LILO/SILO Accounting Issues To Rerun or Not Rerun, That is the Question

1. LILO/SILO Accounting IssuesTo Rerun or Not Rerun, That is the Question William Bosco, Jr. Chairman, ELA Accounting Committee

2. LILO/SILO Accounting Issues • Background • Accounting Issues • Accounting Literature and Comments • FASB Actions and Status • ELA Action Plans • Likely Outcome

3. Background • LILOs have been subject to IRS settlements in the past and many lessors have not rerun the leveraged lease accounting earnings • SILOs will be subject to IRS settlements as a result of the new tax act • Composite income tax rates have changed in the past and some lessors have rerun the leveraged lease earnings while others haven’t • The Big 4 and the FASB are concerned as: • The leveraged lease accounting rules regarding when to rerun the earnings are not explicit • There has been inconsistent application of the rules • The potential adjustments are significant

4. Accounting Issues • Do you rerun the leveraged lease earnings if tax deductions are rescheduled but there is no change in net income? • Do you rerun the leveraged lease earnings if the composite income tax rate changes but it does change net income? • Do you use rescheduled tax deductions when you rerun the leveraged lease earnings due to a change in the composite income tax rate? • Should you reconsider the lease classification as a leveraged lease as a result of rerunning the earnings?

5. Accounting Literature and Comments • Paragraph 46 of FAS 13 states: “If during the lease term the estimate of the residual value is determined to be excessive and the decline in the residual value is judged to be other than temporary or if the revision of another important assumption changes the estimated total net income from the lease, the rate of return and the allocation of income to positive investment years shall be recalculated from the inception of the lease following the method described in paragraph 44 and using the revised assumption. The accounts constituting the net investment balance shall be adjusted to conform to the recalculated balances, and the change in the net investment shall be recognized as a gain or loss in the year in which the assumption is changed. ” • The guidance in paragraph 46 has been applied based on the literal interpretation that merely a change in timing of tax benefits that does not change the total net income from the lease, does not result in the need to recalculate the leveraged lease earnings. The major accounting firms have strictly enforced this and precluded recalculation of earnings when total estimated net income from the lease did not change.

6. Accounting Literature and Comments • FTB 79-16 confirmed that the tax rate is an important assumption affecting the total net income from the lease and a change in the rate requires a rerun. • EITF 87-8, issue 10, “Whether the effect of the AMT on cash flows should be considered in leveraged lease computations and, if so, how”, gives guidance as to the circumstances that would cause a recalculation of leveraged lease earnings. The consensus reached was that “an enterprise should include assumptions regarding the effect of the AMT, considering its consolidated tax position, in leveraged lease computations. In accordance with paragraph 46 of Statement 13, those assumptions should be reviewed at least annually. If a change to the tax assumptions changes total estimated after-tax net income, the rate of return on the leveraged lease should be recalculated from inception, the accounts constituting the lessor's net investment should be adjusted, and a gain or loss recognized in the year in which the assumption is changed. An enterprise whose tax position frequently varies between AMT and regular tax would not be required to recompute each year unless there was an indication that the original assumptions regarding total after-tax net income from the lease were no longer valid. In that circumstance, the enterprise would be required to revise the leveraged lease computations in any period in which total net income from the leveraged lease changes due to the effect of the AMT on cash flows for the lease.”

7. Accounting Literature and Comments • The FTB 79-16 and EITF 87-8, issue 10 guidance has been followed for tax rate changes that result from minor changes in state income tax apportionment that occur virtually every year and vary between positive and negative. Recalculations are not recorded until the change in tax rate results in a change in total net income from the lease that is large enough that it is unlikely to reverse due to future changes in state income tax apportionment. In other words, until it is concluded that the original assumptions regarding total after-tax net income from the lease are no longer valid.

8. Accounting Literature • FAS 13 paragraph 9 requires retesting the lease classification “If at any time the lessee and lessor agree to change the provisions of the lease, other than by renewing the lease or extending its term, in a manner that would have resulted in a different classification of the lease under the criteria in paragraphs 7 and 8 had the changed terms been in effect at the inception of the lease,…”. Paragraph 9 also states “Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased property) or changes in circumstances (for example, default by the lessee), however, shall not give rise to a new classification of a lease for accounting purposes.” • In the ELA’s view, tax assumptions, based on IRS rules and interpretations of IRS rules, are estimates and may be changed based on an IRS audit or by tax legislation. Further, changes in estimates do not give rise to a new classification for accounting purposes.

9. FASB Actions and Status • The Big 4 generally agree that leveraged lease earnings should be rerun when there is a change in the composite income tax rate that is viewed as unlikely to reverse and to use rescheduled tax deductions, if any. They asked the FASB for clarification. • The FASB met on the issue on November 17th and came to 2 tentative conclusions: • Reruns should be done when tax deductions are rescheduled • Leveraged lease classification should be reconsidered if the investment does not phase as a result of the rerun • Most importantly the conclusions are tentative and they instructed the staff to research the issues and to meet again sometime in late January 2005

10. ELA Action Plans • The ELA has scheduled a meeting for 1/7/05 with the FASB liaison board member and the FASB staff. • The agenda is as follows: • Present a comment letter addressing the FASB’s tentative conclusions, providing accounting support to: • Rerun only when tax rate changes occur and are unlikely to reverse • Not consider reclassification when assumptions change • Give them a primer on leveraged leases so they better understand the structure, MISF yield calculations and accounting issues • Present a hypothetical case of a LILO with tax deductions rescheduled as a result of an IRS settlement so they understand the issues

11. Likely Outcome • On the issue of reclassification: • I believe we will get the FASB to change their tentative conclusion that leveraged lease classification should not be in question if there is a change in assumptions as it is not a change in the agreement • In any event, LILO and SILO reruns appear to still result in phasing, so classification is not an issue • On the issue of rerunning: • We may be able to convince them that reruns should not be done if there is a change in timing of deductions but no change in net income • I believe the FASB will require reruns when the composite income tax rate changes and they will require using any changes in assumptions for deductions • The only way to avoid a rerun is to negotiate payment of interest rather than agree to rescheduling deductions in an IRS settlement