Transcript of "2012 02 06 EFRAG presentation re lease accounting"
Navigating through the new lease regulations EFRAGRoel Vriens, February 23, 2012
Navigating through the new lease regulations: EFRAGContent of presentation} Leasing – Current and expected future framework} Expected business impact for lessees and for vendors/lessors} Is there still a future for leasing?} Specific topics 2
Leasing - Current and expected future framework
Navigating through the new lease regulations: EFRAGLeasing: Current frameworkDifferences local GAAP, IFRS and US GAAP} Criteria to differentiate between Financial Lease (on balance sheet) and Operating Lease (off balance sheet) – NPV of the minimum lease payments – Economic life versus term of lease contract Lease payments Economic lifeLocal GAAP 90% (indication) 75% (indication)IFRS IAS 17 ‘substantially all’ ‘major part’US GAAP SFAS 13 90% 75% 4
Navigating through the new lease regulations: EFRAG Leasing: Expected future framework History1996: first Discussion 2009: IASB and FASB 2013: Final rules stillPaper (McGregor/IASB) in Discussion Paper ‘Leases: expected in 2012? Re-which the need to adapt Preliminary Views’ with exposure draft is expectedrules was explained on afairly detailed level Overriding Lessees main focus on principle in Q2 2012. All leases to be shown on the balance sheet of the 1996 2000 2009 2010 2012 2016 lessee 2000: Second Discussion August 17, 2010: Effective Date not decided, Paper IASB Exposure Draft as result of expectation January 2016. the 2009 Discussion Paper But date of initial application Over 785 companies, (DIA) one or two years including DLL, have earlier, i.e., 2015 (IFRS) and responded! 2014 (US GAAP) 5
Navigating through the new lease regulations: EFRAGLeasing: Expected future frameworkLessor accounting: Receivable and residual approach} One model: Receivable and Residual (R&R) approach – Very similar to current finance lease accounting, but more complex – Result is what equipment leasing industry has been pressing for} Important differences compared to current situation: – Two assets on lessor’s balance sheet (R&R) – Both assets generate a return equal to discount rate in the lease} Portion of income to defer when fair value of leased asset is greater than lessor’s carrying value: – This is typical for captives, not applicable to other (bank-owned) lessors – Part of excess fair value associated with the residual asset to be deferred until disposal, re-lease, or realization of the residual asset 6
Navigating through the new lease regulations: EFRAGLeasing: Expected future frameworkObservations} Sound conceptual framework for lessors and lessees: – Proposal (December 23, 2011) much better than 2010 Exposure Draft and current rules – Acceptance of capitalizing all, except short term, leases by the lessees – Choice of lessor R&R model supported by equipment leasing industry – One type of lease for both lessees and lessors, mirroring the lessee position at the lessor} Areas to be addressed: – Eliminating frontloading of lease interest expenses could impact the sound framework mentioned above. Would that be a good decision? – Cost versus benefits of new standard, options to consider are minimizing disclosures and further simplifications or more explicit guidance on: } Hurdle of a “significant economic incentive” to renew/continue the lease } Lessor accounting for residual values guarantees } Accounting for variations based on index or interest rates 7
Expected business impactLessees and Vendors/Lessors
Navigating through the new lease regulations: EFRAGStatementAll parties involved, vendors, dealers, lessors (captives and vendorfinance companies), end-users and lessees will be substantiallyaffected by the changes in lease accounting} Revenue recognition (P&L)} Costs/Investment to be made (P&L) – Frontloading of interest cost for lessees} On and Off balance sheet treatment} Business and co-operation models} Financial products and services offered} Changing playing field in marketplace} Processes and IT 9
Navigating through the new lease regulations: EFRAGThe changing environmentLessees} Lessees to recognize all leases on the balance sheet resulting in: – Increase in administrative burden, due to required increase in data collection, monitoring and internal and external reporting – Increase of complexity, due to changed definitions, methods of calculations and combining data from multiple internal and external sources – Deterioration of debt-equity ratio as assets and liabilities increase. Lessees may no longer meet existing loan covenants or face lower credit ratings – Major task to transition, due to all operating leases coming on balance sheet for the first time} Thus, lessees will search for products and services that: – Mitigate the impact – Do not require the lessee to change its processes and IT systems 10
Navigating through the new lease regulations: EFRAGExpected customer impactPreparation for new rules} 54% of business globally are not aware of the proposed move of all but short-term leases onto the balance sheet – Survey 2800 businesses worldwide} Awareness of change by country – High: USA: 69%, Mexico: 68%, Chile: 63% – Medium: UK: 44%, Germany: 27% (EU: 38%) – Low: China: 5%, Denmark: 8%, Turkey: 14%} Expected consequences: – 33% increase of costs and complexity – (only)15% increase in transparency – 12% change in behavior with respect to leasingSource: survey Grant Thornton International Business Report (September 2011) 11
Navigating through the new lease regulations: EFRAGThe changing environmentVendors / Lessors} Vendors to defer revenue and related margin allocated to the residual asset till disposal of that asset} Vendors/lessors to provide (new) products and services to: – Lessees in answer to the new environment – Dealers, supporting them to sell leasing in the new environment} Thus, vendors will search for solutions that: – Allow for full upfront revenue and margin recognition – Derecognize their lease portfolios (off balance sheet treatment) – Accommodate requests from dealers and lessees to limit the end-user’s administrative burden and need for more information and transparency} Vendors to tune their current business models to new environment – Should they move to in-house financing or (other) third party vendor leasing companies? 12
Navigating through the new lease regulations: EFRAGRevenue deferral related to residual assetImpact differs per major asset types / industriesAsset Types RoU Investment valueIT / Office equipment 94 100Forklifts 85 100Industrial 65 100Cars 65 100Transportation 55 100} Captives (vendors with in house lease book) will see an important shift in the pattern of revenue recognition over time compared to today} Lessees will no longer have a possibility of Off-balance sheet financing, but lease solutions are still partial off balance, as the assumed Residual Value is on the balance sheet of the lessor and not part of the Right-Of-Use asset 13
Navigating through the new lease regulations: EFRAGChallenges for lessees and vendors/lessors} Bank covenants (lessees) – Deterioration of financial ratios e.g., solvency} IT and leasing software (own and 3rd party) – 60% of respondents use MS Excel to record their operating leases. That may require investments in software to track and account for leases} Duty of care of vendors/lessors to end-users – Leases signed today are likely to be affected by new rules (e.g., for contracts with duration in excess of 4 years) – Communication and providing information to lessees 14
Navigating through the new lease regulations: EFRAGCustomers should continue to lease because:} Use of equipment at low monthly costs} 100% cost coverage: equipment, service, shipping, installation, etc.} Flexibility of mid term upgrades and end of term options: easy way to gain use of the latest equipment or technology with maximum financial flexibility} Easier cash flow forecasting: fixed payments allow your customer to budget effectively and avoid risk of future inflation or interest rate rises} Lease commitments often do not reduce existing cash and credit lines} Less costly and lower cash out than a (bank) loan 16
Navigating through the new lease regulations: EFRAGVendors should continue to offer leasing totheir customersBecause leasing puts vendor in control} Protecting customer base against other vendors} Easier closing of deals: offering leasing can remove price objections with customers} Increasing sales and margins: offering a finance package makes it easier to sell added value products such as service and maintenance} Increasing opportunities for upgrade sales: leasing cycles are relatively short, offering more opportunities to approach the customer to sell upgrades or new products 17
Navigating through the new lease regulations: EFRAGHow can the structure be optimized?Understanding the objectives of all the players in the market Vendor Leasing Model Lessor End-user/ Manufacturer/ lessee vendor1. Lessee: reduce admin burden and not on the balance sheet2. Vendor: sales treatment and derecognition of assets3. Lessor: lien on or ownership of the financed equipment 18
Navigating through the new lease regulations: EFRAGConsequences for lessees} Higher lease cost in the beginning of the lease period compared to the current lease accounting standards Lease cost comparison 250.00 200.00 Current Proposed 150.00 100.00 Year 1 Year 2 Year 3 Year 4 Year 5 20
Navigating through the new lease regulations: EFRAGEconomic impact of lease proposalsStudy of Equipment Leasing and Finance Foundation} Study based on 2010 financial data of 1800 US based, publicly traded companies. Assuming new lease rules implemented in 2010} Frontloading of lease interest expenses increases costs by + 9.6% and a -2.4% reduction in pre-tax net income for the first year – However is the method used fair? Which growth assumptions are used?} Capitalization of operating leases: increase in assets of $2 trillion; and +11% more debt – This replaces the current estimates. Will there be significant differences?} Lease standard reduces GDP by $10 billion and 60,000 less jobs – Significant impact, but based upon what assumptions?} Investigated companies face $96 billion (or - 0.5%) less equity 21
Navigating through the new lease regulations: EFRAGLease classification (current status)} Today, classification of the same lease contracts within Office Technology industry differ significantly between: – Vendor/Lessor, reporting about 80% Finance Leases and 20% Operating Leases – Lessee/End-user, reporting these contracts as 30% Finance Leases and 70% Operating Leases} Reasons for different classification by parties involved include: – Different assessment of economic life (75% rule in FAS13) – Different discount factor, incremental borrowing rate versus rate embedded in the lease (90% rule in FAS13) – Third party residual value guarantees issued to vendor – Immaterial items or non-compliance to the rules 22
Navigating through the new lease regulations: EFRAGLease classification (future status)Concerns lease versus service classification – a new bright line?} Criteria to determine whether a contract contains a lease: – Right to use a specified asset, and – Right to control the use of that asset} Vendor/lessors may prefer a lease over a service to have sales treatment of the equipment sold through a lease} Lessees may prefer a service over a lease to have fixed periodic cost, nothing on the balance sheet and very limited administrative burden} Would it be possible that under the new standard a contract is: – Classified as a service but is a lease by common sense? What about long-term service contracts with embedded equipment? – Classified as a lease for the vendor/lessor and as a service for the lessee/end-user? 23
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