The Dbriefs Financial Reporting series presents: Bring it on Discussing the FASB s new leases standard March 15, 2016 Bob Uhl, Partner, Deloitte & Touche LLP James Barker, Partner, Deloitte & Touche LLP Tim Kolber, Senior Manager, Deloitte & Touche LLP Stephen McKinney, Director, Deloitte & Touche LLP Sean Torr, Director, Deloitte & Touche LLP
Agenda The Big Picture Identifying a lease Key ingredients of the leases model Overview of the core accounting models Other provisions, transition, and effective date Operational considerations Question and answer 1
Polling question (#1) Which best describes your organization? Equipment lessee Equipment lessor Real estate lessee Real estate lessor None of the above Don t know/na 2
The Big Picture Key takeaways from this Dbriefs webcast Most leases on balance sheet for lessees Classification will drive expense profile Lessor model largely unchanged Most changes result from alignment with ASC 606 FASB tried to make things easy Classification, reassessment, transition Effective 2019 but don t wait to assess impact Process and systems changes may be required Potential impact on debt covenants 3
Identifying a lease 4
Introducing the new standard What s in and what s out? Scope Applies to leases of property, plant, or equipment Does not apply to: Leases of intangible assets Leases to explore for or use nonregenerative resources Leases of biological assets Leases of inventory Leases of assets under construction 5
Definition of a lease What does the new definition look like? A lease is a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration Lessor Control the use of an identified asset Consideration Lessee 6
Definition of a lease For a contract to be, or contain, a lease it must Depend on the use of an identified asset, and Convey the right to control the use Right to obtain substantially all of the economic benefits from asset use and Right to direct the use of the asset over lease term 7
Identified asset Overview Identified asset criteria Contract must depend on use of identified asset Asset must be explicitly or implicitly identified Physically distinct portion of a larger asset may be an identified asset Capacity portion of a larger asset is generally not an identified asset Right of substitution Would result in the asset not being deemed a specified asset Substitution would be considered substantive if... o Lessor has the practical ability to substitute the asset o Lessor would benefit from exercising its right of substitution Warranty or upgrade considerations Supplier s right or obligation to substitute an alternative asset due to operational failure does not mean the asset is not an identified asset Supplier s right or obligation to upgrade the asset similarly does not mean the asset is not an identified asset 8
Definition of a lease Convey the right to control the use RIGHT TO OBTAIN SUBSTANTIALLY ALL OF THE ECONOMIC BENEFITS FROM USE Can obtain economic benefits from the use of an asset directly or indirectly in many ways Economic benefits from the use of an asset include its primary output and by-products, including potential cash flows derived from these items Benefits related to the ownership of an asset should not be included in the assessment of whether an arrangement contains a lease 9
Definition of a lease Convey the right to control the use (cont d) RIGHT TO DIRECT THE USE OF THE ASSET Right to direct how and for what purpose asset is used throughout the period of use; or Relevant decisions about how and for what purpose asset is used are predetermined before the period of use, and Customer has the right to operate asset without supplier having the right to change operating instructions; or Customer designed the asset in a way that predetermines the most relevant decisions about how and for what purpose the asset will be used during the period of use Protective rights, while defining the scope of the asset use, generally do not, in isolation, prevent the customer from being able to direct the use of the asset 10
Definition of a lease Illustrative example CONTRACT FOR THE USE OF A SHIP FACTS Customer A enters into a contract with Supplier B for the use of a specific ship for a four-year period Supplier B is not permitted to substitute the ship Customer A decides whether and what cargo will be transported and when and to which ports the ship will sail throughout the contract period Certain restrictions prevent Customer A from sailing the ship in waters where there is a high risk of piracy or from carrying hazardous materials as cargo During the contract period, Supplier B operates and maintains the ship and is responsible for the safe passage of the cargo onboard the ship Customer A is prohibited from hiring another operator for the ship during the term of the contract or operating the ship itself 11
Definition of a lease Illustrative example (cont d) CONTRACT FOR THE USE OF A SHIP ANALYSIS In this scenario, A has the right to control the use of the ship throughout the four-year contract period Customer A has the right to obtain substantially all of the economic benefits from the use of the ship during the contract period through its exclusive use of the ship Customer A has the right to direct activities related to the use of the ship because it decides where and when the ship will travel, what cargo it will carry, or whether it will be transporting cargo at any given time While there are contractual restrictions about where the ship can sail and the nature of the cargo to be transported, these are protective rights and do not prevent Customer A from having the right to direct the use of the asset 12
Polling question (#2) How many leases does your organization currently have in its portfolio? None 1-500 501-1,000 1,001-5,000 More than 5,000 Don t know/na 13
Key ingredients of the leases model 14
Contracts that contain multiple components Separating lease and nonlease components Contracts with multiple lease components for different underlying assets An asset will be considered a separate lease component if: Lessee can benefit from the use of the underlying asset either on its own or using other resources that are readily available The underlying asset is not highly dependent on or highly interrelated with other assets in the arrangement NOTE: Land and other elements evaluated separately unless the accounting for the land element would not be significantly different Contracts with lease and nonlease components (i.e., separate services) An activity is a nonlease component if it transfers a good or service to the lessee CAM and utilities would likely be nonlease components Property taxes and insurance would likely be combined with the lease component(s) Standard provides specific lessee and lessor guidance on how consideration should be allocated to each contract component 15
Lease classification Overview of the criteria CLASSIFICATION CRITERIA Lease would be classified as a finance lease (lessee) or a sales-type lease (lessor) when... Lease transfers ownership of the underlying asset to lessee by the end of the lease term Lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise Lease term is for a major part of the remaining economic life of the underlying asset Present value of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset Leased asset is so specialized in nature that it is expected to have no alternative use to the lessor at the end of the lease term The standard states that the bright-line thresholds that exist under ASC 840 could be a reasonable approach to evaluate whether a lease would be classified as a finance lease 16
Lease term Initial determination and reassessment Noncancelable period, plus LEASE TERM Renewal options that are reasonably certain to be exercised by a lessee Termination options that are reasonably certain not to be exercised by a lessee Options to extend (or not to terminate) that are controlled by the lessor REASSESSMENT REQUIREMENTS Lessees are required to reassess lease term when A significant event or change in circumstances occurs that is in the control of the lessee A contract term obliges the lessee to exercise (or not exercise) a renewal or termination option Lessee elects to exercise or not exercise a renewal or termination option that was not previously deemed reasonably certain of being or not being exercised Would reassess when there is a modification that does not result in a separate contract Lessors would not be required to reassess lease term, unless there is a modification that does not result in a separate contract 17
Lease payments What amounts are included in lease payments? Fixed lease payments Payments specified in the lease agreement In-substance fixed payments Variable payments Residual value guarantees Purchase and termination options Payments that depend on an index or a rate Excludes payments based on usage or performance Reassessment required under certain circumstances Lessees amount that it is probable will be owed under the RVG at the end of the lease term Lessors the full amount at which the residual asset is guaranteed by the lessee or third party Treated in a manner consistent with the accounting for renewal options Include options that a lessee is reasonably certain to exercise 18
Discount rate What discount rate should be used? Lessee must use the rate the lessor charges in the lease if readily determinable or, alternatively, its incremental borrowing rate Lessor would use the rate it charges the lessee, which is known as the rate implicit in the lease Lessee Would generally be updated when there is a remeasurement of the lease obligation Would reassess when there is a modification that does not result in a separate contract REASSESSMENT REQUIREMENTS Lessor Would reassess, in certain instances, when there is a modification that does not result in a separate contract Nonpublic business entities are permitted to make an accounting policy election to use the risk-free rate when measuring their lease obligations 19
Polling question (#3) Which lease accounting standard(s) will your organization need to comply with? FASB IASB Both FASB and IASB Neither FASB nor IASB Don t know/na 20
Overview of the core accounting models 21
Lessee accounting model What does the lessee model look like? Most* leases are recorded on the balance sheet using a right-of-use asset approach: Initial Measurement Subsequent Measurement Lease obligation PV of lease payments not yet paid ROU asset lease obligation + initial direct costs lease incentives + prepaid lease payments Lease obligation amortized using the effective interest method ROU asset depends upon lease classification Expense recognition pattern: o Finance lease front-loaded o Operating lease generally straight-line * Short-term leases: A lessee can elect, by asset class, not to record on its balance sheet a lease with a lease term of 12 months or less and which does not include a purchase option that the lessee is reasonably certain to exercise 22
Lessee accounting model Illustrative example This table highlights the differences in accounting for the lease under the finance lease and operating lease models: Finance lease Operating lease 23
Lessor accounting model What does the lessor model look like? Existing lessor accounting retained with minimal changes Classification depends on an assessment of control of the underlying asset Sales-type Direct financing Operating Lessee gains control of the underlying asset Lessee does not obtain control of the asset, but the lessor relinquishes control Lessor retains control of the underlying asset Underlying asset is derecognized Net investment in a lease is recognized Selling profit or loss recognized at lease commencement Initial direct costs recognized at lease commencement unless no selling profit or loss Underlying asset is derecognized Net investment in a lease is recognized Profit deferred and amortized into income over the lease term Initial direct costs deferred and amortized into income over the lease term Underlying asset remains on the lessor s balance sheet Income recognized on a straight-line basis unless another systematic basis is more appropriate Initial direct costs deferred and expensed over the lease term in a manner consistent with income 24
Lessor accounting model Interaction between ASC 842 and ASC 606 Sale treatment linked to lessee control of underlying asset Lease modifications accounted for in a manner similar to the modification guidance in ASC 606 New lessor guidance aligned with the FASB s new revenue standard in many respects Sale recognition depends on whether collectibility of the lease payments plus the residual value guarantee is probable Must consider guidance in ASC 606 when determining how to allocate payments between lease and nonlease components Determination of initial direct costs linked to incremental costs of obtaining a contract in ASC 606 25
Presentation requirements Lessee model Balance Sheet Income Statement Cash Flow Statement Financing Lease ROU asset Lease liability Amortization expense Interest expense Principal (Financing) Interest (Operating) Operating Lease ROU asset Lease liability Lease expense (single line on straight-line basis) Lease payments (Operating) Lessor model Presentation consistent with current lessor model: Balance sheet presentation depends on lease classification Income statement profit or loss recognized in a manner consistent with business model Cash flow statement recognized as cash inflows from operating activities 26
Disclosure requirements DISCLOSURE OBJECTIVE Enable financial statement users to assess the amount, timing, and uncertainty of cash flows arising from leases LESSEE DISCLOSURES LESSOR DISCLOSURES Nature of its leases Information about leases that have not yet commenced Related-party lease transactions Accounting policy election regarding short-term leases Finance and operating lease costs Short-term and variable lease costs Sublease income Gain or loss from sale-and-leaseback Maturity analysis for lease obligations Weighted-average remaining lease term Weighted-average discount rate Information Nature of its leases Significant assumptions and judgments used Related-party leases transactions Tabular disclosure of lease-related income Components of the net investment in a lease Information on the management of risk associated with residual asset Maturity analysis of operating lease payments and lease receivable required by ASC 360 27
Polling question (#4) How prepared is your company to comply with the new lease accounting standards? Extremely prepared Very prepared Somewhat prepared Not too prepared Not at all prepared Don t know/na 28
Other provisions, effective date, and transition
Sale-and-leaseback transactions Seller-lessee should evaluate the transfer of the underlying asset under the requirements of ASC 606 Existence of leaseback would not prevent a conclusion that underlying asset was sold Arrangement in which leaseback is classified as a finance lease would preclude sale accounting Substantive repurchase options would preclude sale accounting Gain recognition Leaseback accounting Failed saleleaseback Entire gain resulting from the sale recognized immediately Special considerations for off-market terms Account for leaseback in a manner consistent with other leases Seller-lessee applies lessee model; buyer-lessor applies lessor model A failed sale will be accounted for as a financing arrangement by both parties 30
Lessee involvement in asset construction Current build-to-suit guidance is not carried forward in the new standard New accounting depends on whether the lessee controls the underlying asset during the construction period: Lessee controls asset during construction Asset is effectively owned by the lessee during the construction period Arrangement would be subject to sale-and-leaseback accounting upon completion of construction Lessee does not control asset during construction Costs related to the construction or design of the underlying asset would be accounted for under other U.S. GAAP topics Standard provides indicators a lessee should consider when evaluating whether it controls the asset being constructed 31
Effective date and transition Effective date Public business entities effective for calendar periods beginning on January 1, 2019 and interim periods therein All other entities effective for calendar periods beginning on January 1, 2020, and interim periods thereafter Early adoption will be permitted Transition Lessees and lessors are required to use a modified retrospective transition method for all existing leases Would apply the new model for the earliest year presented in the financial statements Application of approach linked to current lease classification and new lease classification An entity can use hindsight when evaluating lease term TRANSITION RELIEF PACKAGE Lessees and lessors are not required to reassess the following upon transition: Whether any expired or existing contracts are leases or contain leases The lease classification for any expired or existing leases Initial direct costs for any existing leases 32
Other key provisions and resources But wait, there s more Lease modifications Contract combinations Sublease accounting Leveraged lease accounting Accounting for leases at a portfolio level Leases in a business combination Related-party leases Accounting for leasehold improvements Impairment considerations US GAAP to IFRS comparison FASB s new standard brings most leases onto the balance sheet *Read the complete Heads Up via the link to your left in the console. 33
Polling question (#5) How easy or difficult do you think it will be for your company to implement the new lease accounting standards? Extremely easy Somewhat easy Neither easy nor difficult Somewhat difficult Extremely difficult Don t know/na 34
Operational considerations 35
What to look for As you prepare to implement the new lease accounting standard, the following indicators may suggest a higher level of work effort: High lease volume Complex lease contracts Disparate systems/spreadsheets Decentralized lease transaction processing International locations Prior challenges in lease accounting Potential M&A activity 36
Operational challenges Data The reporting and disclosure requirements of the new lease accounting standard may result in an increase in electronic data needs and a long lead time to abstract and validate data. Factors to consider may include: High volume of data fields Data housed in disparate systems Information isn t all in one agreement Multiple currencies and languages Different arrangements in different countries Internal Controls Internal controls Judgment requirements During the implementation period, your operations don t cease. New leases are entered into and existing leases are modified or terminated 37
Operational challenges Technology As you review your current lease technology capabilities the following functional requirements should be considered: Abstraction technology to support efficient data gathering for large volumes of leases Reporting capabilities to perform necessary calculations and create required disclosures Storage of electronic lease documents and related data fields Operational considerations including key event notifications, what if analyses, workflow management, and data analytics Technology changes may be a longer lead time activity which may necessitate a temporary solution to facilitate data capture and pro forma reporting 38
Polling question (#6) Will your organization invest in technology to comply with the new lease accounting standards? No current software should be adequate Yes software upgrades will be necessary Yes new software will be necessary Don t know or N/A 39
Other implementation considerations The following additional challenges should be considered as you plan your implementation roadmap: Judgment is often required in the lease assessment; proper documentation is critical Third-party data may be needed to ensure a high level of operational quality and efficiency Entities may need to establish change management and employee training programs Application of Judgment and Estimation Data Management Training Increased scrutiny from auditors and regulators may require entities to reexamine their internal controls and processes Careful examination of the effects of increased leverage and potential debt covenant violations will be required Potential tax implications are situational, which requires entities tax department involvement Internal Controls and Business Process Environment Debt Covenants Income Taxes 40
Getting started Initial steps to understand and plan the road ahead 1 2 3 Understand Understand Assess the accounting requirements the lease population capabilities of existing technology 4 5 Perform a data Develop an gap analysis implementation roadmap 41
Polling question (#7) Which will pose the largest implementation challenge for your company's lease accounting standards compliance efforts in the next 12 months? Complying with both IASB and FASB standards simultaneously IT system upgrades Collecting necessary data on all organizational leases in a centralized, electronic inventory Developing and instituting processes to evaluate quarterly adjustments/reassessment for the balance sheet and P&L as required Educating investors and internal stakeholders on the rules impacts to financial statements Don t know/na 42
Question and answer
Join us March 29 at 2 p.m. ET as our Financial Reporting series presents: Quarterly accounting roundup: An update on important developments
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Acronyms used in presentation ASC: Accounting Standards Codification ASU: FASB Accounting Standards Update CAM: Common Area Maintenance CF: Cash Flow FASB: Financial Accounting Standards Board FV: Fair Value IASB: International Accounting Standards Board IFRS: International Financial Reporting Standards IT: Information Technology P&L: Profit and Loss PV: Present Value ROU: Right-Of-Use 46
Contact info Bob Uhl Partner, Deloitte & Touche LLP ruhl@deloitte.com Connect with me on LinkedIn Tim Kolber Senior Manager, Deloitte & Touche LLP tkolber@deloitte.com Connect with me on LinkedIn James Barker Partner, Deloitte & Touche LLP jabarker@deloitte.com Stephen McKinney Director, Deloitte & Touche LLP smckinney@deloitte.com Connect with me on LinkedIn Sean Torr Director, Deloitte & Touche LLP storr@deloitte.com Connect with me on LinkedIn 47
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