Lease & Finance Accountants Conference September 11-13 The Westin Charlotte Charlotte, NC H A N D O U T S
EQUIPMENT LEASING AND FINANCE ASSOCIATION Transitioning to the ASC 842 Guidance Lessee Requirements Tim Kolber Deloitte & Touche LLP Brian Wilson Bank of America Merrill Lynch
SETTING THE STAGE EQUIPMENT LEASING AND FINANCE ASSOCIATION
Transitioning to ASC 842 No small task! 3
Quizzing your understanding The survey says Will the new lease accounting rules be implemented retroactively? X Yes No YES. The new rules will be implemented retroactively, so all operating leases (except for short-term leases) will need to be capitalized in the financials reported in the transition year. If comparative balance sheets and P&L statements are presented, the operating leases must be capitalized in the earliest balance sheet. This means the impact may be sooner that you might realize. 4
Quizzing your understanding The survey says Is transitioning to the new lease accounting standard the concern solely of a company s accounting department? X Yes No NO. Changes in lease accounting will impact all departments that lease equipment, administer leases or use information regarding leases. Company areas that likely need to be included in the transition in addition to accounting are finance/treasury, lease administration, IT and business units. 5
Challenges to consider during transition Application of Judgment and Estimation Data Management Judgment is often required in the assessment of a lease s term, which would affect whether the lease qualifies for the short-term exemption and therefore for off-balance-sheet treatment Since almost all leases will be recognized on the balance sheet, an entity s judgment in distinguishing between leases and services becomes more critical under the new guidance Lease classification without bright line classification tests Determine whether the customer has the right or not to direct the use of the identified asset Third-party data may be needed to ensure a high level of operational quality and efficiency Numerous lease agreements at multiple decentralized locations, lease data in spreadsheets or physical documents. Consequently, collecting and abstracting may be time-consuming and resource-intensive Entities may need to gather information that may not be contained in lease agreements (e.g.: the fair value of an asset, the asset s estimated useful life, incremental borrowing rate, etc.) 6
Challenges to consider during transition Internal Controls and Business Process Environment Increased relevance of leasing to the financial statements, entities may face additional scrutiny from auditors and regulators regarding the design and effectiveness of associated controls under Sarbanes-Oxley Examine internal controls related to their processes for capturing, calculating, and accounting for their leases Internal controls or processes are needed, entities may also need to issue organizational communications and establish change management and employee training programs Debt Covenants Careful examination of the effects of increased leverage and potential debt covenant violations will be required This may depend in part on how various debt agreements define and limit indebtedness as well as on whether the debt agreements use frozen GAAP covenants. The ASC requires entities to present operating lease liabilities outside of traditional debt, which may provide relief to some entities. Nevertheless, it will be critical for all entities to determine the ASC s potential effects on debt covenants. Income Taxes Potential tax implications are situational requiring involvement of entities tax department 7
EXECUTIVE SUMMARY EQUIPMENT LEASING AND FINANCE ASSOCIATION
When will ASC 842 be effective? Public business entities Effective for periods beginning after December 15, 2018 and interim periods therein [calendar beginning January 1, 2019] All other entities Effective for periods beginning after December 15, 2019 and interim periods thereafter [calendar beginning January 1, 2020] Early adoption is permitted 9
How would a lessee transition to ASC 842? ASC 842 only allows for a modified retrospective transition approach: Lessees are required to use a modified retrospective transition method for all existing leases Would apply the new model for the earliest comparative year presented in the financial statements Application of modified retrospective approach linked to ASC 840 lease classification and new lease classification Modified retrospective approach under ASC 842 differs from ASC 606 10
What transition practical expedients are available? ASC 842 includes certain practical expedients that may provide relief when transitioning to the new guidance: Package of Three Not required to reassess the following upon transition: Whether any expired or existing contracts are leases or contain leases The lease classification for any expired or existing leases Initial direct costs for any existing leases Use of Hindsight Entity is permitted to use hindsight when evaluating: Lease term (options to extend, terminate, or purchase asset) Impairment of the underlying ROU asset EACH PRACTICAL EXPEDIENT IS AN ALL OR NONE PROPOSITION MUST BE CONSISTENTLY APPLIED TO ALL LEASES 11
What are the ASC 842 presentation requirements? Public business entities (SEC) BALANCE SHEET All other entities BALANCE SHEET FY 2018 FY 2019 FY 2019* FY 2020 Restate under ASC 842 INCOME STATEMENT (P&L) Restate under ASC 842 INCOME STATEMENT (P&L) FY 2017 FY 2018 FY 2019 Restate under ASC 842 Public business entities: effective for calendar periods beginning after December 15, 2018 and interim periods therein. The Q1 2019 will be the first publication to be presented in compliance SEC and ASC 250 reporting rules require earlier comparative results restated (as early as 2017) Early adoption is permitted FY 2019* FY 2020 Restate under ASC 842 All other entities: effective for calendar periods beginning after December 15, 2019 and interim periods thereafter Topic 205 encourages a comparative presentation as ordinarily desirable, but requirements may differ Shall provide the transition disclosures required by Topic 250 on accounting changes and error corrections, except for the requirements related to effect of changes in the statements 12
Are there any specific SEC reporting considerations? SAB Topic 11.M disclosures Registrant should consider providing additional qualitative disclosures about the impact of a new standard on its financial statements SAB Topic 11.M disclosure should be further refined and be more robust as the effective date of the standard approaches Selected financial data table requirements SEC staff does not expect registrants to reflect the requirements of the new leases standard for all five periods in the selected financial data table Selected financial data table to follow the same transition provisions of the new guidance (i.e., table will only reflect ASC 842 to the most recent three years) Revised financial statement requirements for registration statements ASC 842 modified retrospective transition approach limits the revision requirements to the earliest comparative period presented in the core financial statements Registrants are not required to revise the financial statements for the earliest year presented in a new or amended registration statement filed in the year of adoption 13
EQUIPMENT LEASING AND FINANCE ASSOCIATION COMPREHENSIVE LOOK AT TRANSITION
FASB s overall objectives for ASC 842 transition FASB described its two objectives in its transition decisions at the May 2017 meeting in the hope of addressing future stakeholder questions Transition provisions were meant to FASB Meeting May 10, 2017 Leverage existing systems and processes for in-place leases Limiting optionality xxxx FASB staff reminded preparers that Leases entered into on or after the effective date of ASC 842 should always be accounted for by applying the guidance in ASC 842 Leases that have ended before the date of initial application would generally require no transition accounting 15
Leverage existing systems and processes Modified retrospective approach designed to Leverage legacy ASC 840 information to wind down the accounting for leases during transition Allow entities to carry the existing leases as is for the remainder of the lease term in most cases How is this accomplished? Operating lease liability and corresponding ROU asset measured on the basis of the ASC 840 minimum rental payments Finance lease liability and corresponding ROU asset measured on the basis of the carrying amount of the capital lease obligation and lease asset immediately preceding the earliest application date 16
Transition guidance designed to limit optionality TRANSITION APPROACH Modified retrospective approach designed to limit how a lessee can transition its legacy leases to ASC 842 PRACTICAL EXPEDIENTS All-or-none requirement for applying the practical expedients limits number of potential transition combinations 17
Methods for transitioning to ASC 842 Transition methodology is dependent on the legacy ASC 840 classification and the new ASC 842 lease classification POTENTIAL OUTCOMES Operating under ASC 840 classified as operating under ASC 842 Operating under ASC 840 classified as finance under ASC 842 Capital under ASC 840 classified as finance under ASC 842 Capital under ASC 840 classified as operating under ASC 842 18
Operating under ASC 840/Operating under ASC 842 Overview of the guidance Recognize a lease liability and ROU asset at the later of (1) the beginning of the earliest year presented or (2) the lease commencement date o Lease liability measured at the present value of the remaining minimum rental payments (as defined in ASC 840) and amounts probably of being owed by the lessee under a residual value guarantee o ROU asset measured as an amount equal to the lease liability, adjusted for prepaid/accrued rent, unamortized initial direct costs, impairment of the ROU asset, and the carrying amount of any liability previously recognized under ASC 420 Write off as an adjustment to equity any unamortized initial direct costs that do not meet the ASU s definition of initial direct costs* * Does not apply if an entity elects the practical expedient package of three 19
Operating under ASC 840/Operating under ASC 842 Illustrative Example #1: Facts: On January 1, 2016, Company A (a public entity) entered into a five-year lease which included the following assumptions: Lease commenced on January 1, 2016 Payments due in arrears are $31,000 for years 1-2 and $33,000 for years 3-5 Lessee s incremental borrowing rate is 5.5% at inception Initial direct costs totaled $500 Lease was classified as an operating lease at lease inception Additional facts: ASC 842 is effective for Company A on January 1, 2019 Lessee s incremental borrowing rate at January 1, 2017 is 6.0% Unamortized initial direct costs and accrued rent liability at January 1, 2017 totaled $400 and $1,200 (respectively) Lease remains classified as an operating lease at transition 20
Operating under ASC 840/Operating under ASC 842 Illustrative Example #1: Solution: Step 1: Measure the lease liability The lease liability in this example is measured at the PV of the remaining lease payments using the incremental borrowing rate at the beginning of the earliest period presented: Period Payment 2017 31,000 2018 33,000 2019 33,000 2020 33,000 NPV at 6.0% 112,462 Lease Liability $112,463 21
Operating under ASC 840/Operating under ASC 842 Illustrative Example #1: Solution: (cont d) Step 2: Measure the ROU asset The ROU asset in this example is calculated as the lease liability, adjusted for prepaid/accrued rent and unamortized initial direct costs:* ROU Asset $111,662 Lease Liability $112,463 Accrued Rent $1,200 Unamortized initial direct costs $400 * Only unamortized initial direct costs meeting the new ASC 842 definition are recognized as a component of the ROU asset. 22
Operating under ASC 840/Operating under ASC 842 Illustrative Example #1: Solution: (cont d) Step 3: Recognize amounts in the financial statements: Description DR CR Right-of-use asset 111,662 Lease liability 112,462 Accrued rent liability 1,200 Unamortized initial direct costs 400 23
Operating under ASC 840/Finance under ASC 842 Overview of the guidance Recognize an ROU asset and lease liability at the later of (1) the beginning of the earliest year presented or (2) the lease commencement date o Lease liability measured at the present value of the remaining minimum rental payments (as defined in ASC 840) and amounts probably of being owed by the lessee under a residual value guarantee o ROU asset measured at a proportion of the commencement date lease liability (imputed using the remaining liability), adjusted by any previously recognized prepaid or accrued lease payments, unamortized initial direct costs, and the carrying amount of liabilities recognized under ASC 420 Write off as an adjustment to equity any unamortized initial direct costs that do not meet the ASU s definition of initial direct costs 24
Operating under ASC 840/Finance under ASC 842 Illustrative Example #2: Facts: On January 1, 2016, Company A (a public entity) entered into a five-year lease which included the following assumptions: Lease commenced on January 1, 2016 Payments due in arrears are $31,000 for years 1-2 and $33,000 for years 3-5 Lessee s incremental borrowing rate is 5.5% at inception Initial direct costs totaled $500 Lease was classified as an operating lease at lease inception Additional facts: ASC 842 is effective for Company A on January 1, 2019 Lessee s incremental borrowing rate at January 1, 2017 is 6.0% Unamortized initial direct costs and accrued lease liability at January 1, 2017 totaled $400 and $1,200 (respectively) Lease is classified as a finance lease under ASC 842 25
Operating under ASC 840/Finance under ASC 842 Illustrative Example #2: Solution: Step 1: Measure the lease liability (same as prior example) In this scenario the lease liability is measured at the PV of the remaining lease payments using the incremental borrowing rate at the beginning of the earliest period presented: Period Payment 2017 31,000 2018 33,000 2019 33,000 2020 33,000 NPV at 6.0% 112,462 Lease Liability $112,462 26
Operating under ASC 840/Finance under ASC 842 Illustrative Example #2: Solution: (cont d) Step 2: Measure the ROU asset ROU asset is generally calculated the same way as Illustrative example #1 except the starting point is a proportion of the original commencement date liability* calculated on the basis of the remaining lease term A Period Payment 2017 31,000 2018 33,000 2019 33,000 2020 33,000 Avg. payments 32,500 B Period Payment 2016 32,500 2017 32,500 2018 32,500 2019 32,500 2020 32,500 NPV at 6.0% 136,902 C Proportion of original lease liability $109,522 Determine average remaining lease payment amount PV the average remaining lease payment on the basis of the entire lease term as a means of determining the commencement date liability Apply the proportion of the remaining lease term to the original commencement date lease liability [(4 years/5 years) X 136,902] * ASC 842 indicates that the original commencement date liability can be imputed on the basis of the remaining minimum rental payments (various approaches could be applied). 27
Operating under ASC 840/Operating under ASC 842 Illustrative Example #2: Solution: (cont d) Step 2: Measure the ROU asset (cont d) After determining the appropriate proportion of the original lease liability, the ROU asset in this example is calculated as the proportionate liability amount, adjusted for prepaid/accrued rent and unamortized initial direct costs:* ROU Asset Proportion of original lease liability Accrued Rent Unamortized initial direct costs $108,722 $109,522 $1,200 $400 * Only unamortized initial direct costs meeting the new ASC 842 definition are recognized as a component of the ROU asset. 28
Operating under ASC 840/Finance under ASC 842 Illustrative Example #2: Solution: (cont d) Step 3: Recognizing amounts in the financial statements: Description DR CR Right-of-use asset 108,722 Lease liability 112,462 Accrued rent liability 1,200 Unamortized initial direct costs 400 Equity adjustment 2,940 29
Capital under ASC 840/Finance under ASC 842 Overview of the guidance Recognize a lease liability and ROU asset at the later of (1) the beginning of the earliest year presented or (2) the lease commencement date o Lease liability is recognized at the carrying amount of the ASC 840 lease obligation o ROU asset is recognized at the carrying amount of the ASC 840 lease asset o Any unamortized initial direct costs meeting the definition of such under ASC 842 are included in the ROU asset measurement Write off as an adjustment to equity any unamortized initial direct costs that do not meet the ASU s definition of initial direct costs* Subsequent measurement guidance in ASC 842-20 will then be applied, though a lessee would not remeasure lease payments for amounts probable of being owed under a RVG * Does not apply if an entity elects the practical expedient package of three 30
Capital under ASC 840/Operating under ASC 842 Overview of the guidance Derecognize the capital lease asset and lease obligation at the later of (1) the beginning of the earliest year presented or (2) the lease commencement date with any difference accounted for in a manner similar to prepaid or accrued rent Recognize an ROU asset and lease liability by using (1) the ASU s initial measurement guidance for leases entered into after the beginning of the earliest period presented or (2) the ASU s subsequent measurement guidance that applies to leases entered into before the beginning of the earliest year presented Write off as an adjustment to equity any unamortized initial direct costs that do not meet the ASU s definition of initial direct costs 31
Sale and leaseback transactions Preparer reassesses ASC 840 failed sales during transition Seller-lessees would only be required to reassess legacy sale and lease back transactions when the transaction was a failed sale under ASC 840 o o Failed sales as of effective date should be reassessed for sale If a sale would have occurred under ASC 842, the sale and leaseback is accounted for using a modified retrospective basis from the date of the sale Accounting for deferred gains and losses in transition Prior sale leaseback classified as a capital lease o Amortize the deferred gain or loss straight line, or in proportion to amortization or profit depending on the nature of the underlying asset Prior sale leaseback classified as an operating lease o o Recognize any deferred gain or loss not resulting from off-market terms as a cumulative-effect adjustment to equity Recognize any deferred gain or loss resulting from off-market terms as an adjustment to the right-of-use asset (if a loss) or as a financing liability (if a gain) 32
Build-to-suit lease arrangements Background ASU 2016-02 removed the risk principle and replaced it with a control principle for ownership during construction Standard provides indicators a lessee should consider when evaluating whether it controls the asset being constructed Transition considerations Lessee should derecognize the impact of any build-to-suit arrangements in which the lessee was the deemed owner in the comparative periods and recognize any differences in equity Entity is not required to assess ASU s principles of control during the comparative periods (regardless of whether the lessee was the deemed owner under ASC 840) as long as construction is complete and the lease commenced before the ASU s effective date 33
Build-to-suit lease arrangements Transition for build-to-suit arrangement when construction was not completed and lease had not commenced as of the effective date ASC 840 Determination Lessee was the deemed owner Lessee was the deemed Owner Lessee was not the deemed owner ASC 842 Determination Lessee has control during construction Lessee does not have control during construction Lessee has control during construction Transition Approach No change in accounting; asset and financing obligation remain on the balance sheet during the comparative periods and as of the effective date. Derecognize the asset and financing obligation, and reflect the difference in equity at the later of the beginning of the earliest comparative period presented in the financial statements and the date as of which the lessee was determined to be the accounting owner of the asset in accordance with ASC 840. Recognize the asset and financing obligation at the later of the beginning of the earliest comparative period presented in the financial statements and the date as of which the lessee is determined to be the accounting owner of the asset in accordance with ASC 842. 34
EQUIPMENT LEASING AND FINANCE ASSOCIATION TRANSITION HOT TOPICS
Impairment of ROU asset in transition FASB Meeting November 30, 2016 Describing the issue An asset group that includes a ROU asset post-effective date may have been deemed impaired prior to the effective date of the new guidance Preparers have questioned the appropriate way to consider previously recognized asset group impairment losses Question and interpretive view QUESTION: Is a lessee required to reconsider previously allocated asset group impairment losses when an asset group includes the ROU asset post-effective date of ASC 842? RESPONSE: No. A lessee would not revisit, or reallocate to the ROU asset, impairment losses of an associated asset group prior to the effective date If a ROU asset is deemed impaired post-effective date, a lessee loses the straightline treatment of total lease expense The timing and recognition of impairment during transition and the application of the use of hindsight practical expedient for impairment are still open questions 36 36
Minimum rental payments in transition FASB Staff Technical Inquiry response Describing the issue Calculating the lease liability for an operating lease during transition is dependent on the PV of the minimum rental payments under ASC 840 Some preparers have historically interpreted minimum rental payments to include executory costs under ASC 840 Question and interpretive view QUESTION: Would it be appropriate to include executory costs when determining the minimum rental payments used to calculate the lease liability when transitioning to ASC 842? RESPONSE: It depends. Preparers should follow their past practice and include executory costs as part of their minimum rental payments if that is what was done in the past for their ASC 840 disclosures A lessee should consistently apply its transition approach and disclose whether the minimum rental payments include or exclude executory costs 37 37
Incremental borrowing rate during transition FASB Staff Technical Inquiry response Describing the issue ASC 842 is clear that the incremental borrowing rate to be used in transition is one as of the beginning of the earliest period presented Guidance is not as clear as to whether the transition rate should be based on the original inception date lease term or remaining lease term Question and interpretive view QUESTION: Would the lessee incremental borrowing rate at transition be based on the inception date lease term or remaining lease term? RESPONSE: Either approach would be acceptable. ASC 842 is silent as to whether the transition incremental borrowing rate should be based on the original inception date term or remaining lease term FASB view is either approach would be acceptable insofar as it is (1) consistently applied and (2) properly disclosed if material 38
FX rate to be applied to ROU asset during transition FASB Staff Technical Inquiry response Describing the issue A ROU asset is considered a nonmonetary asset and would generally be measured at the commencement date FX rate It is unclear what FX rate should be used in transition when translating a ROU asset resulting from former ASC 840 operating leases Question and interpretive view QUESTION: Should a lessee use the lease commencement date or initial application date FX rate when translating ROU assets recognized for a former ASC 840 operating lease? RESPONSE: Use the initial application date FX rate to translate any ROU asset recognized at the initial application date of ASC 842. ASC 830 requires a nonmonetary asset to be measured using the exchange rate on the date that the asset is initially recognized ROU assets for former ASC 840 operating leases are not recognized until the date of initial application of ASC 842; therefore, it would be appropriate for a lessee to use the FX rate at that date 39
Variable payments based on index/rate in transition Question is currently being evaluated by SEC staff FASB Staff Technical Inquiry response Describing the issue Payments based on a change in an index or a rate are considered contingent rental payments under ASC 840 Lessees often include the escalators based on the change in an index or a rate in their minimum rental payment disclosures under ASC 840 Question and interpretive view QUESTION: When determining the minimum rental payments for calculating the lease liability during transition, would a lessee need to exclude any minimum rental payments based on the change in an index or rate? RESPONSE: Current view Yes ASC 840 explicitly excludes contingent rentals including those based on the change in an index or a rate from the definition of minimum rental payments Current FASB view is escalators based on the change in the index or a rate would be excluded from minimum rental payments in the transition lease liability calculation 40 40
EQUIPMENT LEASING AND FINANCE ASSOCIATION QUESTIONS AND ANSWERS