BECKER GEARTY CONTINUING PROFESSIONAL EDUCATION

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CONTINUING PROFESSIONAL EDUCATION

Accounting for Leases

Now & Next

973.822.2220

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Accounting for Leases (ASC 840 f/k/aSFAS 13)

•• Learning Objectives:Learning Objectives:

To review recent developments in lease accounting and demonstrate how they have affected accounting for leases as prescribed under SFAS 13, Accounting for Leases.

•• Program Prerequisites:Program Prerequisites: None

•• Program/Course Level:Program/Course Level: Overview

•• Program Content:Program Content:

Lease accounting has been one of the most controversial accounting topics for nearly two decades. This program will begin with a quick overview of the current accounting for leases within ASC 840 (SFAS 13). The focus of the program will be to address the current exposure draft on Leases, the significant rule changes, the impact on both the lessee and lessor, impact on preexisting leases and comment letters associated with this topic.p

•• Advanced Preparation:Advanced Preparation: None

•• Type of Delivery Method:Type of Delivery Method: Live & Group Internet Based

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Accounting for Leases

Developments in Lease Accounting

FASB Proposed ASU

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Accounting for Leases

Developments in Lease Accounting

FASB Proposed ASU

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Accounting for Leases

I. Overview

A lease is a contractual agreement between a lessor, who

conveys the right to use real or personal property (an

asset), and a lessee, who agrees to pay periodic rents over

a specified time.

Rental Sale

Lessee Operating Lease Capital Lease

Lessor Operating Lease Sales Type or

(4)

II. Operating Leases

A. Definition

An operating lease includes a lessor, who collects

rent, and a lessee, who uses the leased asset and

pays periodic rent for such use. The lessee

merely uses the asset; there is no transfer of

ownership, or of any risk or benefit of ownership.

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Accounting for Leases

B. Accounting for Operating Leases

1. Lessee Accounting

a. Lease Rent Expense

The lessee records rent expense over the lease term,

usually on a straight-line basis unless other methods

are warranted (for example, lease expense can be tied

to sales, to the Consumer Price Index, or to the prime

interest rate).

DR Rent expense $XXX

(5)

b. Lease Bonus (Prepayment)

Lease bonus (prepayment) for future expenses should be classified as an asset (deferred charge) and amortized using the straight-line method over the life of the lease.

c. Leasehold Improvements

A l h ld i t i th t i tl ffi d t th t d

A leasehold improvement is one that is permanently affixed to the property and reverts back to the lessor at the termination of the lease. In general, if the property is not moveable from the premises by the tenant, it is a leasehold improvement. Air conditioning ducts would be considered a leasehold improvement, while a painting hanging on a wall would not.

1) Capitalize Leasehold Improvements

The value of leasehold improvements should be capitalized and added to the property, plant, and equipment section or the intangible assets section of the balance sheet. 2) Depreciation—Useful Life or Lease Term

Leasehold improvements should be depreciated (amortized) over the lesser of: a) Lease life

a) Lease life

b) Asset/improvement life d. Rent Kicker

A premium rent payment required for specific events. 1) Period expense

e. Refundable Security Deposit

Is reported as an asset until refunded by the lessor.

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Accounting for Leases

f. Free or Reduced Rent Consideration

If consideration (free rental months or reduced rental charge at beginning) is part of the package, lessee must take total rent expense to be paid for the entire lease term and divide it evenly over each period (matching principle).

X AM P L E Rental-Agreement 5 years (60 months) @ $1,000

*First 6 months are free Net cost for five years Total months rented Monthly rental expense

$60,000 <6,000> $54,000 ÷ 60 mo. $ 900 First 6 months ( Mo. 1 – 6)

E

X

DR Rent expense $900

CR Rent payable $900

Next 54 months (Mo. 7 – 60)

DR Rent expense $900

DR Accrued rent payable 100

(6)

C. Leasing Issues

1. Background and evolution

a

Restatements

a.

Restatements

b.

SEC Staff Letter

2. Primary issues

a.

Amortization of leasehold improvements

b.

Rent holidays

c.

Lease incentives

d.

Disclosures

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Accounting for Leases

Amortized by lessee over the shorter of: Their economic lives

Issue 1: Amortization of Leasehold Improvements

Lease term (as defined in ASC 840, f/k/a SFAS 13)

Amortization of LHIs over a term that includes renewals is appropriate only when renewals have been determined to be "reasonably assured"

A lease that is cancelable……

only upon the occurrence of some remote contingency, only with the permission of the lessor,

only if the lessee enters into a new lease with the same lessor, or

only if the lessee incurs a penalty in such amount that continuation of the lease appears, at inception, reasonably assured

... is considered non-cancelable

KEY POINT

Leasehold improvements cause renewal option to be "reasonably assured: when: 1. LHIs are expected to have significant value at end of initial period such that lessee is

not willing to abandon these assets (i.e. effectively incur a penalty) 2. Renewal option reasonably assured of exercise

(7)

• Apply ASC 840-20-25; f/k/a/ FASB Technical Bulletin 85-3,

Issue 2: Rent Holidays

Apply ASC 840 20 25; f/k/a/ FASB Technical Bulletin 85 3,

"Accounting for Operating Leases with Scheduled Rent

Increases"

• Operating leases with rent holidays should be recognized:

1. On a straight-line basis 2. Over the lease term

3. Including the rent holiday period: lease term for accounting purposes includes all periods lessee has access to and control over leased space

includes all periods lessee has access to and control over leased space.

• Straight-line applies unless another systematic or rational

allocation is more representative of the time pattern in which the leased property is physically employed.

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Accounting for Leases

• Landlord incentives for Leasehold Improvements:

Issue 3: Lease Incentives

1. Acquisition of LHI is capitalized asset

2. Incentive received recorded as a deferred rent by lessee 3. Amortize incentive as reduction to lease expense over the lease

term

4. Cash Flow Statement

a. Acquisition of the leasehold improvement in "investing activities"

(8)

Issue 4: Disclosures

Disclosures: Footnotes, MD&A Critical

Accounting Policies Material Lease Agreements Amortization Period For LHIs Accounting Policies for Leases

Basis for Contingent Rents

Provisions of Material Leases

original term, renewal periods, reasonably assured rent escalations, rent holidays, contingent rent, rent concessions, LHI incentives and other unusual provisions

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Accounting for Leases

2. Lessor Accounting

a. Fixed Asset

The cost of the property is included in the

lessor's property, plant and equipment.

1)

Depreciation—over the asset's useful life

b. Rental Income

Rental income is reported on either the

straight-line or other systematic method

straight-line or other systematic method.

DR Cash/rent

receivable

$XXX

(9)

c.

Security Deposits

Security deposits required by the lease may be either

refundable or nonrefundable:

1)

Nonrefundable—deferred by the lessor

(unearned revenue) and capitalized by the

lessee (prepaid rent expense) until the lessor

considers the deposit earned.

2)

Refundable—treat as a receivable by the lessee

and a liability by the lessor until the deposit is

f

d d t th l

refunded to the lessee.

DR Cash $XXX

CR Refundable deposit $XXX

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Accounting for Leases

KEY POINT

• Do not recognize security deposits as revenue in advance of their being earned (violation of the Rule of Conservatism).

d.

Temporary Difference

1)

GAAP Rule – report prepaid rental income when

earned

2)

Tax Rule – report prepaid rental income when

(violation of the Rule of Conservatism).

• Remember, revenue is only recognized when the earning process is complete; we never anticipate revenue.

2)

Tax Rule report prepaid rental income when

received

e.

Lease Bonus

The lease bonus is deferred (unearned income) and

amortized (into income) over the life of the lease.

(10)

f. Free or Reduced Rent Consideration

If consideration (free rental months or reduced rental charge at beginning) is part of package, lessor must take total rental income to be paid for the entire lease term and divide it evenly over each period (matching principle/revenue recognition principle).

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Rental-Agreement 5 years (60 months) @ $1,000

*First 6 months are free Net rental income for five years Total months rented Monthly rental income

$60,000 <6,000> $54,000 ÷ 60 mo. $ 900 First 6 months ( Mo 1 6)

EXA

M _{First 6 months ( Mo. 1 – 6)}

DR Accrued rent receivable $900

CR Accrued rental income $900 Next 54 months (Mo. 7 – 60)

DR Cash $1,000

CR Rental income $900

CR Rent receivable 100

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Accounting for Leases

III. Capital Lease

A capital lease transfers substantially all of the benefits and

risks inherent in ownership of property to the lessee.

p

p p

y

i. This is an accounting transaction, which is, in substance, an installment purchase in the form of a leasing arrangement. ii. The lessee accounts for this type of lease as the acquisition of

both an asset (leased asset under capital lease) and a related liability (obligation under capital lease).

iii. The lessor accounts for such a lease as a sales-type or a direct financing lease. A sales-type lease results in a dealer's or manufacturer's profit or loss to the lessor. A direct financing lease does not result in a dealer's or manufacturer's profit or loss.

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A. Lessee Capital Lease Criteria

1. Must meet just one condition to capitalize.

DR Fi d t l d t $XXX

DR Fixed asset—leased property $XXX

CR Liability—obligation under capital lease $XXX

Ownership transfers at end of lease (upon final payment or required buyout) Written option for bargain purchase

Ninety (90%) percent of leased property F.V. <= P.V. of lease payments Seventy-five (75%) percent of asset economic life is being committed in lease term

2. Criteria (N) and (S) cannot be used for a lease that begins

within the last 25% of the original estimated economic life of

the leased property.

y ( ) p g

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EXAMPLE

Accounting for Leases

Equipment FV is $3,500, lease payments are $1,000 per year, on 12-31 lease term is four years, t lif i t

asset life is ten years. Incremental borrowing rate is 10% No ownership No written bargain FV $3,500 P.V. Cost 1 2 3 4 $ 910 830 750 $1,000 $1,000 $1,000 $1,000 x 90% $3,150 750 680 $3,170

(12)

B. Lessor: Sales-Type/Direct Financing Type Criteria

1. If a lease, at inception, meets all three of the

following conditions it shall be classified by the

following conditions, it shall be classified by the

lessor as a sales-type or direct financing lease,

whichever is appropriate.

L

Lessee "owns" the leased property (meets any one of the four lessee's criteria)essee "owns" the leased property (meets any one of the four lessee's criteria)

U

Uncertainties do not exist regarding any unreimburseable costs to be incurred by ncertainties do not exist regarding any unreimburseable costs to be incurred by the lessor.

the lessor.

C

Collectibility of the lease payments is reasonably predictable.ollectibility of the lease payments is reasonably predictable.

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Accounting for Leases

IV. Lessee (Capital Lease) Accounting

A. Calculation of Leased Asset and Liability Amounts

The lessee treats the capital lease as if an asset were being

purchased over time; that is, it is a financing transaction in

which an asset is acquired and a corresponding obligation

(liability) is created.

DR Fixed

asset—leased

property

$XXX

(13)

1. Recording the Lease

a. Capitalized Amount

Th l

d th l

t

d

li bilit

The lessee records the lease as an asset and a liability

at the lower (lesser) of:

1) Fair value of the asset at the inception of the lease,

or

2) Cost = present value of the minimum lease

payments.

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Accounting for Leases

a) Includes (all payments that the lessee is obligated to make): 1) Required Payments

2) Bargain Purchase Option

When the lease contains a bargain purchase option the lease When the lease contains a bargain purchase option, the lease obligation includes the present value of the payment required to exercise the bargain purchase option in addition to the present value of the minimum lease payments.

3) Guaranteed Residual Value

The guaranteed residual value is the amount guaranteed by the lessee to the lessor for the estimated residual value of the asset at the end of the lease term.

b) Exclude:

1) Executory Costs

I i t d t b id b th l

Insurance, maintenance, and taxes can be paid by the lessor or lessee. If the lessor pays them, a portion of each lease payment representing executory costs is excluded from the calculation of minimum lease payments. If the lessee pays these costs directly, they are not included in the minimum lease payments.

(14)

KEY POINT

•Beginning = PV of an annuity due

Periodic payment

•Ending = PV of an annuity (in arrears/ordinary) Bargain

OR •PV of $1

Guaranteed residual

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Accounting for Leases

b. Interest Rate

The lessee uses the incremental borrowing rate,

d t

i

d

th l

(l

) f

determined as the lower (lesser) of:

1) Rate implicit in the lease (if known)

(15)

c. Summary

Capitalized Cost (remember, lower of this cost or market):

O

wnership = PV of payments and required buyout—(if any)

W

ritten = PV of payments and bargain buyout

N

inety % FV = PV of payments (not option buyout)

S

eventy five % life = PV of payments (not option buyout)

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Accounting for Leases

B. Term to Use in Computing Depreciation of the Asset

1. Formula for Depreciation

Capitalized lease assets

< Salvage value> Depreciable Basis ÷ Periods of benefit Depreciation Expense (per period) Depreciation Expense (per period)

(16)

2. Period of Benefit (Depreciable Life)

a. Ownership Transfer and Written Bargain

1) Estimated economic life of the asset if the lessee 1) Estimated economic life of the asset if the lessee

takes ownership of the leased asset by the end of the lease or if there is a bargain purchase option as part of the agreement. The asset is depreciated in a manner consistent with the lessee's normal policies.

b. Ninety % FV and Seventy-five % Life

1) The lessee uses the lease term if the lessee does not take ownership of the asset by the end of the lease or if there is not a bargain purchase option.

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Accounting for Leases

3. Summary

Depreciation Rules: (Capitalized "lease" asset salvage value): Depreciation Rules: (Capitalized lease asset—salvage value):

O

wnership = Depreciate over asset life (legal form)

W

ritten = Depreciate over asset life (legal form)

N

inety % FV = Depreciate over lease life (substance over form)

(17)

E. Summary of Lessee Capitalization Rules 1. Capitalize

As PP&E on the balance sheet, the leased asset at the lower LESSER of:

a. Cost a. Cost

PV of future lease payments

Include: Guaranteed Residual Value by Lessee, Bargain Purchase Option (if applicable) Exclude: "Executory Cost" = Insurance, Taxes, and Repair & Maintenance

1) Discount Rate: Incremental borrowing rate is the lower (LESSER) of: a) Rate implicit in the lease (if known)

b) Rate available in market to lessee (not prime) b. Fair Value

Capitalize Depr. Life Ownership = PV of payments and required buyout Asset life Written = PV of payments and bargain buyout Asset life Ninety % FV = PV of payments (ignore option) Lease life Seventy-five % life = PV of payments (ignore option) Lease life

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Accounting for Leases

KEY POINT

If a lease meets more than one of the criteria, then the order of

priority for applying the rules is the exact way they are spelled:

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V. Lessor Accounting

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Accounting for Leases

A. Recording a Sales-Type Lease

Following are the terms which are important to

g

know for sales-type leases:

(19)

1. Gross Investment (lease receivable)

The minimum lease payments plus any unguaranteed

residual value accruing to the benefit of the lessor. This is

g

recorded as Lease Payments Receivable on the lessor's

books.

Lease payment

+ Unguaranteed residual value

Gross investment

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Accounting for Leases

2. Net Investment

This is computed as the sum of the present value of the

minimum lease payments and the present value of any

p y

p

y

unguaranteed residual value accruing to the benefit of the

lessor, using the interest rate implicit in the lease.

Lease payments

+ Unguaranteed residual value

Gross investment

x

PV

(20)

3. Unearned Interest Revenue (Contra-Lease Receivable)

The gross investment less unearned interest revenue equals

net investment. This is amortized over the life of the lease

by the effective interest method and is included in the

balance sheet as a deduction from the gross investment to

report the net investment.

Gross investment

< Net investment >

Net investment

Unearned interest revenue

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Accounting for Leases

4. Cost of Goods Sold

The cost of the leased asset plus any initial direct costs,

such as legal fees or commissions to the lessor, minus the

g

,

present value of any unguaranteed residual value accruing

to the lessor's benefit. This is charged against income in the

period in which the corresponding sale is recorded.

Cost of Asset

< PV Unguaranteed Residual >

Cost of Goods Sold

(21)

5. Sales Revenue

The present value of the minimum lease payments is

recorded as sales revenue. This does include the present

p

value of any guaranteed residual value but does not include

the present value of any unguaranteed residual value.

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EXAMPLE

Accounting for Leases

Recording a Sale

Recording a Sale--Type Lease with Unguaranteed Residual Value (Type Lease with Unguaranteed Residual Value (LessorLessor))

Assume that a lease with a ten

Assume that a lease with a ten--year term requires rental payments of $5,000 on January 1 of year term requires rental payments of $5,000 on January 1 of each year. The

each year. The lessor'slessor's cost for the leased asset is $35,000. The estimated fair value at the cost for the leased asset is $35,000. The estimated fair value at the end of the lease (unguaranteed residual value) is $4,000, and the

end of the lease (unguaranteed residual value) is $4,000, and the lessorlessor retains ownership at retains ownership at the end of the lease. The implicit interest rate is 10 percent (P.V. of annuity due is 6.759 and the end of the lease. The implicit interest rate is 10 percent (P.V. of annuity due is 6.759 and PV of $1 is .386). Compute the information necessary to record this sales

(22)

EXAMPLE (continued)

1. Gross investment = Minimum lease payments + Unguaranteed residual value = ($5,000 x 10 yrs) + $4,000

= $54,000

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Accounting for Leases

2. Net investment = Lease payments x PV of annuity due of $1, 10 periods, 10% + Unguaranteed residual value x PV of $1, 10 periods, 10%

= ($5,000 x 6.759) + ($4,000 x .386)

= $35,339

(The present value of the minimum lease payments, but not the unguaranteed residual value, is recorded as sales, $5,000 x 6.759 = $33,795)

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3. Unearned interest revenue = Gross investment – Net investment

= $54,000 – $35,339

= $18,661

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Accounting for Leases

4. Cost of goods sold = Lessor’s cost of leased asset + Initial direct costs – PV of unguaranteed residual value

= $35,000 + 0 – ($4,000 x PV of $1, 10 periods, 10%) = $35,000 – (4,000 x .386)

(24)

5. Present value of lease

payments (sale) = $5,000 x 6.759 = $33,795

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Accounting for Leases

Journal Entry: To record this sales-type lease

DR Lease payments receivable $54,000

DR Cost of goods sold 33,456

CR Sales $33,795

CR Equipment 35,000

CR Unearned interest revenue (contra-lease receivable) 18,661 Note: The lessor’s profit on sale is $33,795 – $33,456 = $339, which is recognized at the lease’s i ti

(25)

B. Recording a Direct Financing

Since no manufacturer's or dealer's profit is realized in a

direct financing lease, the fair value of the leased property

g

,

p p

y

equals the cost or carrying value at the inception of the

lease. The information necessary to record this type of

lease is:

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Accounting for Leases

1. Gross Investment (Lease Receivable)

Gross investment equals the minimum lease payments

plus the unguaranteed residual value and is recorded

p

g

as Lease Payments Receivable.

Lease payments

+ Unguaranteed residual value

Gross investment

(26)

2. Net Investment

Net investment equals the gross investment plus any

unamortized initial direct costs less the unearned

income. The initial direct costs are amortized over the

lease term by the effective interest

method.

+

Lease receivable

Unguaranteed residual

Gross investment

x

Gross investment

PV

Net investment

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Accounting for Leases

3. Unearned Interest Revenue

This is the gross investment less the cost of the leased

property plus any initial direct costs. It is amortized over

p p

y p

y

the lease term by the effective interest

method.

Gross investment

< Net investment > Unearned interest revenue

Journal Entry: To record a direct financing lease

DR Lease receivable (gross investment) $54,000

CR Unearned interest revenue (contra-lease receivable $18,661

(27)

VI. Sale-Leaseback

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Accounting for Leases

A. Introduction

In a sale-leaseback transaction, the owner of a property

(seller-lessee) sells the property and simultaneously leases

it back from the purchaser-lessor. Usually there is no visible

interruption in the use of the property. Sale-leaseback

transactions are treated as single financing transactions

where, in general, any profit or loss is deferred and

amortized. In general, two questions are involved in

determining the treatment of any profits:

1. Is the lease a capital or operating lease? And

2. What portion of the rights to the leaseback property are

retained?

(28)

B. Terminology

1. Selling Price

S lli

i

i th

ti t d

i

i th

l

Selling price is the negotiated price in the

sale-leaseback agreement. It may be less than, equal to, or

greater than the fair value of the property, depending on

the negotiated terms of the sale-leaseback.

2. Profit or Loss on Sale

Profit or loss on the sale is the amount which would

have been recognized by the seller-lessee assuming

there was no leaseback. It is calculated by subtracting

book value from fair value (sale price).

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Accounting for Leases

3. Excess Profit on Sale-Leaseback

a. Operating Lease Excess Profit

The amount of profit on the sale which

exceeds the present value of the minimum

lease payments.

Sale price

< Asset NBV>

T t ti i

Tentative gain

< PV min. lease payments>

(29)

b. Capital Lease Excess Profit

The amount of profit on sale that exceeds the

recorded amount of the asset. Note that this

amount will be the same as in an operating lease

unless the leaseback asset is recorded at the

lower fair value.

The recorded amount of the leaseback asset is

the lesser of

i.

The fair value of the leased property, or

ii. The present value of the minimum lease

payments.

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Accounting for Leases

4. Rights to Remaining Use of Property Retained by

Seller-Lessee

The rights to the remaining use of the property are determined by the present value of rent payments paid by the seller-lessee. The seller-lessee's rights p y p y g may be categorized as follows:

a. "Substantially All" Rights Retained (Greater than 90%)

The present value of the rent payments is equal to or greater than 90% of the fair value of the property. These leases are usually accounted for as capital leases.

b. Rights Retained Are Less Than "Substantially All" but Greater than "Minor" (Between 90% - 10%)

The present value of the rent payments is less than 90% of the fair value, but greater than 10% of the fair value of property at the lease inception. These leases are accounted for as either capital or operating leases, depending on the criteria

the criteria.

c. "Minor" Portion of Rights Retained by Seller-Lessee (Less than 10%)

The present value of the rent payments is 10% or less of the fair value of the property at lease inception or the lease (back) period is 10% or less of the asset's remaining life. These leases are usually accounted for as operating leases.

Note: To determine whether any sales-leaseback transaction should be accounted for as operating or capital, use the "OWNS" test.

(30)

Sale-Leaseback: Summary

Major Middle Minor

Major

90% or More 90%—10% Middle 10% or Less Minor (Life or Sales Price)

Gain Defer All

(Amortize over leaseback)

Defer (up to PV of leaseback)

(Amortize over leaseback)

No Deferral

Loss (NBV > FMV)

(real economic losses) Immediately Recognize Immediately Recognize Immediately Recognize

Other Losses

(artificial loss)

Defer All (Amortize over leaseback)

Recognize Immediately

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EXAMPLE

Accounting for Leases

Leaseback—Less Than "Substantially All" but More Than "Minor"

On January 1, Year 1, Carlson Company sold an airplane with an estimated useful life of ten years. Carlson simultaneously leased back the airplane for three years. The lease is classified as an operating lease. Applicable data follow:

Sale price, fair value $500,000

Book value of airplane 100,000

Monthly rental 5,100

Present value of lease rentals 153,000

Calculate the amount of Carlson’s profit recognized on January 1, Year 1, and rent expense on December 31, Year 1.

(31)

The present value of lease rentals exceeds 10% of the fair value ($50,000) but is less than 90% of the fair market value ($450 000) Therefore the amount of profit recognized is the amount in excess The present value of lease rentals exceeds 10% of the fair value ($50,000) but is less than 90% of the fair market value ($450 000) Therefore the amount of profit recognized is the amount in excess of the fair market value ($450,000). Therefore, the amount of profit recognized is the amount in excess of the present value of the minimum lease payments. The calculation follows:

Sale price $500,000

Less book value (100,000)

Total profit 400,000

Less present value of lease payments

(deferred amount) (153,000)

Profit recognized at lease inception 1/1/Yr 1

(excess profit on sale leaseback) $247,000

of the fair market value ($450,000). Therefore, the amount of profit recognized is the amount in excess of the present value of the minimum lease payments. The calculation follows:

Sale price $500,000

Less book value (100,000)

Total profit 400,000

Less present value of lease payments

(deferred amount) (153,000)

Profit recognized at lease inception 1/1/Yr 1

(excess profit on sale leaseback) $247,000

Carlson’s rent expense for the year is calculated as follows:

Annual rent payments ($5,100 x 12 months) $ 61,200 Less one year recognition of deferred profit

($153,000 ÷ 3 years) (51,000)

Rent expense 12/31/Yr 1 $ 10,200

Carlson’s rent expense for the year is calculated as follows:

Annual rent payments ($5,100 x 12 months) $ 61,200 Less one year recognition of deferred profit

($153,000 ÷ 3 years) (51,000)

Rent expense 12/31/Yr 1 $ 10,200

61

B

ECKER

G

EARTY

Accounting for Leases

Developments in Lease Accounting

(32)

I. July 2005 – SEC Staff Issued Report to Congress

A. Required under §401 (c) of Sarbanes-Oxley Act

B. The extent of Off-Balance Sheet Arrangements

C. Whether current financial statements

transparently reflect the economics of

off-balance sheet arrangements

D. Among many topics, Lease Accounting is

discussed

63

B

ECKER

G

EARTY

Improving Financial Transparency

Objectives-Oriented Standards

II. SEC recommends: Accounting standards that are

principle-based or "objectives-oriented":

Clearly state the accounting objective

Minimize the use of exceptions in a standard

Avoid use of percentage tests ("bright lines") to evade intent

Based on an approved and consistently applied conceptual

framework

Provide sufficient detail and structure to operationalize and

consistently apply

III. Rules-based standards:

"further a need and demand for voluminously detailed

implementation guidance creating complexity and uncertainty in

the standard."

(33)

B

G

Recommendations—Leases

IV. Reconsider Accounting for Leases

A. Repeatedly identified as an area to be reexamined by the

FASB

FASB.

B. Current "all or nothing" approach

not designed to reflect the wide variety of lease structures.

C. Transparency and consistency in reporting is not achieved.

D. A project on lease accounting would be consistent with several

of the key initiatives identified in achieving transparency in

reporting

reporting.

65

B

ECKER

G

EARTY

SEC Standard Setting

Recommendations—Leases

• Reconsider Accounting for Leases (continued)

E. Currently uses "bright-lines"

1. Increases potential for similar arrangements to be portrayed

differently

F. “Bright-line” tests facilitate structuring leases by form over

substance

1. Seek desired accounting treatment vs. principle-based

(34)

B

G

Recommendations—Leases

V. The lease project is complex and controversial

VI Leases have many different terms including:

VI. Leases have many different terms including:

contingent rents

optional extensions

penalty clauses

purchase options

B

ECKER

G

EARTY

Accounting for Leases

Developments in Lease Accounting

FASB Proposed ASU

(35)

Accounting for Leases

General Provisions of Lease

Accounting

Lessee Accounting

Lessor Accounting

Developments in Lease

Accounting

FASB Proposed ASU

Effects on Financial Reporting

Transition and Effective Date

69

B

ECKER

G

EARTY

Leases

General Provisions

I. Corporate Behavior – Why Enter into a Lease?

A. Avoid large initial cash outlays B. Features and options offered by lessor C. Financial flexibility

D. Off-balance sheet financing

E. Tax Advantages of capital lease – deductions for: 1. Depreciation

2. Interest Expense 3. Synthetic Leases

F. Start-up company may lack credit to borrow from bankp p y y G. Restaurants and Retailers:

1. No need for lease vs. buy decision (shopping malls) 2. Embedded in business model

(36)

II. Leases – 2010 Exposure Draft

A. On August 17, 2010, the ISAB and the FASB issued an exposure draft on Leases that proposes that a new standard on lease p p

accounting for lessees and that lessors would replace IAS 17 Leases, IFRC 4 Determining whether an arrangement contains a Lease, SIC-15 Operating Leases – Incentives, and SIC-27 Evaluating the

Substance of Transactions Involving the Legal Form of a Lease.

71

B

ECKER

G

EARTY

Leases

General Provision

III. Definition

A. Lease – a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration.

IV. Scope

A. The proposed standard will apply to all leases including subleases of right-to-use assets. Some arrangements that are specifically stated to not be within the scope of the exposure draft are: 1. Leases of intangible assets

2. Leases to explore for or use minerals, oil, natural gas, and other nonregenerative resources;

3. Leases of biological assets; and

4. Leases that meet the definition of onerous contracts prior to the date of the commencement of the lease.

5. Contracts that represent the purchase or sale of the underlying asset would be excluded from the scope. A contract constitutes a purchase or a sale if, at the end of the contract, the contract transfers both of the following:

a. Control of the underlying asset.

(37)

B

G

General Provision

IV. Scope

B. Includes:

1. Combined services and lease contracts (bifurcate lease) 2 Short term leases

2. Short term leases 3. Sale-leasebacks 4. Subleases

5. Leveraged leases (tentatively added at the July 13, 2011 meeting) C. Excludes immaterial items.

1. If material in the aggregate, consider a policy similar to PP&E capitalization policy.

B

ECKER

G

EARTY

Leases – 2010 Exposure Draft

• . _{KEY POINT}

DEFINITION OF A LEASE AS UPDATED BY THE BOARDS ON APRIL 12 2011 DEFINITION OF A LEASE AS UPDATED BY THE BOARDS ON APRIL 12, 2011

1. An entity would determine whether a contract contains a lease by assessing whether: a. The fulfillment of the contract depends on the use of a specified asset; and

b. The contract conveys the right to control the use of a specified asset for a period of time. 2. A contract would convey that right to control the use if the customer has the ability to direct the use, and receive the benefit from use, of a specified asset throughout the lease term. Guidance on separating the use of a specified asset from other services should be aligned with the boards’ tentative decisions in March 2011 relating to the separation of lease and non-lease components.

3. A “specified asset” refers to an asset that is explicitly or implicitly identifiable.

4. A physically distinct portion of a larger asset of which a customer has exclusive use is a specified asset. A capacity portion of a larger asset that is not physically distinct (for example, a capacity portion of a pipeline) is not a specified asset.

(38)

• . _{KEY POINT}

T i di B d d i i h th th ill b i l d d i

Topics pending Board decision on whether they will be included in scope: 1. Leases of internal-use software in accordance with Subtopic 350-40, Intangibles–Goodwill and Other Internal-Use Software, of the FASB Accounting

Standards Codification®.

2. Leases of inventory.

B

ECKER

G

EARTY

Leases

General Provision

V. Types of Leases

A. At the Feb 17th_{meeting t}_{he boards tentatively decided to identify a}

principle for identifying two types of leases for both lessees and lessors with different profit and loss effects as follows:

lessors, with different profit and loss effects, as follows:

1. A finance lease with a profit or loss recognition pattern

consistent with the proposals in the exposure draft .

2. An other-than-finance lease with a profit or loss recognition

pattern consistent with an operating lease under existing IFRSs/U.S. GAAP.

B. The boards tentatively decided to establish indicators to distinguish

a finance lease from an other-than-finance lease

C. The boards asked the staff to use these tentative decisions to perform targeted outreach to determine if stakeholders’ concerns about the profit and loss recognition pattern proposed in the exposure draft would be addressed.

(39)

B

G

General Provision

KEY POINT KEY POINT

Ninety (90%) percent of leased property F.V. <= P.V. of lease payments

Seventy-five (75%) percent of asset economic life is being committed in lease term

Operating Leases

B

ECKER

G

EARTY

Leases – 2010 Exposure Draft

• Note: A contract would normally meet both of these criteria when it transfers title of the underlying asset automatically at the end of the contract or includes a bargain purchase option in which it is reasonably certain, at the inception of the lease, that the lessee will exercise the option. But, all facts and circumstances should be considered, not just how the transaction is described in the contract.

KEY POINT

• The determination about whether a contract is a purchase or sale is made at the time of inception and is not subsequently reassessed.

T f f th titl f th t l i i ffi i t f tit t d id

• Transfer of the title of the asset alone is insufficient for an entity to decide that the transaction should be treated as a purchase or sale. For purchase or sale treatment, all but a trivial amount of the risks and benefits must also be transferred to the lessee.

(40)

Accounting for Leases

General Provisions of Lease

Accounting

Lessee Accounting

Lessor Accounting

Effects on Financial Reporting

Developments in Lease

Accounting

FASB Proposed ASU

Effects on Financial Reporting

Transition and Effective Date

75

B

ECKER

G

EARTY

Lessee Accounting - General

General

• A lessee’s rights and obligations

L

R

i

L

R

i

A lessee s rights and obligations under all leases, existing and new, would be recognized on the balance sheet.

• Removes the concept of capital leases and operating lease classifications.

• Straight-line rent expense will be replaced with amortization of the

Lessee Recognizes on

Balance Sheet

“Right

“Right--of

of--use” Asset

use” Asset

Liability to Liability to make Lease make Lease Payments Payments replaced with amortization of the

right-of-use asset and interest expense on the lease obligation

Payments Payments

Income Statement

Amortization Amortization Expense Expense Interest Expense Interest Expense

(41)

I. Initial Measurement

A. Initially recognize asset and liability at present value of lease payments to be made.y

B. The right-of-use asset is measured at the amount of the lease obligations plus any initial direct costs incurred.

1. Initial direct costs: Incremental costs directly attributable to negotiating and arranging the lease that would not have been incurred had the lease transaction not been made (commissions, legal fees) .

C. Present value uses the rate charged by lessor if available or lessee’s incremental borrowing rate.

1. Options (renewal and termination) in lease term

2. Contingent rentals, residual value guarantees and termination payments

77

B

ECKER

G

EARTY

Lessee Accounting – Initial Measurement

E.

Measurement Date

1. The initial measurement of the lease asset and liability as well as the date to determine the discount rate is to be the

commencement date of the lease rather than the inception date.

a) Inception of the lease is the earlier of the date of the lease

agreement and the date of commitment by the parties to the principal provisions of the lease.

b) Commencement of the lease term is the date from which

the lessee is entitled to exercise its right to use the leased asset.

2 The lease standard will also include guidance regarding: 2. The lease standard will also include guidance regarding:

a) The treatment of costs incurred between the inception

and commencement dates.

(42)

II. Lease Term

A. The lease term is now the same for lessee and lessor. It is defined as “the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset together with any options to the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease Lessees would be required to estimate the ultimate expected lease term and periodically reassess such estimate.”

B. The boards are to publish indicators of what defines a clear economic incentive.

C. The lease term will be reassessed by both parties “only when there is a

y p y

significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.”

78

B

ECKER

G

EARTY

Lessee Accounting – Lease Payments

III. Lease Payments

A. Concept of “minimum lease payments” is gone.

B “L t ” ill i l d t t l t l ti t d

B. “Lease payments” will include contractual payments plus estimated

contingent rentals.

1. Percentage rent.

2. Payments which depend on an index or rate – updated at the

July 20 meeting.

a. Initial measurement at date of commencement of lease.

b Reassess at the rate in effect at the end of each reporting

b. Reassess at the rate in effect at the end of each reporting

period.

c. Reflect any adjustment in the income statement if it applies

to the current period or to the value of the right-to-use asset if they relate to a future period.

(43)

IV. Lease Payments

3. Termination penalties – should be consistent with the

accounting for options to extend or terminate a lease accounting for options to extend or terminate a lease.

4. Guaranteed residual values – except for amount guaranteed

by unrelated third parties.

B

ECKER

G

EARTY

Lessee Accounting – Lease Payments

C. Contingent Rentals and Residual Value Guarantees

1. The exposure draft provides that contingent rentals and

residual value guarantees must be estimated and accounted es dua a ue gua a tees ust be est ated a d accou ted for using an expected outcome approach, based on a probability-weighted average for a reasonable number of potential outcomes. Contingent rentals based on interest rate changes would be estimated using spot rates.

a. Amounts payable under purchase options would be

excluded from the present value of lease payments calculation

(44)

b. When determining the present value of lease payments, the lessee must include contingent rents, residual value guarantees, and expected payments under termination penalties.

2. Initial Measurement: The underlying asset would be initially

KEY POINT

This represents a major change from the current lease accounting guidance under GAAP and IAS that call for the exclusion of contingent rents from the minimum lease payment calculation regardless of their probability of occurrence.

measured at the amount of the liability and adjusted for any prepaid lease rentals and any recoverable initial direct costs that the lessee incurs.

87

B

ECKER

G

EARTY

Lessee Accounting – Lease Payments

3. Timing of Recognition: The asset and liability would be

measured at the inception of the lease, but neither would be recognized until the date that the lessor makes the underlying asset available to the lessee for use.

KEY POINT

Under the exposure draft, contingent rents are required to be

estimated and included in the minimum lease payment calculation that is recorded at the commencement of the lease. The current guidance under GAAP calls for the exclusion of contingent rents from the minimum calculation regardless of their probability of occurrence. minimum calculation regardless of their probability of occurrence.

(45)

B

G

Measurement

V. Subsequent Measurement

A. Reassess the carrying amount of the lease payment obligation if there is a significant change

B. Accounting for Subsequent Measurement

1. Changes in lease terms: Adjust the right-of-use asset and the obligation to make rental payments

2. Changes to assumptions (contingent rents, GRV and termination penalties): Reflected in earnings if change arises from current or prior reporting periods

3. Changes related to future reporting periods: Adjust the right-of-use asset and the obligation to make rental payments

g p y

89

KEY POINT

No changes required for the incremental borrowing rate. The discount rate is locked in at initial measurement

B

ECKER

G

EARTY

Lessee Accounting – Financial Reporting

VI. Presentation

A. Balance Sheet

1. Right of use assets presented with PP&E but separate from non-1. Right of use assets presented with PP&E but separate from non

lease assets.

a. Amortization term of LHIs to coincide with lease term. 2. Lease obligation presented separate from other liabilities.

a. Could affect leverage covenants. B. Income Statement

1. Straight-line expense replaced with amortization and interest expense.

2. Foreign exchange differences related to the liability to make lease payments.

C. Statement of Cash Flows

(46)

D. Updated Requirements – Tentative Decisions as of July 21, 2011

1. Statement of Financial Position - Lessees may separately

present or disclose the values related to right of use assets p ese t o d sc ose t e a ues e ated to g t o use assets and liabilities.

a. If they do not separately present they must disclose in

what account the values are included.

b. The right of use assets should be presented as if they are

owned assets.

B

ECKER

G

EARTY

Lessee Accounting – Financial Reporting

2. Statement of Cash Flows:

a. Cash paid for leases payments is classified in financing

activities.

act t es

b. Classify or disclose the cash paid relating to interest using

U.S. GAAP or IFRS.

c.

Classify cash paid for variable lease payments not

included in the measurement of the liability to make

lease payments as operating activities. (FASB: 4 to 3;

IASB: 13 IASB to 2).

d.

Cash paid for short-term leases not included in the

lease liability value are treated as operating activities.

(47)

B

ECKER

G

EARTY

Lessee Accounting – Financial Reporting

(48)

VII. Disclosure

A. As of the July 21st_{meeting the boards tentatively decided on the}

following disclosure requirements: g q

1. A reconciliation of the opening and closing balance of right-of-use assets, disaggregated by class of underlying asset.

2. A reconciliation of the opening and closing balance of the liability to make lease payments – disaggregation is not required as it was in the ED.

3. Maturity analysis of the undiscounted cash flows that are included in the liability to make lease payments The maturity analysis

in the liability to make lease payments. The maturity analysis should show, at a minimum, the undiscounted cash flows to be paid in each of the first five years after the reporting date and a total of the amounts for the years thereafter. The analysis should reconcile to the liability to make lease payments.

90

B

ECKER

G

EARTY

Lessee Accounting – Financial Reporting

4. Information about the principal terms of any lease that has not yet commenced if the lease creates significant rights and obligations for the lessee.

5. Information required in paragraphs 73(a)(ii)-73(a)(iii) of the exposure draft (additional guidance pending on this item.) 6. All expenses relating to leases recognized in the reporting period,

in a tabular format, disaggregated into (a) amortization expense, (b) interest expense, (c) expense relating to variable lease payments not included in the liability to make lease payments, and (d) expense for those leases for which the short-term practical expedient is elected, to be followed by the principal and interest paid on the liability to make lease payments.

(49)

7. Qualitative information to indicate if circumstances or expectations about short-term lease arrangements are present that would result in a material change to the expense in the next reporting period as

compared with the current reporting period

B. Tentatively the boards agreed these items do not require disclosure: 1. The discount rate and range of discount rates used to calculate the

liabilities to make lease payments.

2. The fair value of the liability to make lease payments.

3. The existence and principal terms of any options to purchase the underlying asset or initial direct costs incurred on a lease

underlying asset, or initial direct costs incurred on a lease. 4. Information about arrangements that are no longer determined to

contain a lease.

90

B

ECKER

G

EARTY

Lessee Accounting – Financial Reporting

C. Future Commitments – The 2 Boards Differ on This Point.

1 FASB: lessee should disclose the future contractual

1. FASB: lessee should disclose the future contractual

commitments associated with services and other non-lease

components that are separated from a lease contract.

2. IASB: lessee is not required to disclose the future

contractual commitments associated with services and

other non-lease components that are separated from a

lease contract.

(50)

General Provisions of Lease

Accounting for Leases

Accounting

Lessee Accounting

Lessor Accounting

Effects on Financial Reporting

Transition and Effective Date

Developments in Lease

Accounting

FASB Proposed ASU

B

ECKER

G

EARTY

Lessor Accounting – General

I. Dual Model

A. Performance Obligation Approach

1. Lease receivable and liability to permit lessee’s use of assety p

2. Interest income and lease income as obligation is satisfied

B. De-recognition Approach

1. Used only if lessor does not retain significant risks and rewards

of ownership of leased asset

2. Up-front gain for de-recognition of leased asset

KEY POINT

(51)

II. Estimates for Both

A. Lease term, contingent payments, other assumptions similar to

lessee accounting. essee accou t g

B. Predict lessee’s behavior as to whether or not lessee is likely to

exercise the options built into the lease

B

ECKER

G

EARTY

Lessor Accounting – General

(52)

III. Performance Obligation Approach

KEY POINT

Ownership transfers at end of lease (upon final payment or required buyout)

A. When risks and benefits of underlying asset are retained, lessor

considers:

p ( p p y q y )

Written option for bargain purchase

Seventy-five (75%) percent of asset economic life is being committed in lease term

Operating Leases

1. Significance of contingent rentals during the expected lease

term based on performance or use of the underlying asset,

2. Options to extend or terminate the lease, or

3. Material non-distinct services provided in the lease contract.

98

B

ECKER

G

EARTY

Lessor Accounting – General

B. The underlying leased asset remains on the lessor’s balance

sheet.

C. The lessor recognizes:

C e esso ecog es

1. A lease receivable (right to receive rental payments from the

lessee).

2. A corresponding performance obligation / lease obligation.