www.pwc.com Like-Kind Exchange and Fixed Asset Conference Upcoming Changes in Lease Accounting October 29, 2010 Ryan J. Dent, Senior Manager
Today s agenda Introduction The future of lease accounting The lessee model The lessor model Timing, transition and business implications 2
Convergence The current status of convergence Financial instruments Revenue recognition Leases Fair value measurement Investment properties* Statement of comprehensive income Financial statement presentation Discontinued operations Fin. instr. with characteristics of equity IASB - insurance contracts** Consolidation - broad project*** Consolidation - investment companies*** Balance sheet netting IASB - postemployment benefits**** IASB - contingencies**** Emissions trading schemes Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 2012 Pre-exposure draft deliberations Exposure draft issued or expected Comment period and redeliberations Final standard expected * This is a FASB-only project but is related to the Leases project and is based on IAS 40, Investment Property, an IFRS. ** IASB timeline. The FASB issued a Discussion Paper on September 17, 2010 that seeks input on whether it should adopt some version of the IASB proposal, or whether targeted changes to U.S. GAAP should be made. *** The consolidation project has been divided into two projects: one focused on investment companies and one that is comprehensive. The broad project timeline is that of the IASB. The FASB will decide how it wants to proceed on a comprehensive project after it performs additional stakeholder outreach. **** These are IASB projects that have the potential to impact the views of the FASB as it evaluates existing U.S. GAAP in these areas. 3
GAAP GAP The US path to IFRS will likely be one of continued convergence followed by ultimate conversion US GAAP The planned convergence of US GAAP and IFRS will result in a significant number of new US GAAP standards between 2010 and 2014 Outside the US a growing number of countries require IFRS or an IFRS equivalent for private statutory reporting Convergence Conversion The IASB and FASB convergence project started in 2002. Despite expected progress significant differences will remain even after completion of the convergence agenda. Ultimately, the US will still need to change to IFRS to eliminate remaining differences. Under the SEC s proposed conversion timeline, IFRS could replace US GAAP, but no sooner than 2015-2016 2010 IFRS 2011-2014 Adoption More likely we see that ultimate adoption of IFRS will still occur but that the timeline will be longer given convergence and conversion challenges. 4
History and perceived problems with current models In its 2005 report on off-balance sheet transactions, the SEC Staff specifically asserted that lease standards should be rewritten In July 2006, the FASB and IASB both agreed to add a joint project on lease accounting to their accounting project agendas. Joint FASB/IASB Discussion Paper issued March 19, 2009, almost 300 comment letters received. FASB/IASB Exposure Draft released August 17, 2010. Problems with current model Existing lease model considered to be broken most significantly for lessees. Similar transactions can be accounted for in different ways, reducing comparability. Current standards provide structuring opportunities. Current model is complex and the dividing line between operating and finance lease is a bright-line rather than principles based. Conceptually flawed as a lease meets the definitions of both an asset and a liability in the conceptual framework. Users believe operating leases should be recognized in the financial statements of the lessee. 5
The future of lease accounting summary Proposed rules will eliminate operating lease accounting by lessees - Balance sheet will be grossed up with an obligation and an asset - P&L geography changes - Expense recognition pattern will change and become front-end loaded Lease term, contingent rents, residual value guarantees will need to be estimated and subsequently re-measured More volatility will be introduced in the income statement Broad impacts on debt covenants, real estate and equipment financing strategy (lease vs. own), models for forecasting, impacts on incentive compensation plan metrics, etc. 6
The future of lease accounting - summary Additional accounting processes and/or applications to prepare/maintain records to support estimates on lease commencement date and for the life of the lease; impacts on internal controls to address initial estimates and periodic re-measurements Existing leases are not grandfathered (with the exception of simple capital leases). Initial data gathering and estimating may take considerable time and effort. 7
The impact is far reaching Economic conditions Operational Financing strategies Leasing strategy change Regulatory Taxes Budgetary Corporate real estate 8
Scope Current status Definition of a lease A contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration What is scoped in All leases of tangible assets (property, plantand equipment) Short term leases Leases embedded within other arrangements such as service or supply contracts-including those that meet the definition of a lease under ASU 840-10-15 (formerly EITF 01-8) and IFRIC 4, such as certain power purchase contracts 9
Scope Current status What is scoped out Transactions considered to be a purchase (by lessee) and sale (by lessor) of the underlying asset. Leases of intangible assets, biological assets, and exploration for or use of natural resources such as minerals, oil, natural gas Immaterial items (however, large number of small leases may be material e.g., computers) Investment property accounted for at fair market value under IAS 40 (In the U.S. the FASB board recently agreed to expose an equivalent IAS 40 Investment property standard requiring measurement at fair market value-which presumably would also be excluded from the scope). 10
Lessee accounting model Lessee will recognize right-of-use asset and a liability for obligation to pay lease rentals Initial measurement - Asset is measured at the present value of lease payments plus initial direct costs incurred by lessee - Obligation is measured at the present value of lease payments discounted at lessee s incremental borrowing rate - Initial measurement of asset and obligation done at lease inception Observation: Potential issue on measurement when significant passage of time occurs between lease inception and lease commencement. 11
Lessee accounting model Incremental borrowing rate - The rate of interest that, at lease inception, the lessee would have incurred to borrow over a similar term the funds necessary to purchase a similar asset. - If the lessee has insight into the rate the lessor is charging in the lease, it may be used in lieu of the incremental borrowing rate (i.e., the implicit rate) 12
Lessee accounting model Subsequent accounting - Right-of-use asset Amortized cost based approach (typically straight line method) Will be subject to impairment under existing rules (ASC 350 or IAS 36) IFRS preparers permitted to revalue; US preparers not permitted to revalue - Obligation: Amortized cost using effective interest method Cash payments for the lease recorded as interest expense and reduction of the obligation Adjust estimate if facts and circumstances change 13
Lessee accounting Proposed changes at a glance Item Lease Term (options to extend) Treatment at lease inception date Extension options: Calculated based on longest possible lease term that is more likely than not to occur (consider all relevant factors including market rent renewals) Reassessment at reporting date? Yes If new facts or circumstances indicate that there is a significant change in obligation Adjustment due to change in lease obligation Recognize changes in right-of-use asset 14
Lessee accounting model Lease Term Factors in making lease term assessment - Contractual Level of rentals in any secondary period Existence of residual value guarantees, termination penalties - Non-contractual financial Existence of significant leasehold improvements that would be lost Non-contractual relocation costs, lost production costs, tax consequences - Business Nature of the asset (core, specialized, competitor use of the asset) Location of the asset 15
Lessee accounting model Lease Term Factors in making lease term assessment - Lessee specific Lessee intentions Past practice 16
Lessee accounting Proposed changes at a glance Item Treatment at lease inception date Reassessment at reporting date? Adjustment due to change in lease obligation Cash flows (contingent rentals and residual value guarantees) Included based on probability weighted estimate for a reasonable number of outcomes, no need to consider every possible scenario; contingent rents based on an index or rate to be measured using readily available forward rate (use prevailing rates or indices at lease inception if forward rates not available) Yes If new facts or circumstances indicate that there is a significant change in obligation Recognize changes from current and prior periods in income statement; recognize all other changes in right-ofuse asset Residual value guarantees: accounted for in the same way as contingent rents 17
Lessee accounting Proposed changes at a glance Item Treatment at lease inception date Reassessment at reporting date? Adjustment due to change in lease obligation Discount rate Use incremental borrowing rate; rate lessor charges lessee in the lease can be used if readily determinable (a) No reassessment in the case of a simple lease (i.e., fixed term with no contingent rents, options, etc.); (b) In the case of complex leases, (i) no revision due to subsequent change in expected lease term; (ii) no revision due to changes in amounts payable under contingent rentals unless rentals are contingent on variable reference interest rates N/A unless rentals are contingent on variable reference interest rates. If so, recognize changes in obligation in income statement 18
Annual Pre-Tax Expense Impact of the proposed model on annual expense 2700 2600 2500 2400 2300 2200 2100 2000 1900 1800 1700 1600 1500 1 2 3 4 5 6 7 8 9 10 Proposed Model Current model Cash Rents The chart above depicts the impact on earnings for a basic 10 year lease with an initial annual rent of $2,000, a 2% annual escalation rate and an assumed incremental borrowing rate of 7%. 19
The Future of lease accounting Simple lease example (Lessee) Lease terms and assumptions Lease commenced on 1/1/xx01 Square ft 100,000 Annual initial rent per square ft $ 20.00 (Paid Monthly) Initial annual rent $ 2,000 (000 s omitted) Annual escalation 2.0% Assumed incremental borrowing rate 7.00% (10 year rate) Triple net lease executory costs paid separately No extension options, residual value guarantees or contingent rent observations Total expense is same over term of the lease. Expense for new model is higher in the early years than both current model and cash terms. Lease obligation exceeds net unamortized asset after day 1 until the end of the lease. Longer lease terms or lease terms with contingent rents (usually back ended from cash perspective) would have even more distortion to both current accounting model and cash terms. Example is for net lease and cash payments exclude executory costs. If base year or gross leases, executory costs would need to be removed from payments for leases accounting. 20
Comparison of an assumed 20 year term at outset with two optional 5-year renewal periods $2,900 $2,700 $2,500 $2,300 $2,100 $1,900 $1,700 $1,500 $1,300 1 3 5 7 9 11 13 15 17 19 Current Model Proposed Model - options subsequently added Proposed Model - assuming 20 year term The chart compares (1) a 10-year lease with two 5-year renewals, with renewals determined to be more likely than not to be exercised in years 7 and 12 with (2) a determination at outset that the longest lease term more likely than not to occur is 20 years. 21
Multiple element arrangements Applies to agreements that include both a lease and a service component; for example: - Grounds maintenance or property tax charges passed through to the lessee in connection with a real estate lease. - Ongoing maintenance or supplies associated with an equipment lease. The combined payments would need to be allocated between distinct services and lease of asset; if allocation is not possible, the entire arrangement would be accounted for as a lease. A service component is considered distinct if either: - The entity, or another entity, sells an identical or similar service separately - The entity could sell the service separately because the service has both a distinct function or a distinct profit margin Observation: The definition of distinct service components may present difficulties for lessees to separate executory services from the lease component. If not considered distinct, executory service components (e.g., maintenance charges, property taxes, etc.) would be included in the asset and liability recorded on the balance sheet. If true, this would differ from the accounting treatment if the asset were owned and will be a major issue for many significant users of real estate. 22
Lessor accounting A hybrid approach for lessor accounting is used. Two approaches have been developed Approach 1 Performance obligation The lease contract is viewed as creating a new right, leaving the lessor s rights relating to the leased asset unchanged Asset remains on lessor s balance sheet A separate receivable and a performance obligation are also recognized Approach 2 Derecognition Lessor is viewed as having transferred a portion of the leased item to the lessee Derecognize an allocated portion of leased item and record cost of sale Recognize a lease receivable and sale equal to present value of lease payments 23
Lessor accounting The Boards have decided upon a dual model under which: - The Performance Obligation approach would be used when lessor retains exposure to significant risks or benefits with the underlying asset either a) During the lease term, or b) After the expected term of the lease by having the expectation or ability to generate significant returns by re-leasing or selling the asset. - The Derecognition approach would be used for all other leases. Credit risk of the lessee shall not be considered in determining whether the lessor has significant risk. Assessment is made at inception of the lease and not subsequently reassessed. 24
Lessor accounting Factors to consider in determining if lessor has significant risks or benefits during the lease term: - Significant contingent rentals based on use or performance of the asset - Options to extend or terminate the lease - Existence of contractual material non-distinct services Factors to consider in determining if lessor retains exposure to significant risks or benefits after the expected term of the current lease: - Duration of the lease is not significant compared to remaining useful life - Significant change in value of the asset at the end of the lease term is expected. Lessor shall consider: a) Present value of the underlying asset at the end of the term, and b) The effect that any residual value guarantees (including third party guarantees) may have on exposure to risk or benefits 25
Annual Pre-Tax Income Lessor impact of the proposed performance obligation model on annual income $2,700 $2,600 $2,500 $2,400 $2,300 $2,200 $2,100 $2,000 $1,900 $1,800 $1,700 $1,600 1 2 3 4 5 6 7 8 9 10 Proposed Model Current model Cash Rents The chart above depicts the impact on interest earnings for a basic 10-year lease with an initial annual rent of $2,000, a 2% annual escalation rate and an assumed incremental borrowing rate of 7%. 26
Derecognition approach Under the derecognition approach, the lessor records a lease receivable for the present value of lease payments and records revenue. The lessor also derecognizes an allocated amount of the asset being leased and records cost of sales. The amount derecognized is an allocation of the carrying amount of the underlying asset at lease inception in proportion to the fair value of the rights transferred and the rights retained. Cash payments for the lease recorded as interest income and reduction of the lease receivable. The residual asset remains unchanged throughout the lease term unless an impairment charge is necessary. 27
Sale-leasebacks The principle driving the accounting for sale-leaseback transactions would be whether the underlying asset has been sold - If so, the seller/lessee accounts for the transaction as a sale, recognizes gain or loss, and accounts for the leaseback under the proposed lessee provisions - If not, the seller/lessee accounts for the transaction as a financing The underlying asset is considered sold if: - Control has been transferred and - All but a trivial amount of the risks and benefits associated with the underlying asset have been transferred to the buyer/lessor The determination is made at inception and not subsequently reassessed. 28
Sale-leasebacks Indicators of control transfer: - Automatic transfer of title - Bargain purchase option with reasonable certainty that buyer/lessor will exercise If the sale and leaseback are not at market rates, the asset, liability and gain/loss should be adjusted to reflect market rentals Observation: The Exposure Draft is expected to replace ASC 840, Leases, including the guidance relating to ASC 840-40-55, Criteria for Determining Whether the Lessee Should be Considered the Owner of the Asset Under Construction (formerly known as EITF 97-10), effectively eliminating the issue. 29
Subleases The intermediate lessor (the sub-lessor): Accounts for assets and liabilities arising from the head lease (its lease with the owner/lessor) under the lessee provisions of this proposal Accounts for assets and liabilities arising from the sublease under the lessor model developed by the Boards 30
Impairment At each reporting date, the right-of-use asset should be tested for impairment using ASC 350, Intangibles Goodwill and Other, or IAS 36, Impairment of Assets. Any impairment loss is recognized in accordance with 350 or IAS 36. Lessors should apply ASC 310, Receivables, or IAS 39, Financial Instruments: Recognition and Measurement, to determine whether the right to receive lease payments is impaired. Any impairment loss is recognized in the income statement. For leases under the derecognition approach, lessors should determine at each reporting date whether the residual asset is impaired in accordance with ASC 350 or 360, Property, Plant and Equipment or IAS 36. Observation: Due to the differences in impairment models between US GAAP (2-step model) and IFRS, an impairment charge may be recorded earlier under IFRS than US GAAP. 31
Timing Exposure Draft issued August 17, 2010 Comments are due by December 15, 2010 Boards will consider comments received and re-deliberate the standard Final standard expected in the second quarter of 2011 Effective date tied to the other projects being addressed in the FASB/IASB Memorandum of Understanding. Boards will issue a consultation paper and seek input from constituents on potential effective dates of the convergence projects. 32
Transition Lessees At transition date - Obligation to pay rentals and right-of-use asset will be recorded for all outstanding leases - The obligation measured at present value of remaining lease payments, discounted using the incremental borrowing rate on the date of transition - The asset measured on the same basis as the liability, subject to any adjustment to reflect impairment - When lease payments are uneven over the lease term, the right of use asset is adjusted for any recognized prepaid or accrued lease payments Observation: As written in the ED, leases that expired before the adoption date but existed in the earlier periods will be included in the balance sheets of those periods. 33
Transition Lessees Only simple capital leases will remain unaffected Note that companies are required to use the simplified retrospective approach transition date is earliest date presented. For example, if adoption date is 2013, a calendar year public entity in the US would need to recast 2012 and 2011 Observation: As written in the ED, leases that expired before the adoption date but existed in the earlier periods will be included in the balance sheets of those periods. 34
Transition Lessors Performance obligation approach: - Lease receivable recorded for all outstanding leases, measured at present value of remaining lease payments, discounted using original rate charged in the lease - The performance obligation measured on the same basis as the receivable - Previously derecognized lease assets would be reinstated at depreciated cost, adjusted for impairment (potential revaluation for IFRS preparers) Derecognition approach: - Lease receivable recorded for all outstanding leases, measured at present value of remaining lease payments, discounted using original rate charged in the lease - Residual asset measured at fair value determined on the date of transition Simplified retrospective approach also applies for lessors 35
Transition issues When lease payments are uneven over the lease term (lease incentives, rent increases, etc.), it is uncertain whether the adjustment to the right-of-use asset refers to the amount included on the balance sheet or the contractual amount For lessors, the proposal lacks guidance on how to distinguish between the performance obligation approach and the derecognition approach at transition Lessors are required to measure the lease receivable using the rate charged in the lease determined at lease inception. If the rate wasn t calculated at inception of the lease, determining the rate may be difficult It is currently unclear what happens with existing sale leasebacks with deferred gains Leverage leases are not expected to survive but unclear as to how it will be eliminated in transition 36
Business implications Financial ratios and metrics will change - Balance sheets would expand; leverage and capital ratios may suffer - Expense recognition pattern will change - Rent expense recast as interest and amortization expense will change performance measures such as EBITDA and, in the statement of cash flows, cash flows from operating activities - Loan covenants, credit ratings, internal budgeting, compensation plans and other agreements may be affected Inventorying all leases and gathering data about the key provisions of each lease may be time-consuming 37
Business implications Systems and controls evaluation - Record-keeping and accounting under the new model will likely need to be systems-based - New processes and controls will need to be developed especially around changes in estimates 38
Business implications Consider existing lease modifications prior to adoption (in some cases, it may be advantageous to modify terms today, while markets are depressed; also, in some industries, companies may want to eliminate unnecessary extension provisions or contingent rent terms) Lease v. buy decisions may be affected (for long-dated property needs, it may be cheaper to buy an asset than lease it, especially in a depressed real estate market or where cost of capital differences exist; Common negotiated terms may change (for example, contingent rent provisions in retail leases will likely decline in use) Regulatory capital impact unclear (the front-ended P&L impact will reduce equity and lease assets and liabilities will come on balance sheet, but it is unclear whether and, if so, how the regulators may react) 39
Business implications Sale-leaseback transactions may change focus (if the leaseback is on balance sheet, transactions may become more borrowing- or tax-driven than accounting-driven) Tax considerations may be very significant Lessee's accounting/controls and additional scrutiny/approvals may slow down deal flow Observation: The lease project may act as a catalyst for many to reconsider all aspects of their leasing strategy. 40
Some fundamental questions Why does your company lease or own in particular situations? What are the alternatives to leasing? What are current market opportunities (e.g., lease rates/purchase prices) and how would they affect your real estate strategy? How do federal, state and local taxes factor into your corporate real estate decisions? How does your company manage occupancy costs today? What is the potential impact of the proposed lease model on your company? What changes will your company need to make to manage the process? Do your existing systems have the capabilities necessary to apply the proposed lease standard? 41
How can help has multi-disciplinary teams of specialists who can assist you with all aspects of your journey. Valuation/Marketing analysis Real estate and lease portfolio valuation Market studies Valuation analyses in conjunction with accounting requirements (i.e., FAS 141R) Real estate and accounting advisory Training, planning and implementation assistance with regard to new lease standard Analysis of needs and market trends Analysis of, or assistance with, evaluating financial and strategic impact of new lease project Systems and processes Process/control change consulting/implementation planning with respect to impact of new lease project Strategic information systems planning Gap analysis & system selection Technology integration & implementation Tax and transaction support Analysis of tax implications and structuring opportunities with respect to new lease standard Sale-leaseback transactions REIT spin-offs of corporate real estate to unlock shareholder value Federal and state tax planning transactions Operational effectiveness and cost containment Lease expense audits for potential recovery Process re-design & leading practices in corporate real estate Benchmarking and performance monitoring Spend analysis, strategic sourcing, outsourcing effectiveness Operational & organizational effectiveness 42
Lease publications DataLine 2010-38: A New Approach to Lease Accounting Point of View: The Future of Leasing Catalyst for Change in Corporate Real Estate 43
Thank you For additional information, please visit www.pwc.com/usgaapconvergence 2010 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity.