Lease Accounting Standard Update ASU 2016-02 Presented by: Nicholas Hoefel, CPA Manager, Audit Services Group 1
Overview Introduction Background and current environment Effective dates and transition Key provisions of the new guidance Early planning and action items 2
Introduction Three takeaways 1. Bigger balance sheets Most common operating leases will be added to the balance sheet as an asset and a liability 2. Additional disclosures 3. Advanced planning and communication necessary Lenders, management and other stakeholders Significant changes expected for commonly used metrics and performance indicators 3
Background Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) joint discussion paper issued in 2009 target convergence and improvement 1 st FASB Exposure Draft Aug 2010 Single model (capital/financing) 2 nd FASB Exposure Draft May 2013 Dual model reflecting different levels of consumption Conceptual lessee model departs from IASB Final ASU issued Feb 2016 International Financial Reporting Standards (IFRS) 16 issued Jan 2016 Convergence partially achieved 4
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 and comparability Structured transactions Inconsistent add-backs in the creditor and investor community for off-balance-sheet leases Financing and leverage comparisons between similar firms 5
Effective Dates and Transition Reporting years beginning after Dec. 15, 2019 December 31, 2020 and June 30, 2021 For non-public entities, including not-for-profit entities Early adoption is permitted Governmental Accounting Standards Board (GASB) expected to release guidance in 2017 Transition Modified retrospective approach new and continuing leases will be affected in the implementation period Practical expedients to reduce burden on existing (expired or continuing) leases Certain carve-outs Leases for intangible assets, mineral exploration, biological assets, inventory and assets under construction 6
Key Provisions Lease definition Classifying a lease Financing or operating Accounting for leases Initial and subsequent Modifications Separating/allocating components Lease or non-lease Disclosures and presentation Other: sale-leaseback, business combinations, real estate/structured leases 7
Lease Definition A contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration Determination at inception Only reconsidered for certain modification triggers Underlined terms subject to significant fine-print ASU 10 complete examples 8
Navigating Key Decision Points 1. Is there an identified asset? Explicit versus implicit Supplier substitution rights 2. For the period of use, do we have the right to obtain substantially all of the economic benefits from that asset? 3. Do we have the right to direct how and for what purpose the asset is used (or is use predetermined)? 9
Classifying a Lease Classified as either Short-term (generally all <12 months) Accounting policy election to expense straight-line over life of lease, no asset/liability recognition Financing one of the following 5 tests apply 1. Ownership transfers 2. Exercise of purchase option reasonably certain 3. Term constitutes a major part of the asset s remaining life 4. Present value of lease payments is substantially all of the asset fair value 5. Specialized nature of asset (no future market) Operating NONE of the preceding 5 tests apply 10
Accounting - Initial Measurement Financing and Operating Leases Right-of-use (ROU) asset Lease liability Initial measurement - present value of future lease payments, product of: Discount rate Lease term Lease payments Lease components 11
Discount Rate 1. Implicit rate in the lease 2. Incremental borrowing rate for similar financing 3. Risk-free rate (for similarly termed liability) Accounting policy option, must be applied to all leases U.S. Treasury Notes and Bonds 12
Lease Term Noncancellable term + lessee option term to extend, if reasonably certain + term lessee option to terminate, if reasonably certain not to exercise + term lessor option to extend or terminate (regardless of likelihood) Decisions in our control use probability Decisions out of our control assume maximum term (extensions exercised, terminations waived) 13
Lease Payments Fixed (or in-substance fixed) payments, less incentives Variable lease payments based on an index or stated rate (such as Consumer Price Index) Purchase option, if reasonably certain to exercise Termination penalties, if reasonably certain to exercise Residual value guarantee ** other fine-print adjustments may apply 14
Components Examine contracts to separate... Lease components one or more Non-lease components (if any) typically maintenance and services bundled in the agreement Allocate consideration on stand-alone pricing Non-lease components addressed by other guidance Generally expensed as incurred Practical expedient accounting policy available Leads to larger ROU asset and liability 15
Accounting Initial Measurement ROU asset and liability start at the same value Beginning ROU asset adjusted for: + Initial direct costs - Lease incentives received + (Lease payments made on/before commencement, annuity-due) Liability amortization remains the same over the lease term for both Financing and Operating leases 16
Subsequent Accounting FINANCING LEASE ROU asset amortize straight-line over term P&L impact amortization expense Liability accreted and amortized P&L impact interest expense Results in net acceleration of expenses 17
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 18
Illustration Financing Lease (continued) 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 19 Straight-line amortization of ROU asset, $33,000 / 3 years
Financing Lease Income Statement impact Income Statement Effect of Financing Lease Total Amortization Interest 20
Subsequent Accounting OPERATING LEASE Achieve single lease cost on a straight-line basis in the income statement Liability accredited and amortized ROU asset amortized at difference between SL total and interest expense Results in level expense over lease term 21
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 AND CALCULATIONS AS FINANCING ILLUSTRATION 22
Illustration Operating Lease (continued) 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 23
Operating Lease Income Statement impact Income Statement Effect for Operating Lease Total Interest Amortization 24
Presentation and Disclosure BALANCE SHEET Either (a) separate lines, or (b) together with similarly caption elements along with footnote disclosure of lines/amounts Amounts for financing and operating leases CANNOT be presented in the same lines Amounts currently due on lease liabilities (typically next 12 months) should be classified as current 25
Presentation and Disclosure INCOME STATEMENT Financing Lease ROU asset amortization = amortization expense Liability accretion = interest expense Operating Lease Liability accretion and ROU asset adjustment combined as rent or lease expense within operations 26
Presentation and Disclosure CASH FLOWS Financing Lease Principal financing activity Interest operating activity Amortization operating activity Operating Lease Single lease cost operating activity 27
Presentation and Disclosure New or expanded footnote disclosures General information about the terms and conditions of leases Significant judgments/assumptions in identifying a lease, separating components and applying discount rate Finance, operating, short-term and variable lease costs Weighted-average discount rate Maturity analysis (separate for Financing and Operating) and reconciliation back to balance sheet Related party leases Other matters: short-term leases, practical expedient alternative elections, sale-leaseback transactions 28
Transition Modified-retrospective approach Practical expedient available for existing and expired leases Do not reassess definition of a lease Do not reassess classification of a leases Do not reassess initial direct costs As of beginning of earliest comparative year presented in the year of implementation 29
Transition (continued) Expected effect for plain-vanilla leases Previous operating leases will become OPERATING leases Add to balance sheet at present value NO EQUITY ADJUSTMENT Previous capital leases will become FINANCING leases Re-classification / change in captions only NO EQUITY ADJUSTMENT 30
Transition (continued) Complicating factors for lessees ( non-vanilla ) Not electing transition practical expedients Acquired in a business combination Purchase, termination or extension options Activities in the transition period Modification of lease Impairment of ROU asset Remeasurement of lease liability 31
Lessor accounting Fewer overall changes made to the lessor model Prospective elimination of leveraged leases and real estate transactions possibly qualifying as sales-type leases More restrictive definition of initial direct costs Alignment with ASC 606/revenue recognition updates Separation and allocation of lease/non-lease components Assessment of collectibility 32
Early planning considerations Stakeholder education Impact on performance indicators and commonly used ratios Debt-to-Equity (Leverage), Debt Service Coverage, ROI/ROA EBITDA Implications for incentive compensation plans Debt covenants Transition plan Inventory of leases Accounting policy/expedient elections Tracking key terms and values ahead of implementation Planning opportunities Limited structuring opportunities expected Awareness of financial impact heading into new lease agreements 33