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Increased Scrutiny on Residual Reviews

Expanded regulation and concern over past problems have increased the scrutiny auditors are applying to residual reviews, particularly for banks. Shawn Halladay and Carl Chrappa of The Alta Group discuss the impacts additional scrutiny has, including amplified levels of detailed information and external appraisals that auditors are requiring. The authors say lessors can use this increased scrutiny to create opportunities to better manage portfolios and maximize the value of existing residuals.

 

The accounting rules require lessors to assess their residuals and operating lease assets for impairment at least annually. Although the impairment review is a regulatory requirement, it also can be used as an opportunity to increase the bottom line. This article will examine the residual review process and how it may be expanded beyond a regulatory exercise into a risk management and marketing tool.

 

Background

There has been a decline in fair market value (FMV) leasing activity and leasing products have become commoditized, yet equipment values still remain an important component of the industry. These values come in several forms including residual positions, collateral protection and loss given default (LGD) curves.

A critical aspect of residuals from a financial reporting perspective is how the booked residual drives the income from the lease, as it affects not only the amount of income recognized over the life of the deal but also when that income is recognized. Consider, for example, a four-year lease with a market-based payment of $240,000 per year. As can be seen in Table One, the residual that is booked directly impacts the income to be recognized.

 

This is true whether the lease is classified as operating or direct financing. For this reason, Topics 840 and 360 (Leases and Property, Plant and Equipment, respectively) of the Financial Accounting Standards Board (FASB) Codification require that residuals and operating lease assets be assessed for impairment on an annual basis. This assessment sometimes is referred to as the residual review or, from the asset manager’s perspective, the FASB audit.

 

The objectives of the residual value review are to verify the future economic benefit of the asset and make any necessary adjustments so that the associated income is reflected in the proper period (upward adjustments are not allowed, however). This residual review, although accounting-driven, is an integrated exercise that directly involves asset management and IT, along with the outside auditors and external asset specialists. Portfolio management, sales and tax, among others, also may become part of the process.

 

Accounting Role

The accounting department, of course, has the primary responsibility for the annual residual review as it is a key element of the annual audit. At a high level, this process consists of determining the latest end-of-lease market values, comparing those fair market values to the booked residual values, and then making any necessary adjustments to the asset values.

 

In the past, many companies identified potential impairments by asset group, such as forklifts, trucks, or office equipment. They would look for indicators of asset impairment such as a significant decrease in market value, a dramatic change in asset use, an adverse change in legal or regulatory factors, or costs in excess of original expectations. The Alta Group’s experience, however, indicates that this practice is shifting towards a more granular approach, which will require better documentation, rationale, systems and stronger asset management resources (either internal or external).

 

If there is any “other than temporary” decline in residual value prior to lease end, an impairment must be recognized. As a case in point, after a new generation of disk drives entered the market, the transactional data showed a large decline in the value of the older drives. Several third-party asset managers, without the daily transactional pressures of internal asset managers, correctly predicted that the decline was only temporary as the manufacturing capacity was insufficient to meet demand, which not only drove prices back up on the older drives, but eliminated the need for an accounting write-down.

 

Asset Management Role

While it is the accountants who collect the data, perform the comparisons and book any adjustments, the most critical aspect of this process involves establishing the fair values of the equipment so these values can be evaluated against the booked residuals and operating lease assets. Strong internal or external asset management resources, therefore, are a necessity in residual reviews.

 

Given the important role they have in the residual review process, what essential skills must asset managers bring to the residual value review? The answer will depend on whether residual values are being evaluated internally, by an outside party, or a combination of the two. An outside asset manager, for example, should have broad experience with the equipment types, proper appraisal industry credentials, independence, and a large data base of asset value performance.

 

The choice of using an internal or external resource is up to the individual lessor, although it is the internal asset managers who primarily will interface with the auditors. Trends in the equipment leasing industry, regulatory requirements, and audit practices, however, point to an increasing role for third-party asset management support. This increasing role is based on several factors, one of which is headcount, as some lessors are outsourcing their asset management function. Other factors include auditor and regulator behavior, and the resources available to obtain data.

 

Opportunities

Residual value reviews are not just an accounting exercise and, hence, a cost. They also are a valuable management tool, so savvy lessors are using these reviews to also create economic benefit. The key is to recognize what these benefits are and tweak the processes so that both the audit requirement and economic goals may be met.

Some lessors derive so much benefit from doing so that they conduct residual reviews on a quarterly basis. While this exercise relieves some of the audit pressure at year-end, the real purpose is to identify market opportunities and threats. Whether conducted annually or on a more frequent basis, the residual review allows management to identify factors affecting asset values that might not have been on the horizon at the time the residual was set.

 

By forcing asset managers to look ahead at business trends and potential regulatory changes, the residual review can identify opportunities to introduce programs that either accelerate returns or incentivize lessees to extend their leases. These actions can be taken to enhance residual profits or mitigate portfolio risk, depending on how the identified factors affect residual values.

 

Residual reviews also can be used to map out projected collateral protection, manage capital allocation, or calculate LGD factors. Alta recently completed a comprehensive residual review for a major bank lessor that went well beyond FMV lease residuals to cover almost its entire portfolio. In this engagement, we addressed all the client’s leasing products, including full payout and TRAC leases (both full and split). This bank lessor used the required residual review process to complement its asset management efforts, gain supplementary, outside opinions on their internal views of asset values, and identify collateral gaps.

 

Conclusion

Expanded regulation and concern over past problems have increased the scrutiny auditors are applying to residual reviews, particularly for banks. This additional scrutiny has amplified the level of detailed information and external appraisals/opinions that auditors are requiring. On the positive side, lessors can use this increased scrutiny to create opportunities to better manage the portfolio and maximize the value of their existing residuals.

 

Shawn Halladay (shalladay@thealtagroup.com) brings 30 years of experience as a lessor, trainer, consultant and auditor to his position as managing director and leader of The Alta Group’s Professional Development practice.

 

Carl Chrappa (cchrappa@thealtagroup.com) brings 30 years of expertise in equipment management and appraisals to his role as senior managing director and leader of The Alta Group’s Asset Management Services practice. For more information visit www.thealtagroup.com.