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Construction Breakfast Series:LEASING CHANGES WILL AFFECT YOUR OPERATIONS: ARE YOU PREPARED?
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Topics for today
How will this impact the financials of my company?
How will banking and bonding relationships view this new standard?
Discuss proactive strategies for your benefit.
This discussion will be from the Lessee side of the transaction and will not cover Lessor accounting.
Overview & Basic Concepts of Topic 842 - Leasing
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Overview of Topic 842
Most leases, including what previously would be considered an operating lease, will be recorded on the balance sheet.
New presentation and disclosure requirements in your financial statements.
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Old vs New: what changes will I see?
Under current GAAP, the majority of leases fall under two lease categories:Operating Lease – a lease whose term is short compared to the useful life of the asset
or piece of equipment being leased. ( example: Building lease, copier lease, etc.)Capital Lease – a lease in which the lessor only finances the lease asset and all other
rights of ownership transfer to the lessee for accounting purposes. Capital lease is determined based on meeting one of four criteria:Ownership – transfers at the end of the leaseBargain Purchase option – lessee can purchase asset at end of lease term for
below-market priceLease term – period of lease encompasses at least 75% of the useful life of the assetPresent value (PV) – present value of minimum lease payments is at least 90% of
fair value of asset at inception of lease
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Old vs New: what changes will I see?
Under Topic 842 the two main categories of leases will be:Operating Lease – Same approximate definition as old GAAPFinance Lease – very similar to the definition of capital lease under old GAAP,
subject to five criteria instead of four:Transfer of ownership to Lessee at end of lease termPurchase Option that is reasonably certain to be exercised by LesseeLease term is for the major part of remaining economic life – guideline is 75%, but
a percentage is not stated in the standardPresent Value – PV of minimum lease payments equals or exceeds substantially
all of the fair value of the underlying asset – guideline is 90%, no stated in standard
Underlying asset is of a specialized nature – this is new criteria.Definition of leases under Old vs New have very similar definitions and criteria.
Lessee Accounting
B/S• Right-of-use asset• Lease liability – (non-debt)
I/S• Lease expense
(Straight-line)
C/F• Cash paid for
lease payments
• Rent expense (Straight-line)
• Cash paid for rent
• NONE
Operating Lease – OLD GAAP Operating Lease – NEW GAAP
Lessee Accounting
B/S• Right-of-use asset• Lease liability – (debt)
I/S• Amortization exp• Interest expense
C/F• Cash paid for
principal & interest
• Depreciation exp• Interest expense
• Cash paid for principal & interest
• Capitalized asset• Lease liability – (debt)
Capital Lease – OLD GAAP Finance Lease – NEW GAAP
Lessee Accounting – New GAAP Topic 842
B/S• Right-of-use asset• Lease liability
I/S• Lease expense
(Straight-line)
C/F• Cash paid for
lease payments
• Amortization exp• Interest expense
• Cash paid for principal & interest
• Right-of-use asset• Lease liability
Finance Lease Operating Lease
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An Example:
Case Study – Finance or Operating Lease?Customer enters into a contract to lease a truck for four yearsSupplier will maintain the truck during the contractThe Truck is kept at the Customer’s premise and is specified within the contractConsideration in the contract is $25,000 at the end of each of the 4 years for a total
of $100,000Customer may choose to buy the equipment at the end of the contract for fair
market value.
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Question – Is this an operating or finance lease?
Discuss the 5 criteriaTruck does not transfer at the end of the lease.No bargain purchase option contained within the lease.No specialization on the truck.Economic life of the truck = 10 years
Lease term = 40% (4 year lease / 10 year life)Fair value of the truck is $110,000
Lease payment = 91% (100,000 lease payment / 110,000 fair value) Should factor in present value based on incremental borrowing rate, but simplified due to time.
The lease payments make up over 90% of the fair value of the truck. Truck is a financial lease!
How do we account for this?
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Finance Lease
Lease CommencementRight-of-Use Asset 100,000 Lease liability
Lease Liability (100,000) Lease liability
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Finance Lease
End of Year 1Amortization Expense 25,000 Initial Right-of-Use Asset of $100,000 / 4 year
termRight-of-Use Asset (25,000)
Interest Expense 4,000 Beginning of period Lease Liability of $100,000 x discount rate of 4.00%
Lease Liability (4,000)
Lease Liability 25,000Cash (25,000) Annual payment per lease agreement
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Operating Lease
Lease CommencementRight-of-Use Asset 100,000 Lease liability
Lease Liability (100,000) Lease liability
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Operating Lease
End of Year 1Lease Expense 25,000 Total lease payments $100,000 / total lease
term of 4 yearsRight-of-Use Asset (21,000)Lease Liability (4,000) Beginning of period Lease Liability of $100,000
x discount rate of 4.00%
Lease Liability 25,000Cash (25,000) Annual payment per lease agreement
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Related Party Leases
Topic 842 applies to all related party leases.Use legally enforceable terms and conditions within lease to help classifyMonth-to-month lease exception example
Related party lease for building on a month-to-month termRenewal is expected to occur in a period greater than 12 monthsRelated party entity that leases the building relies on lease payments to fund
existing mortgage.You will need to record a right-of-use asset and lease liability as if this were an
operating/finance lease. Judgement will be used to determine expected lease term.
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How could this leasing standard impact your banking and bonding?
BankingOperating vs Finance classification could have impact on your debt covenants.
Debt service coverage ratio – finance lease would be considered part of your debt.
Current/working capital ratio and others will now be impacted negatively by operating leases.
If you have significant leasing, make sure you are discussing this new standard with your bank.
BondingYour current/working capital ratio will be impacted negatively.Make sure you are having discussions with your bonding company on how these
standards will impact their calculations.
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Proactive strategies
Discussions with banking and bonding relationships before these rules go into effect are paramount. Do NOT get caught off-guard with these changes impacting your borrowing capability or bonding capacity.
EBITDA effectCompanies that utilize EBITDA as an important multiple for performance metrics
and/or debt covenants are benefited by a Finance Lease setup which gives Amortization as an add-back to EBITDA.
Key Points
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Changes to your balance sheet and negative impact to certain ratiosRelated party leases and what to look forLessee expense recognition (Amortization vs Lease expense)More robust disclosuresEffective date (for calendar year entities with quarterly statements)
Public companies = March 31, 2019All other companies = December 31, 2020Earlier adoption is permitted
Next Steps
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Examine the current processes and controls in place to gather informationEvaluate the expected impactPrepare for implementation
We are here to answer any and all questions you may have as you start to look at this. Don’t hesitate
to reach out and ask us!
Questions?
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