Lease & Finance Accountants Conference. September The Westin Charlotte Charlotte, NC

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1 Lease & Finance Accountants Conference September The Westin Charlotte Charlotte, NC H A N D O U T S

2 Basic Principles of Lessors under ASC 842 Mamta Shori, Wells Fargo Equipment Finance Joe Sebik, Siemens Corporation September 2017

3 Agenda Background Definition of a Lease Lessor Models Lease Classification Lease Terms Lease Payments Initial Direct Costs Sale Leasebacks Disclosure Requirements Examples

4 Transition timing by entity Fiscal years beginning after December 15, 2018 including interim periods within those fiscal years Public business entity; entities that must issue publicly certified financial statements; i.e. because they are publicly listed or have public debt Not-for-profits that have issued or are a conduit bond obligor for securities traded, listed or quoted on an exchange An employee benefit plan that files with the SEC Early application is permitted Fiscal years beginning after December 15, 2019 & interim periods within fiscal years beginning after December 15, 2020 All others including Any company issuing financial statements for credit related purposes Non-public companies Hospitals Universities Tax-exempts Early application is permitted Note Some entities follow government accounting standards and may have a different implementation date; GASB standard not yet final; [SEC has not finalized application to SEC reported information which predates FASB timeframes]

5 Timeline for Implementation Leases entered into during 2017 will be subject to modified retroactive capitalization in 2019

6 Practical Expedients for Transition Election 1. No need to reassess whether any expired or existing contracts are or contain leases 2. No need to reassess lease classification 3. No need to reassess initial direct costs Election 1. Use hindsight in determining lease term and impairment of ROU asset Previous Conclusions Hindsight Non-election Assess whether any expired or existing contracts are or contain leases Reassess lease classification Assess initial direct costs under new model Non-election Assess lease term and possible impairment of ROU asset without benefit of hindsight

7 Modified Retrospective Approach Not the same as a full retrospective approach, but will produce substantially similar results while reducing the costs / level of work required No restatement of previously reported income statements or balance sheets Previously reported income or expenses will remain as they were reported Lessors (high-level): For all leases that exist at or after the earliest comparative period presented Apply ASC 840 during the comparative period UNLESS: The lease is modified during the comparative periods, or There is a change in classification (e.g., sales-type under ASC 840 to operating under ASC 842) Apply ASC 842 from the effective date onward

8 Definition of a Lease ASC A contract conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. Asset is specified in the contract and is physically distinct or customer has substantially all rights to asset s output Supplier does not have substantive substitution rights or economic benefit due to substitution Customer obtains substantially all economic benefits from use of the asset Customer can direct the use or control the asset through out the period of use Supplier s economic benefit due to substitution rights and customer s control are new concepts in ASC 842

9 Assets & Contracts that are in scope Equipment leases, including those with multiple elements i.e. software Real estate leases Rental agreements Power purchase agreements (solar arrays, cogeneration assets) Various multiple elements arrangements such as certain supply contracts & maintenance agreements Managed service arrangements (see recent ELFF report) Diagnostic equipment/ reagent Copiers/paper & toners Energy service contracts Energy performance contracts Fractional share leases Tolling arrangements Vessel time charters How have these contracts been accounted for previously?

10 What assets are included / excluded? Applies to property, plant, or equipment Does not apply to: Leases of unidentified parts of an asset; aircraft fractional share Leases of intangible assets Leases to explore for or use non-regenerative resources (timber) Leases of biological assets Leases of inventory (except generally for rotables) Leases of assets under construction Employees or lease accountants

11 Definition of a Lease ASC Once a lease is determined, the consideration in the contract shall be allocated to each separate lease and non-lease component. Contract Lease Component NonLease Component Not Contract a Component Allocate Consideration in the Contract Activities that do not transfer a good or service Consideration associated with the Lease Component is used for Lease Classification

12 Lease Classification ASC A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement: a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

13 Lease Classification ASC (con t) d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph (f) equals or exceeds substantially all of the fair value of the underlying asset. e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Implementation notes allows to continue to use classification tests under ASC 840 as a proxy for the above tests (i.e. 75% test, 90% test, etc) With new qualitative language and allocation of consideration, it will be possible for lessee and lessor to arrive at different decisions

14 Lease Term ASC , An entity shall determine the lease term as the non-cancellable period of the lease, together with all of the following: a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option b. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option c. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. Rent free periods should also be included in lease term. Interpretative guidance also includes consideration whether parties are economically compelled to extend or terminate the lease

15 Lease Payments ASC A lessor shall allocate the consideration in the contract to the separate lease components and the non-lease components using the requirements in paragraphs through A lessor also shall allocate any capitalized costs to the separate lease components or non-lease components to which those costs relate. Gross Leases must bifurcate between any service/non-lease component and lease component. Revenue recognition of the non-lease component is governed by ASC 606. Consideration in the contract that is not a consideration of the lease is allocated to both lease and non-lease components i.e. sales and property tax

16 Lease Payments ASC , 30-6 At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term: Fixed payments Variable payments that depend on an index or rate In substance fixed payments Less: Lease Incentives payable by the Lessor to the Lessee Exclude Other variable lease payments, any guarantee by the lessee of the lessor s debt, or amounts allocated to non-lease components

17 Lease Models - Lessor Leasing under ASC 840 Operating lease Lessor reports the asset on its balance sheet and rents (income) are recognized on a straight-line basis Direct finance lease Lessor reports the receivables plus any residual value on its balance sheet net of unearned income Sales-type leases Leases which involve dealer profit. Follows direct finance lease accounting with corresponding sales and cost of sales entries Leveraged lease A direct finance lease which is financed using non-recourse third party debt. Lessor reports lease Investment net of nonrecourse debt and amortizes income during periods when net investment is positive Changes in ASC 842 Operating lease Virtually no change Direct finance lease Virtually no change Sale-type leases No manufacturer s profit required. 3 rd party residual value guarantees may not be included in lease classification. Leveraged Leases Existing deals are grandfathered. New deals or modifications will be handled as DFLs with debt on balance sheet and no LL income recognition.

18 Initial Direct Costs ASC , Initial direct costs for a lessee or a lessor may include, for example, commissions or payments made to an existing tenant to incentivize that tenant to terminate its lease. Costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as fixed employee salaries, are not initial direct costs. The following items are examples of costs that are not initial direct costs: General Overhead, servicing existing leases, advertising Soliciting Lessees Negotiating Lease terms, reviewing credit, preparing lease documentation Under current gap internal costs associated with successful origination of leases would be considered IDC. Now Lessors will need 2 deferral rates for loans vs leases.

19 Sale Leasebacks Requirements for a successful sale leaseback are noted in ASC , 3: An option for the seller-lessee to repurchase the asset would preclude accounting for the transfer of the asset as a sale of the asset unless both of the following criteria are met: a. The exercise price of the option is the fair value of the asset at the time the option is exercised. b. There are alternative assets, substantially the same as the transferred asset, readily available in the marketplace. In addition Successful sale leasebacks cannot be recorded as a sales-type lease or a direct finance type lease. Under current GAAP, there are different rules for real estate vs other assets related to sale leaseback accounting. Those are eliminated in ASC 842. Currently, repurchase agreements are not allowed in R/E. SLB related to other assets allow for fixed and FV repurchase agreements.

20 Failed Sale Leasebacks Accounting upon Recognition (ASC , 30-6): Buyer/Lessor will not record an asset, but rather accounts for the payments received as a financial asset. Remeasurement (ASC ): Under the new guidance, reassessment of the transaction is required. It is possible to achieve sale status during the term the agreement. For example, a fixed purchase price may expire mid way through the lease term. In this case the Buyer/Lessor would de-recognize the financial asset and record an asset in the same amount.

21 Disclosures Disclosures have not substantially changed to lessor accounting under current GAAP, but it has expanded some requirements to provide more information about residual risk and collectability, and lease income. ASC Qualitative Information: General description, basis, terms and conditions of lease, variable rate payments, extensions, terminations, and lessee purchase options Significant assumptions or judgments regarding initial measurements of residual position, allocation of consideration between lease and non-lease components Lease Transactions between related parties Information on how Lessor manages residual value risk, carrying amount of residual value guarantees, risk management strategies, and other means to reduce residual risk (excess usage billings, etc.)

22 Disclosures ASC Quantitative Information: Table of lease income for sales-type leases, direct finance leases and operating leases including profit recognized, interest income, variable lease income and expected lease payments The carrying amounts of the components of net investment in finance leases Maturity Analysis of undiscounted cash flows on finance leases and operating leases General PP&E disclosures for assets subject to operating leases.

23 Operating Lease Example Monthly lease income: $2,500 x 12 mo = $30,000 + $3,000 x 12 mo = $36,000 + $3,500 x 12 mo = $42,000 Total = $108, mo = $3,000 Monthly depreciation expense: Equipment cost = $100,000 Less: residual value = ($20,000) Total depreciation = $80, mo = $2,222

24 Operating Lease Financial Statements Balance Sheet Year 1 Year 2 Year 3 Cash $ 30,000 $ 66,000 $ 108,000 Investment in leases: Operating lease cost 100, , ,000 Accumulated deprecation (26,667) (53,334) (80,000) Net lease investment 73,330 46,666 20,000 Accrued rents 6,000 6, Total assets $ 109,333 $ 118,666 $ 128,000 Common stock $ 100,000 $ 100,000 $ 100,000 Retained earnings 9,333 18,666 28,000 Total liabilities and equity $ 109,333 $ 118,666 $ 128,000

25 Direct Finance Lease Example Assumptions: Fair market value $100,000 Equipment cost $100,000 Monthly rent $3,700 Term in months 36 Estimated residual value $20,000 Lessor classification: Direct finance lease because PV of MLPs 90% of FMV

26 Direct Finance Lease Example Monthly payment = $3,700 Implicit rate = 26.73% Mo Asset Value Interest Earned Principal Paydown Mo Asset Value Interest Earned Principal Paydown 1 100,000 2,228 1, ,638 1,462 2, ,528 2,195 1, ,400 1,412 2, ,022 2,161 1, ,113 1,361 2, ,483 2,127 1, ,774 1,309 2, ,910 2,092 1, ,383 1,256 2, ,302 2,056 1, ,939 1,201 3, ,658 2,019 1, ,440 1,146 2, ,978 1,982 1, ,886 1,089 2, ,260 1,944 1, ,275 1,031 2, ,503 1,905 1, , , ,708 1,865 1, , , ,872 1,824 1, , , ,996 1,782 1, , , ,078 1,739 1, , , ,117 1,696 2, , , ,113 1,651 2, , , ,064 1,605 2, , , ,969 1,559 2, ,997 (Residual value) 19 67,827 1,511 2,189 TOTALS 53,197 80,003

27 Direct Finance Lease Financial Statements Balance Sheet Year 1 Year 2 Year 3 Cash $ 44,400 $ 88,800 $ 133,200 Investment in leases: Minimum lease payments receivable 88,800 44, Unguaranteed residual 20,000 20,000 20,000 Unearned income (28,802) (10,459) -- Net lease investment 79,998 53,941 20,000 Total assets $ 124,398 $ 142,741 $ 153,200 Common stock $ 100,000 $ 100,000 $ 100,000 Retained earnings 24,398 42,741 53,200 Total liabilities and equity $ 124,398 $ 142,741 $ 153,200

28 Sales Type Lease Example The transaction should be viewed as containing two distinct components Profit/loss on the sale of the asset [net of retained residual value risk] Financing income on the lease Sales Price is equal to the present value of the minimum lease payments at the implicit rate Cost of Goods Sold is the carrying value less the present value of unguaranteed residual value The difference between adjusted FMV and carrying value is recognized as profit or loss at inception The basic lease accounting is the same as a direct finance lease except the FMV is not equal to its carrying value [since that value is less than the FMV] ASSSUMPTIONS Lessor Truck Leasing Co Fair Market Value $100,000 Carry value $ 95,000 Term 36 months Monthly rent $ 2,825 Residual Value $ 12,575 Implicit Interest Rate 8.03% Present Value of minimum payments 90,111 FASB #13 Present Value 90% test % Sales Type Lease because: It is first a direct finance lease under the 90% test The FMV is different from the carrying value and it includes dealer s profit

29 Sales Type Lease Example Lessor Accounting: Debit Credit Record investment: Leases Receivable $101,700 Unguaranteed residual $12,575 Inventory $95,000 Sales Revenue [PV of rents] $90,111 Cost of Goods [Cost -$9889 PV of RV] 85,111 Unearned income $14,275 Month #1: Unearned income $669 Finance income $669 Cash $2,825 Leases Receivable $2,825 Month #2: Unearned income $655 Finance income $655 Cash $2,825 Leases Receivable $2,825

30 Sales Type Lease Financial Statements Income Statement Year 1 Year 2 Year 3 Sales $ 90,111 $ -- $ -- Cost of Goods Sold 8 85,111 Lease income 7,057 4,820 2,398 Pre-tax income [$19,275] $ 12,057 $ 4,820 $ 2,398 Note: Example ignores income taxes and interest cost to fund asset

31 Sales Type Lease Financial Statements Balance Sheet Year 1 Year 2 Year 3 Cash $ 33,900 $ 67,800 $ 101,700 Investment in leases: Lease receivable 67, Unguaranteed residual 12,575 12,575 12,575 Unearned income [7,218] [2,398] -- Net lease investment $ 73,157 44,077 12,575 Total assets $ 107,057 $ 111,877 $ 114,275 Common stock $ 95,000 $ 95,000 $ 95,000 Retained earnings 12,057 16,877 19,275 Total liabilities and equity $ 107,057 $ 111,877 $ 114,275

32 Comparative Income of Different Lease Models Year Operating Lease Direct Finance Lease Leveraged Lease Lease Income 1 (2,098) 19,462 29, ,544 19,106 17, ,404 18,704 10, ,496 18,253 7, ,833 17,745 4, ,431 17,178 4, ,304 16,546 8, ,470 15,840 12, ,945 15,053 17, ,750 14,192 59,602 Asset sale Net Income 172, , , , , , , , ,080 Courtesy of BNA Accounting Policy and Practice Portfolio Leasing Fundamentals

33 Comparative Income of Different Lease Models Comparison of Net Income from Different Lease Accounting Methods Net Income 70,000 60,000 50,000 40,000 30,000 20,000 10,000 - (10,000) Operating Lease Direct Finance Lease Leveraged Lease Years Courtesy of BNA Accounting Policy and Practice Portfolio Leasing Fundamentals

34 Q&A