John Bober, Amie Sweeney and Scott Thacker 2017-03-10 04:07:11
There are many factors that need to be considered when contemplating MSTs.
MANAGED SERVICE TRANSACTIONS (MSTS) have been on the mind of many companies, and ELFA has been helping its members learn more about the implications of these bundled arrangements.1 The Equipment Leasing & Finance Foundation recently published a study prepared by The Alta Group, Managed Solutions: Evolutionary or Revolutionary, that sheds further light on this topic. Th e study covers the major business considerations surrounding MSTs, and it dives into the major accounting questions that arise for service providers and their customers. With the publication of the study, available at www.LeaseFoundation.org, it is time for a deep dive into the accounting for MSTs.
What are MSTs?
MSTs encompass a wide range of transactions and are commonly thought of as bundled arrangements that may include equipment, services and soft ware. An MST includes a series of responsibilities and parties, including the:
● customer/end-user,
● service and service provider,
● financing entity,
● underlying equipment and
● bundler.
The service, the financing, the equipment and the bundler may be separate off erings or the components may be combined and delivered by one provider.
MSTs represent a broad range of transactions.
The study places them into four classes for purposes of analysis: not bundled, partially bundled, bundled appearance and true service offerings. Further information on these arrangements is presented in Table 1.
Accounting for MSTs
While MSTs are a continuum of commercial arrangements, the accounting for them is essentially binary. In the accounting model, these transactions are either wholly a service (which may include a financing component) or a service arrangement that includes an embedded lease. If an MST contains an embedded lease, both the customer and the service provider need to separately account for the lease and service components of the transaction.2
Accounting for these elements is in a state of flux as two new standards have recently been issued. The criteria used to identify an embedded lease is contained within Leases (Topic 842) . The accounting for the service components of these transaction is contained within Revenue from Contracts with Customers (Topic 606).3
Accounting under the New Leases Standard
Under Topic 842 a lease must be separated from a service if there is an identified asset and if the customer:
a. has the right to substantially all the economic benefit from use of the asset during the contract and
b. directs the use of the asset.
There are other factors to consider. The asset must be physically distinct, rather than just a portion of capacity. Also, if the supplier has a substantive right and practical ability to substitute the asset and benefits from the substitution, there is no identified asset and no lease to account for.
Table 1. Accounting Implications of MSTs
While each transaction is different, this table shows some of the accounting implications for the four major classes of MSTs.
Some of the Accounting Implications for Supplier-Lessors
While each transaction is different, Table 1 indicates some of the accounting implications for the four major classes of MSTs. From an accounting perspective, there is little difference in how the Bundled Appearance and True Service Offerings will be analyzed. The accounting outcomes may be significantly different, however, depending upon the terms of the arrangement.
There is an expectation that Bundled Appearance transactions have an identified asset, but a True Service Offering may not. The more integral and harder the asset is to move, upgrade and replace, the more likely there will be an identified asset and a lease. The more integral the asset, the more likely it will be under the customer's control. These factors will also suggest contracts with minimum usage requirements and payment floors. Under these circumstances, it is likely Bundled Appearance arrangements will include an accounting lease with payments that will meet the definition of lease payments for the lessor (and the lessee).
A True Service offering may be wholly a service if the asset underlying the transaction is within the service provider's control. Even if the transaction contains a lease, however, the accounting may be very close to traditional service accounting. If the payments the customer-lessee makes are variable based upon usage or other similar measures of output or utility, the payments related to the asset may be contingent rent and not recognized until earned. The lessee (and the lessor) would have a lease and would need to disclose the contingent rent payments, but there would be no amounts recognized on the balance sheet for the contingent rents. This situation could also exist in Bundled Appearance transactions if the payments were wholly variable.
Service-provider lessors must be careful of one significant accounting pitfall. The new lease standard does not allow lessors to classify leases as operating leases if the rents they will receive are variable. The standard also does not allow lessors to estimate and record the variable rents. If the transaction is for a major part of the asset's life or if the lease transfers ownership, the lessor would have a sales type lease and would have to write off the asset but not recognize the expected value of the payments. This would lead to a dayone loss by the service-provider lessor. If the transaction did not include a lease, the variable consideration could be estimated under the Revenue Recognition standard, which works in a much different manner.
There are many factors that need to be considered when MSTs are contemplated, and one needs to be prepared to spend the time required to analyze the components to determine the accounting model or models that apply.
Keep an Eye Out for Embedded Leases
A common spot for an embedded lease to rear its head in commercial real estate is in a third-party logistics, or 3PL, contract. 3PL firms specialize in warehousing and transporting goods for companies. The specifics of the contract will determine if it is solely a service contract or one that contains an embedded lease.
ABC Company signs a five-year contract with XYZ Logistics, a national 3PL firm, for 100,000 square feet of storage and transportation of goods to its warehouses, and then to its retail outlets.
● If the location of the 100,000 square feet is at the discretion of the 3PL and may change based upon its needs, the contract is likely a service contract.
● If the 100,000 square feet are to be located in rows one through five in the 3PL's facility in Chattanooga, the contract likely contains an embedded lease that will need to be carved out of the contact and capitalized.
John Bober is Managing Director and Global Technical Controller for GE Capital and is Chair of the ELFA Financial Accounting Committee.
Amie Sweeney is a Vice President in Capital Markets at CBRE and a member of the ELFA Financial Accounting Committee.
Scott Thacker is CEO of Ivory Consulting Corporation, a member of the ELFA Financial Accounting Committee and Vice Chairman of the Board of Trustees of the Equipment Leasing & Finance Foundation.
ENDNOTES
1 Hodges, “New Territory, New Rules: Non-standard Financing Agreements,” May/June 2015 Equipment Leasing & Finance magazine; Liberatore, “The Nuts and Bolts of Bundled Transactions: Making ‘MS’ Transactions Less Messy,” January/February 2016 Equipment Leasing & Finance magazine; and sessions at the 2015 Annual Convention are some examples of the ELFA’s activities on this topic.
2 See the Bascom, Elken and Halladay, article “Lease/Non-lease Components,” May/June 2015 Equipment Leasing & Finance magazine for further details on the separation requirements of Topic 842.
3 See Knudson and Shepherd “5 Steps to Revenue Recognition,” May/June 2014 Equipment Leasing & Finance magazine for information on Topic 606.
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