Residual Value Insurance:
Accounting Implications
 
This article will focus on the role of residual value insurance as a tool to assist managers in the lease finance industry in broadening their product line through their ability to account for lease investments in a manner consistent with other units of their parent financial institution.  This application will be effective for banks, insurance companies, commercial finance companies, manufacturing concerns or a publicly owned leasing company.
An area in which the leasing function has differentiated itself from other finance entities within financial and manufacturing corporations is through its financial reporting and accounting methods.  Corporate managers generally evaluate an operating unit's results on Return on Assets (ROA) and Return on Equity (ROE) criteria.  Products are sold, loans are made and the results are evaluated.  When a manufacturer sells a product and finances the sale through a lease or a bank loan, or a finance company leases equipment or real estate to a lessee, the assets may or may not have been "sold" for financial reporting purposes or the bank or finance company may or may not record the lease transaction under a method comparable to loan accounting and record income on a constant yield basis.
The standard method of transaction evaluation may not be the GAAP (Generally Accepted Accounting Principals) method for the measurement and evaluation of corporate results on a year by year basis within most financial and manufacturing concerns.  Lease transaction evaluation is for structuring and pricing purposes first accomplished utilizing the Multiple Investment Sinking Fund (MISF) analysis for true leases or utilizing the constant yield (Internal Rate of Return - IRR) for synthetic leases.  How does a lease based on the MISF or IRR rate of return evaluation translate into the Return on Assets and Return on Equity on a year by year basis?  Even more to the point, how well is the MISF or IRR analysis understood at different levels of a corporation?
Communication of results is a key factor in success at all levels; ranging from the personal to the professional level.  Transactions are "touched" by many departments and individuals within a company prior to the submission of a proposal to a customer; the line marketing manager, the pricing department, the portfolio management department, the finance department and of course the legal department.  The manner in which a transaction affects a company's equipment portfolio, credit portfolio and financial reporting must all be communicated effectively for a transaction to attain an approval.  The questions to be addressed are: 
1.      Is a transaction's MISF yield within targeted criterion,

2.      Is the residual value expectation and booking within corporate targets,

3.      Is the credit risk acceptable,

4.      Is the transaction a positive contributor to the unit's income and retained earnings goals?
Above all, have all these factors been properly portrayed, universally understood and effectively communicated?
A lease financing can effect corporate reporting in numerous ways:
  • A manufacturer's sale accounting classification can be affected.

  • The financial impact of securitizing lease financings may be affected.
  • The financial reporting of a "plain vanilla" lease transaction can be negatively portrayed on a financial statement.

  • An Operating Lease classification can add an expense item to a finance company's or bank lessor's balance sheet for the depreciation expense related to the leased equipment.

  • The ROA, ROE and Retained Earnings contribution of a lease financing can be negatively portrayed.

  • A lessor/lender in a Synthetic Lease may have difficulties achieving symmetry in accounting treatment for both the lender/lessor and the lessee/borrower.
All these issues can arise through the impact of the financial reporting for the "dreaded" Operating Lease. 
Why the Problem?
An Operating Lease has numerous definitions.  It can be either a true Operating Lease (a short term rental), a non full payout lease, or an Operating Lease for Financial Accounting Standard 13 (FAS 13) purposes. The nexus of the financial reporting issues is the Operating Lease as defined by FAS 13.  Broadly stated, FAS 13 provides a "bright-line" test as to a lease being classified as an Operating or Direct Finance Lease; if the FAS 13 ninety percent (90%) test is failed for the lessor, the lessor is deemed (or doomed) for financial reporting purposes, to "own" the equipment as the present value of the rents will not recover sufficient principal.
In owning the equipment the lessor's revenue line will consist of the rental payment and its expense lines will consist of the interest expense allocated to the transaction and depreciation expense attributable to the equipment leased.  In a direct finance or leveraged capital lease the revenue line will consist of the transaction's amortized lease income and the expense line will include interest expense but not any depreciation expense.  This article we will concern itself with lessor accounting as the Operating Lease is the least preferred accounting treatment for a lessor, yet the most preferred accounting treatment for a lessee.  The following are scenarios that may impede accounting efficiency for financial institutions and manufacturers:
  • A manufacturer that has "sold" its product through the sales aid tool of an Operating Lease cannot record a sale.  Instead, the manufacturer recognizes rent income of the lease, offset by depreciation on the manufactured cost of the equipment with one difference being a combination of gross profit and finance income.

  • Securitizing Operating Lease receivables is troublesome in that the asset on the balance sheet is not a receivable but rather it is the leased asset.  Therefore, the leased asset and depreciation remains on the lessor's books and the receivable under the lease may be treated merely as collateral for the securitized debt.  By securitizing Operating Lease receivables, in most cases, all that has been accomplished is to raise more recourse "on balance sheet" debt.

  • A perfectly acceptable single investor or leveraged lease classified as an Operating Lease may produce book losses and contribute negatively to the lease finance unit's ROA, ROE, Income Statement and Retained Earnings.

  • A perfectly acceptable leveraged lease if not classified first as a direct finance lease will be booked without netting the leveraging debt against the lease receivable.  Instead, the leased asset is booked as an Operating Lease asset and the leveraging debt is booked as a liability.

  • Operating Lease accounting can create an expense item on the Income Statement and Balance Sheet of a financial institution.  The equipment's depreciation will add negatively to a bank's expense ratios.

  • As portrayed in Charts I and II the impact of an Operating Lease as a discrete transaction and, as a portfolio of transactions has a negative affect on the lessor's Income Statement and the Retained Earnings component of the Balance Sheet.

  • A popular transaction, the Synthetic Lease, presents particular issues in that what is an Operating Lease for the lessee will also be an Operating Lease for the lessor since the discount for both participants is the basically same rate.
Solving the Problem
A solution to these issues is the inclusion of a certain level of residual value insurance which will allow an Operating Lease to be converted into a Direct Finance Lease for FAS 13 purposes.  FAS 13 states that the payments to be discounted should be the "guaranteed payments" which include the rental payments and any third party guaranteed payments, which includes residual value insurance when properly constructed.  The amount of residual value insurance required depends upon the particular transaction and is calculated based on the FAS 13 test.  Broadly stated, the amount of residual value insurance required to meet the FAS 13 test for Direct Finance Lease treatment is the differential between the present value of the lease payments and ninety percent (90%) of the asset's fair value (usually the asset's purchase price), future valued at the transaction's yield rate (the lessor's implicit rate).
The Operating Lease method of financial accounting can create issues in financial reporting in that a transaction which has an acceptable yield for standard measures, the MISF or constant yield analysis, but still produce adverse book income and balance sheet accounting results.  The example contained in this article portrays a seven (7) year lease financing containing a thirty five percent (35%) residual value priced into the transaction.  For simplicity purposes the transaction's yield rate is calculated on a "money-over-money" basis.  The transaction criteria are as follows:
Transaction Term:   7 Years
Booked Residual Value: 35%
Yield (Rent + Residual): 6.50%
Transaction Spread: 1.00%
Cost of Funds: 5.50%
Present Value Test: 77.76%
Present Value Shortfall:  12.23%
Future Value of Shortfall: 19.25%
Residual Value Insurance
Require to meet FASB13
 13 90% test::

19.25%
   
A transaction with the above profile will produce an Operating Lease per the FAS 13 capitalization tests.  This transaction will produce book losses for the first three (3) years of the seven (7) year lease  (See Chart I - Net Income) and a negative contribution to retained earnings for five (5) years.
The inclusion of residual value insurance in this transaction, at the level outlined above (19.25% of equipment cost) will produce a Direct Finance Lease for FAS 13 capitalization tests and, therefore, positive earnings contribution for all years of the transaction as well as a positive contribution to retained earnings for all years (See Chart II - Retained Earnings). The use of residual value insurance does not add to earnings but instead reports earnings ratably over the transaction's term, permitting its comparison with other, more standard financial transactions on a consistent basis.
The issue of Direct Finance Lease versus Operating Lease accounting is important in that a transaction that has an acceptable rate of return may have an unacceptable book accounting earnings pattern.  The Operating Lease method of accounting bears no relation to "standard" loan accounting.  A standard loan or Direct Finance Lease will have an earnings pattern that reflects a constant rate of return versus the declining principal or unamortized lease balance where an Operating Lease will reflect "back-ended" earnings pattern as revenue from rent is level while the combination of the interest expense to carry the asset and the asset's depreciation declines over the term.  The earnings pattern for an Operating Lease does not create constant "net spread" versus the outstanding earnings pattern for any standard commercial loan.
As lease finance divisions of banks, commercial finance companies and manufacturers
 

look for new product lines, under ever more competitive circumstances the Operating Lease product is more and more a factor in the marketplace.  The issue becomes; how does a company invest in a product line (the Operating Lease) which has an industry acceptable yield based on industry accepted yield analysis yet will produce adverse book accounting results?  The book ROA and ROE for an Operating Lease in certain cases (such as those outlined in this article) may be negative in the early years. Communication to senior corporate management of the fact that a transaction will be competitively structured and priced by industry standards, yet produce a negative ROA and ROE in a transaction's early years, and yet still be regarded within the corporation as a profitable use of capital is inherently contradictory.  Residual value insurance removes the contradiction.
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Thomas A. Orofino is a Managing Partner of Collateral LLC Westport Ct (203.227.7080). He is responsible for the marketing and product design of residual value insurance products and services worldwide. Mr. Orofino is a graduate of Villanova University where he earned his BA in Economics.