FASB s 2013 Proposal on Accounting for Leases

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1 FASB s 2013 Proposal on Accounting for Leases Frequently Asked Questions September 2013 The project on lease accounting is a joint project of the FASB and the International Accounting Standards Board. The Boards undertook the project in an attempt to create a single worldwide standard that would require lessees to recognize assets and liabilities arising from leases. The project has its roots in the financial reporting scandals of the early 2000s that focused attention on off-balance sheet transactions. In 2005, the SEC recommended changes to the existing lease accounting requirements to ensure greater transparency in financial reporting. The FASB and IASB responded with a proposal in 2010 that was modified in 2013 to establish a dual model for lease accounting that would replace the familiar distinction between operating and capital leases under current US accounting standards. MHM Messenger outlines a five-step approach to assessing the impact of the proposal. This document provides the answers to questions that may arise in connection with that approach. The five basic steps are: 1. Identify agreements that meet the definition of a lease. 2. Estimate the impact on the financial statements. 3. Probe the regulatory and tax implications. 4. Anticipate the changes in processes, systems and controls. 5. Weigh the pros and cons of alternative strategies. Table of Contents Scope of proposed guidance How application would affect financial statements Regulatory or tax implications Possible changes in processes, systems or controls What would we do differently? p. 1-2 p. 2-5 p. 5-6 p. 6-7 p Which of our current agreements fall under the scope of the proposed guidance and meet the definition of a lease? The first step in the analysis requires an inventory of leases that are subject to the proposed guidance. This step can raise a number of questions, including the following: Q. Are any types of leases excluded from the scope of the proposed guidance? A. Yes, the proposal excludes leases of intangible or biological assets and leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources. Q. How are leveraged leases affected by the proposed guidance? A. Current accounting standards for leveraged leases are applicable to leases that use non-recourse debt financing and meet certain other criteria. The proposed guidance eliminates the leveraged lease accounting model. As a result, the proposed lessor accounting requirements would be applied to existing leveraged leases retrospectively as of the effective date of the final standard.

2 Q. How has the proposed definition of a lease changed? A. A lease is a contract that conveys the right to control the use of a specified asset (the underlying asset) for a period of time in exchange for consideration. The concept of control would be similar to the proposed revenue recognition standard. Obtaining all the output from an asset is, in isolation, no longer determinative of control. Consistent with current accounting standards, a lease can be embedded in a larger agreement, such as a service contract. When that is the case, the consideration may need to be allocated to the components of the contract (e.g., the lease and the service), and the components may need to be accounted for separately. Q. How can we determine whether a contract contains a lease? A. To determine if a contract contains a lease, an entity would need to determine if: The fulfillment of the contract depends on the use of an identified asset, and The contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration. This determination may be subject to reconsideration as a result of changes that occur during the contract term. Q. If a contract contains more than one lease, do the components need to be separated? A. It depends on how the components are interrelated and requires consideration of more guidance related to unit of account. If a component has the characteristics of both property and non-property, the accounting would be based on the primary component. 2. How would the application of the proposed guidance affect our financial statements, including the income statement and the balance sheet? The second step in the analysis of potential impacts focuses on the effects on the financial statements. These effects reflect the FASB s attempt to address the long-standing criticisms of current accounting. The major changes are summarized in Table 1 below followed by questions and answers about additional aspects of the proposed accounting guidelines. Table 1. Major changes For lessees For lessors Current accounting Proposed accounting Intended benefits Most lease assets are offbalance sheet. Limited disclosure about operating leases. Most lease assets remain on the lessor s balance sheet. Recognition of lease assets and liabilities for all leases of more than 12 months. Enhanced disclosure requirements. Partial sale accounting for most equipment leases. Greater transparency about leverage, assets used in operations and cash flows. Greater transparency about residual values. Limited disclosure about residual values of equipment and vehicles. Separately account for residual asset. Enhanced disclosures about residual asset s exposure to risk. Q. How would leases be classified under the proposed dual model? A. Leases would be classified as Type A or Type B rather than operating and capital. The general rules and exceptions are summarized in Table 2. 2

3 Q. How would the recognition, measurement, and presentation of expenses and cash flows arising from a lease differ for Type A and Type B leases? A. For virtually all leases, the lessee would recognize a right-of-use asset and a liability on its balance sheets. The other effects on the financial statements would vary depending on the lease classification: For Type B leases (most property leases), income and expenses would follow a straight-line pattern. The lessee would recognize expense on a straight-line basis over the lease term in a single financial statement line item. The lessor would continue to recognize the underlying asset and recognize lease income over the lease term, typically on a straight-line basis. For Type A leases (most equipment or vehicle leases), the lessee s expenses would be greater in the initial years due to the combination of (1) straight-line amortization of the right-of-use asset and (2) heavier interest expense in the earlier periods when the lease liability is larger. Amortization of the right-of-use asset and interest expense on the lease liability would be reported separately in the income statement. The lessor would derecognize the leased asset and recognize a receivable and a residual asset. Lessors also would recognize a portion of the profit, if any, at the start of the lease as well as interest income over the life of the lease. The lease classification rules and the effects on the financial statements are summarized in Tables 2 through 4 below. Table 2. Classification of leases Rules Type A General rule: All leases for equipment or vehicles are Type A. Exceptions: (1) Lease term is insignificant relative to total economic life of asset, or (2) Present value of lease payments is insignificant relative to fair value of asset. Type B General rule: All leases for real estate are Type B. Exceptions: (1) Lease term is major part of remaining economic life of asset, or (2) Present value of lease payments is substantially all of fair value of asset. Table 3. Effects on Financial Statements - Lessees Type A. Most leases of equipment or vehicles Type B. Most leases of real estate Balance Sheet Income Statement Cash Flow Statement Right-of-use asset and lease liability Right-of-use asset and lease liability Amortization expense and interest expense Single lease expense on a straight-line basis Cash paid for principal is a financing cash out flows and interest payments are operating cash out flows Cash paid for lease payments is an operating cash out flows Table 4. Effects on Financial Statements Lessors Type A. Most leases of equipment or vehicles Type B. Most leases of real estate Balance Sheet Income Statement Cash Flow Statement Lease receivable and residual asset Continue to recognize underlying asset Interest income and any profit on the lease Lease income, typically on a straight-line basis Cash received for lease payments is an operating cash in flows Cash received for lease payments is an operating cash in flows 3

4 In a significant change from current practice, companies would need to continually re-assess and may be required to re-measure the lease assets and liabilities subsequent to lease commencement date. This could require significant judgment. Under the current US accounting standards, re-assessments are required only for contract modifications. In contrast, under the proposed guidance, lessees would be required to reassess the lease term if there is a change in relevant factors, such as revisions to the estimated lease term and variable lease payments that depend on rates or indices. Q. Did the FASB propose any concessions for short-term leases? A. Yes, lessees could elect to exclude leases with terms of less than 12 months including any options to renew. They could account for these leases the same way that operating leases are accounted for today, that is, as off-balance sheet assets and liabilities with the lease payments recognized in profit or loss on a straight-line basis over the lease term. Disclosure requirements would still apply, and this election would not be permitted for leases that contain a purchase option. Q. Would existing lease contracts be grandfathered under the transition requirements? A.No leases would be grandfathered under the proposal. However, lessees and lessors would not be required to adjust the carrying amounts of assets and liabilities associated with existing lease contracts that are (1) leases under the new guidance and (2) currently classified as finance, capital, direct finance or sales-type leases. The proposal does not grandfather leases that are currently classified as operating leases or leveraged leases. The definition of a lease will be applied retrospectively, and there is no transition relief for leases that have less than 12 months remaining at the initial application date unless the lease is a short-term lease as defined above. Q. What are proposed disclosure requirements? A. There are additional qualitative and quantitative disclosure requirements, as well some required disclosures about judgments and risks. These requirements are highlighted in Tables 5 and 6 below. Table 5. Disclosure requirements - Lessees Qualitative Quantitative Judgment and risks General description of leases Terms of: Variable lease payments Extension/termination options Residual value guarantees Restrictions and covenants Information about leases not yet commenced Maturity analysis of undiscounted cash flows for each of first 5 years plus total thereafter Reconciliation of lease liability Expense relating to variable lease payments Nature and extent of risks arising from leases Significant assumptions and judgments 4

5 Table 6. Disclosure requirements - Lessors Qualitative Quantitative Judgment and risks General description of leases Terms of: Variable lease payments Extension/termination options Purchase options Reconciliations of lease receivable and residual asset Table of lease income Maturity analysis of undiscounted cash flows for each of first 5 years plus total thereafter Carrying amount of residual assets covered by residual value guarantees Nature and extent of risks arising from leases Significant assumptions and judgments Risk management for residual assets Q. Were any concessions made for nonpublic entities? A. Yes, nonpublic entities may make an accounting policy election to use a risk-free discount rate to measure the lease liability. If made, the election must be disclosed. Nonpublic entities are also exempt from the requirement to provide a reconciliation of the opening and closing balance of the lease liability. Q. How would related party leases be treated? A. The recognition and measurement requirements for related party leases would be applied based on the legally enforceable terms and conditions of the lease. The disclosure requirements for related party transactions apply. 3. Would the differences between the proposed guidance and the current guidance have any regulatory or tax implications? When companies probe for the regulatory and tax implications in third step of the analysis, they will find the proposed changes typically result in tax complexities and may increase cash outlays for taxes as well. The changes may have regulatory consequences, too, as described in the following Q&As. Q. What are the potential consequences for US federal income taxes? A. The federal tax consequences will require an analysis of the individual facts and circumstances. Because lease payments are generally deducted on a cash basis for federal income taxes, the proposed changes by the FASB will likely lead to more book-tax differences, along with the need for separate records to track leases for book and tax purposes. Q. What are the potential consequences for state and local income taxes? A. The accounting changes could affect cash outlays for some companies due to reallocations of income among states. This is especially likely in states that use property factors to calculate the amount of taxable income. It is not uncommon for these property factors to include real and tangible personal property owned or leased by the company. If a company does business in a state that bases its property calculations on book values rather than tax values, then it could experience a shift in taxable income from a lower-tax to a higher-tax jurisdiction as it adds leased assets to its balance sheet. Some companies may also be exposed to potential increases in sales taxes and state franchise or net worth taxes. Good tax planning will likely require an analysis of both the projected impacts and the ways to minimize any adverse effects and strengthen the company s tax position. 5

6 Q. Are there other potential tax impacts? A. If a company does business internationally, there may be an impact on taxes paid to non-us tax jurisdictions. Depending on the applicable tax laws in the other countries, this determination can require a complex analysis of a variety of calculations, such as those required for tax depreciation rules, limits on the tax deductibility of interest, and transfer prices. Q. What are the potential regulatory impacts? A. The potential regulatory impacts vary by industry. For example, companies that work on cost-plus government contacts may be using leases now because the government will reimburse 100% of the cost of rent but it does not reimburse capital items, such as interest and amortization. Banks and broker-dealers could have significant adverse regulatory impacts due to changes in ratios that are carefully monitored by regulators, such as capital ratios for banks. Arguably, the greatest impacts will be felt by banks with large leveraged lease portfolios and significant lessee activity for bank branches, ATM locations and processing centers. Additional regulatory impacts or adjustments may evolve over time, if the proposed standard is adopted as a final standard. As a with the result, that ongoing monitoring and evaluation of potential regulatory impacts will be prudent for businesses in industries that are likely to be affected so the company can manage any additional risks and opportunities as they arise. 4. Would the proposed guidance require changes in processes, systems or controls? The fourth step in analyzing the impact of the lease proposal is to assess where changes might be required in the company s processes, systems and controls. Below are questions that typically arise. Q. Will we need to gather data and documents that are not part of our normal record-keeping? A. Yes. Companies will need to sort through contracts and agreements to gather data about existing leases, including the nature of the leased asset, the lease term, renewal options and lease payments, to determine the amounts that need to be recorded on the balance sheet and income statement. This could take some time since it involves identification and analysis of all arrangements that could contain a lease, and the original records may not be available. If the proposed guidance is adopted, companies will also need to collect data on an ongoing basis to reassess leases terms, monitor other contractual changes, and update management judgments relating to contingent payments and renewals. Q. Will we need to establish additional internal controls? A. Additional documentation may be needed to support judgments and changes in estimates. For example, management may need to decide if a contract contains a lease or is solely a service agreement and document the reasons for the decision. Or a company may need to determine the reasons for its identification of the primary asset in complex leases agreements, such as leases of land containing pipelines or cell towers that may need to be treated as equipment rather than property, and then document the reasons for that determination. Q. Will we need to invest in new information technology systems? A. The need for information technology systems will require evaluation. Currently, many companies rely on spreadsheets or their accounts payable systems for leased assets because most of the data collecting and processing is done at the time of initial recognition. Some larger companies have asset management systems, but these systems may not be integrated with the company s accounting system. Integration of systems may be justified to support the disclosure requirements in the lease proposal. Investment in integrated systems may be further justified by the need to capture, catalog, and reassess lease data on a regular basis. If IT investments are anticipated, companies will want to allow sufficient time to design, implement and test new systems. 6

7 Q. Will compliance require more in-house accounting staff or other human resources? A. Accounting for leases is likely to be more complex in the future, and this may require more in-house accountants. Additional demands on tax, treasury, IT, legal, and corporate real estate personnel are also likely as companies come to grips with the broader implications of the new standard. Q. Are there other compliance costs that we should consider planning for? A. Transition costs could be significant since existing operating leases and leveraged leases will not be grandfathered. Companies may wish to run parallel systems for current and former accounting standards for a time prior to the effective date. They may also incur costs in connection with a communication plan to help users of financial statements understand the effects of the new standard. Overall, the level of effort required for both the transition and future compliance costs is likely to be significant, especially for small to mid-sized businesses that do not have as many in-house resources as larger companies. 5. What would we do differently if this proposed guidance were to be adopted? Would the guidance prompt any changes in strategy, such as lease-vs.-buy decisions? The final step in the analysis of the impact of the proposed lease standard is to weigh what the company might do differently in terms of business strategy and decision-making. Although individual facts and circumstances will vary, the general insights in the following Q&As may be helpful. Q. What financial metrics are likely to be altered and how might lessees be affected? A. The accounting changes will likely cause lessees to have more debt-laden balance sheets. This could alter debtto-equity ratios, earnings before interest, taxes, depreciation and amortization (EBITDA), and cash flows from operations. As a result, a lessee s credit ratings and borrowing capability may be affected, and legal agreements containing debt covenants may need to be re-negotiated and re-written. Since debt covenants are often based on accounting principles in effect at the inception of the agreement, lessees generally will be able to anticipate any adverse consequences and renegotiate financing arrangements before the revised lease accounting standard takes effect. Q. Would purchasing of property be more attractive than leasing under the new accounting standard? A. This will require careful analysis. Some companies may have turned to leasing in the past for reasons that will continue to be valid following the accounting changes. For example, alternative financing options may be so limited that leasing is the only option. Other companies may have used operating leases as a way to keep the liability for lease payments off their balance sheets. As the accounting treatment changes, the distinction between operating and capital leases will no longer be relevant. Instead, the focus will be on whether a contract is a service arrangement (and therefore the liability is off the balance sheet) or a lease (and therefore the liability is on the balance sheet). This shift in focus may cause lessees to revisit the economics of lease-vs.-buy decisions, especially in certain real estate agreements such as single-tenant office buildings or single-tenant retail sites. Q. Are there any other decisions or agreements that lessees might want to reevaluate? A. Yes. Many companies use the same accounting for external reporting and for internal performance reporting. The internal reports are often used for comparisons of budget vs. actual results and as a basis for incentive and compensation plans. These companies may wish to revise or renegotiate any employee compensation agreements that are based on financial metrics to avoid unintended consequences from the accounting change. Q. How might lessors adapt their leasing agreements in response to the accounting change? A. It is possible the accounting changes might prompt lessors to develop new leasing models in several ways. Lessees may request shorter lease terms to lessen the impact of the accounting change. 7

8 The proposed accounting changes, accompanying tax consequences, and effects on financial metrics may prompt lessors to change the pricing of the leases or the way services are bundled with assets. For example, one such modification might be to offer to extend the term of a lease and provide more services in exchange for lower rent. The accounting changes might also prompt lessors to modify the financing options offered to potential users of assets in an effort to induce them to purchase an asset rather than lease it. Lessors also might change the way they use third-party residual value guarantees because such guarantees generally would no longer affect lease classification under the proposal. These changes are likely to be gradual and difficult to anticipate. An SEC report on off-balance sheet financing issued in 2005 in response to the Sarbanes-Oxley Act notes that.lease structuring to meet various accounting, tax, and other goals, has become an industry unto itself in the last 30 years. The significant amount of structuring of leases also makes analyzing potential changes to the lease guidance very difficult. Both lessors and lessees will need to stay flexible so they can do their best to adapt to the coming changes as they evolve. Mayer Hoffman McCann Can Help MHM can provide the accounting and industry expertise you need to help you analyze the impact of the FASB s lease proposal. For more information, see our MHM Messenger 15-13: FASB s 2013 Proposal on Lease Accounting or contact MHM s Hal Hunt at hhunt@cbiz.com or our roots run deeptm MAYER HOFFMAN MCCANN P.C. All rights reserved. The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation. Please contact your MHM service provider to further discuss the impact on your financial statements. 8