Edison Electric Institute and American Gas Association New Lease Standard May 16, 2016
Disclaimer The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. 2
With you today Michael Nesta, Partner, Deal Advisory, KPMG LLP (U.S.) 3 3
Agenda Application and transition of ASC Topic 842 Organization Wide Impacts Scope, lease definition, and lease classification Lessee accounting Lessor accounting 4
Application and transition of Topic 842
New lease accounting standard Don t account for the asset; account for the contract Been accounting for the wrong thing all along Have you entered into a contract to utilize a physical fixed asset for a defined period of time that obligates you to make payments over the contract term? Then account for that obligation to make payments as a liability Liability focused 6
New lease accounting implications Capital lease accounting unchanged (now called Finance Leases ) Operating lease accounting the same in the income statement and statement of cash flows All leases presented on balance sheet Classification test largely remain unchanged Now drives presentation in income statement and not whether on balance sheet or not Change in scope for determining whether an arrangement contains a lease 7
Effective date The entity is. Question a public business entity any other type of entity When does Topic 842 take effect? Can entities early adopt? Annual and interim periods in fiscal years beginning after 12/15/2018 Annual periods beginning after 12/15/2019 Interim periods in fiscal years beginning after 12/15/2020 Yes, all entities can adopt Topic 842 immediately. What is the transition method? Modified retrospective, with elective reliefs, which requires application of the new guidance for all periods presented 8
Transition The modified retrospective approach includes elective reliefs that all lessees may apply in transition. These includes: Must be elected as a package May be elected individually or with the other practical expedients At the adoption date, the 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 Whether previously capitalized initial direct costs would qualify for capitalization under the new standard. The entity may use hindsight in determining the lease term and in assessing impairment of right-of-use (ROU) assets. Election of all practical expedients will allow for all leases to be accounted for under current GAAP,* except that lessees are required to: Recognize an ROU asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments under current U.S. GAAP Apply the new requirements with respect to changes in estimates that affect lease accounting during the lease term (i.e., reassessments as discussed further below) beginning on the effective date. * Unless modified on or after the effective date 9
Transition Timeline: US GAAP Modified Retrospective Approach Effective Date January 1, 2019* ASC 842 was issued in February 2016 2019 quarterly & annual reports including comparative periods 2015 and prior 2016 2017 2018 2019 2020 and beyond Present comparative periods under modified retrospective approach Present in accordance with new standard It is important to start preparing today. - Identify lease population - Establish new policies and procedures - Train users to ensure the data is completely & accurately entered across the entity - Collect and enter lease data into a central system that supports both future and transitional accounting needs - Key considerations: Identify embedded lease arrangements Identify and separate executory costs and variable lease payments Determine lease terms and discount rates *Timeline is based on requirements applicable to a public entity with December 31 year-end and assumes company will transition on the effective date of the standard, January 1, 2019. 10
Data Needed for Transition Lessee Operating Leases under ASC 842* If the 1 st period of reporting is Q1 2019 (with a 12/31 fiscal year-end): Total remaining Minimum Lease Payments (per the current ASC 840 guidance) as of: 1/1/2017 (needed for purposes of calculating the Q1 2017 I/S and SCF comparative period activity) 12/31/2017 3/31/2018 = Lease Liability 12/31/2018 Discount rate associated with each lease (consider portfolio approach) Lease Term associated with each lease Unamortized balances of the following for each lease at each date noted above Prepayments Initial Direct Costs (as defined and recognized to date under ASC 840 guidance) Adjustments to the Lease Liability to arrive at the ROU Asset Lease Incentives Deferred Rent balance for each individual lease at each date noted above *Assuming the package of practical expedients is elected: No reassessment of whether a contract is/contains a lease No reassessment of lease classification (Finance = Capital; Operating = Operating) No reassessment of initial direct costs 11
Organization Wide Impacts
Broad potential impacts of the new lease accounting changes Accounting and Reporting Impacts Increased management judgment (e.g., definition of a lease, lease term, service components, lease classification, etc.) Potential for increased level of effort and financial reporting volatility due to ongoing remeasurement for certain items (e.g., lease term) New right-of-use asset subject to impairment Added complexity in calculating book vs. tax differences Need to significantly amend accounting policies and procedures Increased disclosure requirements Initial valuation of opening balance sheet and preparation of comparative periods Need to support transition and ongoing external audit requirements Business Impacts Potential for moderate to significant financial statement changes for lessees: Increase in assets impact ROA calculations and increase in liabilities impact capitalization and debt to equity calculations IFRS only: Interest expense impact will accelerate expense recognition IFRS only: Elimination of rent expense and reflection as amortization and interest expense result in an increase to EBITDA Potential for significant financial statement changes primarily for equipment lessors: Deferred timing of profit recognition on current sales type leases Accelerated timing of profit recognition on most current operating leases Management may choose to review buy versus lease decisions and evaluate the need to renegotiate current lease terms Potentially could impact state and local taxes paid Systems & Processes Impacts Existing lease systems likely do not have sufficient functionality to handle new requirements including remeasurement Transition will require an inventorying of all leases across an organization, potentially including contracts not previously accounted for as leases and contracts previously accounted for as leases that no longer will be (e.g., some contract manufacturing, IT outsourcing arrangements) Once leases are inventoried, physical lease documents will likely need to be obtained so that salient lease terms for every lease can be captured in a database Expanded data needs may necessitate a need for forecasting and other systems Increased management judgment will elevate financial reporting risk, and will require changes to process documentation and SOX 404 testing People & Change Impacts Due to pervasive organizational change there is a need for a strong project management office with an effective governance structure and communication protocols Impacted departments will need appropriate communication and training to understand their role, the impact to their job responsibilities and their level of involvement in the ongoing support of the conversion project and ongoing accounting Departments impacted outside of General Accounting and Financial Reporting will likely include Legal, Real Estate, Treasury, Internal Audit, IT, Tax, Budgeting, Regulatory, Contract Management, and Forecasting 13
Scope and lease definition
Scope Leases of assets Leases of: Long-term leases of land Sale-leasebacks Subleases In-substance purchases/sales Within scope Outside scope Intangibles (other than ROU assets in a sublease) Inventory Natural resources and exploration Biological assets 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. 15
Lease identification Identified asset Control over use Lease Asset is explicitly or implicitly specified in a contract. Asset is physically distinct: Applies to distinct portions but not generic capacity Supplier does not have a substantive substitution right. Customer has the right (throughout the period of use) to: Obtain substantially all of the economic benefits from use of the asset Direct (including the right to change) how and for what purpose the asset is used. Converged FASB/IASB definition 16
Lease definition Comparison to current U.S. GAAP Topic Comparison What has changed? Identified asset concept Substantive substitution rights Control over use concept Consistent N/A New The requirement that a substitution right must benefit the supplier to be substantive is a new concept Different Current U.S. GAAP generally focuses on customer s right to control the operations of an identified asset OR the right to obtain the output. The new standard requires both of these concepts to be met. Supplier protective rights Current U.S. GAAP requires customer to have the right to more than a minor amount of the output. The new standard requires the customer to have the right to obtain substantially all of the potential economic benefits from use of the asset. Elaboration Nothing in current U.S. GAAP about whether a supplier s protective rights prevent a customer from having the ability to direct the use of an underlying asset, but do not expect a change from current practice 17
Agreements with lease and nonlease components Separating 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 relative stand-alone price of components maximize the use of observable information Lessor Always separate and allocate using the revenue recognition standard s guidance (i.e., on a relative selling price basis) Activities (or costs of the lessor) that do not transfer a good or service to the lessee 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 18
Scope: Power and Utility Considerations Revised definition could result in different conclusions for: Power purchase agreements: Example 9 provides three different cases Cases A and B: Offtaker purchases all energy and RECs; supplier takes ITCs Case A: Customer s design of the solar farm indicates right to direct use Case B: Customer did not design the solar farm Case C: Customer controls dispatch and purchases all output Transportation contracts Control over right to use in transportation contract? Unit of account in transportation contracts: Laterals and pipeline 19
Lease classification test Ownership transfers at end of lease? Lessee purchase option reasonably certain of exercise? Lease term = major part (e.g., 75%) of remaining economic life 1? No No No PV of lease payments + Lessee RVG = substantially all (e.g., 90%) FV 1? 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 * For lessors, a sales-type lease ^ For lessors, a lease that is not a sales-type lease can be classified as a direct financing lease or an operating lease 20
Lessee accounting
Lessees Recognition Right to use underlying asset Lessor 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 Lease liability Obligation to make future lease payments 22
Lease liability Initial measurement Lease liability PV 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). 23
ROU asset Initial measurement ROU asset is the sum 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. 24
ROU asset Subsequent measurement Finance leases ROU asset Beginning balance Accumulated amortization* *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 25
ROU asset Subsequent measurement Operating leases (FASB only) Method 1 Amortize the ROU asset ROU asset Beginning balance Accumulated amortization** ** Periodic amortization of ROU asset represents difference between periodic straight-line lease cost and periodic accretion of lease liability using interest method Method 2 Derive the ROU asset from the lease liability Lease liability Unamortized initial direct costs ( ) Prepaid/ (accrued) lease payments Unamortized balance lease incentives received P&L: Straight-line total lease cost ASC 360 impairment testing Once impaired, single lease cost is not straight-line (pattern is equivalent to finance lease) 26
Lease liability Subsequent measurement and reassessments Subsequent measurement 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: Lease liability remeasured when 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. 27
Lease liability Subsequent measurement and reassessments (continued) Lease liability remeasurement Changes in carrying amount of lease liability resulting from: Reassessment of lease payments that increase lessee s right-of-use asset Reassessment of lease payments that decrease lessee s right-of-use asset Adjust ROU asset Recognize in P&L Discount rate is revised unless reassessment relates to a change in: Amounts probable of being owed under a residual value guarantee, or Lease payments resulting from the resolution of a contingency upon which some/all of the variable lease payments (VLPs) will be paid over the remainder of the lease term are based. VLPs that depend on an index or rate are measured using the index or rate at remeasurement date. 28
Reassessment of lease term and purchase options (Lessees only) 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. 29
Reassessment of lease term and purchase options What should I do? 1. Reallocate remaining consideration in the contract to the lease and nonlease components. 2. Remeasure the lease liability (using the discount rate at reassessment date). When lease term or purchase option is reassessed 3. Adjust the ROU asset accordingly. If carrying amount of ROU asset is reduced to zero, remaining adjustment is recognized in profit or loss. 4. Reassess lease classification at reassessment date. 5. If lease classification changes, adjust remaining lease cost recognition pattern and presentation in income statement. 30
Reassessment of VLPs based on an index or rate FASB: Reassess impact of VLPs based on an index or rate on measurement of lease liability and ROU asset only when there is a remeasurement for another reason (e.g., lease term reassessment). Boards decisions IASB: Reassess impact of VLPs based on an index or rate on measurement of lease liability and ROU asset whenever a change in index or rate changes the contractual cash flows of the lease. Effect Lease liabilities will often differ under U.S. GAAP and IFRS. The longer the lease term the greater the differences. Multinational entities may need to maintain multiple lease tracking schedules. Will increase income statement differences. 31
Lessor accounting
Lessors Operating leases Right to use underlying asset Lessor Lessee Lease payments Underlying asset No derecognition of underlying asset Lease income is generally recognized on a straight-line basis. Underlying asset remains on the lessor s balance sheet and continues to be depreciated. 33
Lessors Sales-type and direct financing leases Right to use underlying asset Lessor 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 are 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. 34
Lessors Initial measurement (FASB only) Sales-type lease Direct financing lease Operating lease Underlying Asset Derecognize Do not derecognize Net Investment in the Lease Recognize at lease commencement 1 N/A Selling Profit (FV > Carrying Amount) Recognize at lease commencement. Defer and include as a reduction of the net investment in the lease. Selling Loss Recognize at lease commencement N/A Initial Direct Costs 1 Sales-Type Lease: FV CV asset: Expense at lease commencement FV = CV asset: Defer and include in the measurement of the net investment in the lease. Defer and include in the measurement of the net investment in the lease. N/A Defer and expense over the lease term on the same basis as lease income. NI = Lease receivable 2 + Unguaranteed residual asset 1 Direct Financing Lease: NI = Lease receivable 2 + Unguaranteed residual asset Deferred selling profit 2 Lease receivable includes any residual value guaranteed by the lessee or any other third party unrelated to the lessor. 35
Contacts Today s Presenter Michael Nesta mnesta@kpmg.com 214-840-2730 36
2016 KPMG International Cooperative ( KPMG International ), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. NDPPS 564738 The KPMG name and logo are registered trademarks or trademarks of KPMG International Cooperative (KPMG International).