lease accounting - scacpa.org · lease accounting learning objectives on february 25, 2016, the...

Lease AccountingDEVELOPED AND PRESENTED BY SAMUEL MONASTRA, CPA

Lease Accounting

Learning Objectives

On February 25, 2016, the FASB issued its highly anticipated leasing standard for both lessees

and lessors. Under its core principle, a lessee will recognize lease assets and liabilities on the

balance sheet for all arrangements with terms longer than 12 months. Lessor accounting

remains largely consistent with existing U.S. GAAP. The new standard takes effect in 2019 for

public companies and 2020 for all other companies

The objective of this course is to provide an overview of new guidance regarding topics

of particular interest to professionals responsible for preparation of the financial statements.

Companies will be implementing the new standards for Lease Accounting in 2019 and 2020. It

is imperative that financial reporting professionals begin to learn the basics of this new

standard.

Lease Accounting

Learning Objectives:

This course will enable you to:

1) Understand and identify leases in contracts

2) Understand the difference between an operating lease and a finance lease

3) Understand the criteria for accounting for a finance lease

4) Begin the process to implement the new lease accounting standard

5) Have an enhanced understanding of best practices to implement the new standard

6) Understand the right-of-use model in lease accounting

7) Prepare the financial statement disclosures for leases

Lease Accounting

Samuel Monastra, CPA Mr. Monastra began his career as a client facing audit professional, working with publicly held companies and large privately held companies. Industry focus includes: Healthcare, Life Sciences & Technology, and Manufacturing, & Distribution. Sam has held executive level positions with Big “4” and Top 10 International Accounting Firms. Sam served as a member of the Editorial Board of the Pennsylvania CPA Journal and is a frequent speaker for a variety of national organizations including State CPA Societies, the Institute of Internal Auditors, and the Institute of Management Accountants.

Leases ASC 842

Why did the FASB issue Leases ASC 842?

The FASB issued the update to increase transparency and comparability among organizations by

recognizing lease assets and lease liabilities on the balance sheet and disclosing key information

about leasing arrangements. This update, along with IFRS 16, Leases are the results of the FASB’s and

the International Accounting Standards Board’s (IASB’s) efforts to meet that objective and improve

financial reporting.

The core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise

from leases. All leases create an asset and a liability for the lessee in accordance with FASB Concepts

Statement No. 6, Elements of Financial Statements, and therefore, recognition of those lease assets

and lease liabilities represents an improvement over previous GAAP, which did not require lease

assets and lease liabilities to be recognized for most leases.

Leases ASC 842

Why did the FASB issue Leases ASC 842?

Leasing is utilized by many entities. It is a means of gaining access to assets, of obtaining financing,

and/or reducing an entity’s exposure to the full risks of asset ownership. The prevalence of leasing,

therefore, means that it is important that users of financial statements have a complete and

understandable picture of an entity’s leasing activities. Previous leases accounting was criticized for

failing to meet the needs of users of financial statements because it did not always provide a faithful

representation of leasing transactions. In particular, it did not require lessees to recognize assets and

liabilities arising from operating leases on the balance sheet. As a result, there had been long-

standing requests from many users of financial statements and others to change the accounting

requirements so that lessees would be required to recognize the rights and obligations resulting from

leases as assets and liabilities.

Leases ASC 842

Getting started

Identifying a lease

At inception of a contract, an entity shall determine whether that contract is or contains a lease. A

contract is or contains a lease if the contract conveys the right to control the use (RIGHT-OF-USE) of

identified property, plant, or equipment (an identified asset) for a period of time in exchange for

consideration.

Practice note: pre-ASC 842, there was not a focus to identify leases in a contract. The effect on the

Income Statement was the same whether the contract payments were considered lease expense or a

operating contract expense.

Leases ASC 842

Getting started

Identifying a lease

To determine whether a contract conveys the right to control the use of an identified asset for a

period of time an entity shall possess whether, throughout the period of use, the customer has

both of the following:

a) The right to obtain substantially all of the economic benefits from use of the identified asset

b) The right to direct the use of the identified asset

Practice note: many lease contracts involve property, plant, equipment (including real estate).

These are most common in practice and tend to be easily identified.

Leases ASC 842

Getting started

Identifying a lease

It is ok to substitute

Even if an asset is specified, a customer does not have the right to use an identified asset if the

supplier has the substantive right to substitute the asset throughout the period of use.

Practice note: A practical example could be that the landlord provided an agreed-upon location in

the mall for a franchise fast food restaurant. During the term of the lease, the landlord provides for

your restaurant a location within the mall of equal or greater to the previous location (due to storm

damage to the mall causing limited access to your restaurant).

Leases ASC 842

Getting started

Identifying a lease

Agreed upon monthly rent, plus a percentage of sales is ok

If the contract requires a customer to pay the supplier a portion of the cash flows derived from the

use of an asset (rented space) as consideration, those cash flows paid as consideration shall be

considered as part of the economic benefits that the customer obtains from the use of the asset.

For example:

If the lessee of a franchise restaurant is required to pay the landlord a percentage of sales from use

of the retail space as consideration for that use, that requirement does not prevent the lessee from

having the right to obtain substantially all of the economic benefits from the use of the retail

space. That is because the cash flows arising from those sales are considered to be economic

benefits that the lessee obtains from use of the retail space, a portion of which it then pays to the

landlord as consideration for the right to use that space.

Leases ASC 842

Getting started

Identifying a lease

The customer has the right to direct the use of the identified asset

The customer has the right to direct how and for what purpose the asset is used throughout the

period of use.

You can separate components of a contract and there may be a lease inside the contract. In the

implementation of the new lease accounting standard, this will be a major area of focus for the

team. (imbedded leases)

Leases ASC 842

The FASB reached the conclusion that the economics of leases can vary for a lessee and that those economics should be reflected in the financial statements, therefore, Topic 842 retains a distinction between finance leases and operating leases. The classification criteria for distinguishing between finance leases and operating leases are similar to the classification criteria for distinguishing between capital leases and operating leases in the previous guidance.

At inception, lessees must classify all leases as either finance or operating. Balance sheet recognition of finance and operating leases is similar, but the pattern of expense recognition in the income statement will differ depending on the lease classification. A finance lease is a lease arrangement in which the lessee effectively obtains control of the underlying asset. In an operating lease, the lessee does not effectively obtain control of the underlying asset.

DefinitionLease inception: The date on which a lessor makes an underlying asset available for use by a lessee.

Leases ASC 842

If any of the following criteria is met, the LESSEE account for the lease as a finance lease:

1) The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

2) The lease grants the lessee an option to purchase the underlying asset that the lessee is

reasonably certain to exercise (bargain purchase option; $1 to buy the asset at end of lease)

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

4) The sum of the present value of the lease payments and the present value of any residual value

guaranteed by the lessee amounts to substantially all of the fair value of the underlying asset.

5) The underlying asset is of such a specialized nature that it is expected to have no alternative use

to the lessor at the end of the lease term

Leases ASC 842

LESSEE accounting for finance and operating leases:

Finance Lease

1) Recognize right of use asset and lease liability on the balance sheet, initially measured at the

present value of the lease payments. Include initial direct costs in the initial measurement of the

right of use asset.

2) Recognize interest on lease liability separately from amortization of the right of use asset on

the income statement.

3) Classify repayments of the principal portion of the lease liability within financing activities and

payments of interest on the lease liability and variable lease payments within operating activities

on the statement of cash flows.

Leases ASC 842

LESSEE accounting for finance and operating leases:

Operating Lease

1) Recognize right of use asset and lease liability on the balance sheet, initially measured at the

present value of the lease payments. Include initial direct costs in the initial measurement of the

right of use asset.

2) Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease

term, generally on a straight-line basis on the income statement.

3) Classify all cash payments for leases within operating activities.

After inception, the lessee’s right of use asset will be assessed for impairment under ASC 360 for

both finance and operating leases

Leases ASC 842

LESSOR accounting model

The new standard requires a lessor to classify leases as either sales-type, direct financing or

operating lease, similar to existing U.S. GAAP. Classification depends on the same five criteria used

by lessees plus certain additional factors. Based upon the evaluation:

1) A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the

underlying asset, to the lessee.

2) If risks and rewards are conveyed without the transfer of control, the lease is treated as direct

financing.

3) If lessor does not convey risks and rewards or control, an operating lease results.

Leases ASC 842

Leases ASC 842 is in effect in 2019 for public companies and in 2020 for all other companies

You want to take a step-by-step approach to implement the new standard.

Implementation

Be sure to secure senior management buy in.

1) Implementation of the lease standard begins by building a team or committee to perform the

work. The team members will be from the following departments: accounting & finance, IT,

procurement, treasury, tax. Also, you will need to include the legal group and individuals

responsible for real estate and contract management.

2) Prepare your team to be ready to examine contracts, in great detail. Also, a review of general

ledger transactions and recurring periodic (monthly, quarterly) payments to a vendor, may discover

unrecorded leases. This will be a detail-oriented, time-consuming process.

Leases ASC 842


3) Determine the scope. You will need to build an inventory of all lease contracts and determine materiality, regarding which leases are to be included in the implementation of the new standard and which leases are under the materiality scope.4) After determining which leases are in scope, evaluate whether you can apply a portfolio approach if there are multiple leases of the same type and substance. This may be a practical approach for items such as a fleet of vehicles or leased IT equipment provided to employees

Leases ASC 842


5) Separate the lease and non-lease portions of the payments. A single lease payment may include non-lease related items : common area maintenance, taxes, insurance.

Leases ASC 842


Items to include in your evaluation and scoping of the inventory of leases:A) Related Party Leases: your company may not have formal leases with related parties. It is necessary to have formal leases drawn up between related parties.B) Taxes: the new lease standard may affect calculations of state apportionments in certain states that use property factors to apportion taxable business income.C) Lease renewals: the new lease standard requires renewals be included in determining the lease term for accounting purposes, if it is reasonably certain that the lessee will renew the lease.

Leases ASC 842


Items to include in your evaluation and scoping of the inventory of leases:D) Debt ratios: adding new liabilities onto the balance sheet may affect debt ratios in the company lending covenants.E) Below-market rent leases: A non-profit organization may have entered into a lease which is provided at a discount. The new standard requires non-profit organizations to separate the contribution from the exchange in accounting for the lease.

Leases ASC 842


A very important consideration

As companies are gathering the data to implement the new standard, it is important to consider the IT system in use to handle the accounting for leases. Unless you have a very small number of leases, the company may want to consider the use of a lease module within the accounting system.

Leases ASC 842

Implementation Guidance

If the answer to ALL of the following questions is YES; the contract is a lease or contains a lease. 1) Is there an identified asset?2) Does the customer have the right to obtain substantially all of the economic benefits from the use of the asset throughout the period of use?3) Does the customer or supplier have the right to direct how and for what purpose the identified asset is used throughout the period of use?4) Does the customer have the right to operate the asset throughout the period of use without the supplier having the right to change those operating instructions?5) Did the customer design the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use?

Leases ASC 842

Examples to illustrate Identifying a Lease

Example #1Customer enters into a 15-year contract with a utilities company for the right to use 3

specified, physically distinct red fibers within a larger cable connecting Los Angeles to Philadelphia. Customer makes the decisions about the use of the fibers by connecting each end of the fibers to its electronic equipment (Customer decides what data and how much data the fibers will transport). If fibers are damaged, supplier is responsible for repairs and maintenance. Supplier owns extra fibers but can substitute those for Customer’s fibers only for reasons of repairs, maintenance, or malfunction (and is obliged to substitute the fibers in these cases).

The contract has a lease of red fibers. Customer has the right to use the 3 red fibers for 15 years.

Leases ASC 842


Example #1 (continued)There are 3 identified fibers. The fibers are explicitly identified in the contract and are

physically distinct from the other fibers within the cable. Supplier cannot substitute the fibers other than for reasons or repairs, maintenance, or malfunction.

Customer has the right to control the use of the fibers throughout the 15-year period of use, to obtain substantially all of the economic benefits from the use of the fibers over the 15-year period, has exclusive use of the fibers throughout the period of use, and has the right to direct the use of the fibers throughout the 15-year period.

Leases ASC 842


Example #2Customer enters into a contract with a property owner to use a retail unit for a 5-year period.

The identified retail unit is part of a larger retail space with many units. Customer is granted the right to use the identified retail unit (Unit 125). The property owner

can require Customer to relocate to another retail unit. If that occurs, the property owner is required to provide Customer with a retail unit of similar quality and specifications to Unit 125, and to pay for Customer’s relocation costs.

The contract requires Customer to use Unit 125 to operate its well-known store brand to sell goods during the hours that the larger retail space is open. Customer makes all the decisions about the use of the retail unit during the period of use. Customers decides the mix of goods sold, pricing, and inventory levels. Customer controls the physical access to the unit for the 5-year period.

Leases ASC 842


Example #2 (continued)The contract requires Customer to make fixed payments as well as variable payments based

upon a percentage of sales from Retail Unit 125.The property owner provides cleaning and security services as part of the contract. The

property owner also provides advertising services.

The contract has a lease of retail space. Customer has the right to use Retail Unit 125 for 5 years.

Leases ASC 842


Example #2 (continued)Retail Unit 125 is an identified asset. It is explicitly specified in the contract.

Customer has the right to control the use of Retail Unit 125 throughout the 5-year period of use.

Within the scope of its right of use defined in the contract, Customer makes the relevant decisions about how and for what purpose Retail Unit 125 is being used by being able to decide the mix of products sold in the retail unit and the sale price for those products.

Leases ASC 842


Example #3 Allocation of Consideration to Lease and Non-lease Components of a Contract

— Allocation of Consideration in the Contract Lessor leases a bulldozer, a truck, and a crane to Lessee to be used in Lessee’s construction

operations for three years. Lessor also agrees to maintain each piece of equipment throughout the lease term. The total consideration in the contract is $600,000, payable in $200,000 annual installments.Lessee and Lessor both conclude that the leases of the bulldozer, .the truck, and the crane are each separate lease components. Lessee and Lessor will account for the non-lease maintenance services components separate from the three separate lease components. Lessor further concludes that its maintenance services for each piece of leased equipment are distinct and therefore separate performance obligations, resulting in the conclusion that there are three separate lease components and three separate non-lease components (that is, three maintenance service performance obligations)

Leases ASC 842


Example #3 Allocation of Consideration to Lease and Non-lease Components of a Contract

— Allocation of Consideration in the Contract Lessee first allocates the consideration in the contract ($600,000) to the lease and non-lease

components on a relative basis, utilizing the observable standalone prices. Subtopic 842-20, treating the allocated consideration as the lease payments for each lease component.

The allocation of the consideration to the lease and non-lease components is as follows.

Lease Maintenance Bulldozer $ 171,429 $ 42,857Truck 102,857 17,143 Crane 205,714 60,000

$ 480,000 $ 120,000

Leases ASC 842

Examples to illustrate Determining the Lease Term

Example #1 Assume that Entity P enters into a lease for equipment that includes a noncancelable term of

four years and a two-year fixed-price renewal option with future lease payments that are intended to approximate market rates at lease inception. There are no termination penalties or other factors indicating that Entity P is reasonably certain to exercise the renewal option.

Analysis: At the lease commencement date, the lease term is four years.

Example #2Assume that Entity Q enters into a lease for a building that includes a noncancelable term of

four years and a two-year, fixed-price renewal option with future lease payments that are intended to approximate market rates at lease inception. Before it takes possession of the building, Entity Q pays for leasehold improvements. The leasehold improvements are expected to have significant value at the end of four years, and that value can only be realized through continued occupancy of the leased property.

Analysis: At lease commencement, Entity Q determines that it is reasonably certain to exercise the renewal option because it would suffer a significant economic penalty if it abandoned the leasehold improvements at the end of the initial noncancelable period. At lease commencement, Entity Q concludes that the lease term is six years.

Leases ASC 842

Financial Statement Disclosures

The overall objective of the disclosure requirements is to enable users of the

financial statements to understand the “…amount, timing, and uncertainty of cash

flows arising from leases.” A lessee will need to disclose quantitative and

qualitative information about its leases, the related significant judgments made in

measuring leases and the amounts recognized in the financial statements.

Leases ASC 842


Include the following information in the disclosures:

1) A general description of the leases.2) The basis and terms and conditions on which variable lease payments are determined.3) The existence and terms and conditions of options to extend or terminate the lease. A lessee should provide narrative disclosure about the options that are recognized as part of its right-of-use assets and lease liabilities and those that are not.

4) The existence and terms and conditions of residual value guarantees provided by the lessee.

5) The restrictions or covenants imposed by leases (for example, those relating to dividends or incurring additional financial obligations).

Leases ASC 842


Include the following information in the disclosures:

1) The allocation of the consideration in a contract between lease and non-lease components.2) Operating lease cost3) If relevant, a lessee will separately disclose its lease transactions with related parties

Leases ASC 842

Leases ASC 842

Financial Statement DisclosuresFor each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions: a. Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities. b. Operating lease cost.c. Short-term lease cost, excluding expenses relating to leases with a lease term of one month or

lessd. Variable lease coste. Sublease income, disclosed on a gross basis, separate from the finance or operating lease expense. f. Net gain or loss recognized from sale and leaseback transactionsg. Amounts segregated between those for finance and operating leases

Leases ASC 842

SAMPLE FINANCIAL STATEMENT DISCLOSURE #1

Year Ending December 31, 20X2 20X1

Lease cost Finance lease cost: $ XXX $ XXX

Amortization of right-of-use assets XXX XXXInterest on lease liabilities XXX XXX

Operating lease cost XXX XXXShort-term lease cost XXX XXXVariable lease cost XXX XXXSublease income (XXX) (XXX) Total lease cost $ XXX $ XXX

Leases ASC 842

SAMPLE FINANCIAL STATEMENT DISCLOSURE #1

Year Ending December 31, 20X2 20X1

Other information

(Gains) and losses on sale and leaseback transactions, net $ (XXX) $ XXX Cash paid for amounts included in the measurement of lease liabilities XXX XXXOperating cash flows from finance leases XXX XXXOperating cash flows from operating leases XXX XXXFinancing cash flows from finance leases XXX XXXRight-of-use assets obtained in exchange for new finance lease liabilities XXX XXXRight-of-use assets obtained in exchange for new operating lease liabilities XXX XXXWeighted-average remaining lease term — finance leases XX years XX years Weighted-average remaining lease term — operating leases XX years XX years Weighted-average discount rate — finance leases X.X% X.X% Weighted-average discount rate — operating leases X.X% X.X% 842

Leases ASC 842

SAMPLE FINANCIAL STATEMENT DISCLOSURE #2Leases

The Company leases store locations, distribution centers, the corporate headquarters and equipment used in its operations and evaluates and classifies its leases as operating or capital leases for financial reporting purposes. Any assets held under a capital lease are included in property and equipment, net. As of February 3, 2018 and January 28, 2017, the Company had no material capital leases.

Leases ASC 842

SAMPLE FINANCIAL STATEMENT DISCLOSURELeases

Operating lease expense is recorded on a straight-line basis over the lease term. At the inception of a lease, the Company determines the lease term, which includes periods under the exercise of renewal options that are reasonably assured. Renewal options are exercised at the Company's sole discretion. In September 2016, the Company signed a 15 year lease for a new corporate headquarters location in Philadelphia, Pennsylvania. The Company currently occupies approximately 117,000 square feet of office space and will expand into approximately 50,000 square feet of additional office space by no later than 2020. The lease agreement expires in early 2033 with three successive options to renew for additional term up to approximately fifteen years. The distribution center in Oxford, Mississippi is leased under a lease agreement expiring in 2022 with options to renew for three successive five-year periods. The distribution center in Princeton, New Jersey is leased under a lease agreement expiring in 2025 with options to renew for three successive five-year periods. Generally, the Company’s store leases have expected lease terms of ten years, which are comprised of an initial term of ten years or an initial term of five years and one assumed five-year extension, resulting in a ten-year life. The expected lease term is used to determine whether a lease is capital or operating and to calculate straight-line rent expense.

Leases ASC 842


Substantially all of the Company's leases include options that allow the Company to renew or extend the lease term beyond the initial lease period, subject to terms and conditions agreed upon at the inception of the lease. Such terms and conditions include rental rates agreed upon at the inception of the lease that could represent below or above market rental rates later in the life of the lease, depending upon market conditions at the time of such renewal or extension. In addition, the Company's leases may include early termination options.

Leases ASC 842


Deferred Rent and Other Certain of the Company’s operating leases contain either rent holidays and/or predetermined fixed escalations of minimum rental payments during the original and/or extended lease terms. For these leases, the Company recognizes the related rent expense on a straight-line basis over the life of the lease and records the difference between the amounts charged to operations and amounts paid as deferred rent. The life of the lease is the initial term plus assumed extensions. The Company also receives certain lease incentives in conjunction with entering into operating leases. These lease incentives are recorded as deferred rent at the beginning of the lease term and recognized as a reduction of rent expense over the lease term. In addition, certain of the Company’s leases contain future contingent increases in rents. Such increases in rent expense are recorded in the period in which such contingent increases to the rents take place.

Leases ASC 842


The following table summarizes the Company's deferred rent and other long-term liabilities balances (in thousands):

February 3, 2018 January 28, 2017 Current: Deferred rent $ 5,707 $ 5,519 Total current liabilities $ 5,707 $ 5,519

Long-term: Deferred rent $ 72,547 $ 52,372 Other 143 196 Total long-term liabilities $ 72,690 $ 52,568

Leases ASC 842


Recently Issued Accounting Standards

In February 2016, the FASB issued ASU 2016-02, “Leases.” ASU 2016-02 requires that lease arrangements longer than 12 months result in an entity recognizing an asset and a liability. The updated guidance is effective for interim and annual periods beginning after December 15, 2018, and early adoption is permitted. The standard requires use of the modified retrospective transition approach. While the Company is currently evaluating this standard, given the significant amount of leases the Company is party to, the Company expects this standard will have a significant impact on the Company's consolidated financial statements from the recognition of right of use assets and related liabilities. The Company plans to adopt this standard in the first quarter of fiscal 2019, coinciding with the standard’s effective date.

Leases ASC 842


Commitments and Contingencies

Commitments

Leases The Company leases property and equipment under non-cancelable operating leases. Certain retail store lease agreements provide for contingent rental payments if the store’s net sales exceed stated levels (percentage rents) and/or contain escalation clauses, which provide for increases in base rental payments for increases in future operating costs. Many of the Company’s leases provide for one or more renewal options for periods of five years. As of February 3, 2018, the Company’s operating lease agreements, including assumed extensions, which are generally those that take the lease to a ten-year term, expire through fiscal 2033.

Leases ASC 842


The Company’s minimum rental commitments under operating lease agreements, including assumed extensions, as of February 3, 2018, are as follows (in thousands):

Fiscal Year Retail stores Corporate office, Totaldistribution centers

and other2018 $ 109,199 $ 8,372 $ 117,571 2019 113,168 9,469 122,637 2020 110,162 11,277 121,439 2021 103,539 11,362 114,9012022 94,112 11,402 105,514 Thereafter 301,391 64,547 365,938

$ 831,571 $ 116,429 $ 948,000 Rent expense, including base and contingent rent under operating leases, was $98.2 million, $78.5 million and $66.0 million in fiscal 2017, fiscal 2016 and fiscal 2015, respectively. Contingent rents were $0.6 million, $0.5 million and $0.6 million in fiscal 2017, fiscal 2016 and fiscal 2015, respectively. From February 4, 2018 to March 22, 2018, the Company committed to 15 new store leases with terms of 10 years that have future minimum lease payments of approximately $28.9 million.

Leases ASC 842

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lease accounting - scacpa.org · lease accounting learning objectives on february 25, 2016, the...

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