Industry Insights

Transportation companies will be significantly affected by the proposed lease accounting standards. This article summarizes the main provisions and key impacts on transportation companies and provides examples and steps to prepare for the future. 

Background & Overview

On August 17, 2010, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) issued an exposure draft of an accounting standard update—Leases, Topic 840—that will have implications for both lessees and lessors. In July 2011, the boards agreed to re-expose the accounting standards update; that revision is expected in the first half of 2012.

This topic is broad in its application across industries. FASB and IASB released the chart below in January 2011, indicating the mix of industry respondents from the 760 letters received, including Truck Renting and Leasing Association, American Trucking Associations (ATA), Penske Truck Leasing, Ryder System, Inc. and others. For a full list and the text of those letters, go to the FASB website.

General criticisms from some transportation organizations included how the proposed changes would reflect the economics of leases—particularly short-term leases—and the requirements to estimate and re-adjust leases and contingent rents. As the ATA noted in its letter dated December 15, 2010, the U.S. trucking industry has more than 214,000 for-hire carriers and more than 276,000 private carriers, 95.9 percent with fewer than 20 trucks. A significant concern for those small companies was the complexity of adopting the new standard as proposed and their ability to meet loan covenants under those standards. In addition, estimating contingent rents based on usage (mileage) will be a challenge.

In the FASB/IASB discussions following the original release of proposed changes, many issues raised by respondents have been addressed, but there is little doubt the revised exposure draft will retain changes that effectively eliminate operating lease accounting for all but short-term leases and certain other exceptions. Lessors also will see substantial changes with the elimination of sales, direct-financing, leverage and operating leases, to be replaced by a receivable/residual model.

Key provisions of the changes, as originally released by the exposure draft and as amended by tentative discussion, through December 2011 include the following:

Lessees

• Off-balance-sheet accounting for operating leases is eliminated. Assets (right-of-use) and obligations (lease liabilities) would be established on the balance sheet.
• With some adjustments, right-of-use assets and lease liabilities will be recorded initially as the present value of lease payments for the noncancellable period of the lease, plus options when significant economic incentives exist.
• Rent expense for operating leases would be replaced by amortization and interest expense. Asset amortization will generally be on a straight-line method, while interest will be recognized on the effective yield method, which will front-load the cost.
• Variable lease payments dependent on an index or rate initially will be measured using the index or rate existing at commencement, but these would be reassessed at the end of each reporting period. Those based on usage or other circumstances will be recorded based on a reliable measurement threshold.

Lessor

• Investment property tentatively will be excluded from the receivable approach, resulting in a continued recognition of lease income over the lease term.
• For all other leases, a right to receive payments will be recorded at the present value of the lease payments, discounted at the rate charged the lessee and amortized on an effective interest method—somewhat the mirror of the lessee liability.
• A residual asset will be created from the allocation of the carrying amount of the underlying asset, made up of the gross residual asset at present value and deferred profit.
• The residual asset will be accreted, offsetting the present value calculation, over the lease term with the deferred profit or loss not recognized until the underlying asset is sold or re-leased.

Changes resulting from this standard may have effects not immediately apparent because of the recognition of new assets, liabilities and changes in income statement presentation and resulting performance measurements. These measurements include earnings results, valuations, leverage, debt covenants, budgeting, management performance arrangements and contingent payments based on the change in earnings under generally accepted accounting principles.

Impact & Considerations for Transportation Industry

The elimination of off-balance-sheet accounting could fundamentally change the accounting element of the lease or buy decision process. These decisions would be purely based on economic merit, rather than by the expected accounting result.

In addition, while cash flow under existing guidance and the new guidance does not change, agreements that contain covenants or performance bonuses and existing business metrics will be affected. The changes also will create new temporary tax differences, since assets and liabilities recorded in the financial statements may not be recognized for tax purposes.

The proposed standard also will require revised financial statement presentation and additional disclosures in the footnotes to the financial statements. These disclosures will focus on judgments and assumptions identified in the initial measurement and recording of assets and liabilities. When facts or circumstances significantly change during a lease term, they will need to be disclosed.

Examples:

Comparability – Lease Versus Own

Consider two transportation companies—one that traditionally owns tractors and trailers and another that leases using operating leases.

Under current standards, the owning company would have significant assets and related debt reported with significant financing cash flows and interest/depreciation expense—excluded from earnings before interest, taxes, depreciation and amortization (EBITDA)—that declines as assets are depreciated and debt is reduced. Meanwhile, the leasing company would have straight-line rental expense, included in EBITDA, with potentially only footnote disclosure of future cash flows and no related assets or liabilities recorded.

Under the new standard, the two companies’ financial statements would be much more similar, with differences driven primarily by the term of the lease period.

The charts above are from the perspective of the lessee based on a five-year lease with a 3 percent annual inflationary increase starting at $440,000 (assuming 20 trucks under lease) and an average over the life of $467,000.

In the chart on the left, the red line is lease expense as it is recorded today:  straight line over the entire life of the lease. The blue line shows the upfront impact of recording interest expense and amortization as required under the proposed standards. Straight line drives an equal expense of approximately $467,000 each year, while the interest method combined with a straight-line amortization under the proposed standard creates an initial year expense of more than $522,000, declining to less than $413,000 in the final year. In both scenarios, the total lease expense and actual cash flow over the five-year period is just shy of $2.3 million.

In the chart on the right, the red line depicts the impact of the straight-line lease liability recorded under current standards. The lease expense is recorded straight line while the actual lease payments increase over the life of the lease. At inception, cash outflows are less than the $467,000 of expense, so a liability begins to build, but crosses at the midpoint when the cash outflows exceed the average causing the straight line lease expense to decline through the remainder of the lease life. At its high point, the straight-line lease liability is slightly more than $40,000—a relatively immaterial amount.

Under the proposed accounting, both a new asset and liability are recorded at the inception of the lease. A right-of-use asset is recorded at the present value of lease cash flows plus any indirect costs, while a lease liability is recorded at the present value of the lease cash flows. The lease liability is amortized over the life of the lease on the interest method. Think of it like a mortgage payment—a greater portion of the early payments goes to interest expense than principal with the effect on principal accelerating toward the end of the term. The right-of-use asset is amortized on a straight-line basis. The combination of the interest expense and amortization and the declining nature of the interest expense creates the declining blue line in the left chart.

In either accounting, no asset or liability exists at the termination of the lease.

The above example is for a single lease for multiple trucks. The impact of front-loading expenses through amortization and interest instead of straight-line lease expense may be diminished if you have a larger fleet with different lease dates. Consider five sets of leases, each starting on a different year. Leases later in their life cycle will have lower costs, while leases in an early stage will be higher—the end result could be something more like a straight line across the portfolio. At that point, the most significant difference isn’t the timing but the character of the expenses, such as rent versus interest/amortization.

Which Company Is “Better”?

Answer:  This is the same company. Company A is pre-adoption that leases tractors and trailers on operating leases, while Company B is post-adoption.

What to Do Next?

Being well organized will be key in determining the effect on your company. First, you should start by assigning a member of your team to keep up with exposure drafts and meetings to discuss the changes. In addition, related-party leases have not yet been addressed; if your company has related-party leases, this too will be a topic to monitor. Contact industry associations and determine whether they are following this issue and what guidance they may have.

Second, make a complete listing of all company leases. This list should contain items such as tractors, trailers, terminals and office space. In addition, you will want to identify leases where you are the lessee and lessor. Next, you should summarize all of the significant terms of the leases, such as term, interest rate (if stated), expense cost within leases, renewal options and any other significant provision. Next, it’s time to start modeling. Building a robust model is essential to determine the effect on your company. The model should apply the new standard to your existing balance sheet and then carry forward the future accounting to the income statement. Project these changes for the next five years. This will provide good information on the impact to your company.

Next, create an inventory of all compensation agreements and financial covenants. Compare current agreements and financial covenants to your model so you can plan for the change. There is time now to prepare for these impacts. The new standard is going to occur; it is not a matter of if, but when.

For more on the proposed lease accounting changes and their potential effect on your organization, contact your BKD advisor.