Authors’ Note:

Sign change conventions used by PAMS have been modified to adhere to more standard conventions since PAMS use for creating the examples referenced in this article. The author apologizes for this inconvenience.

 

 

Leveraged Lease Yield Analysis and Accounting Revisited

 

Introduction:

 

It is the purpose of this article to reexamine the yield analysis method chosen for leveraged lease accounting from a critical prospective. This article hopes to demonstrate and focus on an accounting approach that more accurately describes the leveraged lease transaction, and adheres more closely to standard tenets of accounting. The proposed approach will have the effect of changing the timing and amount of earnings recognized and the quotable yield rate inherent in the adjusted flows. The recommended approach is not a new approach, however, the following in dept comparison is new and revealing. The practical value of the changes recommended herein concerns the issues of better and more accurate accounting reporting, and better and more accurate yield analysis. This article will attempt to establish the following points regarding the Leveraged Lease accounting method endorsed by FASB13 and currently in place for the past thirty years (the Multiple Investment Sinking Fund Method):

 

1)      The Multiple Investment Sinking Fund Method (MISFM) is produced using an algorithm that is ostensibly designed to eliminate the MATHMATICAL multiple yield issue with complete disregard for economic and accounting issues.

2)      The MISFM produces a modeled sinking fund (based on modified cash flows) that ignores accounting standards and principals. Examples of principles that are now being ignored are the requirement to reserve for known future liabilities (within the model), and the requirement to match costs against revenues.

3)      The MISFM results in an overstatement of yield as a result of introducing cost free capital in latter years to supplement the shortfall from the under-sizing or under-reserving of the sinking fund (in the model) in earlier years.

4)      There is serious cause to believe that the adjusted flows created by the MISFM do not even fulfill the stated objective of eliminating the potential for more then one rate, thereby reducing the answer so derived to a potentially useless number.

5)      An alternative to the MISFM, referred to herein as the Standard Sinking Fund Method or SSFM ( aka the Traditional Sinking Fund Method) provides a more accurate and supportable accounting model while eliminating all of the above noted issues inherent in the conceptually flawed MISFM.

 

 

The implications of the position being advocated herein (even as the industry contracts) are significant.[1] We will be using seven examples of after tax cash flow exhibits and one pseudo code example to demonstrate our points. In order to bring some familiarity to the issue, we will use the FASB13 Index example. We will also examine each of the adjusted cash flows presented in the examples for the potential of having more then one yield inherent in them.

 

A brief discourse on leveraged lease accounting and yield analysis issues is in order to lay the stage. I believe a critical and comparative analysis has not been demonstrated until now. A change to the Standard Sinking Fund Method, along with the consequent recognition of sinking fund earnings may result in diminished earnings per share for non-consolidated reporting parent companies, and diminished quotable rates of return or yields in most cases. It will also result in increased absolute earnings on the leasing subs’ (department’s) books, and a far better matching of cost with revenues on the parents’ books. Though it is regrettable that some may argue (though yet to be demonstrated) that the marketability of the leveraged lease may suffer, this article is focused on, and concerned with making sense out of the current reporting and yield analysis. For the easiest understanding and best fit of the points being made herein, one should view the discussion from a three-company structure scenario. That is a holding company making the final investment decisions, and two fully owned subsidiaries. One sub is the leasing sub, and the other the taxable income generating manufacturing sub. However, the principles set forth in this article apply regardless of the investors’ structure.

 

Basics of Leveraged leases:

 

The single most overriding issue relating to lease accounting in general surrounds the realization that substance and not form should govern the nature and manner of reporting of lease transactions. This issue is still unsettled in so far as leveraged lease accounting is concerned. Specifically, sinking fund earnings (on the subsidiaries side) and earnings from tax savings generated, or secondary earnings on the parents side, continue to remain an obscure element of leveraged lease reporting. These earnings are an inherent part of the transactions profitability. Soft dollar earnings whether funded or not funded (separately set aside) are among the issues that are not addressed by the current accounting model. The economic nature of the leveraged lease is to create secondary earnings (income on cash invested from deferral of taxes), in addition to the primary earnings of rental and residual income. This presents a huge measurement problem to the accounting profession. The measurement problem, though unavoidable on the parent side, is none-the-less greatly exasperated by the yield method settled upon to account for leveraged leases. [2] The proposed accounting method (SSFM) will recognize income on the sub’s books and impart a cost for the use of money on the parents’ books. This will have the effect of providing some parameters as to the impact and size of the earnings expected on the parent side from the tax savings generated. This aspect of the proposed change will have the effect of eliminating the accounting cost/revenue matching issue in unconsolidated situations. Everything stated as part of subsidiary reporting can be viewed as equally applying to standalone companies using a departmental reporting concept, except that consolidation is inherent. It is important to note that we are making reference to the modeling approach herein, and not the actual economics of the leveraged lease transaction. Though the economics of the transaction are impacted by the modeling approach used, it does not necessarily follow that transaction pricing must flow from a MISFM model in order to produce an attractive and viable deal from an economic standpoint!Please keep this very important point in mind! In fact many companies use other methods of analysis and pricing in arriving at a decision and present the transaction by whatever means may help to sell it. We fully support the leveraged lease as an investment tool regardless of the model and considerations used to arrive at pricing and structure. The basic anatomy of the leveraged lease will not change. We are attempting to have the accounting model changed from the MISFM to the SSFM for the reasons that follow.

 

Getting back to basics. The element that distinguishes a leveraged lease from most of its cousins is the associated debt. The debt is always guaranteed by the lease payments. This element gives rise to off-balance sheet financing, (an issue that will not be examined here). The investment segment is generally small. The profitability of the transaction hinges to a significant extent on soft-dollar earnings from taxes saved (from other corporate profitable activity). Hence the transaction is often designed to only marginally standalone in so far as hard dollar profits are concerned, that is, before tax earnings. Lease deals can serve many other good and practicale business considerations besides directly measurable profit (such as promoting primary product sales…i.e. aircraft). The resulting assumed cash flows then incorporate soft dollar assumptions about tax rates, taxable position, and tax-deductible expenses, (the first of essentially three broad risk categories). It is noted that these assumptions are in fact educated estimates of what will happen in the future. The accounting model further include the more reliable hard dollar flows, such as debt payment and rental income (the second broad risk category), and finally residual realization, the third risk category. Residual realization holds a unique position in the risk spectrum. The model attempts to measure the gain as being the difference between the after-tax outflows versus the after-tax inflows. It further attempts to recognize the measured gain on some pre-tax equivalent interest basis, incorporating all of the assumptions of risk in the three categories. It defines the profitability as a constant rate of interest against the pre-tax equivalent remaining investment without consideration of secondary earnings or sinking fund earnings. Secondary earnings form a significant part of the economic basis for the transactions’ existence. They must by their nature, remain apart from the leveraged lease reporting model as the leveraged lease only provides temporary use of funds to be employed in money making projects and is not part of the those projects themselves. Sinking fund earnings, however, are subject to measurement quite easily as will be demonstrated. The primary issue encountered when trying to measure a yield or rate of return, concerns the after tax cash flows. They swing alternatively between negative and positive over the lease term due to the effects of depreciation, interest expense, and finally residual realization. These flows typically go from a negative initial investment (net cash outflow) phase to a positive (net cash inflow) investment phase, back to a negative investment phase required to pay debt after exhaustion of tax benefits, and then back to a final positive phase on residual realization (positive, hence a profit). Each time the cumulative after-tax cash flows change sign, a separate rate or yield may exist that will satisfy present-valuing the flows to zero according to Descartes’ Rule of Signs.[3] That is, the polynomial curve represented by plotting the present values of the set of flows at different given rates may cross the horizontal axis (zero present value axis) more then once. (Ouch…is the headache starting yet?) It is not the intention of this article to demonstrate a proof of, or even a complete explanation of Descartes’ Rule of Signs. This rule should be taken as a given for purposes of this article. The point being made is that this phenomenon (Descartes’ Rule of Signs) reduces rate as a tool of measurement of profitability to a meaningless mathematical solution. A solution that can produce results that discount to a zero present value using more then one rate. This element of the transaction necessitates the adjustments to the real cash flows to eliminate the potential for more then one rate present valuing to zero. These adjustments to the cash flow in turn, open the door to yield and accounting manipulation. It is critical to understand that Descartes’ rule is what necessitates the adjustment to the real cash flows within the transaction for the sole and only purpose of being able to quote a single yield figure.[3] It is unacceptable to approach investors or associates and say the rate in this deal is 8%, or 27% or 39%, take your pick. This demonstrates the obvious need to refine the measurement process. Hence came the birth of the modified yield analysis methods of which the Multiple Investment Sinking Fund Method is but one of many methods available to work with.

The Not so Basics of Leveraged Lease Accounting:

It would be a mistake to consider the yield derived from using the MISFM approach as somehow being inherent to the transaction in a manner analogous to that of the Internal Rate of Return (in a single rate flow scenario). Further, it is misleading for FASB13 to use the term “inherent” in the leveraged lease example given within the appendix. The MISFM rate is neither inherent nor unique to the transaction. It only tries to assume the mantra of being “inherent” after certain adjustments to the real cash flows are made, rendering the result a “Modified” yield analysis. Even at that point the term “inherent rate” is a questionable and poor choice of words, as will be shown. It is accurate to state that the rate is ostensibly inherent to the adjusted flows (using the MISFM algorithm), not the actual cash flows. This is a subtle point often overlooked by the uninitiated. Among some of the other yield analysis approaches that are used for various analysis purposes are the Standard Sinking Fund Method and the Modified Standard Sinking Fund Method. They each produce a different yield inherent to their own particular adjusted set of flows in accordance with the assumptions within the method. The afore-mentioned methods all employ the concept of setting up a fund to provide monies in the future when rents and tax savings are not sufficient to meet the cash outflows. It should be noted that amounts set aside in the sinking fund differ fundamentally in principal and underlying assumptions (not to mention amount) as between the SSFM and all other methods reviewed including the MISFM method. The Standard Sinking Fund Method is one of two methods reviewed that fully encapsulates the deal by providing for all liabilities from within the deal itself (after the initial investment, of course). Some other methods available attempt to view and split the transaction into one or more separate transactions, an approach that is poorly approximated by the MISFM. In that regard (multiple separate deals) it is important to note, that the MISFM looks to new investment where the fund is insufficient to meet the outflows required as is generally the case using the assumptions associated with the MISFM. This is another subtle, but important point that is sometimes overlooked, in spite of the revealing name being Multiple Investment Sinking Fund Method. One must consider the unlikely probability (in the authors opinion), that a rational thinking business person would enter into a transaction today that he knows will require new capital ten years in the future to stay viable (making reference to the MISFM model only … not the economics of the deal). How is he to know today, his opportunity costs ten years down the road? How is he to know if capital will at all be available? Further, how is he to time value that future investment so as to compare it using constant dollars to the initial investment being made today? The MISFM ignores all these issues! The essence of the MISFM concept is fundamentally flawed in that it is impossible for a decision maker to know the future cost of capital needed by the investment being made today. It also fails to present value that future investment so as to compare it in today’s dollars with the initial investment. We are speaking to measuring the cost of capital on a consistent basis and not to the return on investment as measured from within the deal itself (the deals’ yield). This is a clear indication or alarm that something is wrong with the analysis approach. This element of assumptions inherent in the MISFM leveraged lease accounting model is one that presents a fourth class of risk less visible then the others, that is the risk regarding the availability of capital at some future date and at some unknown opportunity cost. This fourth risk then leads to the questions of how does one compare the new future capital inflows to the current investment so as to produce a present valued analysis for those future in-flows of new capital Further, the MISFM model obscures the amount of capital needed as new money in the intricacies of the sinking fund, and related sinking fund earnings. The Standard Sinking Fund Method eliminates the fourth risk element entirely. The SSFM fully encapsulates the transaction by following required accounting principles of reserving for future known liabilities and measuring in constant dollars all investment ( as there is only the initial investment, this point becomes a given). Future known tax liabilities are not reserved for under the MISFM (in the yield and accounting model, not the real books of account). The encapsulation of the transaction, that is the modeling of the transaction so as not to require new investment, and so as to require creation of reserves for known future debts from flows within the transaction leads to the potential of being able to recognize some of the soft dollar earning on the subsidiary side from the sinking fund. This in turn allows for charging the parent for the use of the temporary monies created by the lease, thereby permitting a fair and balanced matching of costs to revenues. Currently, the secondary earnings created and reported on the parents’ books do not reflect matching associated costs hidden on the unconsolidated subsidiaries books. Reference is made to earnings associated with the sinking fund (leasing subsidiary side or department side), and not the unidentified earnings generated on the parent side from the use of the funds. Otherwise stated, the SSFM is the only method examined by the author that has the following desirable properties:

1) It remains in the investment mode throughout its life and does not expect the investor to commit to future investment without knowing what other future opportunities will be. Further, it is consistent with the common sense axiom that the investor is invested until the last dollar of principal and earnings expected from the deal is collected.

2) The SSFM requires that all monies come from within the deal itself after the initial investment. This materially reduces the ability to manipulate latter cash flows for whatever reason. It also provides a single initial investment against which to measure profitability.

3) It adheres to accounting standards requiring that known liabilities be reserved for in full. By providing time-valued monies only from within the deal, the profitability so measured is untainted by future cost free capital infusions that are not time valued. Because of the unique properties of the SSFM, it is fair to state that the SSFM rate is far closer to being the “true” inherent rate in the deal then that produced by the MISFM. That is, if there is such a thing as an “inherent” rate once cash flows are manipulated via different algorithms, the SSFM has positive properties that are unique and far more protected from manipulation, when compared to the other methods.

4) The encapsulation of the transactions permits the reasonable estimate and measurement of the earnings of the sinking fund on the leasing sub (department) side, and consequently permits imparting a reasonable cost to the parent to be associated with the parents’ expected secondary earnings. This permits a matching of costs to revenues improving vastly on reporting from where it currently stands in unconsolidated situations. Even in consolidated scenario, earnings on the sinking fund will for the first time provide a realistic estimate of the expected earnings from the parent.

5) The SSFM is the only method that appears to clearly pass the Descartes’ Rule of Signs test as noted below. As such, it may produce the only genuinely real and quotable yield.

Before Looking at Sample Numbers:

The author has on two occasions coded the MISFM algorithm along with having coded the SSFM algorithm. Short of having the reader examine the For/Next loop employed in the algorithm used to modify the cash flows under the MISFM, it is impossible to demonstrate the fact that the loop is only solving for sign change without regard to economic or accounting principals.[4] If the MISFM is doing more than this, let someone explain that to the author and, to the readers. I am confident that no one will come forward with an explanation, as there is none. It is arguable whether better and more descriptive reporting will improve the use of leveraged leasing. Reasonable people can agree to disagree on that point. The author does not believe it is naïve to expect that improved and more understandable reporting will enhance the use of leveraged leases as a business tool. The value of the leveraged lease is not diminished because the accounting has been improved or because the yield analysis method has been changed for accounting purposes. The author doesn’t subscribe to the condescending attitudes regarding the investors’ ability to understand these issues.

A synopsis would serve to point towards our attempted explanation of the mathematical peculiarities of leveraged leases. Further we have tried to refresh concepts regarding the economics of leveraged leases, focus on the leveraged lease accounting model, and introduce the concept of four distinct classes or components of risk. The fourth risk being a direct result of using a model (MISFM) that requires the assumption of cost free non-time valued future new investment capital.

Accounting Issues:

At this point, it would be appropriate to examine the tenets of accounting that should be satisfied in a well-defined approach to a leveraged lease. Before we do this, lets put some potential issues to rest. The recommendations contained within this article do not require that interest or earnings be imputed or fabricated as some have mistakenly argued. That being said, it is appropriate to point out that most of FASB 13 is about recognizing imputed interest in finance type leases. Hence the concept of imputing interest income is well established in accounting tenets, and in particular in lease accounting. The term “economic reality”, coined in an article published in 1975 speaks to imputed interest.[5] It was the essence of that article to demonstrate the imputation of interest inherent in finance leases. The interest being recognized as secondary earnings from the sinking fund on the leasing subs’ books (as recommended below) is not imputed, but can more accurately be described as estimated. The primary tenets of accounting that are being overlooked and savaged by the model employed by the MISFM under FASB13 (in accounting for leveraged leases) is the “Matching” tenet (there is no cost on the parents’ books). Further the spreading of income over the term on a realistic and more even basis, and the reserving in full for future known liabilities is trampled in the MISFM. Under current accounting, in the typical unconsolidated parent-subsidiary scenario, the parent gets to report all of the secondary earnings derived from the tax savings, while the cost of the investment giving rise to those savings remains obscured in a footnote regarding the unconsolidated subsidiaries earnings. The Subs’ earnings are understated by a substantial (but not like) amount. Hence we have the one-sided overstatement of Earnings Per Share on the parent. By avoiding reporting of secondary earnings of the subsidiary, that is, earnings on the sinking fund carried on its’ books, overstatement of earnings per share on the parents’ books easily follows. The other matching issue inherent in the MISFM is the zero earnings reported in so-called negative investment years. Grossly uneven and conceptually unsupportable principals give rise to the so called “negative investment phase”. The income, instead of being spread over the term of the lease is bunched into the positive investment years with nothing showing in the negative investment years. An explanation of the failure to reserve for future taxes (in the model) is self-evident…(that is why you need new cost free capital towards the end of the deal). The flaws inherent in using an ostensible mathematical solution to Descartes’ Rule of Signs issue have the effect of snowballing into other distortions over the lease term.

As noted earlier, we will use the example given in FASB13 for our comparison. This will hopefully provide some degree of familiarity with the numbers. Simply put, the SSFM provides for all expenditures required by the transaction from prior received funds using monies put aside from within the transaction and placed in a sinking fund. The FASB13 model under the MISFM assumes the fund earns at a zero after tax rate, an assumption that is both unrealistic, and distorts any hope of accurately measuring and reporting the transactions profitability. The MISM ‘s sinking fund being designed so as to provide for only some of the monies needed to meet future outflows requires the infusion of new cost free investment in the future. The fund is designed to minimally eliminate the Descartes’ Rule of Signs problem (ostensibly), and does not look at any of the economic issues of the transaction. The purely mathematical manipulation of the cash flows and the unrealistic requirement for infusions of distant future cost free non-time-valued new capital so as to ostensibly bring about the elimination of the multiple yield issue is at best a chance marriage to the economics of the transaction. The cost of this new investment is outside the transactions measurement process under current accounting standards. The SSFM does not phase in and out of investment based on some arbitrary mathematical procedure that is measuring whether or not the present value of the flows has gone negative or positive and then jumping between the two to try to eliminate the multiple yield potential. It instead follows a set of reasonable business assumptions that include making a single investment at a known cost of capital (today’s cost). It provides for all future liabilities before they are due, from money generated within the deal thereby eliminating the need for new future investment. It is following required principles of accounting by providing a reserve for liabilities generated prior to their due date. Because of these properties, it becomes realistic and possible to measure earnings from the fund and to impart a cost to the parent for the use of the fund. The resulting accounting is far superior by any reasonable measure, compared to the MISFM. Further, the SSFM model does not require the unrealistic and exotic concept of cycling in and out of investment (while actually being in the investment all the time). The inadequate fund created by the MISFM does not allow for such a matching process, as the funds’ principal is grossly inadequate to meet the negative flows. It is based on the need for future new investment for which there is no associated cost. It is customary to not associate a cost to day-one investment money. It is not customary not to time value future investment requirements as the MISFM does. Again we are speaking to the cost of capital and not the return on investment as measured by the yield in the deal. The MISFM is an inherently flawed concept as it fails to provide a present value approach to the needed future capital.

 

Mathematics Issues:

 

I never intended to include this paragraph in what was essentially supposed to be an article on accounting. Further, though I can claim a natural propensity for getting A’s in mathematics, (as opposed to a natural propensity for getting F’s in English, a point that should be abundantly obvious by now) I am not holding myself out to be a mathematician. It is therefore with some trepidation that I make the following statement:

 

After all is said and done, there is serious cause to believe that the MISFM does not even serve to eliminate the multiple yield issue!

 

I am basing that statement on the tests for existence of multiple yields as presented on pages 80 and 81 of the book “Investment Decision Analysis”.[6] It is clearly stated therein that if the cumulative cash flows change sign more then once over the study period (term), it is possible that more than one rate may exist that satisfies the requirement of discounting to zero. It is also clearly stated that this condition (of more than one sign change) must be eliminated in order to use yield as a measure of profitability. The reader is referred to Exhibit H that demonstrates the fact that the pattern of sign changes for all the exhibits using the adjusted cash flows created by the MISFM follow the same course of going from negative to positive to negative and to positive…(three changes, not one) ... and here comes the kicker…the one that really hurts….so too do the unadjusted cash flows follow this exact pattern. This begs the entire question of exactly what did the MISFM do to eliminate the potential for multiple yields? I will defer to those mathematician types to perhaps refine the test so as to explain the use of the MISFM for supposedly eliminating the sign change problem and the errors or omissions that must exist in the book quoted if such an explanation is in fact forthcoming. In the interim, please note per Exhibit H that the SSFM has only one sign change! The SSFM is the only method (algorithm) that meets Descartes Rule of Signs issue per the book referenced. Some things thankfully do seem to hold true! There is considerable explaining to be done regarding the mathematics’ issue. However, putting the math problem aside, the concept of cost free future capital being used as an equivalent to the initial investment remains an unfathomable leap into oblivion from the authors’ viewpoint.

 

Looking at the Numbers:

 

Examining the FASB13 model in Exhibit (A), you can see that the adjusted (MISFM algorithm) cash flows require that new investment be made in year ten in the amount of$8,318.98. The balance of the total outflow of $ 14,649.00 comes from the sinking fund in the amount of$ 6,330.02.Likewise, new investment is needed for each of the years eleven thru fifteen. Secondary earnings are ignored entirely. The sinking fund, flawed as it may be in the method of development and, the resulting size, removes itself further from the economics of the transaction by assuming a zero earnings rate on the invested funds. To sum up, the model employs a mathematically contrived sinking fund approach that ostensibly results in solving a mathematical issue with only chance regard to the economics of the transaction. It ignores entirely a key element of the transaction, sinking fund secondary earnings. Further, the method unrealistically and arbitrarily requires the introduction starting in year ten, of cost free capital.

 

Examining Exhibit (B), the same transactions’ cash flows are modified using the Standard Sinking Fund Method. This method not only eliminates the multiple rate of return issue by every measure uncovered by the author, but also incorporates the requirement that all future cash outflows come from within the deal itself. It encapsulates the transaction so that it can stand by itself and be measured by itself without the added risk of trying to measure the cost of future investment capital, the fourth risk element. Further, it greatly reduces the opportunity to manipulate flows (see latter exhibits proving this point) by requiring a reserve for all future debt from within the measured costs of the deal itself. It also remains in the investment phase throughout the deal, earning interest each year the deal is alive in accordance with the realistic concept that recognizes that until the investor collects the last dollar of principal and earnings, he remains invested in the deal. This results in a more even distribution of earnings over the term.However, it still does not attempt to measure the secondary earnings element of the transaction, as it too incorporates a zero rate of earnings on the sinking fund and is presented to highlight the impact of sinking fund earnings. By introducing a return on the sinking fund, we can introduce the element of the secondary earnings into the transaction. However, this results in a new issue. Specifically, what is the appropriate rate to use? The answer to that question is the sinking fund rate should approximate the after tax cost of funds for a loan of similar term and size from an arms length lender. The appropriate rate is an estimated rate based on market realities, not to be confused with an imputed rate. At this point, we have removed the uncertainty of the cost of future capital by providing for all investment up front and providing adequate sinking fund monies to meet all projected future cash outflows without the need of new investment. Further, we have attached an approximate economic value to the money being put into the sinking fund that creates the secondary earnings on the parents’ side. This imparts some measure of the expected profitability from the tax savings on the parent side also. Though not measuring the earnings on the parent side, it still serves as a standard of expectation from the parent. This approach vastly improves the understandability and reporting of the transaction.

 

Exhibit Cprovides an analysis using the SSFM assuming an approximated arms length after tax funds rate of 4.5 %. As can be seen, the rate of return is 7.661% and is approximately 100 basis points less then that generated by the using the zero rate sinking fund earnings under the MISF approach. This rate differential should have been another alarm ringing bell that there were issues. Even with earnings at 4.5% on the sinking fund being recognized in the SSFM, as compared to a zero rate under the MISFM, the SSFM still comes in 100 basis points lower then the MISFM in terms of quotable yield. It is approximately 230 basis points higher then the SSFM using a zero sinking fund earnings approach which approach once again, fails to address the secondary earnings issue. The sinking fund interest rate would presumably approach but not reach (because of the other inherent risks assumed by entering into a leveraged lease) the parents borrowing rate for a like term loan on an after tax basis. If consolidated, the cost and income would eliminate. By accounting in this manner for the transaction, the profit from the lease appears appropriately on the books of the leasing subsidiary including the secondary earnings element created by the sinking fund, and the cost for the use of the monies generated by the tax savings appears appropriately on the books of the parent to match and partly offset the parents currently cost free use of the reserve money. For those debit and credit thinkers, the Parent would charge Interest Expense over the lease term to the tune of$ 40,752.31 and the sub would recognize income in like amount. Looking at Exhibit C, the leasing sub would record a loan due from the parent starting in year four and growing to a total of $ 114,682 by year six. For each of the years the loan remains outstanding, an interest charge would be recognized as income on the books of the sub, and expensed on the books of the parent. The higher the sinking fund rate used, the more income to the leasing sub and the lower the income to the parent.As to the issue of consolidation and elimination, we would expect the elimination for tax reporting of the entire sinking fund profit and loss elements in a consolidated return as part of going to the operating method of reporting. The issues surrounding financial reporting present the likelihood of non-consolidation. It is self-evident that stand-alone reporting would more accurately reflect the earnings of each entity and more fully describe the nature and economics of the transaction in spite of the fact that EPS and the quotable yield may suffer from such improved reporting. The matching of costs to revenues would be affected by this approach. It is important to note that on a non-consolidated basis, the absolute earnings of the subsidiary are enhanced by the estimate of secondary earnings in the amount of$ 40,752.31. The leasing sub will get the appropriate credit for their efforts in creating and funding the deal. The true economics of the transaction will not change!The holding company should be as anxious to do the deal as ever for good and sound business reasons. The approach to pricing the rents may change somewhat. The MISFM has become a Standard in the industry and may continue to be used as a measure of return (assuming the mathematics issues can be resolved or do not exist), but hopefully, not as an accounting model. I see these issues as being inter-related and therefore would hope to ultimately see all aspects of the MISFM abandoned. Issues that remain a concern are no less a concern under the present approach. They have to do with the complexity of changing assumptions as to tax appetite and tax rate at future dates. Is this issue exasperated by the introduction of secondary earnings to the transaction? It may be, however, improved reporting is hopefully the result. It is the authors’ opinion that any changes in assumptions that may occur after the fact should be handled strictly on the parents side using a separate reserve type accounting approach that respects the sanctity of the originally booked transaction. In those instances where a subsidiary is not part of the scenario, inter- divisional or inter-departmental reporting would replace the inter-company reporting delineated above.

 

 

Exhibits (D, E,F, and G)

 

The adjusted cash flows in these exhibits have been arbitrarily modified to borrow more money from the ending flows ($ 20,000 or $ 60,000) that is then put into the flows in the early years at $ 20,000(s) per year. These examples are presented to demonstrate how easily the rate of return can be manipulated by massaging the cash flows using the MISFM as a starting point. They also demonstrate how little effect this sort of early/late switching manipulation has on the SSFM. Note how small the rate change is under the SSFM These deals assume an additional $ 60,000 of money is added to the negative ending outflow and given to the early inflow(s) at $ 20,0000 (per year). This demonstrates the same approach that is being used by the MISFM with about as much logical support as I can attribute to the MISFM. Borrow cost free from the late years, (by calling it capital), and introduce it back as cash in the early years where the present value effect is considerable. What a deal!

 

 

We’re telling the Tax Guys too much!

 

On the issue of the tax-shelter nature of the leveraged lease, and some of the resulting misgivings associated with that misbegotten (in so far as business purpose leases are concerned) characterization, it should be pointed out that tax incentives (not shelters) are a useful tool by which our government stimulates certain areas of the economy, as it perceives a need to do so. As a business stimulus, leveraged leasing is one of the most efficient and accurately targeted methods available to our government for generating new business.It is narrowly focused on equipment sales, usage and construction all of which generates jobs, that in turn generate a return of taxes many fold the breaks given. So, having the secondary earnings (from tax savings), as a significant part of the transaction is not only acceptable, it is highly desirable as an economic stimulus tool, and our government would be hard put to find a more efficient new-business generating tool. I believe the leasing industry can stand tall as an example of how to contribute in a productive fashion to our economy in so far as leveraged leases are concerned. It is unfortunate that certain non-lease tax abusive products masquerade under the name of a “lease product”.

 

Conclusion:

The MISFM method of accounting for leveraged leases creates an incomplete and distorted picture of the transaction. It fails in five important areas.

 

1)      First, it fails to encapsulate the transaction in such a manner that permits its’ profitability to be measured inclusive of secondary earnings to the unconsolidated subsidiary or leasing department.

2)      Secondly it prevents a matching of costs to revenues in an unconsolidated situation and does not attempt to provide any measure of expected secondary earnings.

3)      Thirdly, the MISFM promotes the quotation of a fictitiously overstated yield resulting from the arbitrary manipulation of the cash flows within the deal through the mechanism of cost free future capital investments. This results in a fundamentally and conceptually flawed approach that mixes current investment with future investment while not accounting for the time value of the investment funds.

4)      Fourthly, it does not permit reserving for known debt, or an even distribution of earnings, on a realistic basis over the lease term.

5)      Lastly, according the referenced material on the mathematics, the MISFM may fail to eliminate the Rule of Signs issue thereby reducing the rate produced to potentially one of several rates that may exist, thereby being a useless number.

 

The MISFM is entirely based on mathematical considerations (which it may not satisfy) without any regard for business realities or accounting principals. The concept of multiple investment phases appears to have been built around the ostensible mathematical solution to Descartes’ Rule[7] . Unless someone can explain why future investment should be treated with the same zero rate of interest used for current investment, and demonstrate that the MISFM is doing more or other than that which is described herein, the continued use of the MISFM is unjustified. It has more than one serious conceptual flaw, several serious accounting flaws, and serious concerns regarding the fact that the rate so generated and quoted may be meaningless.( if Descartes Rule of Signs issue is not eliminated). A potential solution to all the negative issues implicit in the MISFM lies in the use of the Standard Sinking Fund Method or Traditional Sinking Fund Method. It is the only method examined that adheres to good accounting principals. Further, in the authors’ opinion it is the only method that adheres to realistic business concepts by staying in a positive income earning position until the last dollar of principal and earnings is recovered. The rate of return or yield that it produces is not dependant on future new investment or future new cost free money. The rate is not only inherent to the adjusted cash flows, the SSFM rate is the most inherent to, and descriptive of, the deal itself.

 

 

 

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Authored by

Philip J. Tirino, CPA(Copyright Pending Oct 2003)

 

For comments or inquiries please feel free to Contact: philtirino@aol.com

 

Authors’ note….If you made it this far, my hat is off to you. Have a drink!