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Proposed Accounting Standards Update to Lease Accounting. February 22, 2011. Presenters. Today’s presenters:. Paul Anderson, CPA Director of Assurance GBQ Partners LLC [email protected] 614.947.5203 Jeff Alton, CPA Assurance Manager GBQ Partners LLC [email protected] 614.947.5202. Overview. - PowerPoint PPT Presentation
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Proposed Accounting Standards Update to Lease AccountingFebruary 22, 2011
2 February 10, 2011
Presenters
Paul Anderson, CPADirector of AssuranceGBQ Partners LLC
Jeff Alton, CPAAssurance ManagerGBQ Partners LLC
Today’s presenters:
3
Overview
• The core principle is that lease contracts give rise to assets and liabilities that should be reflected in the balance sheets of lessees and lessors.
• All lessees would use a single method of accounting for all leases.
• The accounting by a lessor would reflect its exposure to the risks or benefits of the underlying leased asset.
• Users of financial statements would have more timely information about variable features such as renewal options and contingent rentals.
• A simplified approach would apply to short-term leases.
• The proposal does not change the current definition of a lease contract.
February 10, 2011
Proposed Accounting Standards Update: Leases (Topic 840)
• Released August 2010/Joint project with IASB
• Significant change to existing lease accounting model
• Would impact both lessees and lessors
• Eliminates off-balance sheet (i.e., operating) leases
• Retrospective application on adoption, thus no grandfathering of existing leases is expected
• Comment period ended: December 15, 2010
• Final standard issuance: June 2011 (expected)
• Effective date: ?
February 10, 20114
Key Term Definitions
Term Abbreviation Definition
Contingent rentals
CR Lease payments that arise under the contractual terms of a lease because of changes in facts or circumstances occurring after the date of inception of the lease, other than the passage of time.
Date of commencement of the lease
DCL The date on which the lessor makes the underlying asset available for use by the lessee.
Date of inception of the lease
DIL The earlier of the date of the lease agreement and the date of commitment by the parties to the lease agreement.
Initial direct costs
IDC Recoverable costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made.
Lease Lease A contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration.
February 10, 20115
Key Term Definitions (continued)
Term Abbreviation Definition
Lease liability
LL The lessor’s obligation to permit the lessee to use the underlying asset over the lease term.
Lease payments
LP Payments arising under a lease including fixed rentals and rentals subject to uncertainty, including, but not limited to, contingent rentals and amounts payable by the lessee under residual value guarantees.
Lease term LT The longest possible term that is more likely than not to occur.
Residual asset
RA An asset representing the rights to the underlying asset retained by the lessor under the derecognition approach for lessor accounting
Residual value guarantee
RVG A guarantee made by the lessee that the fair value of the underlying asset that the lessee will return to the lessor will be at least a specified amount. If the fair value is less than that amount, the lessee is obliged to pay the difference to the lessor.
Right-of-use asset
ROU asset An asset the represents the lessee’s right to use, or control the use of, a specified asset for the lease term.
February 10, 20116
Scope
• Applies to all entities
• Includes leases of property, plant, and equipment
• Excludes:
Leases of intangible assets
Leases to explore for or use natural resources (i.e., minerals, oil and gas)
Leases of biological assets
Contracts that represent the purchase or sale of the underlying asset
• Includes contracts with both service and lease components, with certain exceptions
Most contracts viewed as leases under current GAAP will be subject to the new guidance
February 10, 20117
Lessee Accounting Model - Recognition
• Right-of-use (“ROU”) approach
Right to use an asset for a specified period of time
Gives rise to both an asset and a liability
• Asset = right to use item for lease term
Recognized and carried at amortized cost
• Liability = obligation to pay rentals
Present value of payments
One accounting model replaces current two model approach (capital and operating leases)
February 10, 20118
Lessee Accounting Model - Recognition
• Right of use asset and liability recognized on statement of financial position on date of commencement of lease (“DCL”)
• The following will be subsequently recognized in the income statement:
Interest expense on the liability
Amortization expense of the asset
Changes in the liability resulting from reassessment of contingent rentals, residual value guarantee, or term option penalties
Any impairment losses on the right of use asset
February 10, 20119
Measurement of Asset and Liability
• Initially done as of date of inception of lease
• Present value of lease payments
Discounted at either:
Lessee’s incremental borrowing rate, or
Rate charged by lessor, if known
• At inception, asset will be the same as the liability plus any initial direct costs, such as:
Commissions
Legal fees
Costs incurred in evaluating lessee, guarantees, and collateral
Closing costs
Note: the following costs are not considered initial direct costs: general overhead expense, advertising or soliciting expense, costs associated with servicing an existing lease.
February 10, 201110
Measurement - Lease Term
• “Longest possible term that is more likely than not to occur”
• Include optional renewal periods that are more likely than not to be exercised
Different than “old’ accounting where optional renewal periods were ignored
• Continually reassessed based on significant changes
Renewal periods and early termination options
Estimates adjusted in period that facts and circumstances change
• Assessment should consider both contractual and non-contractual factors
February 10, 201111
Example - Lease Term
• Non-cancellable 10-year term
• Option to renew for 5 years at the end of 10 years and an option to renew for an additional 5 years at the end of 15 years
• The lessee estimates the probability for each term as follows: 40% for 10-year term, 30% for 15-year term and 30% for 20-year term
• Under these scenarios, the term would be at least 10 years, with a 60% chance that the term would be 15 years or longer, but only a 30% chance that the term would be 20 years. Therefore, there is a 60% chance that the term would be 15 years, which is the longest possible term more likely than not to occur. As such, the lease term would be 15 years.
This example is adapted from Paragraph B17 of the Exposure Draft.
February 10, 201112
Measurement - Lease Payments
• Initially used to measure asset and liability
• “Expected outcome approach”
Present value of the probability-weighted average of the cash flows for a reasonable number of outcomes
Estimating expected outcome involves:
a. Identifying each reasonably possible outcome. An entity need not assess every possible outcome to identify the reasonably possible outcomes included in the expected PV of the cash flows.
b. Estimating the amount and timing of the cash flows for each reasonably possible outcome
c. Determining the present value of those cash flows
d. Estimating the probability of each outcome
• Include contingent amounts
• Continually reassess
February 10, 201113
Expected Outcome Approach – Contingent Rents Example
The Facts: A retailer enters into a 5 year lease which, in addition to fixed monthly payments, calls for contingent rents to be paid at a rate of 1% of annual sales in excess of $1M. Contingent rents are to be paid at the end of each year of the lease. Based on past performance and future projections, management prepares the following analysis related to estimated forecasted sales. The retailer’s incremental borrowing rate is 10%. As a result of the foregoing analysis, the retailer would include contingent rent of $39,221 in its estimate of lease payments. The present value of estimated yearly payments is $7,844 ($39,221/5).
Estimated Present ProbabilityEstimated Annual Sales Probability Contingent Rent Value Weighted
< $1.0 million 0% -
-
-
$1.0 M to $1.5 M 25% 25,000 19,611
4,903
$1.5 M to $2.0 M 50% 50,000 39,221
19,611
$2.0 M to $2.5 M 25% 75,000 58,832
14,708
$2.5 M > 0% -
-
-
150,000 117,664
Probability weighted outcome 39,222
February 10, 201114
Expected Outcome Approach – Contingent Rents Example (Continued)
Carrying on with the example on the previous slide, assume fixed monthly payments of $5,000. Further assume the retailer incurred $20,000 in initial direct costs. The present value of the lease payments, including the contingent rent determined above, is $274,548. The recognized right of use asset at lease inception is $294,548; the lease liability is $274,548. Assume actual sales in Year 1 were $2M; contingent rent due is $10,000.
•During the first year of the lease, the retailer will record the following:
Amortization of the right of use asset of $58,910 ($294,548/5)
Interest expense on the lease liability of $25,450 (based on a lease amortization schedule using interest method)
Reduction of the lease liability for cash payments of $70,000 ($60,000 + $10,000)
Additional expense of $2,156 would need to also be recorded to "true up" contingent rent ($10,000 - $7,844)
Effect in first year of lease of adopting the exposure draft:
Revised (ED) accounting model total expense of $86,516 ($58,910 + $25,450 + $2,156)
Current accounting model total expense of $74,000 ($60,000 + $4,000 + $10,000)
February 10, 201115
Subsequent Measurement
• Right of Use Asset:
Amortized on a systematic basis over the shorter of the lease term or useful life of the underlying asset
Subject to impairment analysis under ASC 350
• Liability:
Amortized cost using the using the interest method
Subject to periodic reassessments “…if facts or circumstances indicate that there would be a significant change”
Discount rate is not reassessed unless specifically based on an index
February 10, 201116
Presentation
• Right of use asset:
Presented as a tangible asset within PP&E
Segregated from non-leased assets
• Liability:
Separately from other financial liabilities
• Interest and amortization expense presented separately from other interest/amortization expense (either on P&L or in the footnotes)
• Principal and interest cash payments will be a financing activity in the Statement of Cash Flows
February 10, 201117
Recognition/Presentation – Financial Statement Impact
• Income Statement
Current GAAP
Rent expense classification
Included in Operating Income/Loss
Proposed GAAP
Interest and amortization expense classification; no rent expense
Amortization expense included in Operating Income/Loss; Interest excluded
• Statement of Financial Position
The addition of lease liability on the balance sheet may impact debt ratios and possibly covenant calculations
Note: Change in classification may impact EBITDA
February 10, 201118
Lessor Accounting Model - Recognition
• Dual model approach
Performance obligation or
Derecognition
• Centers on whether significant risks or benefits of the leased asset are retained
Exposure to risk/benefits can occur during and after the lease term
If retained = performance obligation model
If transferred = derecognition
• Model determined at Date of Inception and not reassessed
• Both models require estimates of lease term and contingent rentals
February 10, 201119
Recognition – Performance Obligation Approach
• Underlying asset stays on the lessor’s books
• As of date of commencement of the lease, lessor will recognize:
Asset for the right to receive lease payments
Liability at the present value of the lease payments
• Subsequently, lessor will recognize:
Interest income on right to receive lease payments
Lease income as lease liability is satisfied
Changes in lease liability resulting from reassessment of contingent rentals, residual value guarantee or term option penalties
Potential for impairment losses on right to receive lease payments
February 10, 201120
Measurement – Performance Obligation Approach
• Lease liability measured as the sum of the PV of lease payments, discounted using the rate lessor charges the lessee
• Right to receive asset measured as the sum of lease liability and any initial direct costs
Initial measurement based on longest possible lease term that is more likely than not to occur
Measured at date of inception of the lease
Expected outcome approach
PV of the probability-weighted average of the cash flows for a reasonable number of outcomes
Asymmetrical amounts for lessor/lessee are probable
February 10, 201121
Subsequent Measurement – Performance Obligation Approach
• Right to receive asset is carried at amortized cost using the interest method
Subject to impairment testing under ASC 310-10 (loan impairment)
• Remaining lease liability measured based on pattern of use of the underlying asset by the lessee, if pattern can be reliably determined using either inputs or outputs
If not reliably determinable, use straight-line method
• Underlying asset is depreciated over its expected useful life
Systematic and rational approach
If none based on pattern of use, straight-line method should be used
Asset subject to ASC 360 impairment testing (long lived assets impairment)
22
Recognition - Derecognition Approach
• Apply if performance obligation criteria not met
• As of date of commencement of lease, lessor will:
Recognize a receivable for the right to receive rental payments with the offset to lease income
Remove portion of the carrying amount of underlying leased asset from books which represents the lessee’s right to use the asset during the lease term
Residual asset for the portion of the carrying amount of the leased asset that represents the lessor’s non-transferred rights in that asset
Portion of the carrying value of leased asset removed from balance sheet and recorded as cost of sale
February 10, 201123
Recognition - Derecognition Approach
Recognized in the income statement:
• Lease income = PV of lease payments
• Lease expense = cost of underlying asset derecognized
• Interest income on right to return asset
• Lease impact of any reassessments in right to return asset due to change in estimates of contingent amounts
• Impairment losses on right to return asset
If lessor’s ongoing, major, or central activities involve leasing activities, lease income is reported as revenue and lease expense as cost of revenue
February 10, 201124
Measurement - Derecognition Approach
Allocation:
• Amount to be derecognized computed as:
(FV of right to receive lease payments/FV of the underlying leased asset) X Carrying amount of the underlying leased asset
Residual asset is computed as the remaining amount of the carrying amount of the underlying leased asset
• Reassess when facts and circumstances indicate that there could be a significant change
February 10, 201125
Subsequent Measurement - Derecognition Approach
• Right to receive asset at amortized using interest method
• No remeasurement of residual asset unless:
Terms change
Asset is impaired
• ASC 310 used to assess impairment of right to receive asset
• ASC 350 or 360 used to assess impairment of residual asset
February 10, 201126
Lessor Accounting Model - Presentation
Financial Statement
Performance Obligation Approach Derecognition Approach
Statement of Financial Position
• Present the following gross, totaling to a net lease asset or liability
• Underlying asset• Right to receive asset• Lease liability
• Right to receive asset separately from other financial assets
• Residual asset, separately within PP&E
Income Statement
Interest income, lease income, and depreciation presented gross, totaling to a net lease income or expense amount
• Lease income and expense will be gross or net depending on the nature of the lessor’s business
• Separate interest income from RTR asset from other interest income
Statement of Cash Flows
• Cash received from lease payments treated as operating activities
• Present separately from changes in other operating receivables
Cash received from lease payments treated as operating cash flow, separate from changes in other operating receivables
February 10, 201127
Disclosure – Lessors and Lessees
• Quantitative and qualitative information relative to lease arrangements
• User should be able to understand amount and timing of expected cash flows; disaggregation of information to the appropriate level
• Significant NEW disclosure requirements:
Reconciliation of opening and closing balances of right-of-use assets and liabilities to make lease payments, disaggregated by class of underlying asset
Narrative disclosure about the options that were recognized as part of the right-of-use asset and those that were not
Assumptions and judgments relating to amortization methods and changes to those assumptions and judgments
Initial direct costs incurred during the reporting period and included in the measurement of the right-of-use asset or right to receive lease payments
Basis and terms on which contingent rentals are determined
February 10, 201128
Income Tax Considerations
• New model will create temporary differences
Assets/liabilities created for book purposes not reflected for tax purposes
ASC 740 requires gross basis recognition – no offsetting of deferred tax asset and deferred tax liability arising from lease items
• State and local taxes may be impacted
February 10, 201129
Short Term Leases
• Maximum possible term (including all extension options) of 12 months or less
• Lessee measurement:
At date of inception of lease, accounting election on a lease-by-lease basis:
1. Measure similarly to long term lease; or
2. Measure using simplified approach
Right of use asset and liability equal to undiscounted lease payments
Lease payment recognized in income statement over lease term
• Lessor measurement:
At date of inception of lease, accounting election on a lease-by-lease basis:
1. Measure similarly to long term lease; or
2. Measure using simplified approach
No recognition of right-to-receive asset and lease liability; no derecognition of underlying asset
Lease payments recognized in income statement over lease term
February 10, 201130
Short Term Leases
Simplified Approach – Example
The Facts: A lessee enters into a 12 month lease for storage space; the lease requires monthly payments of $1,000. The lessee elects to account for the lease using the simplified approach. Based on the fact pattern, the lessee would record the following entries:
Debit CreditAt date of inception of lease:
Right of Use Asset 12,000Lease Liability 12,000
Each of the subsequent 12 months:Amortization Expense 1,000Lease Liability 1,000
Right of Use Asset 1,000Cash 1,000
To record asset and liability arising from the storage space lease.
To record cash paid and expense arising from the storage space lease.
February 10, 201131
Adoption/Transition
• All outstanding leases as of the date of initial application will be subject to the new accounting
No grandfathering of leases in existence as of the adoption date
• Date of initial application - the beginning of the first comparative period presented in the first financial statements in which the lessee applies the new guidance
• Recognize and measure all outstanding contracts within scope of guidance
• Simplified retrospective approach
• No specific effective date in exposure draft
February 10, 201132
Sale and Leaseback Transactions
Scope
If an asset is transferred and leased back, transaction to be accounted for under the proposed ASU if the contracts are:
• Entered into at or near the same time
• Negotiated as a package with a single commercial objective
• Performed either concurrently or consecutively
Sale Criteria - at end of contract, seller-lessee transfers control and all but a trivial amount of risks/benefits
February 10, 201133
Sale and Leaseback Transactions
Seller-Lessee
• If sale criteria are met:
Record sale pursuant to other GAAP
Record lease asset and obligation pursuant to lease standard
Buyer-Lessor
• If purchase criteria are met:
Account for purchase pursuant to other GAAP
Account for lease using the performance obligation approach
February 10, 201134
Questions?
February 10, 201135
Thank you!