Spoiler Alert: Before I get started, the fact is that off-balance-sheet service-contract leases are not going to happen in the world of bank-owned lessors or independent finance company lessors. The main issue is residual risk, but regulated companies also face accounting and regulatory issues.
It may happen with captive finance companies, as they are the only ones able to take on high residual risk, keep the gross profit inherent in the asset, and avoid the “safety and soundness” regulatory concerns of an institution with government-insured deposits. They can also remarket the returned assets to other customers.
Regulatory Residual Limitations
Residual risk in depository institution leasing portfolios presents core safety and soundness concerns regarding asset quality, capital adequacy, and valuation accuracy. Regulators require strict oversight of estimated residual values, robust credit underwriting, and ongoing asset tracking to prevent material financial losses, as the Federal Government insures the deposits that fund their business. Bank managers are conservative to avoid regulatory sanctions.
Leasing is a permitted banking activity provided the lease is a “full payout net lease” as defined. Under banking regulations, a full payout lease is an agreement in which a bank reasonably expects to recoup its entire investment in the property, plus a return on that investment, from rental payments, estimated tax benefits, and the estimated residual value at the end of the term. Under federal banking regulations, a net lease is a lease agreement in which the financial institution (the lessor) is not directly or indirectly obligated to cover operating burdens such as asset servicing, maintenance, parts, or insurance. A bank can partner with a third-party service provider to deliver a full-service lease but cannot be liable for providing the service.
Regulated institutions must base lease arrangements on solid credit evaluations, ensuring recovery depends on contractual rent obligations supported primarily on lessee creditworthiness rather than speculative unguaranteed residual values. Under regulatory rules, a bank's estimate of an unguaranteed residual value cannot exceed 25% of the property's original cost. An exception allows unlimited residuals, but the total value of those leases cannot exceed 10% of the bank's total assets. Third-party residual guarantees and residual insurance from creditworthy providers can reduce residuals to the regulatory limits.
Consider a 12-month firm term PPU, with renewal and return options, where the customer chooses not to use the asset and returns it after 12 months; the assumed resale value of the one-year-old asset is 50% – I imagine the required termination penalty needed for the lessor/service provider to recover its investment will be 58%, assuming a 7% discount rate and no PPU payments received. Consider a 12-month EaaS service contract involving the use of a piece of equipment that has a fixed payment and is renewable at the same fixed rate up to 60 months when the asset is expected to have a 30% residual value – I imagine there will be a schedule of termination penalty values designed to protect the service provider’s investment. I calculate the 12-month termination penalty to be 88% assuming a 7% discount rate.
What does this mean?
Pay Per Use (PPU) or Equipment as a Service (EaaS) arrangements must be structured with residual guarantees or penalties for failure to renew to ensure regulatory compliance, and they will be based on an IRR calculation. Also, the remaining unguaranteed residual risk assumed by the lessor must be prudent so the recovery through a re-lease or sale is reasonably assured. It means the termination penalties/residual guarantees will be high. The presence of the guarantees and penalties that protect the service provider’s investment are features of a financing – not a service contract.
Accounting Issues
ASC 842 requires that all leases with terms of more than one year be capitalized. It also requires all financial statement preparers (meaning your customers) to review all contracts to determine whether they contain embedded leases and to account for the embedded leases as leases. The lease term for classification and capitalization is extended to include renewal periods and fixed purchase options if it is reasonably assured that the lessee will renew or purchase.
Under ASC 842, an embedded lease is a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. The contract must explicitly or implicitly specify the asset (such as by serial number). If the supplier can practically substitute alternative assets during the period of use and benefit economically from doing so, no identified asset exists (a bank cannot own “back-up” assets that are not under lease). The customer must have the right to obtain substantially all economic benefits from using the identified asset throughout the period of use (the lessor cannot allow another company to use the asset). The customer must have the right to direct how and for what purpose the asset is used throughout the period of use. If the supplier dictates how and what is produced without customer input, it remains purely a service agreement.
What does this mean?
A PPU or an EaaS will be considered to have an embedded lease. As such, you must determine its lease term. Many of these contracts will be structured with a 12-month term and a series of renewals at the lessee's option. The customer must justify the lease term; that is, it must demonstrate that it is not reasonable to assume it will renew.
If a 12-month lease term is reasonable, the embedded lease is off-balance-sheet, and the customer recognizes rent expense on a cash basis as incurred.
If the lease term is judged to be longer than 12 months, the lease must be classified and capitalized. The 90% PV test for classification includes any residual guarantees at their maximum amount and any penalty for failure to renew at the penalty amount. The amount capitalized will be the present value of the fixed contractual rents (including variable rents based on a rate or index, while variable rents based on usage, like PPU rents, are ignored) and any penalty for failure to renew. A residual guarantee or residual insurance is ignored as they are considered variable – the amount payable is unknown at lease commencement.
Conclusion
Most PPU and EaaS agreements contain embedded leases, and that must be accounted for as leases. For a bank-owned lessor or independent finance company, extremely high lessee residual guarantees or termination penalties are required to reduce residual risk to an acceptable level. The 12-month lease term will be difficult to justify for off-balance-sheet treatment, as the lessee must justify bearing the cost of terminating the lease and acquiring a replacement asset (or show it will not need to replace the asset to continue its business). Those are the “GAAP” rules, but I've heard in the marketplace that some lessees ignore ASC 842 when determining the lease term; they treat it as 12 months even though they are likely to renew. Lessors should not rely on lax accounting to make their products “work;” actually, it may violate the CLFP code of ethics.