Lease accounting update

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Lease accounting update

Financial Executives International

22 March 2012

Agenda

►

Where are we now?

►

Timing?

►

What are the proposed changes to lease accounting?

►

Overview of implications and considerations

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What are companies doing now?

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Q&A

(2)

Where are we now?

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In a nutshell . . .

►

Operating leases will be on balance sheet.

►

FASB and IASB differ on a revised lessee income statement

model.

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Lessor model is still under discussion.

►

Definition of a lease is likely to be a bit more narrow than

current guidelines.

►

Timing continues to slide

Page 2 Lease accounting update

►

Timing continues to slide.

Timing

Discussion

Paper

Exposure

Draft

Final

Standard

Second

Exposure

Draft

August

March August ₃_rd_{Qtr 2012?} _{Mid 2013?} 2010

March 2009

Effective date: TBD (To be aligned with

revenue recognition – not likely before 2016*)

*

Companies will be required to restate comparative periods (i.e., if

the standard is effective for year end 2016, 2014 and 2015 will need

(3)

Scope

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Excludes leases of:

►

Intangible assets

►

Biological assets

►

Biological assets

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Leases to explore for or to use natural resources

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Investment property within an investment property entity that are at

fair value – lessors only!

Accounting policy election to treat leases with a

maximum possible term of 12 months or less as

operating leases

Definition of a lease

►

Definition of a lease – a contract in which the right to use a

specified asset is conveyed, for a period of time, in exchange

for consideration

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Specified asset (similar to current GAAP)

►

Right to control the use of a specified asset (different from current

GAAP)

(4)

Definition of a lease

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Specified asset

►

Includes a physically distinct portion of a larger asset (e.g., a floor in

a building would be included, whereas 50% of the capacity of a

pipeline would be excluded)

►

Excludes contracts that provide the lessor with substantive

substitution rights (e.g., lessor can substitute the asset without the

lessee’s consent; economically feasible)

►

Right to control the use

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Direct the use AND

► Make decisions that significantly impact economics (i e raw materials

► Make decisions that significantly impact economics (i.e., raw materials,

processes applied) ►

Receive the benefits

► Based on economics, not only physical attributes ► 100% of output does not dictate a lease

Multiple elements

►

Contracts that contain lease and non-lease (services,

supplies, etc.) components

►

Both lessors and lessees would be required to separately account

for lease and non-lease components

►

Lessors would allocate payments in accordance with revenue

recognition standard (separate criteria)

►

Lessees would generally use observable prices to allocate

payments on a relative purchase price basis

► Lessees can apply a residual method.pp y

► Items that cannot be separated based on observable prices are included

(5)

Overview of right-of-use model

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Lessee will recognize

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A right-of-use asset representing the lessee’s right to use the

leased asset

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A liability for its obligation to make lease payments

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Lessor will recognize (if not investment property)

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A receivable representing the lessor’s right to receive lease

payments

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A residual asset for the portion of the underlying asset retained

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Initially measure lessee’s liability and the lessor’s receivable

►

Initially measure lessee s liability and the lessor s receivable

at the present value of lease payments to be made over the

lease term

Lease term

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Recognized lease term would include non-cancellable period,

plus any optional periods where there is a significant

economic incentive to extend (or not terminate) the lease

►

Purchase options – include on a basis consistent with

renewal options

►

Assume exercise if significant economic incentive to exercise exists

►

Similar to current GAAP, though some reassessment required

(6)

Lease payments

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Lease payments include:

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Fixed payments

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Variable payments based on index or rate (e g CPI or LIBOR)

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Variable payments based on index or rate (e.g., CPI or LIBOR)

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Termination penalties (if term is assumed not to be renewed)

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Residual value guarantees, at the amount expected to be paid, if

any (lessees only)

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Exercise price of purchase options that are included in lease term

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Contingent rents based on performance or usage would be

excluded

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Recognized as incurred/accrued

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Contingent rents must be truly variable to be excluded

Lessee accounting

Initial recognition and measurement

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Lease-related assets and liabilities initially recognized and

measured as of lease commencement date

Li bilit i iti ll

d t th

t

l

f th l

►

Liability initially measured at the present value of the lease

payments

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Discounted using rate the lessor charges the lessee (when

available) or the lessee’s incremental borrowing rate

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Right-of-use asset is measured initially at cost

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Amount of the liability

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Plus: any initial direct costs incurred

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Plus: any initial direct costs incurred

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Less: any lease incentives received

(7)

Lessee accounting

Subsequent measurement

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Still up in the air

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ED “Approach A” (current tentative proposal):

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Right-of-use asset amortized generally on a straight-line basis over

either the lease term or economic life of the leased asset

►

Interest expense recognized using the interest method, and lease

payments reduce the liability

►

Accelerated expense recognition pattern

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Interest-based amortization (“Approach B” – FASB)

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Underlying asset (“Approach C”

IASB)

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Underlying asset (“Approach C” – IASB)

Lessee accounting (ED; Approach A)

Example

A company enters into a three-year lease for office space and agrees

to pay the following: $10,000 in year 1, $12,000 in year 2 and

$14,000 in year 3. The present value of lease payments is $32,500

( i

di

t

f 5%)

Initial

Year 1

Year 2

Year 3

Lease expense recognized

Interest expense

1,625

1,208

667 Amortization expense

10,833

10,833 10,834

Total

12 458

12 041 11 501

(using a discount rate of 5%).

Total

12,458

12,041 11,501

Balance sheet

Right-of-use asset

32,500

21,667

10,834

–

(8)

Lessee accounting

Subsequent measurement – Approach B

►

Interest-based amortization (two types of leases)

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Finance/capital type leases – straight-line amortization of

i ht f

t

right-of-use asset

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Same as ED

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Operating type – method allocates more amortization

expense to later periods – smoothes out total lease expense

when combined with interest method for liability

►

The ROU asset at the beginning of each reporting period is equal to

PV of the estimated remaining economic benefits under the lease

g

as estimated at lease commencement discounted at the rate used

to PV liability initially.

►

When rents are due in equal monthly amounts, pattern of total

expense recognition approximates straight-line.

Lessee accounting

Subsequent measurement – Approach C

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Underlying asset approach

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Amortization based on consumption of underlying asset over

tterm

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Estimate decrease in value of asset at end of term

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If decrease is small (e.g., real estate), higher amortization

toward end

►

When combined with interest expense, closer to straight-line

total expense

►

If decrease is significant (e.g., equipment), closer to

straight-line asset amortization

(9)

Lessee accounting

Reassessment

Consideration

Indicator to reassess

Accounting treatment

Lease term and purchase options

A significant change in factors (except market factors) relevant to

Adjust right-of-use asset

p p )

determining whether a significant economic incentive exists

Discount rate Change in lease payments due to a change in lease term

Residual value guarantees

Events or circumstances indicate that there has been a significant change in the amounts expected to be payable

Amounts relating to current or prior periods – net income; Amounts relating

to future periods – adjust right-of-use asset Lease payments that

depend on an index or rate

When the rate changes

Lessee accounting

Presentation and disclosure

Balance sheet

Income

statement

Cash flow

statement

Right-of-use assetg Present separately in p y Amortization Supplementary

balance sheet or disclose in notes (if in notes disclose line item in balance sheet)

expense not combined with interest expense pp y non-cash disclosure of acquisition Liability to make lease payments Separately present or disclose interest expense Principal payments – financing Interest payments – operating operating Variable lease payments

(10)

Lessee transition

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May choose full retrospective approach or modified retrospective approach

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Under modified retrospective approach:

► Liability to make lease payments measured at the present value of the remaining

► Liability to make lease payments measured at the present value of the remaining lease payments

► Right-of-use asset calculated based on the liability to make lease payments at

lease commencement prorated for the remaining lease term

► Differences between the liability to make lease payments and right-of-use asset

would be a cumulative adjustment to opening retained earnings

► Discount rate based on incremental borrowing rate on effective date

► May be determined at a portfolio level for leases with similar characteristics

► Adjust right-of-use asset by prepaid/accrued rents, subject to impairment review

► Adjust right of use asset by prepaid/accrued rents, subject to impairment review ► May elect to use hindsight when preparing comparative information and not

evaluate initial direct costs for leases that began before the effective date

►

Not required to adjust carrying amounts for existing capital leases

Lessor accounting (for now)

Scope of lease same as lessees except:

►

Leases of investment property (would include most real estate

property, including integral equipment)

►

If lessor is an investment property entity – out of scope

► Apply the FASB’s investment property ED – account at fair value and

recognize lease revenue when contractually due ►

If lessor is not an investment property entity – in scope

► Apply current operating lease accounting ► Further consideration of cell tower assets?

►

All other leases would be subject to the receivable and residual

j

approach

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Receivable and residual approach

► Record a lease receivable

► Allocate a portion of the carrying

value of the underlying asset to the right-of-use asset “sold”

► Recognize profit (or loss) for the

difference between the PV of lease payments and the carrying value allocated to right-of-use asset “sold”

► Record a residual asset for the carrying value not allocated to the leased asset that is “sold” Underlying

asset

Right-of-use “sold”

the leased asset that is sold

► Profit associated with the

residual asset would be deferred until the asset is subsequently sold or re-leased

Residual asset

Receivable and residual approach

Initial and subsequent measurement

Initial measurement:

►

Lessor lease term same as lessee

►

Lessor receivable = PV of lease payments similar to lessee but

does not include any amounts for residual value guarantees

(considered in impairment assessment only)

►

Lessor discount rate as of the lease commencement date using the

rate the lessor charges the lessee

Subsequent measurement:

►

Lease payments received by lessor allocated as a reduction of the

lease receivable and interest income using the interest method

►

Recognize interest income to accrete the residual asset to its

(12)

Illustrative example

Lessor

Assumptions:

► A lessor manufactures a machine for $7,500 with a fair value of $10,000

► Enters into a three-year lease with annual lease payments of $2,400 paid at end of each year

► Expected fair value of the residual asset at the end of the lease term is $4,770

► Interest rate implicit in the lease is approximately 7.9%

Lease receivable (PV of annual lease payments of $2 400 at 7 9%) = $6 200 (rounded)

Commencement Lease receivable $6,200 Gross residual $3,800* Cost of sales $4,650 Deferred profit $950* Asset $7,500 Revenue $6,200

*Presented as net residual: $2,850

Subsequent (year 1)

Cash $2,400

Interest income – receivable $ 488 Lease receivable $1,912

Residual $ 299

Interest income – residual $ 299

Lease receivable (PV of annual lease payments of $2,400 at 7.9%) = $6,200 (rounded) Carrying value of asset allocated to right-of-use asset “sold”: $7,500 x $6,200/$10,000 = $4,650 Profit recognized at lease commencement: $6,200 – $4,650 = $1,550

Gross residual (PV of the estimated FV of residual asset of $4,770 at 7.9%) = $3,800 (rounded) Carrying value of asset allocated to residual asset (net residual): $7,500 – $4,650 = $2,850 Deferred profit: $3,800 – $2,850 = $950

Interest income on gross residual: $3,800 x 7.9% = $299 (rounded)

Illustrative example

Proposed standard vs. current standard

– lessor

Proposed standard Current

standard

P i d R i bl G id l D f d fit N t id l P fit

Profit ( l t l ) Period Receivable Gross residual Deferred profit Net residual Profit (sales-type lease) Initial $6,200 $3,800 $ (950) $2,850 $1,550 $2,500 Year 1 $4,288 $4,099 $ (950) $3,149 $ 787 $ 787 Year 2 $2,225 $4,422 $ (950) $3,472 $ 660 $ 660 Year 3 $  $4,770 $ (950) $3,820 $ 523 $ 523 Total prior to sale of residual $3,520 $4,470

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Lessor presentation

Balance sheet

►

Lease receivable and residual asset presented separately (summing to a

total “lease assets”) or shown as one “lease assets” with two amounts

total lease assets ) or shown as one lease assets with two amounts

disclosed in notes

►

Present gross residual and deferred profit together as a net residual asset

Income statement

►

Lease income and expense (i.e., profit and cost of sales) in separate line

items or net in a single line item (interest income), depending upon lessor’s

business model

►

Income and expense from lease transactions presented separately in

income statement or disclosed in the notes

►

Accretion of residual asset in interest income

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Amortization of initial direct costs as an offset to interest income

Lessor transition

►

Similar to lessees, may choose full retrospective approach or

modified retrospective approach

►

Under modified retrospective approach:

►

Under modified retrospective approach:

► Lease receivable measured at the present value of the remaining lease payments subject to any adjustments required to reflect impairment

► Allocate the carrying value of the underlying asset between the right-of-use asset

“sold” and the residual asset using the estimated fair value of the leased asset at the beginning of the earliest comparative period presented

► Discount rate based on the rate charged in the lease determined at the date of

commencement

► Adjust cost basis of underlying asset derecognized by prepaid/accrued rents ► Adjust cost basis of underlying asset derecognized by prepaid/accrued rents ► May elect to use hindsight when preparing comparative information and not

evaluate initial direct costs for leases that began before the effective date ►

Not required to adjust carrying values for existing direct finance or

(14)

Sale-leaseback transactions

►

No difference between real estate and equipment

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No “lessee involvement in asset construction” guidance

►

Apply control criteria described in revenue recognition project

to determine whether a sale has occurred

►

If a sale has occurred, seller-lessee would derecognize the

leased asset and recognize a right-of-use asset and a liability

to make lease payments for the leaseback

►

Gain/loss would be recognized at transaction date

►

If a sale has not occurred, seller-lessee would account for as

a financing

Implications and considerations

What is potentially affected?

►

Financial metrics, key performance indicators and capital

structure

►

Changes to timing and characterization of income/expense

►

Changes to timing and characterization of income/expense

► Will changes in characterization of income impact income tax

deductibility of lease payments?

►

Return on assets; EBITDA/EBIT levels and multiples; accretion and

dilution; impairment

►

Debt covenants; interest coverage ratios; debt to equity ratios;

liquidity

►

Market and leasing strategy

►

Market and leasing strategy

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Lease vs. buy strategy

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Unbundling of services (warranty, maintenance, etc.)

►

Length of lease term, amount of lease payments, residual value

guarantees, lease incentives or other lease options

(15)

Implications and considerations

What is potentially affected

►

Infrastructure, process and control changes

►

Resources (people, systems, input knowledge); controls; data

capture; procurement and technical accounting, internal controls

►

IT and systems

►

New lease data requirements will result in IT system modifications

and changes to financial reporting requirements

►

Tax accounting issues

►

Initial adjustments to deferred taxes

►

Tracking book/tax differences related to amortization expense rent

►

Tracking book/tax differences related to amortization expense, rent

and interest deductions

What are companies doing now?

Example activities

► Understanding the magnitude of the changes to the company to minimize the effect

on financial metrics and make informed decisions in current negotiations

► Establishing project management and planning activities (timeline, tasks, resources) ► Determining training requirements for individuals responsible for lease accounting

and related judgments

► Determining the population of lease arrangements that would be in scope under the

proposal

► Identifying lease data to be accumulated based on the requirements of the proposal ► Does the lease contain any non-lease components?

► What should be included in the lease term and payments?

Wh i h f i l f h l d l d h i d

► What is the fair value of the leased asset at lease commencement and the estimated residual value at the end of the lease term?

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What are companies doing now?

Example activities

► Establishing a process for gathering and analyzing lease data ► Where is the lease data maintained? Is it readily available?

► How will you evaluate whether you have the most up-to-date lease agreement or the e istence of side agreements?

existence of side agreements?

► Will the review of lease arrangements be performed locally or by a centralized team to maintain consistency in corporate approach?

► How will management document its judgments and estimates to maintain an audit trail? ► Establish protocols for summarizing shortfalls in available information necessary to

adopt the proposed lease standards

► Perform impact assessment on a sample of lease arrangements or entire lease

portfolio to understand the magnitude of the changes to the company

► Considering requirements for maintaining multiple sets of lease data for comparative

periods, as well as book/tax differences upon adoption ► Will IT systems be able to manage both sets of data?

► Will the company need separate systems to accumulate data for book and tax?

What are companies doing now?

Technology options

►

Existing lease management software and database-type solutions

► Develop workarounds using existing software

► Create a database to compile the required data fields and calculate the lease-► C eate a database to co p e t e equ ed data e ds a d ca cu ate t e ease

related assets and liabilities, along with the related income statement impact

► More advanced solutions include interface with document workflow tool with

scanned copy of the lease and data tagging of key terms ►

Lease specific vendor solutions

► Work with existing lease accounting software vendors to understand their plans and timing for upgrading packages, which is in part pending definitive guidance ►

ERP-based solution

► Determine whether SAP and Oracle are working on modules that will interface

with existing systems, although the timing is uncertain and likely pending definitive guidance

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Lease accounting proposal

Q&A

!@#

Disclaimer

►

The views expressed by presenter(s) are not necessarily

those of Ernst & Young LLP.

►

These slides are for educational purposes only and are not

intended, and should not be relied upon, as accounting

advice.

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