

1) If the amount to be paid is based on usage, such as a percentage of sales or machine hours of use, the up-front estimate is zero. All payments based on usage are considered contingent rent, and fall outside of the "minimum lease payments" for the lease (since if you end up not using the asset, your minimum charge is 0); they are expensed as incurred.

2) If the amount to be paid is based on a rate or index, such as LIBOR or the consumer price index, the minimum lease payments are calculated as if the rate or index will be the same over the entire life of the lease. This calculation is not changed over the entire life of the lease (unless the agreement is renegotiated). The difference between the estimate and the actual payment is expensed as incurred; note that this difference could be positive or negative.

One question that often comes up is whether to treat the CPI as a rate or as an index. Officially, CPI is an index, showing the value of a basket of goods and services. The overall value was normed to 100 in 1967; the percentage increase that is broadcast on the news is the change in that index. While some companies take the position that they should assume the current rate of increase in calculating their minimum lease payments, a strict reading of FAS 13 seems to indicate that instead one should assume that the index will not change, i.e., there will be no inflation (or deflation), and future inflation adjustments will be treated entirely as contingent rent.

Of course, if the increases in rent are specified in advance, they must be considered part of the minimum lease payments, even if they're supposedly intended to cover inflation. The key is whether the rent amount is known at inception, or dependent on future events.

The current version of EZ13, v2.2, does not track contingent rents at all, because they're not part of the minimum lease payments. However, we are currently working on a new release which will include the ability to record and report contingent rents; that will be released later this year.

The FASB/IASB revision plans to change this. According to the boards' current thinking, lessees will need to estimate their rents for all types of contingent rent. Unfortunately, the two boards have differing opinions on how to estimate: The FASB wants to use a "best estimate" approach, while the IASB wants a probability-weighted expected outcome approach. Both want lessees to remeasure their leases at each reporting date (normally every fiscal quarter), with the obligation changed by the change in present value of the remaining rents. They disagree about how to balance the change transaction: for changes caused by contingent rents, the FASB wants an immediate recognition of profit or loss, with no change to the carrying value of the asset, while the IASB wants to add or subtract the change to both the obligation and the asset. The depreciation on the asset would then be altered to depreciate the remaining asset over the remaining life.

Since the boards intend to release a united standard, some negotiation between the boards will be necessary to resolve this. Further, it remains to be seen how companies and users of financial statements will respond to this idea; clearly this is a potentially large increase in the complexity of accounting for leases, with the possibility that valuations would change every quarter with corresponding changes in interest and depreciation, along with the change in the actual rent.

Friday, March 13, 2009

What's the impact?

The chairman of the IASB, Sir David Tweedie, has said as a half-joking example of the need for lease accounting reform that it's his life's ambition to fly on an airplane that's shown on the books of the airline flying him. This slightly overstates the situation (for instance, United Airlines' annual report shows capital as well as operating leases, as well as some owned aircraft), but it is true that corporations have made huge commitments through operating leases that currently have no impact on the balance sheet (aside from the possible impact of leveling scheduled rent increases) and are only reported as a footnote to the financial statements. (United's operating lease commitments are nearly 3 times its capital leases, and include the majority of its aircraft.) The SEC recently estimated that the total value of future rent commitments in the U.S. is $1.25 trillion (yes, that's with a T).

In mid-2007, the Georgia Tech College of Management's Financial Analysis Lab did a study looking at the impact of forcing operating leases to be capitalized on a number of presumably representative retail store chains. Chain stores are one of the industry groups likely to be most affected by forcing all leases to be capitalized, as the FASB & IASB intend. While the Lab didn't have complete information available to calculate precise results, their estimates were stunning: while the impact would be modest for many stores, they estimated that BJ's Wholesale could face an 80% drop in reported earnings per share. (The median impact was a much more modest 5.3% drop, still significant, and likely to be larger in the current difficult retail environment.) The effect on stores' leverage was even more significant: the median increase in the liabilities to equity ratio was 26%, and several companies would see that ratio more than double.

What would be the impact on loan covenants? We don't know. It might be minimal, as some banks already require their borrowers to treat operating leases as capital for covenant calculations. Yet there are probably other lenders who haven't taken that careful a view of operating leases; if a borrower suddenly doubles its reported debt load, they could easily find themselves either in default or facing penalty interest rate hikes.

The FASB/IASB haven't said how they plan to transition to the new regime of capitalizing leases that are currently operating. The most likely scenario would seem to be booking the remaining rent commitments at the effective date of the new regulation, rather than restating from inception. Some people are holding out hope that existing leases would be grandfathered, but that doesn't seem to mesh with the boards' stated intention of recognizing the "economic reality" that leases convey a benefit and obligation.

FCS has been providing indenture reporting capabilities for our clients for years, calculating operating leases as capital at either a single rate or a series of rates based on our customer's cost of debt at different terms. EZ13 allows users to use either the incremental borrowing rate or a fixed interest rate to capitalize operating leases, without changing the lease record (so that regular and indenture reports can be run without changes).

Discussion Paper coming

The FASB and IASB have been discussing the revision of the lease accounting regulations for over 2-1/2 years (first announced in July 2006). Finally, they have reached the point of releasing a Discussion Paper, which details the decisions they have made to this point and asks for public comment. The boards have a joint meeting scheduled for March 23 & 24 in London; we expect that the DP will be approved at that meeting. The FASB project page indicates that the deadline for public comments will be some time during Q2 2009.

Getting started

Welcome to the lease accounting blog! This is offered by Financial Computer Systems, Inc., which for over 30 years has specialized in providing lease accounting software to corporations throughout the United States and Canada.

Lease accounting is in the midst of a major overhaul, as the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) agreed jointly in 2006 to begin a comprehensive review of the regulations for lease accounting (FAS 13 and IAS 17, respectively), with the goal of developing a joint revised standard. Rising unhappiness with the level of off-balance-sheet financing through leasing has been the major driver of this decision, and the boards have agreed to essentially eliminate what are currently known as operating leases, which have no impact on the balance sheet.

Later this month, a discussion paper presenting the boards' intentions will be released for public comment. I'm going to take time both now and in coming days to look at what has been decided so far, what is still undecided, and what the implications are for lessees (and to a certain extent for lessors, including sublessors).

Financial Computer Systems markets both software and services to provide complete lessee accounting for both capital and operating leases. We have been specialists in FAS-13 compliance ever since FAS-13 was issued in 1976 (we actually developed our first version of software in 1975 to meet the predecessor regulation, ASR-147). We'll talk more about how our EZ13 software can help with lease accounting on this blog as well.