SEC Speaks on Third Party Residual Guarantees

SEC Speaks on Third Party Residual Guarantees

Keyes, Robert

Lessors must change practices and take corrective action.

At the Emerging Issues Task Force meeting on May 15, 2003, the SEC Observer described the SEC’s views on two issues involving the proper accounting treatment by lessors of third-party residual value guarantees. The announcement was subsequently published by the EITF as Topic No. D-107.

The result of the SEC’s comments is that some current practices must be changed, and corrective action should be considered for some existing lease transactions. Before addressing the SEC views, I will describe why lessors may elect to use residual value guarantees with their lease structures.

Lease Classification

One of the key objectives in structuring a lease transaction is often to meet the lessee’s desire to obtain operating lease treatment, while obtaining sales-type or direct financing lease classification for the lessor. The most common test used for lease classification under FASB Statement No. 13, Accounting for Leases, is application of paragraph 7(d). Under this test, if the present value of the minimum lease payments, excluding that portion of the payments representing executory costs to be paid by the lessor, equals or exceeds 90 percent of the fair value of the leased property, then the lease is a capital lease for the lessee. For the lessor, if the lease meets the 90 percent test, the collectibility of minimum lease payments is reasonably predictable, and there are no important uncertainties about unreimbursable costs yet to be incurred by the lessor, then the lessor gets its desired lease classification. The goal is to fail the 90 percent test for the lessee, and pass it for the lessor. The lessor uses the implicit rate in the lease to determine the present value of the minimum lease payments. The lessee uses its incremental borrowing rate for a like term borrowing unless it can determine the lessor’s implicit rate, and it is lower than the incremental borrowing rate. Lessees usually do not know the lessor’s implicit rate, so leases can be priced to meet the dual objectives with no other efforts required.

There are situations, however, where the lessee is aware of the lessor’s residual value. SFAS 13 says that the lessee’s minimum lease payments include the rental payments and any lessee guaranty of the lessor’s residual value. In many automobile leases, the lessee guarantees a significant portion of the residual value. Since the lessee knows the lessor’s residual value, it can determine the implicit rate in the lease. Both parties are using the same discount rate, so the only way to both pass and fail the test is to apply the rate to different cashflow streams. This can be accomplished by having an unrelated third party guarantee a portion of the lessor’s residual value that is not covered by the lessee. The lessor only has to obtain a guarantee of enough residual value to include in its minimum lease payments to raise the present value to 90 percent. This is usually a low cost way for the lessor to get its desired accounting treatment. There can be other situations where the lessor may use third-party residual guarantees to meet its objectives, but the automobile lease example will serve our purposes here.

The Troublesome Structure

Some lessors have purchased residual value guarantees on a pool of automobile leases. This could be a lease of many automobiles to one lessee, or it may be a pool of many individual leases of automobiles to unrelated lessees. The common characteristic is the homogeneous pool of a large quantity of underlying assets. In this scenario, the third-party guarantee may be structured such that coverage is on the pool rather than each individual asset. Gains from the disposition of assets are used to cover losses on others until there is a net deficiency in the pool. Only then would the guarantor be required to make payment. The lessor is only economically assured a minimum residual value for the pool. This structure has the effect of driving down the cost of the guaranty, which is why it is attractive to a lessor.

SEC’s View & What to Do

In Topic D-107, the SEC Observer has clarified that the SEC believes that residual value guarantees of a portfolio of leased assets preclude a lessor from determining the amount of the guarantee of any individual leased asset within the portfolio at lease inception. Accordingly, no such guarantee amounts should be included in the determination of minimum lease payments. To be included, the guarantee must be specific to each individual asset in the portfolio.

If a lessor must make an accounting change for existing leases at the balance sheet date to comply with this announcement, then all prior periods should be restated not later than the beginning of the first fiscal quarter beginning after December 15, 2003 (January 1, 2004 for a calendar-year company). The presumption is that such leases would have to be re-characterized as operating leases. The SEC observer went on to say that it is understood that some registrants may wish to modify some of their residual value guarantees that are subject to this announcement in order to meet the criteria for sales-type or direct financing lease accounting. The third-party guarantees must be modified prior to the adoption of the announcement. The modification will be treated as a modification of an existing lease. The lessor must follow the guidance in paragraphs 9, 17, and 18 of SFAS 13 when evaluating the change. If the modification results in a sales-type or direct finance lease at its inception under this guidance, then the SEC will not object if the lessor does not restate prior periods for the accounting for such leases.

Time is running out. If you are a lessor, and you utilize third-party residual value guarantees to achieve your desired accounting treatment, review your contracts now to make sure that they comply with Topic D-107 by covering each asset individually. If they do not, you only have until December 31st to modify them if you wish to preserve your existing accounting.

Another Potential Pitfall

The SEC Observer also addressed situations where the lessor assumed a residual value guarantee at lease inception but had not obtained it as of that date. For example, a lessor might wait until the end of a month before placing the insurance coverage for all of the assets placed under lease during the month. The SEC staff would view such a circumstance as an error, which would require restatement of prior period financial statements regardless of whether a residual value guarantee is subsequently obtained.

The bottom line is that residual value guarantee coverage must be asset specific, and must be in place at lease inception.

ELT thanks Robert Keyes, Bank of America Leasing and Capital Group, for this month’s column.

Copyright Equipment Leasing Association of America Nov/Dec 2003

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