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 Leveraged lease accounting may be on its last legs

Tax Issues

Leveraged lease accounting may be on its last legs

Summary: The FASB wants to issue a final standard from proposed ASU No. 1850-100 and converge the accounting for lease contracts with U.S. GAAP and IFRS. Before it does, it has to decide whether the principle for leveraged lease contracts is worth keeping in the final standard.

The FASB is set to decide at its July 13, 2011, meeting whether to scrap an accounting method for lease contracts that was once common in the U.S. but has become less prevalent. Overseas, the practice was rarely seen. Leveraged lease accounting, as it is known under U.S. GAAP, does not exist under IFRS and is used primarily when a company finances the purchase of a large asset such as an airplane or power plant before leasing it to another business.

The companies that use leveraging call it a solid financial tool that can help present investments in a leveraged lease on a net basis. With leveraging, the lessor's after-tax net income is lifted through an accelerated depreciation schedule or investment credits. The savings are passed on to the lessee.

“By putting out a relatively small portion of cash to make an investment but getting all the tax benefits from it, [lessors] are able to basically get a highly levered return out of the transaction,” said John Bober, managing director, structuring group GE Energy Financial Services and an alternate member of the Financial Executives International's (FEI) committee on corporate reporting. “Because of that, if you look at just the cash they’re putting out, they’re actually getting returns that are maybe [one to two percentage] points above what they were going to get if they had to put all the funds out themselves,” Bober said.

The accounting method is especially helpful to renewable energy companies, where investors can take advantage of several tax breaks.

The FASB is reviewing the leveraged lease issue after planning to drop the accounting method from U.S. GAAP in proposed Accounting Standards Update (ASU) No. 1850-100, Leases (Topic 450). The draft guidance aims to end a longstanding practice under U.S. GAAP that leaves most operating leases off company balance sheets and converge lease accounting in this country with IFRS.

The proposal offers no special provisions for leveraged leasing, nor does it provide transition guidance allowing for grandfathering of leveraged leases.

At a June 29 education session, staff members told the board that leveraged leases should be left out of the final standard. One of the project's goals is to eliminate the distinctions—and potential confusion—among different types of leases. Eliminating the special accounting “would result in comparability across all lessor financial statements as well as in financial leases guidance that is converged,” the FASB staff wrote in a memo to the board.

At the education session, board members and the staff discussed the grandfathering idea, but that didn’t gain traction with members. “If we were to decide to grandfather, make an exception of some sort... other than just saying, ‘Well, it’s been done, it’s worked well,’ is there any conceptual justification for this treatment?” FASB member Daryl Buck asked.

FASB member Lawrence Smith said he believed leveraged lease accounting as it currently stands does indeed properly reflect the economics of the transactions, but “the point is, there is a lot of other tax incentive transactions that we don’t do separate accounting for.”

Proponents of keeping leveraged lease accounting in U.S. GAAP say lenders may no longer be willing to provide capital for businesses that cannot afford such large assets because they no longer would be allowed to present their investment in the lease on a net basis and recognize income on an after-tax basis, according to a staff memo.

Already some investment money is drying up, Bober said, because investors are worried about the pending changes to lease accounting although they are still only at the proposal stage. “For certain transactions that would be very well suited—renewable energy such as solar and wind, because they have heavy tax benefits—those transactions are not happening,” he said.

Some comment letters on the exposure draft expressed support for leaving the leveraged lease principle intact. For example, FEI argued that because leveraged leases are largely found in the U.S., there would be no hinderance to convergence. The “impacts of changing the current accounting for leveraged leases is primarily a domestic issue,” FEI wrote in a December 14, 2010, letter.

Source: WG&L Accounting & Compliance Alert on Checkpoint 7/8/2011



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