Accounting rule changes, in the works for several years, are likely to have a mixed effect on the market for securitization of equipment leases. They could curtail leasing of new, large equipment, but lessors may have additional incentives to securitize the leases that they do make.
The second version of the Financial Accounting Standards Board’s proposal to update accounting for leases may be less controversial than the first. A major bone of contention around the FASB’s 2010 proposal was its complex requirements for real estate leases, such as factoring in whether a lease would be renewed or not. Those elements have largely been smoothed over, but the proposal nevertheless could significantly change how lessees recognize their lease-related expenses and affect their equipment-sourcing decisions, potentially impacting the volume of leases available to securitize.
Lessors, on the other hand, would be able to move securitizations of leases for big-ticket items off-balance sheet, which is not possible under current accounting rules.
“Now, virtually all equipment leases would look like direct finance leases and they’re going to be ready to securitize and go off-balance-sheet,” said Bill Bosco, president of consultancy Leasing 101 and a former Citibank executive specializing in leases.
That means lessors of aircraft, rail cars, shipping containers and other costly equipment that tend to have longer lease terms and are now accounted for as operating leases would be able to free up capital to originate more leases.
“Operating lessors may be more likely to feel the effect than what I would describe as financial lessors” who provide direct-finance leases, said Joe Turfler, chief financial officer of GreatAmerica Leasing Corp., which focuses on leasing out “small-ticket” equipment such as copiers and printers.
Turfler said the proposal would likely have little direct effect on GreatAmerica’s business because its direct-finance leases typically have tenors between 48 months and 60 months, in which time the lessor recoups most of the purchase price. Under current accounting rules those direct-finance leases are already reflected on a lessees’ balance sheet.
Although the proposal would benefit lessors seeking off-balance-sheet treatment, their clients’ operating leases would have to move onto the balance sheet.
“Lessees that now have operating leases may see the greatest impact. Some may get favorable accounting treatment under today’s rules and they could lose that under the new rules,” Turfler said.
Such a change could affect lessees’ decisions about how much equipment they source. In doing so, the proposed rule would potentially influence the types and quantity of leases available to be securitized. For example, the proposal would allow off-balance-sheet treatment for leases with tenors of less than 12 months and that may prompt lessees to shorten their leases. Real estate leases as well as equipment leases under 12 months would be classified as Type B leases, and most other equipment leases would fall under the Type A category.
FASB’s proposal would have a more direct impact on lessors that today provide operating leases. Those lessors securitize leases because it’s a cost-efficient form of financing, even though the deals must be reported on their balance sheets. The proposal would give them cheaper financing and off-balance-sheet treatment, freeing up capital.
An additional benefit for the lessor, said Dave Mirsky, co-founder and CEO of Pacific Rim Capital, a major forklift lessor, is that operating leases require depreciating the asset and paying more interest at the beginning of the lease, creating a book loss and a drag on earnings early on. Direct-finance leases, instead, incur straight-line expense recognition.
“So under the new proposal, leases won’t throw off losses in the early months and instead will provide earnings,” Mirsky said.
This benefit may prompt some lessors to consider securitization as an option, but it’s unlikely to create a surge in new issuers of lease ABS.
Mirsky said the costs involved in “creating a bond” mean that securitization tends to make the most sense for public lessors originating high volumes of leases.
Sectors today where lessors regularly tap the securitization market include rail cars and shipping containers. In an August report, Fitch Ratings said that $2.5 billion in asset-backed bonds were issued last year in nine transactions, and the first half of this year saw six deals totaling $1.7 billion.
ASR’s Scorecards Database includes at least two rail car equipment lease deals this year as well as three offerings of equipment trust certificates from airlines, including American Airlines and US Airways.
Overall, equipment financing is on the rise. The Equipment Leasing and Finance Association reported in late August that the new business volume of the 25 companies in its Monthly Leasing and Finance Index, representing a cross section of the $725 billion equipment-finance sector, increased by 9% in July compared to the same month last year. However July’s volume dipped 16% compared to June’s. Year to date, new business volume increased 10% over the same period in 2012. The survey does not distinguish between lease financings and other types of equipment financing.
While equipment lessors stand to benefit from FASB’s proposal, lessees may find the new requirements challenging enough to impact their equipment sourcing decisions and ultimately the volume of leases available for securitization. Not only will they have to put virtually all equipment leases on balance sheet, but they will have to recognize the cost of the lease upfront, similar to accounting for debt financing.
The amount of upfront cost recognition increases with the length of the lease, so a three-year lease would see recognized costs increase by 7% in the first year, and a 20-year lease by 28%, according to ELFA. Those increases, especially for longer leases supporting big-ticket items, could eat into lessee’s capital available for replenishing equipment.
“It’s a big number, but I still do think an airline would first make the decision to acquire the aircraft and then may decide to lease,” said Bosco, a member of ELFA’s financial accounting committee.
He noted that there are several other advantages to leases: The capitalized value of the lease payments will be significantly less than the cost of acquiring a plane, providing some ongoing balance-sheet benefit, and the front-ended cost of the lease may be less than borrowing to fund a purchase because interest on the loan is also front-ended. In addition, he said, the after-tax cost of a lease may be less than the after-tax cost of a loan, a discrepancy the airlines have routinely taken advantage of.
Those advantages apply to leases for other types of equipment as well. Bosco said that, rather than forgoing the lease, companies may choose instead to cut costs in other areas.
Mirsky said the straw that could break the camel’s back in terms of lessees deciding whether to source new equipment may be the costs associated with compliance. Public companies, for example, would have to restate the earnings of all existing leases fitting into the Type A category going back as many as three years. “This is true for leases stemming from small- and large-ticket equipment,” Mirsky said, adding, “It’s a one-time effort, but like Sarbanes Oxley it’s a massive expense.”
The Aerospace Industry Association (AIA), which represents manufacturers of commercial and military aircraft and related products, lists several additional areas of complexity that will ramp up costs in its Aug. 22 comment letter. They include separating components in lease agreements such as maintenance or taxes, judging whether leases fit into the proposal’s Type A or Type B categories, calculating the amortization of Type B leases, and the administrative burden of applying the model to a large number of small dollar leases.
“We believe that the costs to comply with the proposed requirements will exceed the resulting benefits due to the unnecessary complexity of the proposed requirements,” Terrence Regis Marcinko, AIA’s director of finance and accounting, wrote in a comment letter.
While it’s difficult to gauge what the proposal’s effects could be on lessees’ sourcing of new equipment, even a marginal impact could affect the volume of leases available for securitization. Mirsky noted that the proposal’s hurdles are “front-loaded for lessees,” tying up their capital at least in the short-term. Asked whether that could reduce companies’ sourcing of new equipment, he says, “I think it will.”