ASC Topic 842 Leases. September 25 &

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1 ASC Topic 842 Leases September 25 & This presentation is intended solely for the information and use of the EEI and AGA and is not intended to be and should not be used by anyone other than these specified parties. This presentation is not intended for general use, circulation, or publication and should not be published, circulated, reproduced, or used for any purpose without our prior written permission in each specific instance KPMG International Cooperative ( KPMG International ). KPMG International provides no client services and is a Swiss entity with which the independent member firms of the KPMG network are affiliated. 1

2 Presenters/Speakers Darin Kempke Audit Partner & National Audit Energy Sector Leader Michael Nesta Power and Utilities (PU) Accounting Advisory Partner Todd Fowler PU Audit Partner Landon Westerlund Audit Partner at KPMG Department of Professional Practice (DPP) and Lease Implementation team Brian Yurko Audit Partner at DPP and Lease Implementation team Scott Heiser PU Audit Partner Robert Wilson PU Audit Senior Manager Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 2

3 Agenda Day 1 Introductions Overview of ASC 842 Lessee Accounting Lunch Lessee Accounting Lessor Accounting Examples/Scenarios throughout Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 3

4 Agenda Day 2 Day 1 Re-Cap Other Issues (i.e. Sub Leases) Transition, Disclosures, Practical Expedients Additional Examples Wrap up Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 4

5 Background of Scenarios/Examples Company A Traditional Regulated T&D Electric Utility. Company B Traditional Regulated Natural Gas Utility Company C Subsidiary or separate company with owned Generation (both fossil fired & renewable) NOTE: Examples and Scenarios throughout of PU related situations around the new lease standard and will refer to the above Companies. Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 5

6 Overview of ASC 842

7 Where are we today? The FASB issued its new lease accounting standard on February 25, 2016 (ASU ) The IASB issued its new lease accounting standard on January 13, 2016 (IFRS 16). The final standards are not converged. 7

8 Scope Non-core assets Long-term leases of land Certain sales with repurchase rights (supplier s perspective) Within scope Outside scope Leases of/to: Intangible assets Explore for or use non-regenerative resources Biological assets Inventory Assets under construction Short-term leases (lease term 12 months) Underlying assets of low value ( $5,000, when new IASB only) Scope with exceptions Comparison to current U.S. GAAP The scope of the new leases standard is substantially aligned with current U.S. GAAP. 8

9 Exemptions and practical expedients Short-term leases (lessees only) Leases with a lease term 12 months and do not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise may apply current operating lease accounting If elected, the exemption is applied to all leases within that class of underlying asset Still subject to qualitative and quantitative disclosures Underlying assets of low value (IASB only) Exemption for leases of underlying assets that are individually low in value (e.g., $5,000, when new) even if material in aggregate Leases would be accounted for off-balance sheet under IFRS, but on-balance sheet under U.S. GAAP (if not short-term) Portfolio approach Aspects of the new standard may be applied at a portfolio level (e.g., determination of discount rate and lease term) Must be a reasonable expectation that the portfolio approach is not materially different than application to individual leases 9

10 Lease definition, components, and key definitions/concepts

11 Overview Lease definition Identified asset Control over the use of the identified asset Lease Asset is explicitly or implicitly specified in the contract Customer has right to obtain substantially all economic benefits from use of the asset Converged FASB/IASB definition Asset is physically distinct or customer has rights to substantially all of the asset s capacity Customer can direct the use of the asset Supplier does not have a substantive substitution right Definition of a lease: A contract that conveys the right to use an asset for a period of time in exchange for consideration 11

12 Identified Asset Lease definition Is the asset specified in the contract (explicitly or implicitly)? Yes Is the asset physically distinct or does the customer have the right to receive substantially all the capacity of the asset No No STOP Contract does not contain a lease (apply other GAAP) Yes Does the supplier have substitution rights? No There is an identified asset Yes No Yes Can the customer prevent the supplier from substituting the asset? Are alternative assets readily available/sourced by the supplier within a reasonable period of time? Would the supplier benefit economically from its right of substitution? Yes No 1 No Yes 1 Or it is impractical for the customer to make this determination Supplier does not have a substantive substitution right. Contract depends on an identified asset. STOP Supplier has a substantive substitution right. Contract does not contain a lease. 12

13 Supplier substitution rights New consideration vs. current GAAP Can the customer prevent the supplier from substituting the asset? No Are alternative assets readily available, or could be sourced by the supplier within a reasonable period of time? Yes Would the supplier benefit economically from exercising its substitution right? Yes Yes No 1 No 1 1 Or it is impractical for the customer to make that determination. Supplier does not have a substantive substitution right. Contract depends on an identified asset. Supplier has a substantive substitution right. Contract does not contain a lease. Evaluation is based on facts and circumstances at contract inception. Evaluation excludes consideration of future events, that at inception of the contract, are not likely to occur. 13

14 Control over use of the identified asset Lease definition Step 1 Determine the scope of the customer s right of use within the contract Step 2 Identify the economic benefits from use of the identified asset Step 3 Step 4 Does the customer have the right to obtain substantially all of the economic benefits from use of the identified asset? Yes Does the customer have the right to direct the use of the asset? No No STOP Contract does not contain a lease. Apply other GAAP Yes Contract is or contains a lease 14

15 Economic benefits from use of the underlying asset Lease definition Economic benefits include: Direct benefits (from using, holding, or subleasing the underlying asset) Other economic benefits relating to the use of the underlying asset. Include By-products arising from use of the underlying asset. For example: Exclude Benefits derived from ownership of the asset. For example: Renewable energy credits Steam produced from manufacturing Benefits related to tax attributes IMPORTANT: Capacity (e.g. to produce widgets or power, storage capacity) is not necessarily the entirety of the economic benefits that can be derived from use of an asset. 15

16 Rights to direct the use of the underlying asset Lease definition Rights in the contract Example rights to direct how and for what purpose asset is used throughout the period of use Other rights Right to change type of output produced ~WHAT~ Right to change when output is produced ~WHEN~ Supplier protective rights Maintaining the asset Right to change where output is produced ~WHERE~ Right to change whether output is produced and, if so, quantity produced ~WHETHER & HOW MUCH~ Insuring the asset Operating the asset (1) (1) See next slide for when rights are predetermined 16

17 Who has the right to direct the use? Lease definition Who has the right to direct how and for what purpose the asset is used? Customer Predetermined Supplier Contract is or contains a lease 1 Contract may contain lease 1 Contract does not contain a lease (1) See next slide 17

18 When to apply predetermined rights guidance Contract 1 Relevant how and for what purpose decisions that are predetermined: Contract 2 Relevant how and for what purpose decisions that are predetermined: Where What Where What Relevant how and for what purpose decisions available to be made during the period of use: When Whether How Much When How Much Whether Relevant how and for what purpose decisions available to be made during the period of use: None Do not apply predetermined rights guidance when only SOME of the relevant decisions are predetermined Apply predetermined rights guidance 18

19 Example Lease identification Contract for a truck Key Facts Customer enters into a contract with Supplier for the use of a truck for 4 years. The contract specifies the truck and Supplier does not have substitution rights. The contract includes restrictions on where the truck can travel (only in the U.S.), how far it can travel (not to exceed 120,000 miles), and restricts the size of trailers that may be towed. Subject to restrictions, Customer still has substantive rights to determine when, whether, and where the truck goes, what the truck is used for (e.g., what cargo it transports), and how much output it produces (e.g., how much cargo it transports). Contract for a truck Relevant decision-making rights that are partially predetermined (restricted): Where Relevant decision-making rights available to be made during the period of use: When Whether What Where How Much How Much What Substantive decisions about how and for what purpose the asset is used are not predetermined Customer has the right to direct how and for what purpose the asset is used Contract contains a lease 19

20 Example Lease identification Specialized production facility Key Facts Customer enters into a contract with Supplier to purchase all of the widgets produced by a specialized facility for 12 years. The contract specifies the facility and Supplier does not have substitution rights. The widgets cannot be provided by Supplier from another asset. Customer cannot change the output of the facility i.e., the facility can only produce the specialized widgets it was designed to produce; but Customer decides when (and whether) the facility produces and how many widgets i.e., how much output it produces. That is, Customer controls the relevant how and for what purpose (HAFWP) decisions that are available to be made during the period of use Supplier operates and maintains the facility. Contract for specialized facility Relevant decision-making rights that are predetermined: Relevant HAFWP rights available to be made during the period of use: When What Whether Where Contract contains a lease How Much Substantive decisions about how and for what purpose the asset is used are not predetermined Customer has the right to direct how and for what purpose the asset is used because it controls the relevant, available HAFWP decisions 20

21 Example Lease identification Contract for a ship Key Facts Customer enters into a contract with Supplier for the use of a ship for 4 years. The contract specifies the vessel and Supplier does not have substitution rights. The contract includes restrictions on where the ship can travel (e.g., not permitted to travel off the coast of Somalia), restricts certain types of cargo (e.g. explosives, hazardous materials), and requires Customer to put the ship into port at predetermined intervals for maintenance. Supplier operates and maintains the ship Subject to restrictions, Customer still has substantive rights to determine when, whether, and where the ship goes, and what/how much output it produces (i.e., what it transports and how much) Contract for a ship Relevant decision-making rights that are partially predetermined (restricted): Where Relevant decision-making rights available to be made during the period of use: When Whether What Where How Much Contract contains a lease When What Substantive decisions about how and for what purpose the asset is used are not predetermined Customer has the right to direct how and for what purpose the asset is used 21

22 Predetermined rights Lease definition Decisions about how and for what purpose the asset is used are predetermined Customer has right to operate asset (or direct others to operate asset) without supplier having right to change operating instructions throughout period of use No Customer designed asset (or aspects of asset) in a way that predetermines how and for what purpose the asset will be used throughout period of use Yes Yes Contract contains a lease No Contract does not contain a lease 22

23 Example Lease definition (1 of 2) Lease definition 5-year agreement to store products in a warehouse. Customer A Is there a lease? Supplier B Supplier B is required to store the products in a specified warehouse: Customer A has exclusive use of the warehouse. Supplier B has no substitution rights. 23

24 Example Lease definition (2 of 2) Lease definition As per the previous slide: Supplier B is required to store the products in a specified warehouse: Supplier B has no substitution rights. Identified Asset In addition, assume: Lease Customer A has exclusive use of the warehouse. Customer A has the right to decide (and change) what products it stores in the warehouse during the 5-year term. Supplier B has the right to approve any change in use of the warehouse for purposes other than storage. Control over Use? 24

25 Definitional implementation issues* Lease definition Options controlled by a third-party Market rent Non-cash consideration While all optional periods to renew (or not to terminate) a lease controlled by the lessor are included in the lease term, those controlled by an unrelated third party (e.g. a sublessee) are not automatically included in the lease term (subject to reasonably certain considerations). Market rent is an index; therefore, any lease payments based on market rent are variable lease payments that depend on an index or rate and should be included in the measurement of the lease based on the market rental rate at lease commencement. Non-cash consideration given by the lessee to the lessor for the right to use an identified asset not explicitly excluded from the lease payments by Topic 842 (e.g. lessee guarantee of lessor s debt) is included in the lease payments. * Examples, not all-inclusive! Entities should continue to monitor additional developments, including from FASB and SEC. 25

26 Separating components of a contract Step 1 Identify the separate lease components. In many cases there will be a single lease component, but in some cases there will be multiple lease components. Step 2 Identify any non-lease components e.g., a maintenance or operating services Step 3 Measure the consideration in the contract. This calculation is different for the lessee versus the lessor. Step 4 Separate and allocate the consideration in the contract between the lease and non-lease components. This process differs slightly for the lessee and lessor, but in both cases requires the entity to maximize the use of observable data. 26

27 Step 1: Identify the separate lease components Separating components of a contract A right to use an underlying asset (i.e., a lease), or a bundle of leases, is a separate lease component if both of the following criteria are met: The lessee can benefit from the lease (or bundle of leases) on its own or together with other resources that are readily available to the lessee, and The lease (or bundle of leases) is neither highly dependent on, nor highly interrelated with, the other ROUs in the contract. Separately account for land elements (even if above criteria are not met) unless accounting effect of doing so would be insignificant 27

28 Step 1 Identify the separate lease components Contract 1 Contract 2 Lease of asset A Lease of asset B Lease of asset C Lease of asset D Lease of asset E Separate lease component Separate lease component Separate lease component Separate lease component Separately account for land elements (even if above criteria are not met) unless accounting effect of doing so is insignificant 28

29 Step 2: Identify any non-lease components Separating components of a contract Contract Lease components Non-lease components (1) Not a component Allocate consideration in the contract (Step 4) Activities (or lessor costs) that do not transfer a good or service to the lessee (2) 29

30 Step 2 Identify any non-lease components Components of a contract = only items or activities that transfer a good or service to the lessee Example non-lease components Providing utilities (e.g., water or electricity) to the lessee Common area maintenance Equipment maintenance Not a component Delivering the leased asset Reimbursement of lessor costs for property taxes or insurance Residual value guarantees 30

31 Step 3: Measure the consideration in the contract (lessee) Separating components of a contract Payments relating to use of the underlying asset 1 Other fixed or in-substance fixed payments Other variable payments that depend on an index or rate 2 Incentives paid or payable to the lessee 3 Consideration in the contract (lessee) 1 See paragraph The payments are calculated using the commencement date index or rate 3 Other than those include in paragraph

32 Part 2 Part 1 Step 3: Measure the consideration in the contract (lessor) Separating components of a contract Consideration in the contract (lessee) Are there any other variable payments that specifically relate to either: The lessor s efforts to transfer one or more goods or services that are not leases? OR An outcome from transferring one or more goods or services that are not leases? No No adjustment necessary Yes Yes Apply variable consideration requirements in Topic 606 to measure the amount to be included in the consideration in the contract: Step 1: Estimate the amount using the expected value or most likely amount Step 2: Determine the portion (if any) of that amount for which it is probable that a significant revenue reversal will not subsequently occur Consideration in the contract (lessor) 32

33 Step 4: Separate and allocate consideration between lease and non-lease components Separating components of a contract When there is an observable standalone price for each component: When there is not an observable stand-alone price for some or all components: Lessee Unless the practical expedient** is elected, separate and allocate based on the relative standalone price of components. Estimate the standalone price, maximizing the use of observable information. Lessor Always separate lease and non-lease components. Allocate consideration following the Topic 606 transaction price allocation guidance i.e., generally on a relative standalone selling price basis. Remember: Activities (or costs of the lessor) that do not transfer a good or service to the lessee are not components of the contract. Therefore, no consideration is allocated to such items. ** As a practical expedient, a lessee may elect not to separate the non-lease components of a contract from the lease component to which they relate. 33

34 Example Separating components of a contract (1 of 2) Separating components of a contract Customer A enters into a lease with Supplier B for a warehouse for 5 years. Initial annual payments of $100,000 increase by $5,000 per year. Of the annual fixed payment, approximately $11,000 is intended to reimburse lessor s costs of property taxes and building insurance. Total consideration of $550,000 Lessee A Lessor B Right to use warehouse for 5 years How much of the consideration in the contract is allocated to the lease component? (continues on next slide) 34

35 Example Separating components of a contract (2 of 2) Separating components of a contract How much of the $550,000 total consideration in the contract is allocated to the lease component? A. $500K (the initial fixed payment of $100,000 x 5 years). B. $550K (the initial fixed payment of $100,000 increased by $5,000 starting from year 2, i.e. the total fixed payment due under the contract). C. $495K (the initial fixed payment of $100,000 increased by $5,000 starting from year 2, reduced by the estimated amount attributable to the lessor s property taxes and building insurance of $55,000 for 5 years). D. $605K (the initial fixed payment of $100,000 increased by $5,000 starting from year 2 plus the estimated amount of the lessor s property taxes and building insurance of $55,000 for 5 years). 35

36 Example Determine and allocate the consideration in the contract Lessee and Lessor enter into a 3-year lease of equipment that includes maintenance services of the equipment throughout the lease term. Lessee will pay Lessor: Scenario 1 A fixed payment of $110,000 per year, A variable payment of $7,700 each year the equipment is operational for a minimum number of hours at a specified level of productivity. Scenario 2 A fixed payment of $110,000 per year, A variable payment of $7,700 each year the equipment is operational for a minimum number of hours at a specified level of productivity. Scenario 3 A fixed payment of $102,700 per year, A variable payment of $15,000 each year the equipment is operational for a minimum number of hours at a specified level of productivity. Variable payments not solely related to performance of maintenance services quality and condition of the equipment affect its performance Variable payments relate specifically to Lessor s performance of the maintenance services equipment is tried and tested; maintenance services are specialized and critical to any entity s use of the equipment Same conclusion as Scenario 2 36

37 Example Determine and allocate the consideration in the contract (continued) Lessee evaluation: Scenario 1 Fixed payment: $110,000 per year, Variable payment: $7,700 per year. Scenario 2 Fixed payment: $110,000 per year, Variable payment: $7,700 per year. Scenario 3 Fixed payment: $102,700 per year, Variable payment: $15,000 per year. For all scenarios, Lessee does not include variable payments in the consideration in the contract Consideration in the contract is: $330,000 ($110,000 3) $308,100 ($102,700 3) Component Stand-alone price Allocation scenarios 1 & 2 Allocation scenario 3 Equipment lease $315,000 $292,817 $273,385 Maintenance 40,000 37,183 34,715 $355,000 $330,000 $308,100 37

38 Lease term Lease term comprises Non-cancellable period Periods for which lessee has option to extend (or not terminate) Periods for which lessor has option to extend (or not terminate) Includes any rent-free periods Include if lessee is reasonably certain to extend/not terminate Include Comparison to current U.S. GAAP Determination of lease term remains substantially unchanged from current U.S. GAAP. 38

39 Reasonably certain Reasonably certain is a high threshold of probability that must be met to include optional lessee payments in the measurement of lease assets and lease liabilities. Lessee must have a compelling economic reason to exercise the renewal or purchase option (or not to exercise a termination option). Consider all economic factors relevant to the assessment. Contractbased factors Entity-based factors Asset-based factors Market-based factors 39

40 Example Lease term Other information with respect to the lease of the warehouse is as follows: Non-cancellable period of the lease Optional renewal period (rent approximates fair value) Remaining economic life of warehouse 5 years 5 years 30 years At lease commencement, it is not reasonably certain Lessee A will exercise the 5- year renewal option: Lessee considers relevant economic factors in reaching that conclusion, including, but not limited to: Market rental payments for renewal period are at fair value The warehouse is not customized for Lessee A s needs Lessee A has not committed to install leasehold improvements that will have significant economic value after the non-cancellable period. What is the lease term? 40

41 Lease payments Present value (PV) of future lease payments over the lease term Includes: Fixed payments 1 Purchase options 3 Variable lease payments (VLPs) 5 Termination penalties 2 Residual value guarantees (RVGs) 4 Special-purpose entity structuring payments 6 Discount rate 7, 8 1. Fixed payments include in-substance fixed payments, less lease incentives paid or payable to the lessee 2. Only include the termination penalty if the lease term reflects the lessee exercising an option to terminate the lease 3. Include the exercise price of a purchase option if lessee is reasonably certain to exercise it 4. For RVGs lessee includes the amount probable of being owed 5. Include VLPs based on an index or rate (e.g., CPI) using the index/rate at lease commencement; and if in-substance fixed 6. Payments include those made by the lessee to owners of a special-purpose entity for structuring the transaction 7. A lessor is required to use the rate implicit in the lease. A lessee uses its incremental borrowing rate if the lessor s implicit rate is not readily determinable. 8. Nonpublic business entities may make an accounting policy election to use a risk-free discount rate (FASB only) 41

42 Initial direct costs Incremental costs of a lease that would not have been incurred if the lease had not been obtained (i.e., not been executed) Include Exclude Commissions Legal fees Payments made to existing tenant to incentivize that tenant to terminate the lease Cost of evaluating the prospective lessee s financial condition Cost of negotiating lease terms and conditions General overheads 42

43 Lessee Accounting

44 Example Storage warehouse lease Lessee accounting 5-year non-cancellable lease of a storage warehouse, with one 5-year renewal option Lessee A is not reasonably certain to exercise at lease commencement. Annual payments (in advance) of $100,000 that increase by $5,000 per year. Annual payments during the renewal period are $125,000 (in advance), increasing by $5,000 per year. Lessor B provides Lessee A with a moving allowance (i.e., a lease incentive) of $15,000 which Lessor B pays to Lessee A at lease commencement in cash. Lessee A Lessor B 44

45 Lease classification test Lessee accounting lease classification Ownership transfers at end of the lease term? Lessee purchase option reasonably certain of exercise? Lease term = major part (e.g., 75%) of remaining economic life 1, 2? PV of 1) lease payments + 2) lessee RVG substantially all (e.g., 90%) FV 1? No No No No Specialized asset with no alternative use to lessor? No Operating lease Yes Yes Yes Yes Yes Finance lease 1 Comparison to current U.S. GAAP Assessment criteria are similar to current U.S. GAAP, but without explicit bright lines 2 If the commencement date is at or near the end of the underlying asset s economic life, this test does not apply 45

46 Thresholds for lease classification tests Lessee accounting lease classification Paragraph permits (but does not require) use of bright-line thresholds when performing the lease term and present value tests: Threshold Major part of the remaining economic life Substantially all of the fair value of the underlying asset At or near the end of the economic life of the asset Permitted Bright Line 75% = major part 90% = major part 25% of the total economic life remaining = at or near the end May be appropriate to conclude that for some assets < 75% = major part of its remaining economic life if the asset is of a type that degrades in economic utility in a significantly front-loaded manner, while for others > 75% major part of its remaining economic life if asset holds its economic utility or value. Because substantially all is used elsewhere in U.S. GAAP and generally considered similarly, may not be substantial flexibility around that threshold. Generally do not think there is flexibility around 25% at or near the end threshold because it relates to an exception to the classification principle 46

47 Alternative use test New to Topic 842 Lessee accounting - lease classification Consider: Contractual restrictions Practical limitations Underlying asset being of a highly specialized nature or subject to highly specialized circumstances is key to meeting this test. Alternative use test not met solely because of contractual restrictions. Not another lease term test When considering alternative use, consider the characteristics of the asset that will ultimately be returned to the lessor at the end of the lease term (i.e., customizations or modifications agreed on or committed to at lease commencement). 47

48 Example Lease classification test Lessee accounting lease classification Ownership transfers at end of the lease term? Lessee purchase option reasonably certain of exercise? Lease term = major part (e.g., 75%) of remaining economic life? PV of 1) lease payments + 2) lessee RVG substantially all (e.g., 90%) FV? No No No No Specialized asset with no alternative use to lessor? No Operating lease Yes Yes Yes Yes Yes Finance lease Assumptions used: Rate implicit in the lease not readily determinable. Lessee A uses its incremental borrowing rate (which is 6%). FV warehouse: $1,500,000 PV lease payments: $488,564 Remaining economic life: 30 years 48

49 Recognition Lessee accounting Lessor Right to use underlying asset Lessee Lease payments Comparison to current U.S. GAAP For lessees, all leases (other than short-term leases) will be recognized on the balance sheet Presentation of interest expense in the income statement depends on lease classification ROU asset Right to use underlying asset during lease term Lessee A has the right to use the warehouse for 5 years Lease liability Obligation to make future lease payments Lessee A has an obligation to make the 4 remaining, unpaid annual lease payments 49

50 Initial measurement Lease liability Lessee accounting Lease liability Present value of unpaid lease payments A lessee initially measures a lease liability (and a right-of-use asset) at the lease commencement date. That is, the date on which the lessor makes the underlying asset available for use by the lessee. Comparison to current U.S. GAAP Under current U.S. GAAP, the date a company performs its lease classification test and initially measures a capital lease is at lease inception (i.e., the date an agreement is reached). 50

51 Example - Initial measurement Lease liability Lessee accounting The rate implicit in the warehouse lease is not readily determinable. Accordingly, Lessee A uses its incremental borrowing rate (which is 6%). There are 5 annual payments (in advance) of $100,000 that increase by $5,000 each year The 1st lease payment ($100,000) is made at lease commencement and therefore is excluded from the measurement of the lease liability. Lease liability $388,564 PV of unpaid lease payments Payment Date Amount Beg. of Year 2 $ 105,000 Beg. of Year 3 $ 110,000 Beg. of Year 4 $ 115,000 Beg. of Year 5 $ 120,000 51

52 Initial measurement ROU asset Lessee accounting ROU asset is the sum of: Initial measurement of lease liability Initial direct costs* Prepaid lease payments Lease incentives received * Only incremental costs to obtain the lease qualify no allocation of internal fixed costs is permitted and costs that would have been incurred even if the lease was not obtained (e.g., legal fees to draft the lease contract) are not initial direct costs. 52

53 Example - Initial measurement ROU asset Lessee accounting Lessee A: Incurred $10,000 in initial direct costs (e.g., broker commission) Prepaid $100,000 at lease commencement Received a lease incentive of $15,000 at lease commencement ROU asset is $483,564, which is the sum of: Initial measurement of lease liability Initial direct costs* Prepaid lease payments Lease incentives received $388,564 $10,000 $100,000 $(15,000) 53

54 Subsequent measurement ROU asset (Finance leases) Lessee accounting ROU asset Beginning balance Accumulated amortization* Accumulated impairment losses *Amortized, generally on a straight-line basis, over the shorter of the lease term or useful life of the ROU asset Together with interest expense, results in a front-loaded pattern of total lease cost ASC 360 impairment testing While finance lease accounting (Topic 842) is substantially similar to capital lease accounting (current U.S. GAAP), be aware of definitional differences (lease payments vs. minimum lease payments) and significant changes resulting from the reassessment requirements and new lease modification guidance. 54

55 ASC 360 Impairment Testing Potential triggering events (As defined under ASC ) A significant decrease in the market price of a long-lived asset A significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition A significant adverse change in legal factor or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator An accumulation of costs significantly in excess of the amounts originally expected for the acquisition or construction of a long-lived asset A current period operating or cash flow loss combined with a history of losses or a projection/forecast that demonstrates continuing losses associated with the use of long-lived assets A current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. 55

56 Subsequent measurement ROU asset (Operating leases, FASB only) Lessee accounting Method 1 Derive the ROU asset from the lease liability Lease liability carrying amount Unamortized initial direct costs Prepaid/ (accrued) lease payments Unamortized balance lease incentives received Method 2 Amortize the ROU asset ROU asset Beginning balance Accumulated amortization** P&L: Straight-line total lease cost (see next slide) ASC 360 impairment testing Once impaired, single lease cost is not straight-line (pattern, but not presentation is equivalent to finance lease). ** The amortization of the right-of-use asset each period is calculated as the difference between the straight-line lease cost for the period (including amortization of initial direct costs) and the periodic accretion of the lease liability using the effective interest method. 56

57 Example: ROU asset subsequent measurement Operating leases (FASB only) Method 1 Amortize the ROU asset ROU asset Beginning balance Accumulated amortization Lessee A will recognize straight-line lease cost of $109,000 each year of the lease, which includes: (a) straight-line amortization of the $10,000 in initial direct costs (IDCs) and (b) straight-line recognition of the $(15,000) lease incentive received. - ($535,000 in lease payments [$550,000 rent payments $15,000 lease incentives] + $10,000 in IDCs) 5 years = $109,000 Year 1 Amortization of ROU asset is $85,686 - Lease cost of $109,000 accretion of lease liability of $23,314 (6% x $388,564) Carrying amount of ROU asset at the end of Year 1: $397,878 - $483,564 beg. of Year 1 ROU asset $85,686 Year 1 amortization 57

58 Example: ROU asset subsequent measurement Operating leases (FASB only) (continued) Method 2 Derive the ROU asset from the lease liability Account balances at the end of Year 1: Lease liability Unamortized initial direct costs Prepaid/ (accrued) lease payments Unamortized balance lease incentives received $ 411,878 $8,000 $(10,000) $(12,000) $411,878 = $105,000 (due beginning of Year 2) + 3 additional remaining annual payments, discounted at 6% $8,000 = $10,000 initial IDCs $2,000 Year 1 amortization ROU asset $(10,000) = $100,000 Year 1 payment $110,000 straightline operating lease cost (excl. effect of IDCs and lease incentives) $(12,000) = $(15,000) initial lease incentives + $3,000 Year 1 accretion $397,878 Same as Method 1 58

59 ROU asset subsequent measurement Operating leases (FASB only) Regardless of the method chosen to subsequently measure the operating lease ROU asset, the following represents the effect of the operating lease in this example on Lessee B s financial statements throughout the lease term: Balance sheet Income statement Cash flows Date ROU asset Lease liability Net effect on equity Single lease cost Operating cash outflows (Net) Lease Commencement 483, ,564 95,000 End of Y1 397, ,878 (14,000) 109,000 (95,000) End of Y2 307, ,291 (18,000) 109,000 (105,000) End of Y3 211, ,208 (17,000) 109,000 (110,000) End of Y4 109, ,000 (11,000) 109,000 (115,000) End of Y5 109,000 (120,000) Total 545,000 (545,000) 59

60 Example - Subsequent measurement ROU asset (Operating leases, FASB only) (1/3) Lessee accounting subsequent measurement (ROU asset) Method 1 Derive the ROU asset from the lease liability Account balances at the end of Year 1: Lease liability carrying amount Unamortized initial direct costs Prepaid/ (accrued) lease payments Unamortized balance lease incentives received $411,878 $8,000 $(10,000) $(12,000) $411,878 = $105,000 (due beginning of Year 2) + 3 additional remaining annual payments, discounted at 6% $8,000 = $10,000 initial IDCs - $2,000 Year 1 amortization ROU asset $(10,000) = $100,000 Year 1 payment - $110,000 straight-line operating lease cost (excl. effect of IDCs and lease incentives) $(12,000) = $(15,000) initial lease incentives + $3,000 Year 1 accretion $397,878 Same as Method 1 60

61 Example -Subsequent measurement ROU asset (Operating leases, FASB only) (2/3) Lessee accounting Method 2 Amortize the ROU asset ROU asset Beginning balance Accumulated amortization** Lessee A will recognize straight-line lease cost of $109,000 each year of the lease, which includes: (a) straight-line amortization of the $10,000 in initial direct costs (IDCs) and (b) straight-line recognition of the $(15,000) lease incentive received ($535,000 in lease payments [$550,000 rent payments $15,000 lease incentives] + $10,000 in IDCs) 5 years = $109,000 Year 1 Amortization of ROU asset is $85,686 Lease cost of $109,000 accretion of lease liability of $23,314 (6% x $388,564 Carrying amount of ROU asset at the end of Year 1: $397,878 $483,564 beg. of Year 1 ROU asset - $85,686 Year 1 amortization 61

62 Example - Subsequent measurement ROU asset (Operating leases, FASB only) (3/3) Regardless of the method chosen to subsequently measure the operating lease ROU asset, the following represents the effect of the operating lease in this example on Lessee A s financial statements throughout the lease term: 62

63 Reassessments and modifications

64 Subsequent measurement and remeasurement Lease liability Lessee accounting Subsequent measurement Measured at present value of unpaid lease payments throughout the lease term No fair value option Lease liability remeasured when The lease is modified and that modification is not accounted for as a separate contract There is a change in: - The assessment of the lease term - The assessment of a purchase option exercise - The amount probable of being owed under a RVG A contingency is resolved resulting in some or all variable lease payments becoming fixed payments Comparison to current U.S. GAAP Under current U.S. GAAP, lease accounting is not revised after commencement unless the lease is modified. 64

65 Reassess lease term or purchase option Reassessment of lease term and purchase options (Lessees only) Lessee accounting lease reassessments Triggering events: Significant events or changes in circumstances within the lessee s control Example triggering events Constructing significant leasehold improvements Subleasing the asset for a period beyond the end of the lease term Significantly modifying or customizing the asset Making a business decision that is directly relevant to option exercise Or: Lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so; or Lessee does not elect to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so. 65

66 Summary Lessee accounting lease reassessments Lease modification not accounted for as a separate contract Change in lease term Change in assessment of lessee purchase option exercise Change in amount probable of being owed under RVG Resolution of contingency When do I reassess? N/A Only when there is a triggering event (as defined) Whenever relevant facts and circumstances change Do I revise: Lease payments? Consideration in the contract? Allocation of consideration? Discount rate? Lease classification? 66

67 Accounting for a change arising from a reassessment Lessee accounting lease reassessments Change in lease term Change in assessment of lessee purchase option exercise Change in amount probable of being owed under RVG Resolution of contingency 1. Remeasure and reallocate consideration in the contract 2. Remeasure lease liability using updated discount rate 3. Remeasure lease liability using original discount rate 4. Adjust ROU asset. If ROU asset reduced to zero => P&L 5. Reassess lease classification at reassessment date 6. If lease classification changes, adjust recognition & presentation 67

68 Lessee accounting for lease modifications Lessee accounting Does the modification grant the lessee an additional ROU 1? No Yes Is the additional ROU priced commensurate with its standalone price? Yes Account for additional ROU as a separate contract No Does the modification decrease the lessee s ROU 1? Yes Account for modification as a full, or partial, early lease termination. Decrease carrying amount of ROU asset on a basis proportionate to full (or partial) termination. Difference between decrease in lease liability and ROU asset = gain or (loss) No Adjust the lease liability and record an equal and offsetting change to the ROU asset Topic 842 includes additional guidance when the original lease was a finance lease, and the modified lease is an operating lease 1 Lease term is an attribute of the lessee s right to use the underlying asset (i.e., does not grant the lessee an additional right of use). 68

69 Accounting steps for lease modification Lessee accounting Remeasure and reallocate the contract consideration to the remaining lease and nonlease components Remeasure the lease liability to reflect revised lease payments, using a discount rate at modification effective date Modifications that decrease lessee s right-of-use: ROU asset carrying amount reduced on a proportionate basis to the full (or partial) termination of the existing lease. Remainder in P&L. Other modifications, adjust ROU asset by the amount of the lease liability remeasurement. Account for IDCs, lease incentives, and other payments in same manner as for a new lease. Reassess lease classification as of the effective date of the modification based on the circumstances at that date. If there is a change in lease classification, adjust the remaining lease cost recognition pattern and presentation in the income statement and statement of cash flows prospectively. 69

70 Lease liability Subsequent measurement and reassessments Subsequent measurement Lease liability remeasured when Measured at PV of unpaid lease payments throughout the lease term No fair value option The lease is modified and that modification is not accounted for as a separate contract There is a change in: - The assessment of the lease term - The assessment of a purchase option exercise - The amount probable of being owed under a RVG A contingency is resolved resulting in some or all variable lease payments becoming fixed payments Comparison to current U.S. GAAP Under current U.S. GAAP, lease accounting is not revised after commencement unless the lease is modified. 70

71 When to reassess Change in the lease term Change in assessment of lessee purchase option exercise Change in amount probable of being owed under RVG Resolution of a contingency Reassess ONLY: When there is triggering event An event written into the contract obliges the lessee to exercise (or not to exercise) an option The lessee elects to exercise an option it had previously determined that it was not reasonably certain to exercise The lessee elects not to exercise an option it had previously determined it was reasonably certain to exercise. Reassess whenever relevant facts or circumstances change (e.g., market value of the underlying asset changes) 71

72 Reassessment of lease term and purchase options Significant Events or Significant Changes within Lessee s Control Example Triggers Constructing significant leasehold improvements Significantly modifying or customizing the underlying asset Making a business decision that is directly relevant to the lessee s ability to exercise or not exercise an option Subleasing the underlying asset for a period beyond the exercise date of an option Lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so Lessee does not elect to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so 72

73 Example Change in lease term At the end of Year 3, Lessee A constructs leasehold improvements that will have significant economic value beyond the non-cancellable period of the lease such that A is reasonably certain to exercise the 5-year renewal option. The remaining lease term is now 7 years. Lessee A s incremental borrowing rate at the end of Year 3 is 6.5%. Annual payments during the renewal period are $125,000 (payable in advance), increasing by $5,000 each year. Since Lessee A is now reasonably certain to exercise the 5-year renewal option, Lessee A: - Remeasures the lease liability at the end of Year 3, using a discount rate of 6.5%: $751,999 (which increases the lease liability balance immediately prior to the remeasurement date by $523,791) - Records the following journal entry: Account Debit Credit Right-of-use asset 523,791 Lease liability 523,791 - Reassesses lease classification considering the facts and circumstances at the remeasurement date (i.e., FV and remaining economic life of warehouse at that date) 73

74 Build-to-suit lease considerations

75 Lessee costs relating to construction or design of underlying asset Scenario An entity negotiates a lease before the underlying asset is available for use by the lessee. The underlying asset needs to be constructed or redesigned for use by the lessee. The entity incurs costs related to the construction or design of the underlying asset.* If the lessee: Controls the underlying asset being constructed before the commencement date Apply sale-leaseback guidance in Topic 842 DOES NOT control the underlying asset being constructed before the commencement date Not a sale-leaseback transaction * Account for costs related to the construction or design of the asset in accordance with other Topics (e.g., Topic 360 on PP&E). Payments for the right to use the underlying asset are lease payments regardless of when paid. 75

76 Lessee control over the underlying asset before the commencement date of the lease Lessee controls the underlying asset being constructed before the commencement date if:* The lessee has the right to obtain the partially-constructed underlying asset at any point during the construction period (e.g., by making a payment to the lessor); The lessor has an enforceable right to payment for performance to date and the asset has no alternative use to the owner-lessor; The lessee legally owns the asset and, if applicable, the land upon which it is being built; The lessee controls the land that property improvements will be constructed upon and has not leased the land to the lessor for substantially all the economic life of the property improvements; or The lessee has a lease of the land that the property improvements will be constructed upon for at least substantially all the economic life of the improvements and has not subleased the land to the lessor or an unrelated third party for substantially all the economic life of the improvements. * Not an all-inclusive list 76

77 Example Lessee control over the asset under construction #1 Facts Lessee LE enters an agreement to lease a building from Lessor LR that will be constructed LE agrees to manage the construction process The agreement permits LE to acquire the in-process asset from LR, but only in the case of certain events of default. None of the other indicators on the prior slide (or other factors) suggest LE controls the underlying asset as it is being constructed Evaluation LE would be considered to control the building as it is being constructed and, therefore, would be within the scope of the sale-leaseback guidance if: One or more of the events of default that would permit LE to exercise an option to acquire the in-process asset are substantially within LE s control. For example, if LE is managing the construction process, and construction delays trigger the purchase option, LE would control the underlying asset just as if the purchase option was noncontingent. In contrast, if the events of default are not within LE s control, then LE would not control the building while it is being constructed 77

78 Example Lessee control over the asset under construction #2 Facts Lessee LE and Lessor LR enter into a contract whereby LR will construct a building with a 40-year economic life to LE s specifications and lease that building to LE once it is complete. LE does not legally own the building and does not have a right under the contract to obtain the building while it is under construction. Although the building is being developed to LE s specifications, it has an alternative use to LR. LE controls the land on which the building is to be constructed. LE agrees to lease the underlying land to LR for 25 years, beginning at the end of the construction period. The contract does not permit LR to renew the ground lease. Evaluation In this scenario, LE controls (i.e., is the accounting owner of) the building as it is being constructed, because: LE controls the land on which the building will be constructed, and The lease of the building does not both (1) grant LR the right to control the use of the land before the beginning of the construction period, and (2) permit LR to control the use of the land for substantially all of the economic life of the building. 78

79 Example Comparison of current guidance versus new guidance Restaurant LE agrees to lease from REIT LR a basic retail storefront in an enclosed shopping mall that is under construction. Restaurant LE agrees to construct certain portions of the space for which LE s use requires greater than the standard specifications, including an upgraded floor-drain system, and a high-capacity HVAC system. In exchange for bearing this cost, REIT LR provides Restaurant LE with a tenant improvement allowance equal to the budgeted amount for the standard flooring and HVAC. The lease agreement does not contain any indicators as per Topic 842 that Restaurant LE controls the underlying asset during the construction period. 79

80 Example Comparison of current guidance versus new guidance (continued) Current U.S. GAAP LE evaluates whether its involvement in construction of the underlying asset results in LE having substantially all of the construction period risks. As part of this evaluation, LE considers whether the commitment to pay for certain construction costs causes it to fail the maximum guarantee test. LE must also consider whether the entirety of the build-to-suit agreement violates any of the specified automatic indicators of ownership. New U.S. GAAP LE evaluates whether it controls the underlying asset during the construction period. If LE does not control the building, it does not control the HVAC or floor-drain system it is paying for. It is, in effect, paying for a portion of LR s asset. Therefore, LE accounts for the cost of those building improvements as lease payments to LR. 80

81 Transition guidance for build-to-suit (BTS) transactions Beginning of earliest period presented January 1, 2017 December 31, 2018 Effective date (date of adoption) January 1, 2019 December 31, 2019 Comparative period Comparative period Current period Construction completed prior to comparative periods If transaction resulted in saleleaseback, apply general transition guidance to lease. If transaction resulted in failed sale-leaseback, derecognize Topic 840 build-to-suit assets and liabilities at beginning of earliest comparative period presented. Record any difference as an adjustment to equity at that date. Construction completed during comparative periods Derecognize Topic 840 build-to-suit assets and liabilities at the later of: Beginning of earliest comparative period presented, or Date the lessee is determined to be accounting owner. Record any difference as an adjustment to equity at that date. If construction is completed prior to the effective date, lessee is not required to assess whether it was the accounting owner under Topic 842 for purposes of modified retrospective presentation. Construction period in progress at effective date Evaluate whether lessee is the accounting owner under Topic 842 If the lessee is accounting owner under Topic 840 and Topic 842: Continue to recognize the BTS assets and liabilities until they qualify for derecognition in accordance with the sale-leaseback requirements in Topic 842. If the lessee is accounting owner under Topic 842 but not Topic 840: Recognize BTS assets and liabilities back to later of beginning of earliest period presented or start of construction If the lessee is not the accounting owner under Topic 842: Derecognize the assets and liabilities that were recognized solely as a result of a transaction s BTS designation under Topic 840 at the later of (a) the beginning of the earliest period presented and (b) the date the lessee is determined to be the accounting owner of the asset under Topic 840. Record any difference as adjustment to equity at that date. Apply the general lessee transition guidance for the lease itself. 81

82 Leases acquired in a business combination

83 Leases acquired in a business combination - overview Acquiree is a lessee Acquiree is a lessor Operating and finance leases Operating leases Sales-type and direct financing leases Lease liability Present value of the remaining lease payments Right-of-use asset Equal to the liability, adjusted for any favorable/unfavorable terms Property, plant, and equipment Underlying asset at fair value Lease receivable Present value of the remaining lease payments and guaranteed residual value Intangible assets Associated with the lease Asset or liability Favorable/unfavorable terms Unguaranteed residual asset Difference between fair value of underlying asset*, and lease receivable * Fair value of the underlying asset in this context takes into account the terms and conditions of the acquired lease. Intangible assets Associated with the lease 83

84 Leases acquired in a business combination - other considerations Adjustments for market terms Similar to a favorable/unfavorable operating lease asset/liability Intangible assets Component of the right-ofuse asset when acquiree is a lessee Separate asset/liability when acquiree is a lessor in an operating lease* Entry into a controlled market In-place lease asset or customer relationship * The terms and conditions of a lease, including the nature of terms as off-market, if applicable, are taken into account in determining the fair value of the underlying asset in a sales-type or direct financing lease, and therefore no separate asset or liability is recognized. 84

85 Example Acquisition of lessee Company AR acquires Lessee LE, which leases its main distribution center from Lessor LR. The distribution center comprises a large building and surrounding land near a major interstate highway interchange. The lease has been properly classified as an operating lease. Key facts: Lease term: 25-year original term at commencement, 19-year remaining term at acquisition (i.e., acquisition occurs on first day of year 7 of the lease) Contractual lease payments: $1 million annually, with 3% escalation annually after year 1 ($1,194,052 lease payment for Year 7) Fair value of property at lease commencement: $30 million Remaining economic life of building at lease commencement: 45 years LE s incremental borrowing rate at commencement: 7%, AR s incremental borrowing rate at acquisition date: 8% Accrued rent liability at acquisition: $2,281,816 There are no identifiable intangible assets associated with the lease 85

86 Example Acquisition of lessee (continued) Scenario 1: Assume that the remaining contractual lease payments approximate market rates Scenario 2: Assume that the Year 7 lease payment approximates an at-market lease payment. However, current market conditions would call for a 4% annual escalation beginning in Year 8 through the remainder of the lease term (rather than 3%). AR recognizes a ROU asset and lease liability on the acquisition date as follows: Lease liability of $14,177,970 (the present value of the contractual payments using a discount rate of 8%) Right-of-use asset of $14,177,970, which equals the lease liability because lease is at market terms AR recognizes the same lease liability as in Scenario 1 AR measures the right-of-use asset as follows: Amount of the lease liability: $14,177,970 Off-market adjustment*: 1,100,451 Total ROU Asset: $15,278,421 * Calculated as the difference between contractual and atmarket lease payments, discounted at the same 8% discount rate. 86

87 Transition guidance for assets and liabilities from previous business combinations The process of transitioning existing assets (liabilities) arising from favorable (unfavorable) lease terms in previous business combinations depends on the combination of status as lessee or lessor and the classification of the lease under current U.S. GAAP: Lease is a(n): Entity is the lessee Entity is the lessor Operating lease Finance lease (lessee) Sales-type/direct financing lease (lessor) Asset (liability) is derecognized, with a corresponding adjustment to the ROU asset N/A No Change Asset (liability) is derecognized, with a corresponding adjustment to beginning retained earnings 87

88 Lessor accounting

89 Lease classification test (Part A) Lessor accounting lease classification Part A tests Ownership transfers at end of the lease term? Lessee purchase option reasonably certain of exercise? No Lease term = major part (e.g., 75%) of remaining economic life? 1,2 PV of 1) lease payments + 2) lessee RVG substantially all (e.g., 90%) FV? No No No Specialized asset with no alternative use to lessor? 3 No Go to Part B tests Yes Yes Yes Yes Yes Sales-type lease 1 Comparison to current U.S. GAAP Assessment criteria are similar to current U.S. GAAP, but without explicit bright lines 2 If the commencement date is at or near the end of the underlying asset s economic life, this test does not apply 3 Refer to discussion of this criterion on Slide 33 89

90 Lease classification test (Part B) Lessor accounting lease classification Part B tests Does the present value of the sum of (1) the lease payments and (2) any residual value guarantee from the lessee or a third party unrelated to the lessor equal or exceed substantially all (e.g. 90%) of the underlying asset s fair value? Yes Is it probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee? No No Operating lease Yes Direct financing lease 90

91 Additional lease classification considerations for lessors Lessor accounting lease classification Determine the present value of lease payments and residual value guarantees using the rate implicit in the lease Present value of lease payments Present value of estimated future residual value Fair value of underlying asset 1 Initial direct costs deferred 2 Rate implicit in the lease 1. FV of underlying asset is reduced by amount of any investment tax credit related to underlying asset that is retained and expected to be realized by lessor. 2. IDCs are not deferred if lease is a sales-type lease and the FV of the asset is different from its carrying amount at lease commencement. Solely for the purpose of determining whether a lease is a sales-type lease, the discount rate used in the present value test assumes no IDCs will be deferred if at the commencement date the fair value of the underlying asset is different from its carrying amount. 91

92 Thresholds for lease classification tests Paragraph permits (but does not require) use of bright-line thresholds when performing the lease term and present value tests: Threshold Major part of the asset s remaining economic life Substantially all of the asset s fair value At or near the end of the asset s economic life Permitted bright line 75% = a major part 90% = substantially all 25% of the total economic life remaining = at or near the end May be reasonable to conclude that for some assets < 75% = major part of its remaining economic life if the asset degrades in economic utility in a significantly front-loaded manner, while for others > 75% major part of its remaining economic life if asset holds its economic utility or value Because substantially all is used elsewhere in U.S. GAAP and generally considered similarly, may not be substantial flexibility around that threshold Generally there is not flexibility around 25% at or near the end threshold because it relates to an exception to the classification principle 92

93 Alternative use test New to topic 842 Consider: Contractual restrictions Practical limitations Underlying asset being of a highly specialized nature or subject to highly specialized circumstances is key to meeting this test. - Alternative use test not met solely because of contractual restrictions - Not another lease term test When considering alternative use, consider the characteristics of the asset that will ultimately be returned to the lessor at the end of the lease term (i.e., customizations or modifications agreed or committed at lease commencement) 93

94 Key classification differences vs. current U.S. GAAP Fair value of underlying asset compared to its carrying amount no longer dictates whether lease is a sales-type or a direct financing lease. Leveraged lease classification and accounting no longer exists prospectively from the effective date of Topic 842. Real estate leases no longer have special rules (e.g., transfer of title to be a sales-type lease) they are subject to the same guidance as all other leases. Collectibility uncertainties do not preclude a lease from being classified as a sales-type lease. However, a lease cannot be classified as a direct financing lease if the collectibility test is failed. No important uncertainties about unreimbursable costs test in Topic 842. Exception pertaining to leases entered into at or near the end of the economic life of the asset only applies to lease term test, not the present value test. 94

95 Example: Forklift lease Lessor accounting lease classification Lessor leases a forklift to Lessee for 3 years. Lease payments (annual, paid in arrears) $11,000 Transfer of ownership, purchase option, or renewal option None Fair value of forklift $40,000 Carrying amount of forklift $36,000 Initial direct costs (Topic 842) $1,500 Remaining economic life 5 years Estimated future residual value $12,500 Residual value guarantee provided by third-party $9,200 Rate implicit in the lease 4.15% Rate implicit in the lease (IDCs not considered) 5.88% Collectibility of lease payments and RVG at commencement Probable 95

96 Example: Forklift lease Lessor accounting lease classification Part A tests Ownership transfers at end of the lease term? Lessee purchase option reasonably certain of exercise? No Lease term = major part (e.g., 75%) of remaining economic life? 1 PV of 1) lease payments + 2) lessee RVG substantially all (e.g., 90%) FV? No No No Specialized asset with no alternative use to lessor? No Go to Part B tests Yes Yes Yes Yes Yes Sales-type lease Calculations: Lease term remaining economic life of forklift = 60% PV lease payments (discounted at 5.88%): $29,469 PV lease payments FV of forklift = 74% 96

97 Example: Forklift lease Lessor accounting lease classification Part B tests Does the present value of the sum of (1) the lease payments and (2) any residual value guarantee from the lessee or a third party unrelated to the lessor equal or exceed substantially all of the underlying asset s fair value? Yes Is it probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee? Yes Direct financing lease No No Operating lease Calculations: PV (lease payments + RVG), discounted at 4.15%: $38,579 PV (lease payments + RVG) FV of forklift = 96% 97

98 Operating leases Lessor accounting Lessor Right to use underlying asset Lessee Lease payments Underlying asset No de-recognition of underlying asset Lease income recognized generally on a straight-line basis Underlying asset remains on the lessor s balance sheet and continues to be depreciated 98

99 Sales-type and direct financing leases Lessor accounting Lessor Right to use underlying asset Lessee Lease payments Lease Receivable Right to receive future lease payments + guaranteed residual value Unguaranteed Residual Asset Unguaranteed portion of estimated residual value Total Net Investment in the Lease* Lease receivable and unguaranteed residual asset discounted using rate implicit in the lease. Interest income is accrued on the net investment in the lease using the rate implicit in the lease. The lessor s entire net investment in the lease is assessed for impairment using the financial instruments impairment guidance. *If the lease is a direct financing lease, any selling profit is deferred and deferred selling profit reduces the net investment in the lease 99

100 Sales-type vs. direct financing leases Lessor accounting Sales-type leases Recognize at lease commencement Recognize at lease commencement FV underlying asset carrying amount Expense at lease commencement Exclude from determination of rate implicit in the lease FV of underlying asset = carrying amount Defer and include in net investment in the lease Include in determination of rate implicit in the lease Selling profit Selling loss Initial direct costs* Direct financing leases Defer as a reduction of the net investment in the lease Recognize at lease commencement Defer and include in net investment in the lease Include in determination of rate implicit in the lease * Topic 842 s definition of initial direct costs is different from current US GAAP 100

101 Example Direct financing lease with selling profit Lessor leases a forklift to Lessee for 3 years. Lease payments (annual, paid in arrears) $11,000 Transfer of ownership, purchase option, or renewal option None Fair value of forklift $40,000 Carrying amount of forklift $36,000 Initial direct costs (Topic 842) $1,500 Remaining economic life 5 years Estimated future residual value $12,500 Residual value guarantee provided by third-party $9,200 Rate implicit in the lease 4.15% Rate implicit in the lease (IDCs not considered) 5.88% Collectibility of lease payments and RVG at commencement Probable Same example used for lease classification 101

102 Example Direct financing lease with selling profit (continued) Balance sheet End of year Lease receivable 2 Unguar. resid. asset 2 Deferred selling profit 1 Net invest. In lease Income statement Interest on receivable 2 Residual accretion 2 Earned selling profit 1 Total income * 0 $38,579 $2,921 ($4,000) $37,500 $ $ $ $ 1 29,182 3,042 (2,351) 29,873 1, ,649 3, ,394 3,168 (1,002) 21,560 1, ,349 2, ,200 3, , ,002 1,940 Totals $3,621 $379 $4,000 $8, Subsequent to lease commencement, earned selling profit recognition = total income* interest on lease receivable unguaranteed residual asset accretion *Total income (incl. deferred profit release) each year is calculated as the net investment in the lease the discount rate that would have been required for the sum of the lease receivable and the unguaranteed residual asset to equal the forklift s carrying amount + the deferred IDCs (9.00%) 2. Calculated using the rate implicit in the lease (4.15%) i.e., the discount rate that makes the PV of the (lease payments + estimated future residual value) = the FV of the forklift at lease commencement of $40,000 + the deferred IDCs of $1,

103 Example Comparison to current U.S. GAAP Topic 842 Commencement Year 1 Year 2 Year 3 Total Lease income $ $ 3,373 $ 2,687 $ 1,940 $ 8,000 Selling profit 1 1,649 1,349 1,002 4,000 IDCs amortization 1 (627) (505) (368) (1,500) Note 1: Lease income is net of IDCs amortization and includes earned selling profit; therefore, the amounts in these 2 lines are illustrative only (for comparison purposes to current U.S. GAAP). Current U.S. GAAP 2 Commencement Year 1 Year 2 Year 3 Total Interest income $ $ 2,351 $ 1,843 $ 1,306 $ 5,500 Selling profit 4,000 4,000 Expense IDCs (1,500) (1,500) Lease income $ 2,500 $ 2,351 $ 1,843 $ 1,306 $ 8,000 Note 2: Lease would be a sales-type lease under current U.S. GAAP 103

104 Collectibility lease classification considerations Lessor accounting The assessment of collectibility occurs after the Part A classification tests. Collectibility issues do not prevent classification as a sales-type lease. However, a lease cannot be classified as a direct financing lease if collectibility of the lease payments and RVG is not probable at lease commencement. Changes in assessment of collectibility after commencement date do not change lease classification (whether change in collectibility is positive or negative). Example: A lease classified as an operating lease at commencement date solely because of collectibility issues is not reclassified as a direct financing lease if collectibility subsequently becomes probable. 104

105 Collectibility sales-type leases (1 of 2) Lessor accounting Collectibility of lease payments and lessee residual value guarantee is assessed after a lease has already been classified as a sales-type lease. If collectibility is not probable, the lessor: Does not derecognize the underlying asset! Recognizes lease payments (including variable lease payments) as a deposit liability until one of the following occurs: a) collectibility becomes probable b) contract is terminated and lease payments received are nonrefundable c) lessor has repossessed asset, has no further obligation to lessee, and lease payments received are non-refundable 105

106 Collectibility sales-type leases (2 of 2) Lessor accounting If collectibility becomes probable, the lessor will: Derecognize the underlying asset Derecognize the deposit liability Recognize a net investment in the lease Recognize selling profit (loss) Selling profit (loss) Lease receivable Carrying amount of deposit liability Carrying amount of underlying asset, net of unguaranteed residual asset When one of the two designated events occurs: Derecognize the deposit liability Recognize lease income equal to the derecognized deposit liability 106

107 Example Sales-type lease Collectibility not probable Lessor leases a bulldozer to Lessee for 5 years. Lease payments (annual, paid in arrears) $13,500 Transfer of ownership, purchase option or renewal option None Fair value of bulldozer $72,000 Carrying amount of bulldozer $65,000 Remaining economic life 7 years Estimated future residual value $17,000 Residual value guarantee provided by lessee $14,000 Rate implicit in the lease 4.90% Collectibility of lease payments and RVG at commencement Not probable Lease is classified as a sales-type lease even though collectibility is not probable. 107

108 Example Sales-type lease Collectibility not probable (continued) Because collectibility is not probable at lease commencement, Lessor: - Does not derecognize the asset nor recognize a net investment in the lease, - Does not recognize selling profit, - Continues to depreciate the bulldozer, - Recognizes lease payments received as a deposit liability. In Years 1 and 2, Lessor concludes collectibility is still not probable. At the end of Year 3, Lessee makes 3 rd lease payment timely. Considering all relevant facts and circumstances, including 3 timely payments and an improvement in Lessee s financial condition, Lessor determines collectibility is now probable. Balances at the end of Year 3: - Carrying amount of bulldozer: $37,142 ($65,000 [$9,286 depr. 3 years]) - Deposit liability: $40,500 (3 payments of $13,500) 108

109 Example Sales-type lease Collectibility not probable (continued) Journal entry at the end of Year 3 Account Debit Credit PP&E 65,000 Accumulated depreciation 27,858 Deposit liability 40,500 Net investment in lease 40,588 Selling profit 43,946 Worksheet for journal entry PV of 2 lease payments 25,139 PV of Lessee RVG 12,723 Lease receivable 37,862 PV unguar. residual value 2,726 Net investment in lease 40,588 Lease receivable 37,862) Deposit liability 40,500) Carrying amount bulldozer (37,142) Unguar. Residual value 2,726) Selling profit 43,946 Note: Lessor uses rate implicit in the lease at lease commencement (i.e., 4.90%) to calculate the net investment in the lease at the end of Year 3 when collectibility becomes probable. 109

110 Collectibility Leases other than sales-type leases If collectibility of lease payments and any residual value guarantee(s) is not probable at the commencement date, the lease is classified as an operating lease. Cumulative lease income is limited to the lesser of: a) Income that would be recognized for an operating lease (generally straight-line) b) Lease payments, including variable lease payments, collected from the lessee If collectibility becomes probable, any difference between a) and b) above is recognized as a current-period adjustment to lease income. 110

111 Example Lessor accounting Collectibility not probable Assume the same bulldozer lease as in previous example, except that: - The residual value guarantee is provided by a third-party, not Lessee - The lease payments increase by $1,000 each year (Year 1: $13,500) Because collectibility of the lease payments and the third-party residual value guarantee is not probable at lease commencement => operating lease Year 1 & 2 Collectibility not probable Lessor recognizes lease income when Lessee makes lease payments Lessor recognizes lease income of $13,500 in Year 1 and $14,500 in Year 2 (total = $28,000) Year 3 Collectibility becomes probable at end of year Lessor recognizes lease income of $18,500 in Year 3, calculated as: (S/L lease income of $15,500 x 3 years) (lease income previously recognized of $28,000). Year 4 & 5 Collectibility is probable Lessor recognizes lease income of $15,500 in each of years 4 and 5) 111

112 Part 2 Part 1 Measure the consideration in the contract (Lessor) Consideration in the contract (Lessee) Are there any other variable payments that specifically relate to either: The lessor s efforts to transfer one or more goods or services that are not leases? OR An outcome from transferring one or more goods or services that are not leases? No No adjustment necessary Yes Yes Apply variable consideration requirements in Topic 606 to measure the amount to be included in the consideration in the contract: Step 1: Estimate the amount using the expected value or most likely amount Step 2: Determine the portion (if any) of that amount for which it is probable that a significant revenue reversal will not subsequently occur Consideration in the contract (lessor) 112

113 Separate and allocate consideration to lease and non-lease components When there is an observable stand-alone price for each component: When there is not an observable stand-alone price for some or all components: Taxes and insurance on the property Accounting policy election by class of underlying asset Lessee Unless accounting policy elected (see below), separate and allocate based on the relative stand-alone price of components Estimate the stand-alone price, maximizing the use of observable information Lessor Always separate and allocate following the Topic 606 transaction price allocation guidance (i.e., generally on a relative stand-alone selling price basis) Activities that do not transfer a good or service to the lessee (or solely reimburse costs of the lessor) are not components of a contract and do not receive an allocation of the consideration in the contract Account for lease and nonlease components together as a single lease component Important Reminder Allocation to lease and non-lease components is critical, especially as a result of required disclosures. 113

114 Executory costs Executory costs A lessee s reimbursement or payment of the lessor s property taxes and insurance is an example of activities (or costs of the lessor) that do not transfer a good or service to the lessee. Therefore, fixed payments attributable to such activities or costs are part of the consideration that is then allocated to the separate lease and non-lease components. Gross lease Payments of lessor costs such as property taxes and insurance are fixed as part of the rental payment specified in the contract. Net lease The lessee makes variable payments, either to the lessor or to a third party, for items like property taxes and insurance. 114

115 Non-lease component revenue recognition method

116 Non-lease component revenue recognition method Identification of nonlease components (maintenance, other services) Topic 842 Identify the performance obligations in the contract Topic 606 Measure the consideration and allocate Topic 842 and 606 Recognize revenue for non-lease component Topic

117 Lessor Lease Modifications

118 Lessor accounting for a lease modification that is not a separate contract Original lease is a direct financing lease Lessor accounting lease modifications If modified lease is a Operating lease Sales-type lease Direct financing lease Carrying amount of underlying asset = Net investment in original lease, immediately prior to effective date of modification Account for modified lease in accordance with sales-type lease guidance in Subtopic with effective date of modification as commencement date of lease 1 Adjust discount rate so that initial net investment in modified lease = Carrying amount of net investment in original lease immediately prior to effective date of modification 1 In calculating the selling profit (loss) on the lease: - The fair value of the underlying asset is its fair value at the effective date of the modification; and - The carrying amount of the underlying asset is the carrying amount of the net investment in the original lease immediately before the effective date of the modification. 118

119 Lessor accounting for a lease modification that is not a separate contract Original lease is a sales-type lease Lessor accounting lease modifications If modified lease is a Operating lease Sales-type lease or direct financing lease Carrying amount of underlying asset = Net investment in original lease, immediately prior to effective date of modification Adjust discount rate so that initial net investment in modified lease = Carrying amount of net investment in original lease immediately prior to effective date of modification 119

120 Effect of contract modifications on separation and allocation Effect on: Separation conclusions Separation conclusions may be affected by the addition of lease or non-lease components and, therefore, are reassessed Allocation conclusions The remeasured consideration in the contract is allocated on a relative stand-alone selling price basis based on information at the effective date of the modification 120

121 Summary of key differences from U.S. GAAP (1 of 3) Lessor accounting Changes in lease classification between salestype and direct financing Recognition of selling profit Narrowed definition of initial direct costs (IDCs) No longer differentiated by whether there is manufacturer/dealer profit or loss. Now differentiated by whether lessor effectively transfers control of the underlying asset to lessee or transfers substantially all of the risks/benefits of ownership of underlying asset to lessee and an unrelated third party. Selling profit arising from direct financing leases is deferred and recognized over lease term. IDCs include only those incremental costs of a lease that would not have been incurred if the lease had not been executed. Allocated internal employee costs and other costs that would be required to be paid even if the lease was not executed (e.g., most legal fees) are not IDCs. 121

122 Summary of key differences from U.S. GAAP (2 of 3) Lessor accounting Allocation of consideration in the contract to lease and nonlease components Lessors always separate lease from non-lease components Apply transaction price allocation guidance in new revenue standard. Lessors separate lease and non-lease components and allocate consideration between them based on revenue recognition guidance. Executory costs Collectability Executory costs that do not represent payments for a good or service are allocated to the lease and non-lease components; they are not excluded from lease classification and certain other aspects of lease accounting. Leases with collectability uncertainties are not precluded from sales-type lease classification. New guidance about lease income recognition when collectability of the lease payments, plus any amounts necessary to satisfy residual value guarantees, is not probable. 122

123 Summary of key differences from U.S. GAAP (3 of 3) Lessor accounting Leases with significant variable payments Leases with entirely or predominantly variable payments may be classified as sales-type or direct financing leases. Lease modifications Leveraged leases Substantially different guidance on lease modifications aligns more closely with contract modification accounting in new revenue recognition guidance. Lease classification is reassessed on a lease modification that is not accounted for as a separate contract. Lessor accounting for a lease modification depends on the classification of the original and the modified lease. Leveraged lease classification and accounting is eliminated prospectively. Lessors continue to account for leveraged leases that commenced before the effective date in accordance with ASC 840, unless lease is modified on or after the effective date of ASC

124 Other issues

125 Subleases Subleases Head lessor Apply lessor accounting Head lessee/ intermediate lessor (sublessor) Apply lessee accounting to the head lease Apply lessor accounting to the sublease Generally present gross Sublessee* Apply lessee accounting * Sublease classification based on underlying asset for U.S. GAAP; ROU asset for IFRS Most U.S. GAAP subleases will be classified as operating leases by sub-lessor Most IFRS subleases will be classified as finance leases by sub-lessor 125

126 Sale-leaseback transactions - overview Sale-leaseback transactions Sale is recognized in accordance with applicable GAAP For a sale to occur, transaction must meet ASC 606 requirements for a sale Sale Purchase is recognized in accordance with applicable GAAP Seller-lessee Buyer-lessor Leaseback is accounted for using the lessee right-of-use model Leaseback Gain on sale* is adjusted for off-market terms Each component of the transaction is assessed separately * For IFRS, gain on sale is restricted to the residual interest in the underlying asset. For U.S. GAAP, gain on sale is based on entire underlying asset. 126

127 Step 1: Does a contract exist? (Topic 606) Sale-leaseback transactions A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability is a matter of law. Contracts can be written, oral, or implied by an entity s customary business practices. Additionally: collection of consideration is probable rights to goods or services and payment terms can be identified A contract exists if it has commercial substance it is approved and the parties are committed to their obligations 127

128 Step 5: Transfer of control at a point in time (Topic 606) Sale-leaseback transactions The guidance in , which links to for purposes of determining whether a sale has occurred in a sale-leaseback transaction, relies on the control principle and specified indicators of the transfer of control. Control Principle ( ) Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. Indicators that control has passed include a customer having...a present obligation to pay...physical possession legal title...risks and rewards of ownership...accepted the asset 128

129 Additional sale/purchase considerations Sale-leaseback transactions Classification of the leaseback Seller-lessee repurchase options If the leaseback would be classified as a finance (or sales-type) lease, no sale/purchase of the asset occurs and the transaction is accounted for as a financing arrangement Preclude sale/purchase accounting unless both criteria are met: Option is exercisable only at the thenprevailing fair value of the asset at the exercise date There are alternative assets, substantially the same as the transferred asset, readily available in the marketplace According to the FASB, this 2 nd criterion cannot be met for real estate assets because real estate is unique. Therefore, any repurchase option for a real estate asset will preclude sale/purchase accounting. 129

130 Example: Sale-leaseback accounting Does sale/purchase occur? Sale-leaseback transactions Seller-Lessee SL enters into a contract with Buyer-Lessor BL to sell and lease back a truck. Title to the truck transfers to BL at commencement of the leaseback Payment of the transaction price is due to SL at commencement of the leaseback Additionally, the following facts are relevant: Remaining economic life of the truck 5 years Fair value of the truck at the commencement date $10,000 Leaseback term 3 years Fixed leaseback payments, payable annually in arrears $2,800 SL s incremental borrowing rate 7% Expected residual value $3,000 Residual value guarantee Repurchase option Sale is recognized and the leaseback is classified as an operating lease. None None 130

131 Example: Sale-leaseback accounting Does sale/purchase occur? (alternative scenario) Sale-leaseback transactions Now let s consider the following alternative facts, and the impact that they may have on whether a sale occurs: Consider if: The implications are: The agreement contains a seller-lessee repurchase option with a fixed exercise price The agreement contains a seller-lessee repurchase option with a variable repurchase price that is set based on the fair value of the truck at the time of option exercise The term of the leaseback is 4 years instead of 3 The seller-lessee provides the lessor with a significant residual value guarantee Any repurchase option with a fixed exercise price precludes sale accounting; therefore the sale-leaseback transaction is accounted for as a financing arrangement by both parties. Because the exercise price is the then-prevailing fair value of the truck at the date of option exercise, if there are equivalent trucks readily available in the marketplace, this repurchase option would not preclude the sale from being recognized. The longer leaseback term results in classification of the leaseback as a finance lease; classification of a leaseback as a finance lease precludes accounting for the transaction as a sale and a leaseback. Therefore the sale-leaseback transaction is accounted for as a financing arrangement by both parties. Judgment is required when evaluating the effect of residual value guarantees. A residual value guarantee provided by the seller-lessee may suggest that the buyer-lessor has not taken on the significant risks and rewards of ownership of the asset, which is one of the indicators to consider in evaluating whether control of an asset has transferred to the buyer-lessor. 131

132 Comparison to current U.S. GAAP Sale-leaseback transactions Topic Real estate assets and assets other than real estate Failed purchase accounting Accounting for the sale/purchase What s changed? The same guidance applies to all sale-leaseback transactions, regardless of the nature of the underlying asset (i.e., no separate guidance for sale-leaseback transactions of real estate assets and assets other than real estate) Sale-leaseback accounting will be easier to achieve for real estate than under current U.S. GAAP, but more difficult for assets other than real estate Buyer-lessors are required to account for a sale-leaseback transaction as a failed purchase if the transaction does not meet the requirements for a sale in A sale occurs only if the Step 1 and Step 5 guidance in Topic 606 is met. A substantive repurchase option for the seller-lessee precludes sale accounting except as follows: Seller-lessee repurchase option does not preclude sale accounting for sale-leaseback transactions of non-real estate if 1) the option is exercisable only at fair value at date of exercise and 2) there are alternative assets, substantially the same as the transferred asset, readily available in the marketplace (FASB Only) Regardless of the guidance in Topic 606, there is no sale (or purchase) if the leaseback would be a finance lease for the seller-lessee (or sales-type lease for the buyer-lessor) (FASB only) A seller-lessee will measure the gain on sale as the amount by which the selling price of the underlying asset exceeds its carrying amount, unless the sales price is not at market terms 132

133 Example: Sale-leaseback transaction at market terms Sale-leaseback transactions Seller-Lessee SL enters into a sale-leaseback of a forklift with an unrelated third-party (Buyer- Lessor BL) Information re: the sale-leaseback of the forklift is as follows: 1. Sale price (and fair value) of forklift $50, Noncancellable term of leaseback 3 years 3. Remaining economic life of forklift at leaseback commencement 6 years 4. Present value of contractual leaseback payments $20, Carrying amount of forklift at leaseback commencement $30,000 There are no renewal or repurchase options in the agreement. Amount of gain recognized under Topic 842)? $20,000 (#1 #5) 133

134 Example: Sale-leaseback transaction at market terms (cont d) Sale-leaseback transactions Party A transfers ownership of the underlying asset to Party B. Party A (Seller-Lessee) $30,000 Carrying Amount of Underlying Asset at Transaction Date $20,850 M easurement of ROU Asset The seller-lessee sells the entire underlying asset to the buyer-lessor (gain = $20,000) The seller-lessee obtains a new right to use the underlying asset (i.e. the ROU asset) Party B (Buyer-Lessor) $50,000 Buyer-Lessor s Underlying Asset Party B transfers the right to use the asset to Party A. 134

135 Accounting for off-market terms in a sale-leaseback transaction Sale-leaseback transactions Are the contractual lease payments equal to fair market value lease payments? NO Do the contractual lease payments exceed fair market value lease payments? NO NO YES YES Is the fair value of the underlying asset more readily determinable than the fair market value lease payments? Account for the transaction based on its contractual terms there is no adjustment for offmarket terms EXCESS: Recognize a financial liability (i.e., additional financing) DEFICIENCY: Recognize as prepaid rent (i.e., increase ROU asset) YES YES YES Is the sales price equal to the fair value of the underlying asset? NO Does the sales price exceed the fair value of the underlying asset? NO 135

136 Example: Sale-leaseback transaction at off-market terms Sale-leaseback transactions Assume the same facts as the previous example except as follows: 1. Sale price of forklift $55, Present value of leaseback payments at contractual rate $26, Present value of leaseback payments at estimated market rate $20, Fair value of forklift at leaseback commencement $50, Carrying amount of forklift at leaseback commencement $30,000 Assume: the fair value of the forklift is more readily observable than the market rentals. Amount of additional financing to recognize under the Boards new standards? $5,000 (#1 - #4) ADJUSTED amount of gain to recognize under Topic 842? $25,000 (#1 - #5) - $5,000 (the additional financing) = $20,

137 Example: Sale-leaseback transaction at off-market terms (cont d) Sale-leaseback transactions Seller-Lessee SL makes the following entries to recognize the sale-leaseback transaction at the time of sale (and leaseback commencement): Account Debit Credit Cash 55,000 ROU asset 1 21,000 PP&E (forklift) 30,000 Lease liability 2 21,000 Financial liability 3 5,000 Gain 4 20,000 1 Equal to the lease liability (i.e., there are no adjusting items such as lease incentives, initial direct costs, or rent prepayments) 2 $26,000 present value of contractual leaseback payments $5,000 off-market adjustment 3 The amount of the off-market adjustment: $55,000 sales price $50,000 fair value of the forklift. 4 $50,000 adjusted sale price $30,000 carrying amount of the forklift. 137

138 Implementation disclosures, and transition

139 Lessee presentation - Finance leases Presentation Balance sheet ROU assets Separate line-item; or Within another line item, separate from where operating lease ROU assets are presented Lease liabilities Separate line-item; or Within another line item, separate from where operating lease liabilities are presented Income statement ROU asset amortization Consistent with presentation of depreciation or amortization of similar assets Interest expense on lease liability Consistent with presentation of other interest expense Statement of cash flows Principal repayments Financing activities Interest payments In accordance with Topic 230 (typically, in operating activities) Variable lease payments Operating activities 1 1 Unless the payments represent costs to bring another asset into service. 139

140 Lessee presentation - Operating leases Presentation Balance sheet ROU assets Separate line-item; or Within another line item, separate from where finance lease ROU assets are presented Lease liabilities Separate line-item; or Within another line item, separate from where finance lease liabilities are presented Income statement Lease expense Included in lessee s income from continuing operations (operating expense) Statement of cash flows Lease payments Operating activities, unless payments are for costs to put another asset in service Variable lease payments Operating activities 140

141 Lessor presentation Presentation Lease type Balance sheet Income statement Statement of cash flows Sales-type and direct financing Present net investment in the lease separately from other assets on the face of the balance sheet Disclose the components of the net investment in the lease (lease receivable, unguaranteed residual asset, and deferred selling profit) Lease income separately presented or disclosed in the notes Accretion of unguaranteed residual asset presented as interest income Gross or net presentation of profit (loss) at lease commencement depending on lessor s business model 1 Operating activities all cash inflows 2 Operating Continue to recognize underlying asset in the balance sheet Total lease income recorded in a single line item caption No recognition of interest income 1 Direct financing leases are precluded from recognizing selling profit at lease commencement. 2 Some direct financing lessors classify cash payments as investing activities under current GAAP. This will no longer be permitted. 141

142 Disclosures Disclosures Disclosure Objective: Enable financial statement users to assess the amount, timing and uncertainty of cash flows arising from leases. Lessees New qualitative and quantitative disclosures to provide better information to users. Lessees will exercise judgment to determine the appropriate level at which to aggregate, or disaggregate, disclosures. Lessors New disclosures principally about exposure to residual asset risk. 142

143 Example - Lessee quantitative disclosure Disclosures This table is an example of how the FASB envisions a lessee might satisfy the quantitative disclosures requirements. However, the FASB has not mandated use of the tabular presentation. Lease Cost Finance lease cost: Year ending December 31, Amortization of right-of-use assets $XXX $XXX Interest on lease liabilities XXX XXX Operating lease cost XXX XXX Short-term lease cost XXX XXX Variable lease cost XXX XXX Sublease income (XXX) (XXX) Total lease cost $XXX $XXX 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 XXX Operating cash flows from finance leases XXX XXX Operating cash flows from operating leases XXX XXX Financing cash flows from finance leases XXX XXX Right-of-use assets obtained in exchange for new finance lease liabilities XXX XXX Right-of-use assets obtained in exchange for new operating lease liabilities Weighted-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 XX% XX% Weighted-average discount rate-operating leases XX% XX% 20X9 XXX 20X8 XXX 143

144 Effective dates Transition Public business entities, certain notfor-profit entities, and certain employee benefit plans Interim and annual periods in fiscal years beginning after December 15, 2018 All other entities Fiscal years beginning after December 15, 2019, and interim periods in fiscal years beginning one year later Early adoption permitted for all entities upon issuance 144

145 Transition overview Transition Transition approach Package of practical expedients (All or nothing) Use of hindsight (Elect on its own or with the package of practical expedients) Apply a modified retrospective transition approach: Restate all comparative periods presented No revisions to the accounting for leases that expired prior to date of initial application An entity may elect not to reassess: Whether expired or existing contracts contain leases under the new definition of a lease; Lease classification for expired or existing leases; and Whether previously capitalized initial direct costs would qualify for capitalization under Topic 842. Hindsight allowed when considering likelihood of exercising lessee options to extend or terminate a lease or purchase the underlying asset, and in assessing impairment of ROUs 145

146 Example Operating lease with practical expedients (1 of 4) Transition Lessee Z is a public company with a calendar year-end adopting Topic 842 on the mandatory effective date. The following table outlines the key terms of the lease to which it will apply the transition provisions and an illustrative timeline. 146