lease accounting - the new exposure draft

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UNIVERSITY OF NORTH ALABAMA2013 ACCOUNTING SEMINAR

LEASES – THE NEW EXPOSURE DRAFT ROBERT BELCHER | July 19, 2013

Leasing is an important source of finance and the FASB objective is to provide greater transparency around a company’s leasing transactions

Current standards omit relevant information about rights and obligations that meet the definitions of assets and liabilities –users currently adjust financial statements to recognize assets and liabilities arising from operating leases

Complexity of the current standard because of the “bright-line” distinction between capital leases and operating leases

Part of the Convergence Project – this is a joint project of the IASB and FASB

Why a Leases Project

For the lessee – other than some short term leases, would feature a right to use model that would require all leases to be on the balance sheet Short term lease

At date of commencement has a maximum possible term, including any options to renew, of 12 months

Need not recognize lease assets or liabilities Recognize payments on a straight-line basis

Changes to both balance sheet and income statement

Could impact key ratios and covenant calculations

Could impact EBITDA calculations

Could impact incentive compensation plans

Changes accounting treatment when lease contains non-lease components such as services

Leases would be classified into two types (Type A and Type B) and the classification would be used principally for determining the method and timing for recognizing lease revenue and expense

Key Impacts

For lessee – two types of leases Type A lease – (Accelerated expense) – Assets other than real property

(e.g. equipment, vehicles) Type B lease – (Straight line expense) – Primarily land and/or building

leases

For lessor – Type A leases – Approach similar to today’s accounting for sales-type

leases Type B leases – Would be accounted for using a method similar to current

operating lease accounting

Key Impacts

Estimated leases coming on balance sheet ($1.25 trillion for SEC registrants)

Approximately 70% related to real estate

All companies with lease obligations will be affected

Industries that could be significantly impacted Industries with multiple locations (retail operations) Industries with significant investment in PPE (transportation companies)

Key Impacts

Discussion paper was issued in March 2009

Exposure draft was issued in August 2010

New exposure draft issued in May 2013 – comment period ends September 2013

Redeliberations beginning fourth quarter 2013

Final standard and effective date - TBD

Likely effective date no earlier than January 1, 2017

Will also have to be aligned with the new revenue recognition standard

Companies will be required to restate comparative periods – so if standard becomes effective in 2017, a restatement of 2016 and 2015 could be required

Proposed standard has created a lot of discussion – hundreds of comment letters were received, numerous roundtable discussions were held

Current Status

Definition of a lease Contract in which the right to use a specified asset is conveyed for a period

of time in exchange for consideration, as determined based on the substance of the contract, by assessing whether both of the following conditions are met: The fulfillment of the contract depends on the use of an explicitly or implicitly

specified asset or assets The contract conveys the right to control the use of the specified asset or assets

for a period of time

Recap of Some Key Conceptsfor Lessee and Lessor

Lease determination dependent on the substance of the contract Fulfillment of the contract depends on the use of a specified asset

Specified asset is an asset that is explicitly or implicitly identifiable A physically distinct portion of a larger asset is a specified asset (one floor in a 20 story

office building would be included – where as a non physically distinct portion of an asset such as a specified percentage of the capacity of a pipeline would be excluded)

Customer controls the use of the specified asset throughout the term of the arrangement Customer has the ability to direct the use (make decisions that impact how the

asset is used) Receive substantially all of the benefits Contracts excluded would include those where the lessor can substitute the

asset without the lessee’s consent or the customer cannot use the asset on its own – contracts where the right to use the asset and the services are not negotiated separately


The proposed definition of a lease would be similar in scope but in some respects has a little bit of broader scope than the existing definition. Today’s standard applies only to property, plant and equipment. The definition in the exposure draft would apply to leases of all assets except the following:

Excludes leases of Biological assets, including timber Right to explore for or use minerals, oil, and/or gas Intangible assets are not required to be treated as leases Short term leases (at the date of commencement has a maximum possible term,

including any options to renew, of 12 months or less)

Scope would include Subleases Leases involving assets other than property, plant and equipment – however such

arrangements (e.g. assets often treated like inventory – spare parts, supplies) would not likely meet the definition of a lease

Scope

Lease Term Determined at lease commencement date based on the noncancellable

period for which the lessee has the right to use the underlying asset plus Any period covered by an option to extend the lease if the lessee has an

economic incentive to extend the option Period covered by an option to terminate the lease if the lessee has a

significant economic incentive not to exercise the option


Lease Payments Present value of the lease payments over the lease term would be

recognized as a lease liability for lessees or a lease receivable for lessors of a Type A lease – Payments would include Fixed lease payments Variable payments that depend on an index or rate such as CPI or LIBOR Purchase options if lessee has a significant incentive to exercise a purchase

option Any variable rents not based on an index or rate (based on performance or

usage) would be excluded and recognized as accrued/incurred


Discount Rate Would be determined on a lease by lease basis and used to determine

present value of the lease payments

If lessee can determine the rate charged by lessee then that rate should be used – when that rate is not known the lessee would use its own incremental borrowing rate

The lessee’s incremental borrowing rate would be the interest rate that the lessee would have to pay to borrow over a similar term to purchase an asset of a similar value for the right to use the asset in a similar economic environment


Lease Classification The principle for determining between the two lease types would be

based on the portion of the economic benefits of the underlying asset expected to be consumed by the lessee over the lease term

Leases of assets that are not property (e.g. equipment, vehicles) would be classified as Type A leases – An exception to classifying these leases as Type A leases would be Lease term is for an insignificant part of the life of the asset Present value of the lease payments is insignificant relative to the fair value

of the underlying asset


Lease Classification Leases of property (building or part of building) would be classified as a

Type B lease unless the lease term is for a significant portion of the economic life of the asset or the present value of the lease payments is for substantially all of the fair value of the leased asset

If the lessee has a significant economic incentive to exercise an option to purchase the underlying asset then the lease would be classified as a Type A lease

Many of the leases classified as operating leases today would probably be Type A leases under the proposal


What is significant – no bright lines

The proposed standard does not provide a definition of “insignificant” for purposes of assessing the exception criteria for classifying leases of assets other than property For Type A leases some examples given were as follows:

More than insignificant 2 year lease of an asset with an expected life of 12 years Present value of lease payments is $16,700 compared to fair market value of

equipment of $60,000

For Type B leases: Insignificant

15 year lease of an office building with a 40 year life Present value of lease payments of $300,000 compared to fair market value of

property of $400,000 Lease term and present value of lease payments considered insignificant


Would recognize an asset representing its “right-of-use” of an underlying asset during the lease term and a liability representing its obligations to make lease payments during the lease term at the commencement of the lease

Liability would be recognized at the present value of the lease payments including expectations about the lease term, variable payments that depend on an index or rate, purchase options where the lessee has significant economic incentive to exercise, etc.

Right-of-use asset would be measured initially at cost Amount of the liability Plus: Direct costs incurred – costs directly attributable to negotiations and arranging a

lease that would not have been incurred had the transaction not been made Less: Any lease incentives received

Initial recognition of the right to use asset and the lease liability would be the same for a Type A lease and a Type B lease

Lessee – Right-to-Use Model

Expense Recognition Two approaches

(Type A) Accelerated method – non property leases (equipment, vehicles) (Type B) Straight Line method – property leases – building and real estate

Type A (Accelerated Method) Amortize the right-of-use asset on a systematic basis that reflects the usage

of the asset – generally on a straight line basis Interest expense would be calculated on the effective interest method Combined amortization expense and interest expense on the lease liability

result in generally front-loaded pattern of total lease expense Recognize interest and amortization expense separately in the income

statement


Type B (Straight Line Method) Interest expense calculated under the effective interest method Measure the right-of-use asset each period as a balancing figure such that

lease expense would be recognized on a straight line basis, regardless of timing of lease payments

Recognize lease expense as one amount in the income statement


Lessee Accounting (Type A)Example

A company enters into a three-year lease for equipment that has an economic life of six years and agrees to pay the following: $12,000 in year 1, $14,000 in year 2 and $16,000 in year 3. The present value of lease payments is $37,220 (using a discount rate of 6%).

At lease commencement the lessee would recognize the lease-related asset and liability:

Right-of-use asset $37,220Liability to make lease payments $37,220

To initially recognize the lease-related asset and liability


The following journal entries would be recorded in the first year:

Interest Expense $2,233Liability to make lease payments $2,233

To record interest on the liability to make lease payments using the interest method ($37,220 *6%)

Amortization expense $12,407Right-of-use asset $12,407

To record amortization of the right-of-use asset ($37,220/3 years)

Liability to make lease payments $12,000Cash $12,000

To record cash paid


A company enters into a three-year lease for equipment that has an economic life of six years and agrees to pay the following: $12,000 in year 1, $14,000 in year 2 and $16,000 in year 3. The present value of lease payments is $37,220 (using a discount rate of 6%).

Initial Year 1 Year 2 Year 3Lease expense recognized (consists of):

Interest expense $ 2,233 $ 1,647 $ 900Amortization expense $ 12,407 $ 12,407 $ 12,406

Total $ 14,640 $ 14,054 $ 13,306Balance sheet

Right-of-use asset $ 37,220 $ 25,533 $ 12,766 $ -Liability to make lease payments $ 37,220 $ 27,453 $ 15,100 $ -

Lessee Accounting (Type B)Example

Initial Year 1 Year 2 Year 3Lease expense presented on I/S(consists of):

Interest expense $ 2,233 $ 1,647 $ 900Amortization expense $ 11,767 $ 12,353 $ 13,100

Total lease expense presented on I/S $ 14,000 $ 14,000 $ 14,000Balance sheet

Right-of-use asset $ 37,220 $ 25,453 $ 13,100 $ -Liability to make lease payments $ 37,220 $ 27,453 $ 15,100 $ -

A company enters into a three-year lease for new office space and agrees to pay the following: $12,000 in year 1, $14,000 in year 2 and $16,000 in year 3. The present value of lease payments is $37,220 (using a discount rate of 6%).

Lessee AccountingPresentation

Financial Statement Lessee Presentation

Balance Sheet

• Right-of-use assets and liabilities to make lease payments for each type of lease presented separately or disclosed in notes along with the line item in the balance sheet

• Whether presented separately or together with other assets, right-of-use assets presented as if the underlying asset were owned

Income Statement

• Type A leases: lease-related amortization and interest expense presented separately from other amortization and interest expense or disclosed. Lease-related amortization and interest expense cannot be combined

• Type B leases: lease-related expense presented as a single line item (e.g., lease or rent expense)

Statement ofCash Flows

• Type A leases: cash payments for principal presented as financing activities and cash payments for interest presented as operating activities

• Type B leases: cash payments for lease payments presented as operating activities• Both types of leases: cash payments for variable lease payments not included in the liability

presented as operating activities• Cash payments for short-term leases presented as operating activities

The following table summarizes how lease-related activity would be presented on the financial statements of lessees:

Two Models for the Balance Sheet and Income Statement Receivable/Residual Approach

Used for most equipment leases – leases which consume more than an insignificant portion of the underlying asset over the lease term

Record a lease receivable for the right to receive payments at the present value of the lease payments At the discount rate using the rate charged to lessee

Derecognize the underlying asset

Profit recognition Gain or loss on the transfer of the right-to-use asset – calculated as the difference

between the present value of the lease payments to be received and the carrying value allocated to the right-to-use asset sold

Interest income and profit from the accretion of the residual asset recognized over the lease term

Lessor Accounting

Operating Lease Approach Most land and building leases Lessor would keep property, plant and equipment on balance sheet Rental income would be recognized over the lease term generally on the straight

line basis

Balance Sheet and Income Statement Presentation Lease receivable and residual assets (including deferred profit), as, or totaling to,

a single caption (e.g. leased assets) or disclose separately in the notes if not separately presented

Lease income and expense (i.e., revenue and cost of sales) in separate line items or net in a single line item (lease income)

Lessor Accounting

Transition Option for modified retrospective approach or full retrospective approach

At date of initial application (beginning of earliest comparative period presented) recognize and measure a liability to make estimated lease payments and a right of use asset

Liability measured as the present value of the remaining lease payments discounted using the lessee’s incremental borrowing rate

For Type A leases, right-of-use assets based on the liability to make lease payments at the lease commencement prorated for the remaining lease term

For Type B leases, right-of-use assets measured at the related liability Difference between the liability to make lease payments and the right-of-use

asset would be a cumulative adjustment to opening retained earnings Discount rate based on the incremental borrowing rate on the effective date Not required to adjust carrying amounts for existing capital leases

Lessee Accounting

Should a right of use asset and obligation to make lease payments be recognized for a related party lease? The FASB decided to eliminate the guidance that requires entities to

evaluate related party leases on the basis of their substance. The exposure draft requires entities to evaluate related party leases on the basis of its legal terms and conditions, acknowledging that some related party leases are not documented or at arm’s length. The FASB also discussed whether related party leases would be considered cancelable or non cancelable leases. FASB decided against a presumption that related party leases would be considered noncancellable.

Related Party Leases

Sale-leaseback transactions would no longer provide off-balance sheet financing because lessees would recognize all leases (other than short term leases) on the balance sheet. A sale and leaseback of the underlying asset would be recognized if the requirements for sale recognition in the revenue recognition standard are met; otherwise, the transaction would be accounted for as a financing transaction. There would be no special criteria for assessing sale-leaseback transactions.

For a seller-lessee – if the transaction qualifies as a sale Derecognize the leased property Recognize a right-of-use asset Recognize a liability to make estimated future lease payments

For a buyer-lessor – if the transaction qualifies as a sale Recognize a lease receivable for estimated future lease payments Recognize a residual asset

If no sale, account for the entire transaction as a financing transaction by the seller-lessee.

If sale and leaseback are at fair value, gains and losses should be recognized when the sale occurs and should not be deferred. If the consideration is not at fair value, the assets, liabilities, gain or loss would be adjusted to reflect current market rentals.

Sale-Leaseback Transactions

Financial metrics, key performance indicators and capital structure Grossed up balance sheet Changes to timing of income/expense Financial ratios – return on assets, EBITDA Debt covenants, interest coverage ratios, debt to equity ratios Compensation arrangements

Lease procurement and strategy Understand effect of lessee’s behavior Lease vs. buy strategy

IT and systems, processes and controls Need to understand any modifications or new software necessary to capture

information

Tax accounting issues Adjustments to deferred taxes

Overview of Implications

ROBERT BELCHER, CPAAssurance Principal | [email protected]

Robert Belcher has provided audit and accounting services for public and privately-held businesses, as well as governmental entities, for 30 years.

Robert is a trusted assurance principal providing audit, attestand due diligence services to clients in a wide range of industries. His clientele includes manufacturers in the textile, food, furniture, construction, printing, portrait studios and carpet sectors, as well as brokerage and investment firms, government contractors and governmental entities. Robert provides clients with industry-specialized assistance related to cost accounting and other inventory issues, revenue recognition and internal control framework, as well as merger and acquisition services.

Questions

lease accounting - the new exposure draft

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