KPMG s CFO Financial Forum Webcast A Detailed Look at the FASB/IASB Revised Leases Exposure Drafts Part I (Scope, Definition, and Lease Classification) June 13, 2013 Administrative CPE regulations require online participants to take part in online questions You must respond to a minimum of 4 questions in order to be eligible for CPE credit Polling questions will appear on your media player on top of the slides Send Questions via Ask a Question Button Help Desk: 1-877-398-1471 or outside the U.S. at +1-954-969-3342 You can print out presentation slides from the Supporting Material icon Reference materials are available: Slides Defining Issues Issues In-Depth 2 1
Agenda Scope Definition of a lease Agreements with lease and non-lease components Agreements with multiple leased assets Lease classification Question & answer session 3 Polling Question #1 Is the organization you represent primarily a lessee, a lessor, or both? A. Lessee B. Lessor C. Both 4 2
Scope Within scope Scope with exceptions Outside scope Leases of assets Leases with service Leases of: Long leases of land Sale-leasebacks Subleases components Short-term leases ( 12 months with no purchase option) In-substance purchases / sales Leases of inventory Intangibles (other than ROU assets) Natural resources and exploration Biological assets FASB/IASB LEASES PROJECT 5 Short-Term Leases A lease contract that does not include a purchase option at any exercise price and for which the longest possible term is 12 months Lessee Lessor Policy election by class of underlying assets to not recognize lease assets or lease liabilities Recognize lease payments in P&L over term on a straight-line basis Policy election by class of underlying assets to not recognize lease receivables and residual assets Continue to recognize the leased asset Recognize lease payments in P&L over lease term (generally straight- line) Leases cancelable by both lessee and lessor Leases in which the lessee and the lessor each have a right to cancel the lease at any point in the future without a significant penalty (i.e., with only a nominal charge) would meet the definition of short-term leases when the notice period, together with any initial non-cancellable period, is less than one year. 6 3
Polling Question #2 Which of the following would qualify as a short-term lease? A. A lease of equipment for 1 month that automatically renews until canceled by the lessee B. A lease of equipment for 12 months that includes no options to renew the lease and no purchase option C. A lease of equipment for 10 months, without any renewal options, that includes an option for the lessee to purchase the equipment at fair market value at the end of the lease term D. A lease of equipment for 15 months that can be terminated after 1 month without penalty 7 Polling Question #2 Answer The correct answer is B. The lease in option B has a maximum possible term of 12 months or less. Options A and D have a maximum possible term of > 12 months. The lease in option C contains a lessee purchase option so would not qualify as a shortterm lease regardless of the maximum possible lease term or the likelihood that the purchase option would be exercised. 8 4
Lease Definition A contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. Definition focuses on control of an identified asset. Use of identified asset Supplier cannot substitute an asset Asset must be physically distinct applies to distinct portions but not generic capacity Right to control use Ability to make decisions that most significantly affect economic benefits derived from use Ability to derive substantially all of the potential economic benefits throughout contract term FASB/IASB LEASES PROJECT 9 Example #1: Lease Definition Determining if There Is an Identified Asset Example: Mocha Liquid enters into an arrangement for a storage service that involves the use of a refrigerator for coffee beans. The supplier has the right to substitute the refrigerator without Mocha Liquid s consent. The supplier has many identical refrigerators that are maintained in a single, accessible location and the supplier could easily substitute another unit for the refrigerator in the contract at a nominal cost. Would this contract contain an identified asset under the revised lease accounting Exposure Drafts? 10 5
Example #1: Lease Definition Determining if There Is an Identified Asset (continued) Solution: Fulfillment of the contract would not be considered dependent on an identified asset because the substitution right is substantive (i.e., the supplier has the right to substitute the refrigerator without Mocha s consent and there are no economic or other barriers to the supplier exercising its substitution right). Therefore, this contract is not (or does not contain) a lease. 11 Polling Question #3 Following on from the previous example, would the contract depend on an identified asset if the refrigerator is significantly customized and located in an isolated area? A. Yes B. No 12 6
Polling Question #3 Answer The correct answer is yes. The substitution right would not be substantive if the cost of similarly customizing and/or delivering an alternative unit would create an economic or operational barrier to substitution. Therefore, fulfillment of the contract would depend on an identified asset. 13 Example #2: Lease Definition Controlling the Use of an Identified Asset Example: Customer enters into a time charter contract with Shipowner for transportation of cargo on a named ship for a period of 5 years. Customer determines the cargo to be transported, and the timing and location of delivery. Customer pays a daily hire rate for the use of the ship and navigation and cargo management services (including the use of the ship s captain, crew, and equipment). Customer does not pay for hire when the ship is off-hire (i.e., unavailable for use due to maintenance or repairs). Customer can decide when the ship is off-hire if the specified conditions for doing so under the time charter are met. Shipowner pays for the costs of the ship when it is off-hire and remains responsible for the navigation and condition of the ship. Shipowner is also responsible for maintenance and overhaul, cleaning services relating to the cargo space, regulatory compliance on matters of ship safety, and for the cargo when it is onboard its ship. Shipowner pays for all operating expenses of the ship, while Customer pays for the fuel used by the ship (except when the ship is off-hire) and for the port costs. Would this contract meet the definition of a lease in the revised lease accounting Exposure Drafts? 14 7
Example #2: Lease Definition Controlling the Use of an Identified Asset (continued) Solution: The contract contains a lease based on the following: The contract s fulfillment depends on an identified asset (i.e., the named ship) Customer controls the use of the ship: - Customer directs the use of the ship because it determines when it is on or off-hire, and the ship s crew is under Customer s control when on-hire, meaning Customer can determine when and where the ship carries cargo; and - Customer has the right to obtain substantially all of the potential economic benefits from use of the ship during the contract term because no other party can utilize the ship during the contract term (e.g., Shipowner cannot use the ship to transport another customer s cargo when Customer is not using the ship or when it is off-hire). 15 Polling Question #4 Following on from the previous example, would the contract meet the definition of a lease if Shipowner could use the ship to transport another customer s cargo when Customer is not using the ship or when it is off-hire? A. Yes B. No C. It depends 16 8
Polling Question #4 Answer The correct answer is C it depends. If the proportion of the arrangement term that Customer is not using the ship is expected to be insignificant, it is likely that the contract would meet the definition of a lease. Otherwise, if there are significant economic benefits that would accrue to shipowner from operating the ship when Customer is not using it, the contract may not meet the definition of a lease because Customer does not control the use of the ship throughout the contract term. 17 Agreements with Lease and Non-Lease Components Lessee Lessor When there is an observable Separate and allocate Always separate and standalone price for each component When there is an observable standalone price for one or more, but not all, components based on relative standalone price of components Separate and allocate using the residual method allocate using the revenue recognition standard s guidance (i.e., on a relative selling price basis) When there is not an observable standalone price for any of fthe components in the arrangement Assets incidental to the delivery of specified services All lease All service FASB/IASB LEASES PROJECT 18 9
Example #3: Separation and Allocation of Contract Consideration to Lease and Non-Lease Components Example: Lessor leases a specialized machine for two years, and provides consulting services to help Lessee effectively use the machine in its production processes. The machine is not sold or leased separately by Lessor and there are no similar machines for sale or lease from other suppliers. Lessor estimates the standalone price to lease the machine would be $160,000. Similar consulting services are sold on a standalone basis for $40,000 by alternate service providers. The contract is for fixed consideration of $100,000 for the first year and $80,000 for the second year. The lower second-year price is based on the assumption that Lessor will provide more consulting services in the first year. How would Lessor and Lessee each separate and allocate consideration to lease and non-lease components of this contract (i.e., the machine and the consulting services, respectively)? 19 Example #3: Separation and Allocation of Contract Consideration to Lease and Non-Lease Components (continued) Solution: Lessor is required to separate the lease component from the non-lease component. Lessee will separate the lease component from the non-lease component because there is an observable standalone price for one of the two components. Standalone Allocated Consideration Component Price Lessor Lessee Machine lease $160,000 E $144,000 $140,000 Consulting services 40,000000 O 36,000 40,000000 Totals $200,000 $180,000 $180,000 E Estimated standalone price. O Observable standalone price. 20 10
Polling Question #5 Which party to a lease contract must separate lease from non-lease components in all circumstances? A. Lessee B. Lessor C. Neither party 21 Polling Question #5 Answer The correct answer is B the lessor. The Boards proposals presume that a lessor should always be able to separate payments made for lease and non-lease components because it would need to have information about the value of each component to price the contract. In addition, the Boards decided that application of the forthcoming revenue recognition guidance would ensure consistency for entities that are both a lessor and a seller of goods or services within the same contract. 22 11
Agreements with Multiple Leased Assets Identifying Separate Lease Components Lessor A leased asset is a separate lease component if it is distinct, which requires that both: The lessee can benefit from use of the asset either on its own or together with other readily available resources; and The leased asset is not highly dependent on or highly interrelated with other underlying assets in the contract Lessee A leased asset is a separate lease component if: It is distinct (same criteria as for lessors); and There are observable standalone prices 1 for the leased asset or for all of the other leased assets in the contract 2 1 Observable standalone prices are those charged by the lessor or a similar supplier for a good or service or a similar good or service when sold separately. 2 A leased asset for which the lessee does not have an observable standalone price would be combined with any other lease and/or non-lease elements for which the lessee does not have an observable standalone price. 23 Example #4: Identifying Separate Lease Components Example: Lessor leases three items of heavy machinery (a bulldozer, a truck, and an excavator) to Lessee to be used in Lessee s mining operations. Lessee can benefit from each of the three machines on its own or together with other readily available resources (e.g., Lessee could readily lease or purchase an alternative truck and/or excavator to use alongside the bulldozer). Despite the fact that Lessee is leasing all three machines for one purpose (i.e., to engage in mining operations), the machines are not highly dependent upon, or highly interrelated with, each other because the machines are not inputs to a combined single item for which Lessee is contracting, and none of the machines is significantly modifying or customizing another. How would Lessor and Lessee each determine the separate lease components in this contract? 24 12
Example #4: Identifying Separate Lease Components (continued) Lessor Solution: Lessor concludes that the lease of each underlying machine is a separate component for accounting purposes (i.e., there are three lease components). Lessee Solution: Lessee will reach the same conclusion as Lessor as long as there are observable standalone prices for at least two of the three equipment leases; otherwise it will have to combine those lease elements for which standalone prices are not observable. 25 Example #5: Identifying Separate Lease Components Example: Lessor leases a gas-fired turbine plant to Lessee so that it can produce electricity for its customers. The plant includes the turbine, a building that exists only to house the turbine, and the land on which the building is located. The building has been designed for use only with the turbine, has a similar useful life, and has no alternative use. How would Lessor and Lessee each determine the separate lease components in this contract? 26 13
Example #5: Identifying Separate Lease Components (continued) Solution: The lease of the turbine, building, and land would be treated as a single lease component for accounting purposes by both Lessor and Lessee based on the following evaluation, indicating that the underlying assets are not distinct : - Lessee can benefit from the turbine on its own (evidenced by fact that manufacturer sells turbines separately) or together with other readily available resources because the turbine could be housed in a different building on other land. - Lessee benefits from the land and building together as a single unit (i.e., an entity cannot benefit from the building without the land on which it is located). - However, the turbine, the building, and the land are highly interrelated because the turbine, building, and land are each inputs to the customized combined item for which Lessee has contracted (i.e., a gas-fired turbine plant that can produce electricity for distribution to Lessee s customers). 27 Lease Classification Tests* No Is the underlying asset property (land and / or a building)? Yes Type A lease** Type B lease** Unless Unless Lease term for an insignificant part of the total economic life; or PV of the lease payments insignificant compared to FV of underlying asset Lease term for a major part of the remaining economic life; or PV of the lease payments amounts to substantially all FV of underlying asset * Lease classification would be performed only at lease commencement or upon lease modification. ** If the lease includes a purchase option that the lessee has a significant economic incentive to exercise, it would always be classified as a Type A lease. FASB/IASB LEASES PROJECT 28 14
Classification of Leases with Multiple Underlying Assets Property vs Non-property Primary asset Applicable lease term test based on life of primary asset Primary asset predominant asset for which the lessee entered into the contract Non-primary assets enable lessee to obtain benefits of the primary asset Land and building Land and building = single item No allocation of payments between land and building Economic life of building = economic life of property for lease term test In some cases may result in lease income/ expense recognized on an accelerated basis FASB/IASB LEASES PROJECT 29 Example #6: Lease Classification Property + Example: Lessor and Lessee enter into a 15-year lease of a storage warehouse, which has a remaining economic life of 40 years at the lease commencement date. The present value of the lease payments is $300,000. 000 The fair value of the property at the lease commencement date is $400,000. How would Lessor and Lessee classify this lease (i.e., Type A or Type B)? + Based on Example 12 in proposed FASB ASC Subtopic 842-10 of the 2013 FASB ED and Example 13 of the 2013 IASB ED. 30 15
Example #6: Lease Classification Property (continued) Solution: The lease would be classified as a Type B lease because the underlying asset is property and: The lease term of 15 years is for less than a major part (37.5%) of the remaining economic life of the property, and The present value of the lease payments represents less than substantially all (75.0%) of the fair value of the property at the lease commencement date. The Boards have not defined major part of the economic life or substantially all for purposes p of evaluating lease classification. Therefore, how much higher the thresholds for major part and substantially all would be than the benchmarks illustrated in the Boards example is likely to be the subject of future interpretive debate. 31 Example #7: Classification of a Lease with Multiple Underlying Assets Fact pattern for example: Lease of laboratory (integral) equipment, laboratory building, and underlying land Underlying assets comprise a single lease component Laboratory equipment is primary underlying asset Lease term 5 years Total economic life of laboratory equipment 10 years Remaining economic life of building 25 years Present value of minimum lease payments $ 375,000 Fair value of underlying assets in aggregate $1,000,000 No renewal or purchase option / title transfer in lease agreement ED s Proposals Type A Lease Lessee: Accelerated ROU Model Lessor: R&R Model ASC 840 Lessee: Operating lease Lessor: Operating lease FASB/IASB LEASES PROJECT 32 16
Polling Question #6 What is the appropriate basis upon which to determine which asset in a single lease component with multiple underlying assets is the primary asset? A. The asset with the highest lease commencement date fair value is always the primary asset B. The asset with the longest remaining economic life is always the primary asset C. The asset with the longest total economic life is always the primary asset D. The predominant asset for which the lessee entered into the lease contract is always the primary asset 33 Polling Question #6 Answer The correct answer is D. The 2013 EDs propose that the primary asset in a lease component that contains multiple underlying assets would be the predominant asset for which the lessee entered into the lease contract. 34 17
Question & Answer Session Presenters contact details Kimber K. Bascom 212-909-5664 kbascom@kpmg.com Scott A. Muir 212-909-5073 smuir@kpmg.com 36 18
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