2012 02 06 EFRAG presentation re lease accounting

Navigating through the new lease regulations EFRAG

Roel Vriens, February 23, 2012

Navigating through the new lease regulations: EFRAG

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Content 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

Leasing - Current and expected future framework


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Differences local GAAP, IFRS and US GAAP

Lease payments Economic life

Local GAAP 90% (indication) 75% (indication)

IFRS IAS 17 ‘substantially all’ ‘major part’

US GAAP SFAS 13 90% 75%

Leasing: Current framework

}  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


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1996: first Discussion Paper (McGregor/IASB) in which the need to adapt rules was explained on a fairly detailed level

2009: IASB and FASB Discussion Paper ‘Leases: Preliminary Views’ with main focus on Lessees

2013: Final rules still expected in 2012? Re-exposure draft is expected in Q2 2012.

2000: Second Discussion Paper IASB

August 17, 2010: Exposure Draft as result of the 2009 Discussion Paper Over 785 companies, including DLL, have responded!

Effective Date not decided, expectation January 2016. But date of initial application (DIA) one or two years earlier, i.e., 2015 (IFRS) and 2014 (US GAAP)

1996 2000 2009 2010 2012 2016

Leasing: Expected future framework History

Overriding principle

All leases to be shown on the balance sheet of the

lessee


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}  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

Leasing: Expected future framework Lessor accounting: Receivable and residual approach


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}  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

Leasing: Expected future framework Observations

Expected business impact Lessees and Vendors/Lessors


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Statement

}  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

All parties involved, vendors, dealers, lessors (captives and vendor finance companies), end-users and lessees will be substantially affected by the changes in lease accounting


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The changing environment

}  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

Lessees


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}  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 leasing

Source: survey Grant Thornton International Business Report (September 2011)

Expected customer impact Preparation for new rules


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The changing environment

}  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?

Vendors / Lessors


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Revenue deferral related to residual asset

Asset Types RoU Investment value IT / Office equipment 94 100 Forklifts 85 100 Industrial 65 100 Cars 65 100 Transportation 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

Impact differs per major asset types / industries


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Challenges 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

Is there still a future for leasing?


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Customers 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


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Vendors should continue to offer leasing to their customers

}  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

Because leasing puts vendor in control


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Vend

or L

easi

ng M

odel

End-user/ lessee

Lessor

Manufacturer/ vendor

Understanding the objectives of all the players in the market How can the structure be optimized?

1.  Lessee: reduce admin burden and not on the balance sheet 2.  Vendor: sales treatment and derecognition of assets 3.  Lessor: lien on or ownership of the financed equipment

Specific topics


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Consequences for lessees

}  Higher lease cost in the beginning of the lease period compared to the current lease accounting standards

Lease cost comparison

100.00

150.00

200.00

250.00

Year 1 Year 2 Year 3 Year 4 Year 5

CurrentProposed


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}  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

Economic impact of lease proposals Study of Equipment Leasing and Finance Foundation


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}  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

Lease classification (current status)


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}  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?

Lease classification (future status) Concerns lease versus service classification – a new bright line?

Economy & Finance

2012 02 06 EFRAG presentation re lease accounting