Commentary: Rail-car lessees need to know the new lease accounting standards

By Richard Kloster and Rob Hart

The answer is: “Over $2 trillion.” What’s the question? If this were the television show “Jeopardy!,” it would be: “How much will U.S. companies that lease all types of assets have to collectively add to their balance sheets to comply with the new lease accounting standards?”

This figure will have a profound impact on corporate America, including rail-car lessees. Considering that rail-car lessors own 65 percent of today’s 1.65 million rail cars, lessees will be adding an estimated $7 billion to $10 billion to their balance sheets. Unfortunately, not many rail-car “Jeopardy!” players will get this question right, given the low level of awareness in our industry right now.

In February 2016, the Financial Accounting Standards Board (FASB) issued ASC 842 (Accounting Standard Codification), a lease accounting standard that takes effect Jan. 1, 2019, for publicly traded companies and Jan. 1, 2020, for private companies. The standard replaces the FASB 13 lease accounting rules enacted in 1976.

Under FASB 13, lessees were required to determine if a lease were a “finance” or “operating” lease. Assets, including rail cars, deemed to be on a finance lease were treated on the balance sheet as long-term assets.

Operating leases, however, were not put on a lessee’s balance sheet. Instead, lessees were only required to disclose these lease obligations in a footnote to their financial statements.

Capital-market reactions to off-balance sheet leasing varied. Some viewed operating leases as a form of debt, while others ignored them. Some treated them as contingent liabilities.

The U.S. Securities and Exchange Commission and FASB became concerned that footnote disclosure was not enough. The Enron scandal magnified these concerns and FASB began the process of developing new rules, which were issued in February 2016.

Since rail-car lessees are generally not interested in owning the asset at lease end and prefer shorter term leases, most leases are operating leases. Since 1976, FASB 13 has motivated lessee CFOs to enter into operating leases to improve their financial ratios by essentially taking debt off the books. In the end, FASB 13 created the complication for banks of having to add back off-balance sheet obligations to a company’s financial ratios to get a clearer picture of their ability to service those obligations. These days are ending.

While FASB 13 finance lease accounting essentially will remain unchanged under ASC 842, all operating leases of 12 months or more now will have to be put on the balance sheet as “Right of Use” (ROU) liabilities.

Implications for rail-car lessees

FASB has stated that a ROU liability is not to be deemed debt. Whether the capital markets will agree is unknown. Lessees are concerned lenders will add ROU liabilities to their corporate debt-to-equity and other risk ratios.

The ROU liability will be the present value of the “finance cost” inherent in the lease rate for all future lease payments. However, “full service” operating leases include maintenance and other operating costs, which can be excluded from the ROU liability as “service” costs.

Lessees will need to differentiate between the “financing” and “services” portions of the lease payment. Depending on the type, age, condition, commodity and mileage usage of the equipment, the maintenance portion can vary from as little as 15 percent to over 50 percent of the full-service lease rate.

Determining how much is “service” will be difficult for lessees. So far, it appears lessors are not willing to provide their lessees with this information and lessee CFOs will want to minimize their ROU liability. Lessees will have to come up with a way of identifying these costs that will comply with ASC 842, such as determining costs based on observable market data.

So, why bother splitting the lease payments? At stake for lessees is over-reporting ROU liabilities and the negative effects this could have on their financial ratios and bank covenants. Conversely, under-reporting ROU liabilities could create issues with lessees’ auditors and financial fillings.

So, while Jan. 1, 2019, is still some months off, the hope is that our industry will become more aware of these changes and that by next year, we’ll all be able to know the question to the “Over $2 trillion” answer.