The New Lease Accounting Standard Hunter Mink, CPA, CCIFP Brian Rosenberg, CPA, MBA 1
Agenda Introduction Lease Identification and Classification Lessee Accounting Other Considerations Disclosures Impact on Clients and Financial Statements Implementation Approach 2
3 Why is this standard being issued?
Introduction Current Environment Operating leases not recognized on the balance sheet Most leases are off-balance-sheet but disclosed in footnotes Existing GAAP contains two very different accounting outcomes for economically similar transactions Users seeking transparency & comparability Structured transactions Inconsistent add-backs in the creditor & investor community for off-balance-sheet leases Financing & leverage comparisons between similar firms 4
Why? The FASB felt that the previous leasing guidance did not meet the needs of users of financial statements because it did not always provide a faithful representation of leasing transactions, in particular it did not require lessees to present assets and liabilities arising from operating lease activities. Many of the criticisms associated with previous leases guidance related to the accounting for operating leases in the financial statements of lessees, and addressing those concerns with lessee accounting was the main focus of the Boards. As such, the Boards decided to not fundamentally change lessor accounting with the amendments in this Accounting Standards Update, but there have been some changes to conform to the new lessee accounting. 5
Introduction Three takeaways 1. Bigger balance sheets Most common operating leases will be added to the balance sheet as an asset & liability 2. Additional disclosures 3. Advanced planning & communication necessary Lenders, management & other stakeholders Significant changes expected for commonly used metrics and performance indicators 6
Introduction FINANCIAL STATEMENT IMPACT Lessees are required to recognize lease assets and lease liabilities on the balance sheet for all leases with terms longer than 12 months Classified as either finance or operating (classification affects pattern of expense recognition in income statement) 7
Introduction EFFECTIVE DATE, SCOPE, and TRANSITION Issued as ASU 2016-02 on February 25, 2016 under Topic 842 o Effective Date will be for year ends beginning after December 15, o 2019 for private companies (12/31/2020 year-ends); one year earlier for public business entities Early adoption is permitted 8
Introduction EFFECTIVE DATE, SCOPE, and TRANSITION (continued) Applies to all leases, except: Leases of intangible assets Leases for exploration or use of certain mineral resources Leases of biological assets, including timber Leases of inventory Leases of assets under construction 9
Introduction EFFECTIVE DATE, SCOPE, and TRANSITION (continued) Will apply to all applicable leases existing at the beginning of the first comparative period present upon adoption o No grandfathering of existing leases Transition o Modified retrospective approach 10
Introduction MODIFIED RETROSPECTIVE APPROACH Simple approach for existing leases if the lessee adopts the practical expedients (recommended): Existing operating leases remain operating leases Lease term will be the remaining term (including consideration of renewal options) under the existing agreement for the earliest period presented Existing capital leases become finance leases Current accounting will continue; will be a terminology change only 11
Introduction MODIFIED RETROSPECTIVE APPROACH Practical expedients for leases that commenced prior to the effective date (1/1/2020): P A C K A G E 1a.) An entity need not reassess whether any expired or existing contracts are or contain leases 1b.) An entity need not reassess the lease classification for any expired or existing leases 1c.) An entity need not reassess initial direct costs for any existing leases 2.) Can use hindsight in determining the lease term 12
Introduction INTERNATIONAL CONVERGENCE? FASB and IASB have converged on this topic in many aspects, but there are several differences and one key difference is the lease types: FASB Dual lease type to be explained in a later slide, but the FASB has allowed for two types of leases (Finance and Operating) IASB Single lease type all leases are Finance 13
Key Provisions Lease definition Classifying a lease Financing or Operating Accounting for leases Initial & subsequent Modifications Separating/allocating components Lease or non-lease Disclosures & presentation Other sale-leaseback, business combinations, real estate/structured leases 14
Lease Identification and Classification LEASE IDENTIFICATION At inception of a contract, an entity should determine whether the contract is or contains a lease. Lease Definition: A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. 15
Lease Identification and Classification LEASE IDENTIFICATION (continued) Right to Control the Use (definition): The customer has both: the right to obtain substantially all of the economic benefits from the use of the identified asset and the right to direct the use of the identified asset. 16
Lease Identification and Classification LEASE IDENTIFICATION (continued) Identified Asset Definition: An asset typically is identified by being explicitly specified in a contract. However, an asset also can be identified by being implicitly specified at the time that the asset is made available for use by the customer. 17
Lease Identification and Classification LEASE IDENTIFICATION (continued) Substantive Substitution Rights: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier s right to substitute an asset is substantive only if both of the following conditions exist: a. The supplier has the practical ability to substitute alternative assets throughout the period of use b. The supplier would benefit economically from the exercise of its right to substitute the asset 18
Lease Identification and Classification LEASE IDENTIFICATION (continued) Lease Components: Consider whether the contract contains separate lease components within the contract. Contracts may contain a lease coupled with an agreement to purchase or sell other goods or services (non-lease components) (i.e. a maintenance contracts). For these contracts, the non-lease components are identified and accounted for separately from the lease component, in accordance with other US GAAP. ASC 842 provides a practical expedient that permits lessees to make an accounting policy election (by class of underlying asset) to account for each separate lease component of a contract and its associated non-lease components as a single lease component. 19
Lease Identification and Classification LEASE IDENTIFICATION (continued) Lease Components (continued): Lessees that do not make an accounting policy election to use this practical expedient are required to allocate the consideration in the contract to the lease and non-lease components on a relative standalone price basis. 20
Lease Identification and Classification LEASE CLASSIFICATION Finance or Operating? FINANCE lease if one of the following applies: 1 - The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. 2 - The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise 3 - The lease term is for the major part of the remaining economic life of the underlying asset 21
Lease Identification and Classification LEASE CLASSIFICATION (CONTINUED) FINANCE (CONTINUED) : 4 Net present value of the lease payments is substantially all of the fair value of the underlying asset 5 - 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. OPERATING: When 1 through 5 are not met, a lessee will classify the lease as an Operating lease. 22
Lease Identification and Classification LEASE CLASSIFICATION (CONTINUED) When determining lease classification, one reasonable approach to assessing the criteria would be to conclude that: 75% or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset. A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls in the last 25% of the total economic life of the underlying asset. 90% or more of the fair value of the underlying asset amounts to substantially all of the fair value of the underlying asset. NOTE: This approach is consistent with current GAAP 23
Lease Identification and Classification LEASE CLASSIFICATION (CONTINUED) Example Fact Pattern: Asset: Truck Term: 10 years Asset economic life: 13 years Lease payments (LP): $9K per year PV of LP: $73K (using rate lessor charges lessee, 4.00%) Fair value of truck at commencement: $90K Is this a Finance or Operating lease? 24
Lease Identification and Classification LEASE CLASSIFICATION (CONTINUED) Example Answer: Finance 25
Lease Identification and Classification LEASE CLASSIFICATION (CONTINUED) Example REASONS WHY Finance, met 1 of the 5 criteria: The lease term is for the major part (10 yr. term/13 yr. economic life=77%)of the remaining economic life of the truck, even though the present value of the lease payments was not considered substantially all of the fair value of the truck NOTE: Because this is a reasonable approach and not a bright-line test, keep in mind that professional judgment would allow for the possibility of the life or the PV of payments to be less than 75% or 90%, respectively 26
Lessee Accounting At commencement, lessee s record ALL leases as follows (Finance and Operating): Recognize right-of-use (ROU) asset Record a lease liability for future rental payments 27
Lessee Accounting Measure BOTH the asset and the liability at present value (PV) of future lease payments, Based on both lease term and lease payments Discount at implicit interest rate within the lease: If implicit rate is not readily determinable the lessee could use its incremental borrowing rate - rate company would incur for a similar debt instrument and related terms Lessees that are not public entities could make an accounting policy election and elect to use the risk free rate - using a period similar to the lease term US Treasury Notes & Bonds for a similar term Include initial direct costs in the ROU asset (see later slide) 28
Lessee Accounting TWO ELEMENTS FORM the BASIS FOR PV of FUTURE LEASE PAYMENTS: 1) Lease Term Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. (assume the lessor will not cancel the lease) 29
Lessee Accounting 2) Lease Payments Include: Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option 30
Lessee Accounting 2) Lease Payments Include (continued): Payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease. Fees paid by the lessee to the owners of a specialpurpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph842-10-25-2(d). For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36). 31
Lessee Accounting SUBSEQUENT ACCOUNTING For Finance Leases Amortize ROU Asset Method: straight-line basis, unless another basis is more representative Period: shorter of the estimated lease term or underlying asset s useful life o However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset. 32
Lessee Accounting SUBSEQUENT ACCOUNTING (CONTINUED) For Finance Leases Separately Reflect in the P&L: Interest component of the lease liability Amortization of ROU asset Variable lease payments incurred after commencement (that were not included in the original lease asset/liability) 33
Lessee Accounting SUBSEQUENT ACCOUNTING (CONTINUED) For Operating Leases Amortize ROU Asset Difference between periodic lease cost and effective interest on lease liability o i.e. asset amortization is a plug Reflect a single lease cost on the P&L o Combine effective interest on lease liability with amortization of ROU asset, so the remaining cost of the lease is allocated over the remaining lease term on Straight-Line basis 34
Lessee Accounting SUBSEQUENT ACCOUNTING (CONTINUED) For both Finance and Operating Leases Assess ROU asset for impairment in accordance with Topic 360, Property, Plant, and Equipment Remeasure the lease liability and reassess classification each period for contract modifications not accounted for as a separate contract Recognize amount of re-measurement of lease liability as an adjustment to ROU asset Exception: o When related to a change in an index or a rate attributable to the current period or when the carrying amount of the right-of-use asset has been reduced to zero, the remeasurement should be reflected in P&L 35
Leases Financial Statement Balance Sheet Lessee Presentation Finance Lease Right-of-use assets presented either: - Separately from other assets - Together with the corresponding underlying assets as if they were owned, with disclosures of the balance sheet line items that include Finance lease right-ofuse assets and their amounts Lease liabilities presented either: - Separately from other liabilities - Together with other liabilities with the disclosure of the balance sheet line items that include Finance lease liabilities and their amounts 36
Leases Financial Statement Balance Sheet Lessee Presentation Operating Lease Right-of-use assets presented separately from Finance lease right-of-use assets with disclosure of the related balance sheet line items that include the Operating lease assets Lease liabilities presented separately from Finance lease liabilities The FASB decided not to otherwise specify how lessees would separately present Operating lease right-of-use assets and lease liabilities except to say the presentation should be rational and consistent with similar leases and appropriate based on the facts and circumstances 37
Leases Financial Statement Income Statement Lessee Presentation Finance lease: Lease-related amortization and lease-related interest expense are presented separately (i.e., lease-related amortization and interest expense can not be combined) Operating leases: Lease-related expenses are presented as a single line of lease or rent expense 38
Leases Financial Statement Statement of Cash Flows Lessee Presentation Finance lease: Cash payments for the principal portion of the lease liability would be presented within financing activities and cash payments for the interest portion would be presented within operating activities in accordance with ASC 230, Statement of Cash Flows Operating lease: Cash payments for lease payments would be presented within operating activities 39
Leases Financial Statement Statement of Cash Flows (continued) Lessee Presentation Both types of leases: - Lease payments for short-term leases not recognized on the balance sheet and variable lease payments (not included in the lease liability) would be presented within operating activities - Noncash activity, e.g., the initial recognition of the lease at commencement) would be disclosed as a supplemental noncash item 40
Lessee Accounting Lessee Accounting Example FACTS: 10-year lease, option to extend 5 years Lease Pmts (LP) = $50k/year The lessee is not reasonably certain to exercise the option, therefore lease term = 10 years Payments due at the end of each year Initial direct costs (IDC)= $15k Lessee s incremental borrowing rate = 5.87% Present Value (PV) of remaining LP at inception= $370,282 41
Lessee Accounting FINANCE AND OPERATING LEASE Lease Commencement: January 1, Year 1 Debit Credit Right of Use Asset 385,282 Lease Liability 370,282 Cash (IDC) 15,000 Lease Liability is the PV of lease payments at 5.87% discount rate 42
Lessee Accounting First-year Accounting Entries: FINANCE LEASE December 31, Year 1 Debit Credit Lease liability 28,264 Interest expense 21,736 Cash 50,000 Amortization of lease liability per amortization table Interest Expense is recorded as (5.87% x $370,282) Amortization expense 38,528 Right of Use Asset 38,528 To record amortization of ROU asset Amortization expense is recorded as ($385,282/10) 43
Lessee Accounting First-year Accounting Entries: OPERATING LEASE December 31, Year 1 Debit Credit Lease Liability 28,264 Cash 50,000 Lease expense 51,500 Right of Use Asset 29,764 To record payment, lease expense & adjustment of ROU asset Lease expense calculated as (($500,000 + $15,000)/10) Interest expense component calculated as (5.87% x $370,282=$21,736) ROU adjustment calculated as ($51,500 - $21,736=29,764) 44
Illustration Financing Lease Company enters three year equipment leases on Jan 1, Year1; fixed payments as follows; implicit rate is 4.235%; qualifies as financing lease Payments Dec 31, Year1 $ 10,000 Dec 31, Year2 $ 12,000 Dec 31, Year3 $ 14,000 $ 36,000 Implicit Rate 4.235% Present value, Jan 1, Year1 $ 33,000 45
Illustration Financing Lease (cont) Lease Commencement: January 1, Year1 Debit Credit Right of Use Asset 33,000 Lease liability 33,000 Present value of lease payments at 4.235% discount rate First-year Accounting Entries: December 31, Year1 Debit Credit Lease liability 8,602 Interest expense 1,398 Cash 10,000 Amortization of lease liability per schedule Amortization expense 11,000 Right of Use Asset 11,000 46 Straight-line amortization of ROU asset, $33,000 / 3 years
Financing Lease Income Statement impact Income Statement Effect of Financing Lease Total Amortization Interest 47
Subsequent Accounting OPERATING LEASE Achieve single lease cost on a straight-line basis in the income statement Liability accredited & amortized ROU asset amortized at difference between SL total and interest expense Results in level expense over lease term 48
Illustration Operating Lease Company enters three year equipment leases on Jan 1, Year1; fixed payments as follows; implicit rate is 4.235%; qualifies as operating lease Payments Dec 31, Year1 $ 10,000 Dec 31, Year2 $ 12,000 Dec 31, Year3 $ 14,000 $ 36,000 Implicit Rate 4.235% Present value, Jan 1, Year1 $ 33,000 SAME FACT PATTERN & CALCULATIONS AS FINANCING ILLUSTRATION 49
Illustration Operating Lease (cont) Lease Commencement: January 1, Year1 Debit Credit Right of Use Asset 33,000 Lease liability 33,000 Present value of lease payments at 4.235% discount rate First-year Accounting Entries: December 31, Year1 Debit Credit Lease liability 8,602 Cash 10,000 Rent/lease expense 12,000 Right of Use Asset 10,602 Record payment, accretion of lease liability & adjustment of ROU asset 50
Operating Lease Income Statement impact Income Statement Effect for Operating Lease Total Interest Amortization 51
Presentation & Disclosure BALANCE SHEET Either (a) separate lines, or (b) together with similarly caption elements along with footnote disclosure of lines/amounts Amounts for financing & operating leases CANNOT be presented in the same lines Amounts currently due on lease liabilities (typically next 12 months) should be classified as current 52
Presentation & Disclosure INCOME STATEMENT Financing Lease ROU asset amortization = amortization expense Liability accretion = interest expense Operating Lease Liability accretion & ROU asset adjustment combined as rent or lease expense within operations 53
Presentation & Disclosure CASH FLOWS Financing Lease Principal financing activity Interest operating activity Amortization operating activity Operating Lease Single lease cost operating activity 54
Presentation & Disclosure New or expanded footnote disclosures General information about the terms & conditions of leases Significant judgments/assumptions in identifying a lease, separating components & applying discount rate Finance, operating, short-term & variable lease costs Weighted-average discount rate Maturity analysis (separate for Financing & Operating) & reconciliation back to balance sheet Related party leases Other matters short-term leases, practical expedient alternative elections, sale-leaseback transactions 55
Other Considerations Short-Term Leases A lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. As an accounting policy election, A lessee may elect not to apply the recognition requirements in this Standard to short-term leases. May recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred. This election shall be made by class of underlying asset to which the right of use relates. 56
Other Considerations Sale-Leasebacks Standard requires seller-lessees and buyer-lessors to consider the new revenue recognition standard and other criteria in this standard (e.g., a sale with a finance leaseback would not qualify as a sale) to determine whether a sale has occurred. If control of an underlying asset passes to the buyerlessor, the transaction is accounted for as a sale (or purchase) and a lease by both parties. If not, the transaction is accounted for as a financing by both parties. 57
Other Considerations Subleases Separate section in the Standard dealing with the lessee accounting for subleases 58
Other Considerations Initial Direct Costs Initial direct costs for a lessee or a lessor may include, for example, either of the following: a. Commissions b. Payments made to an existing tenant to incentivize that tenant to terminate its lease. 59
Other Considerations Costs Not Considered Initial Direct Costs a. 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: b. General overheads, including, for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time c. Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities d. Costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms 60
Other Considerations Leases Between Related Parties should be classified in accordance with the lease classification criteria applicable to all other non-related party leases on the basis of the legally enforceable terms and conditions of the lease. In the separate stand-alone financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties. Substance over form can be ignored as it relates to the lease term of a RP lease. To avoid adopting the new lease standard, RP lessors should have a legally binding lease with a month-to-month term. 61
Other Considerations Software solutions for implementation of the lease standard - waiting to see what becomes available over the next year Overhead Implication If classification is a financing lease (old capital lease) then the portion of the expense considered interest would be eliminated from the schedule of general overhead (no change from previous guidance) 62
Disclosures Disclosures Extensive quantitative and qualitative disclosures, including disclosures about significant judgments made by management, will be required to provide greater insight into both the revenue and expense recognized and expected to be recognized from existing contracts. General description of leases the basis on which variable rents are determined, a description of extension and termination options, significant judgments and assumptions made (e.g., with respect to embedded leases and the allocation of consideration between leases 63
Impact on Companies and Financial Statements Wall Street Journal Headline - November 10, 2015: Coming to a Balance Sheet Near You - $2 Trillion in Leases At the end of 2014 - the following companies operating lease commitments versus Long-Term Debt was as follows: Company Operating Lease Commitments Long-Term Debt AT&T $31 billion $76 billion CVS 23.7 billion 11.7 billion Delta 12.7 billion 8.6 billion 64
Impact on Companies and Financial Statements Potential Business Impacts Impact on Bank Debt Covenants Share-based payment or Bonus Plans Performance hurdles may need to be renegotiated 65
Impact on Companies and Financial Statements Financial Impacts Financial Ratios Ratio Change Assumption Current Ratio Decrease Increase in current liabilities for lease debt Debt to Equity Increase Debt increases EBITDA Increase Additional interest and amortization expense on leases classified as Finance leases 66
Impact on Companies and Financial Statements Steps Companies Should Take: Entities should perform a preliminary assessment in the near future to determine how their lease accounting will be affected. Two critical first steps include: (1) obtain an inventory of all the Company s leases and lease data and (2) accumulating that data in a way that will facilitate the application of the Standard. Be aware now as you enter into new leasing or bank arrangements the impact of the new Standard relative to those arrangements 67
Conclusion QUESTIONS Contact Information: Hunter Mink > hmink@rklcpa.com Brian Rosenberg > BrianRosenberg@bssf.com 68