a lawyer's guide to proposed lease accounting rules

A LAWYER’S GUIDE TO PROPOSEDLEASE ACCOUNTING RULES

Steve Quinlivan, Jill Radloff, Ethan Mark and David Jenson

A Professional Association

Law offices in Minneapolis, Mankato, St. Cloud, Bismarck, Washington, D.C.

www.leonard.com

TA B L E O F C O N T E N T S

Current Lease Accounting 1

Lease as Defined in the Proposed Standard 2

New Lease Categories 2

Lease Term 3

Initial Measurement of Lease Liability 3

Initial Measurement of Lease Payments 4

Initial Measurement of Right-of-Use Asset 4

Subsequent Amortization of Right-of-Use Asset and Treatment of Lease Liability 5

An Example of Initial Measurement 6

An Example of Subsequent Amortization of Right-of-Use Asset and Treatment of Lease Liability 7

Short-Term Leases 7

Transition 8-9

Modifications and Reassessments of Lease Terms 10

Federal Income Tax 11

Implications for Lawyers 11

A LAWYER’S GUIDE TO PROPOSED LEASE ACCOUNTING RULES

As part of an ongoing joint project between the Financial Accounting Standards Board

(FASB) and the International Accounting Standards Board (IASB) to comprehensively

reconsider lease accounting, on May 16, 2013, the FASB issued Proposed Accounting

Standards Update, Leases (Topic 842): a revision of the 2010 proposed Accounting Standards

Update, Leases (Topic 840) (the Update). The Update presents far-reaching revisions to

accounting for leases. Lawyers will need to understand the rules to advise clients on the

impact of the new rules on transactions, securities filings and debt covenants. For the sake

of simplicity, this guide focuses on accounting for lessees.

CURRENT LEASE ACCOUNTING

Currently, the main standard for lease accounting is found in the FASB’s Statement of Financial Accounting Standards No. 13,

released in November of 1976 and now known as Topic 840 under the FASB’s current accounting standards codification. Under

Topic 840, there are two types of leases: capital leases and operating leases. In a capital lease, the related leased asset is recorded

on the balance sheet as owned, and the present value of the lease payments are recorded on the balance sheet as a liability.

The theory is the terms and effect of the lease are so similar to a purchase of an asset and incurrence of debt that the accounting

ought to reflect the substance of a purchase/debt transaction.

In an operating lease, the assets do not appear on a balance sheet and the lease payments are not recorded as a liability. The lease

payments are recorded as an expense as the payments are made. This results in so-called “off balance sheet financing,” which has

been criticized by the Securities Exchange Commission (SEC) and a number of academic studies, leading the SEC in 2005 to call for

changes to the lease accounting rules to improve transparency.

The difference between an operating lease and a capital lease is determined by reference to several tests included in Topic 840.

The tests are very mechanical. A lease will be treated as a capital lease if any one of the following four criteria are met:

• The lease transfers ownership to lessee.

• The lease includes a bargain purchase option allowing the lessee to purchase the leased asset for a price that is significantly lower

than the property’s expected fair value at the date the option becomes exercisable.

• The lease term equals or exceeds 75% of the asset’s economic life.

• The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the asset.

This type of accounting has been criticized because of the mechanical nature of the tests and arbitrary line drawing.

1


LEASE AS DEFINED IN THE PROPOSED STANDARD

A lease is a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.

To determine whether a contract is or contains a lease requires an assessment of both of the following:

• Whether fulfillment of the contract depends on the use of an identified asset.

• Whether the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.

The analysis is not always straightforward as demonstrated by the following example. A customer enters into a contract for coffee

services for two years. The supplier puts 25 coffee machines in the customer’s premises that are tailored for use with coffee

consumables provided by the supplier. The coffee machines function only with the consumables provided by the supplier and have no

use to the customer other than when they are used in conjunction with those consumables. The supplier is responsible for repairs and

maintenance of the coffee machines. The customer’s staff operate the machines (that is, they select the coffee they wish to drink,

and the machines deliver the coffee).

The contract does not contain a lease. Although fulfillment of the contract may depend on the use of the machines, the contract does not

give the customer the right to control the use of those machines. That is because the customer does not have the ability to derive the benefits

from use of the machines on their own; the machines function only with the consumables that are supplied by the supplier. Accordingly, the

machines have no use or value to the customer without the consumables. The machines are incidental to the delivery of the coffee services.

The machines and the consumables combine to deliver coffee services to the customer over the two-year term of the contract.

NEW LEASE CATEGORIES

Under the proposed standard there will generally be two types of leases: Type A leases and Type B leases. The accounting for the

two types of leases will be roughly equivalent, and resemble the current accounting for capital leases.

If the underlying asset is not “property,” the lease is a Type A lease unless one of the following two criteria is met:

• The lease term is for an insignificant part of the total economic life of the underlying asset.

• The present value of the lease payments is insignificant relative to the fair value of the underlying asset at the commencement date.

If either criterion above is met, the lease is classified as a Type B lease.

“Property” is land or a building, or part of a building, or both.

If the underlying asset is property, the lease is a Type B lease unless one of the following two criteria is met:

• The lease term is for the major part of the remaining economic life of the underlying asset.

• The present value of the lease payments accounts for substantially all of the fair value of the underlying asset at the commencement date.

If either criterion above is met, the lease is classified as a Type A lease.

Notwithstanding the foregoing, a lease is classified as a Type A lease if a lessee has a significant economic incentive

to exercise an option to purchase the underlying asset.

22) LEASE AS DEFINED IN THE PROPOSED STANDARD / NEW LEASE CATEGORIES


LEASE TERM

The lease term is the noncancellable period of the lease, together with both of the following:

• Periods covered by an option to extend the lease if the lessee has a significant economic incentive to exercise that option.

• Periods covered by an option to terminate the lease if the lessee has a significant economic incentive not to exercise that option.

To determine whether the lessee has a significant economic incentive to exercise, or not to exercise, an option, the lessee

must consider all factors relevant to that assessment—contract-based, asset-based, market-based and entity-based factors.

The assessment will often require the consideration of a combination of those factors because they are interrelated.

Examples of factors to consider include, but are not limited to, any of the following:

• Contractual terms and conditions for the optional periods compared with current market rates, such as:

— The amount of lease payments in any optional period.

— The amount of any variable lease payments or other contingent payments, such as payments under

termination penalties and residual value guarantees.

— The terms and conditions of any options that are exercisable after initial optional periods (for example,

the terms and conditions of a purchase option that is exercisable at the end of an extension period

at a rate that is currently below market rates).

• Significant leasehold improvements that are expected to have significant economic value for the lessee when the option

to extend or terminate the lease or to purchase the asset becomes exercisable.

• Costs relating to the termination of the lease and the signing of a new lease, such as negotiation costs, relocation costs,

costs of identifying another underlying asset suitable for the lessee’s operations, or costs associated with returning the

underlying asset in a contractually specified condition or to a contractually specified location.

• The importance of that underlying asset to the lessee’s operations, considering, for example, whether the underlying asset

is a specialized asset and the location of the underlying asset.

INITIAL MEASUREMENT OF LEASE LIABILIT Y

The lease liability is initially measured at the present value of the lease payments discounted using the rate the lessor charges

the lessee. If that rate cannot be readily determined, the lessee uses its incremental borrowing rate.

Nonpublic entities are permitted to use a risk-free discount rate, determined using a period comparable to that of the lease term,

as an accounting policy election for all leases.

3


INITIAL MEASUREMENT OF LEASE PAYMENTS

The lease payments included in the lease liability shall consist of the following payments relating to the use of the underlying

asset during the lease term that are not yet paid:

• Fixed payments, less any lease incentives receivable from the lessor.

• Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate),

initially measured using the index or rate at the commencement date.

• Variable lease payments that are in-substance fixed payments (for instance, if annual payments of 2% of sales are required,

with a minimum of $100,000).

• Amounts expected to be payable by the lessee under residual value guarantees.

• The exercise price of a purchase option if the lessee has a significant economic incentive to exercise that option.

• Payments for penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

INITIAL MEASUREMENT OF RIGHT-OF -USE ASSET

The cost of the right-of-use asset shall consist of all of the following:

• The amount of the initial measurement of the lease liability.

• Any lease payments made to the lessor at or before the commencement date, less any lease incentives received from the lessor.

• Any initial direct costs incurred by the lessee.

4


SUBSEQUENT AMORTIZATION OF RIGHT-OF -USE ASSET AND TREATMENT

OF LEASE LIABILIT Y

Balance Sheet

Following the initial measurement, the lease liability is increased to reflect the unwinding of the discount on the lease liability

(i.e., the interest accrual on the recorded liability) and reduced to reflect the lease payments made during the period. The unwinding

of the discount on the lease liability in each period is calculated as the amount that produces a constant periodic discount rate on

the remaining balance of the liability.

The right-of-use asset is reduced by accumulated amortization.

Income Statement—Type A Leases

For Type A leases, a lessee will recognize an expense for the unwinding of the discount on the lease liability as interest

and the amortization of the right-of-use asset.

A lessee amortizes the Type A lease right-of-use asset on a straight-line basis, unless another systematic basis is more representative

of the pattern in which the lessee expects to consume the right-of-use asset’s future economic benefits. A lessee amortizes the

right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the

lease term. However, if the lessee has a significant economic incentive to exercise a purchase option, the lessee shall amortize the

right-of-use asset to the end of the useful life of the underlying asset.

Any variable lease payments not included in the lease liability are treated as expenses in the period during which

the payment obligation is incurred.

Income Statement—Type B Leases

For Type B leases, a single lease cost is recognized, combining the unwinding of the discount on the lease liability with the

amortization of the right-of-use asset. Amounts are calculated so that the remaining cost of the lease is allocated over the remaining

lease term on a straight-line basis. However, the periodic lease cost cannot be less than the periodic unwinding of the discount

on the lease liability.

Any variable lease payments not included in the lease liability are treated as expenses in the period during which the

payment obligation is incurred.

5


AN EXAMPLE OF INITIAL MEASUREMENT

Assume a lessee has an opening balance sheet as follows:

Assets Liabilities and Equity

Cash $100,000 Liabilities $0

Equity $100,000

The lessee enters into a ten-year lease of an asset. Lease payments are $50,000 per year during the term, payable at the beginning

of each year. The lessee incurs initial direct costs of $15,000.

The rate that the lessor charges the lessee is not readily determinable. The lessee’s incremental borrowing rate is 5.87% , which

reflects the fixed rate at which the lessee could borrow a similar amount for the same term, and with similar collateral

as in the lease.

At the commencement date, the lessee makes the lease payment for the first year, incurs initial direct costs and measures the lease

liability at the present value of the remaining nine payments of $50,000, discounted at the rate of 5.87% , which is $342,017.

The lessee’s balance sheet now looks like this:


Cash $ 35,000 (1) Lease Liability $342,017

Right-of-Use Asset $407,017 (2) Equity $100,000

Total Assets $442,017 Total Liabilities and Equity $442,017

(1) Original cash balance reduced by first-year lease payment of $50,000 and initial direct costs of $15,000.(2) Sum of lease liability of $342,017, first-year lease payment of $50,000 and initial direct costs of $15,000.

6


AN EXAMPLE OF SUBSEQUENT AMORTIZATION OF RIGHT-OF -USE ASSET

AND TREATMENT OF LEASE LIABILIT Y

Continuing with the previous example:

Type A Lease

Assume the lessee expects to consume the right-of-use asset’s future economic benefits evenly over the lease term.

The lessee therefore amortizes the right-of-use asset on a straight-line basis.

The lessee would recognize interest expense related to the lease liability of $20,076 (5.87% x $342,017),

which increases the lease liability.

The lessee would recognize amortization expense on the right-of-use asset of $40,702 ($407,017 ÷ 10 years),

which would reduce the right-of-use asset by being recorded as accumulated depreciation.

At the beginning of the second year of the lease, the cash payment of $50,000 would reduce the lease liability.

Type B Lease

The lessee would calculate the cost of the lease as the sum of $500,000 (sum of the lease payments for the lease term)

and $15,000 (initial direct costs incurred by the lessee). The annual lease expense to be recognized would therefore be $51,500

($515,000 ÷ 10 years).

The lease liability would increase by $20,076 (5.87% x $342,017).

The lessee would reduce the right-of-use asset by recording $31,424 ($51,500 (total expenses) - $20,076 (change in lease liability))

as accumulated depreciation.

At the beginning of the second year of the lease, the cash payment of $50,000 would reduce the lease liability.

SHORT-TERM LEASES

A lessee may elect, as an accounting policy, not to apply the new lease accounting requirements to short-term leases. A short-term

lease is defined as a lease that, at the commencement date, has a maximum possible term under the contract, including any options

to extend, of 12 months or less. Any lease that contains a purchase option is not a short-term lease.

If the election is made, a lessee recognizes the lease payments in profit or loss on a straight-line basis over the lease term.

The accounting policy election for short-term leases is made by class of underlying asset to which the right-of-use relates.

7


TRANSITION

This section describes adjustments made to financial statements for existing leases if the proposed rules become effective.

Equity

Lessees will adjust equity at the beginning of the earliest comparative period presented, and the other comparative amounts

disclosed for each prior period presented, as if the new lease accounting rules had always been applied.

Leases Previously Classified as Operating Leases

At the beginning of the earliest comparative period presented, a lessee will recognize the following:

• A lease liability, measured at the present value of the remaining lease payments, discounted using the lessee’s incremental

borrowing rate at the effective date.

— Nonpublic entities are permitted to use a risk-free discount rate determined using a period comparable to that

of the remaining lease term as an accounting policy election for all leases.

— For each Type A lease, a right-of-use asset measured as the applicable proportion of the lease liability

at the commencement date, which can be imputed from the lease liability. The applicable proportion is the

remaining lease term at the beginning of the earliest comparative period presented relative to the total

lease term. A lessee shall adjust the right-of-use asset recognized by the amount of any previously

recognized prepaid or accrued lease payments.

— For each Type B lease, a right-of-use asset measured at an amount that equals the lease liability. A lessee shall adjust

the right-of-use asset recognized by the amount of any previously recognized prepaid or accrued lease payments.

• A lessee can apply a single discount rate to a portfolio of leases with reasonably similar characteristics (for example, a similar

remaining lease term for a similar class of underlying asset in a similar economic environment). The lessee needs to consider its

total financial liabilities when calculating the discount rate for each portfolio of leases.

Leases Previously Classified as Capital Leases

For leases that were classified as capital leases, the carrying amount of the right-of-use asset and the lease liability at the beginning

of the earliest comparative period presented is the carrying amount of the lease asset and lease liability immediately before that

date in accordance with the prior accounting rules.

Example of Transition From an Operating Lease to a Type A Lease

Assume a lessee has an opening balance sheet as follows:


Cash $101,200 Accrued Lease Payment $ 1,200

Equity $100,000


8


TRANSITION — CONTINUED

The lessee had previously entered in an operating lease. Since it was an operating lease, nothing is reflected on the lessee’s

balance sheet other than accrued lease payments.

The operating lease is a five-year lease of a vehicle entered into on January 1, 20X1, with annual lease payments payable at the

end of each year. On January 1, 20X2 (and before transition adjustments), the lessee has an accrued rent liability of $1,200 for

the lease, reflecting rent that was previously recognized as an expense but was not paid at that date. Four lease payments remain:

one payment of $31,000 followed by three payments of $33,000.

At the effective date, the lessee’s incremental borrowing rate is 6%. The lessee classifies the lease of the vehicle

as a Type A lease.

On January 1, 20X2, the lessee measures the lease liability at $112,462, the present value of one payment of $31,000 and

three payments of $33,000, discounted at 6%.

The lessee determines the carrying amount of the right-of-use asset at the date of initial application in two steps: the lessee

estimates the commencement-date lease liability and it calculates the right-of-use asset (before adjustment for accrued rent)

on the basis of the proportion of the commencement-date lease liability that relates to the remaining lease term.

The lessee estimates the commencement-date lease liability on the basis of the average remaining lease payments. The average

lease payment for the remaining four years of the lease is $32,500. The lessee estimates the commencement-date lease liability

at $136,902 (the present value of a $32,500 annuity for the five-year total term of the lease). Thus, the lessee measures the

right-of-use asset before adjustment for accrued rent at $109,522 ($136,902 × 4 remaining years ÷ 5-year lease term).

The difference between the right-of-use asset and the lease liability on January 1, 20X2, is an adjustment to opening retained

earnings at that date.

Accrued rent of $1,200 is eliminated and the right-of-use asset is reduced by the same amount.

As a result, the lessee’s balance sheet will look like this:


Cash $101,200 Lease liability $112,462

Right-of-Use Asset $108,322 (1) Equity $97,060(2)


(1) Equal to right-of-use asset of $109,522 before adjustment for accrued rent less accrued rent of $1,200.(2) Opening equity ($100,000) is reduced by the difference between the right-of-use asset before the adjustment for accrued rent

($109,522) and the lease liability ($112,462).

9


MODIFICATIONS AND REASSESSMENTS OF LEASE TERMS

Modifications

If the contractual terms and conditions of a lease are modified, resulting in a substantive change to the existing lease, an entity

accounts for the modified contract as a new contract at the date that the modifications become effective. An entity recognizes any

difference between the carrying amounts of the assets and liabilities arising from the previous lease and those arising from any new

lease in profit or loss. Examples of a substantive change arising from a contract modification include changes to the contractual

lease term or to the amount of contractual lease payments that were not part of the original terms and conditions of the lease.

Reassessments

A lessee shall reassess the lease payments if there is a change in any of the following:

• The lease term, in certain prescribed circumstances. These include factors such as the lessee no longer having a significant

incentive either to exercise an option to extend the lease or not to exercise an option to terminate a lease. Likewise, exercising

an option to extend a lease when it was previously determined that there was no economic incentive to do so would result in

reassessment. Market-based factors do not trigger reassessments.

• Relevant factors that result in the lessee having or no longer having a significant economic incentive to exercise an option

to purchase the underlying asset, in certain prescribed circumstances.

• The amounts expected to be payable under residual value guarantees.

• An index or a rate used to determine lease payments during the reporting period.

The discount rate must also be reassessed in many of the above circumstances.

An example is helpful. In the sixth year of the lease, the lessee makes significant leasehold improvements. Those improvements

are expected to have significant economic value for the lessee at the end of the original noncancellable period of ten years. That

is because the improvements result in the underlying asset having greater utility to the lessee than alternative assets that could be

leased for a similar amount. Consequently, at the end of Year 6, the lessee concludes that it has a significant economic incentive

to exercise the option to extend the lease. Here the lessee will be required to remeasure the lease liability and make a corresponding

change to the right-of use asset.

10


FEDERAL INCOME TAX

For U.S. federal income tax purposes, leases are classified as either a true lease, which is akin to an operating lease, and a financing

lease, which is akin to a capital lease. The distinction is based on tax common law, including U.S. Supreme Court decisions, and

relates more generally to the concept of tax ownership. We think it is likely the current tax treatment will remain unchanged as

modification would turn taxpayers’ expectations on their head. For instance, if tax were to follow the proposed FASB announcement,

all lessees of operating leases would be entitled to depreciate the leased property (instead of the lessor) as owner of the property.

IMPLICATIONS FOR LAWYERS

The proposed standard gives rise to a number of implications for lawyers. Most significantly, the transition adjustment which

may reduce equity and ongoing accounting could potentially impact compliance with debt covenants. Most sophisticated

credit arrangements in recent years likely permit application of “static GAAP” for covenant compliance in anticipation of the

change. However, utilization of these provisions will most likely require maintenance of records under the old accounting rules

to determine covenant compliance.

Other arrangements that are based on net income, EBITDA and the like, will be impacted as well and should be examined.

Examples include compensation arrangements tied to financial performance measures and earn-out arrangements

in M&A transactions.

Public companies wishing to make transition “before” and “after” comparisons need to be cognizant of Regulation G and Item

10(e) of Regulation S-K promulgated by the SEC. Those rules impose prohibitions and limitations on the use of non-GAAP

financial measures when such measures are included in SEC filings and other public disclosures.

Public companies may also have to revise prior year MD&A’s included in new SEC filings since the proposed rules require the

earliest comparative period to be adjusted to reflect application of the new standard.

It is not always obvious what is a lease. Lawyers should be cognizant of that fact and seek accounting help where necessary.

Purchase, extension and termination options can have a significant impact on lease accounting. Those provisions should be

reviewed while the lease is being negotiated to make sure they are not undesirable.

Lawyers should also be aware that renegotiating lease terms can also have an accounting impact. In addition,

as per the above examples, events seemingly unrelated to the lease contract can cause reassessment of the lease,

such as leasehold improvements.

11

a lawyer's guide to proposed lease accounting rules

Documents

treatment of lease liability

new lease categories

reassessments of lease

lease transfers ownership

leases topic

capital leases

operating leases

use asset