Lease accounting update

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1 Financial Executives International 22 March 2012 Agenda Where are we now? Timing? What are the proposed changes to lease accounting? Overview of implications and considerations What are companies doing now? Q&A Page 1

2 Where are we now? In a nutshell... Operating leases will be on balance sheet. FASB and IASB differ on a revised lessee income statement model. Lessor model is still under discussion. Definition of a lease is likely to be a bit more narrow than current guidelines. Timing continues to slide. Page 2 Timing Discussion Paper Exposure Draft Second Exposure Draft Final Standard March 2009 August rd Qtr 2012? Mid 2013? Effective date: TBD (To be aligned with revenue recognition not likely before 2016*) * Companies will be required to restate comparative periods (i.e., if the standard is effective for year end 2016, 2014 and 2015 will need to be restated.) Page 3

3 Scope Excludes leases of: Intangible assets Biological assets Leases to explore for or to use natural resources Investment property within an investment property entity that are at fair value lessors only! Accounting policy election to treat leases with a maximum possible term of 12 months or less as operating leases Page 4 Definition of a lease 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 Specified asset (similar to current GAAP) Right to control the use of a specified asset (different from current GAAP) New on/off balance sheet switch! Page 5

4 Definition of a lease Specified asset Includes a physically distinct portion of a larger asset (e.g., a floor in a building would be included, whereas 50% of the capacity of a pipeline would be excluded) Excludes contracts that provide the lessor with substantive substitution rights (e.g., lessor can substitute the asset without the lessee s consent; economically feasible) Right to control the use Direct the use AND Make decisions that significantly impact economics (i.e., raw materials, processes applied) Receive the benefits Based on economics, not only physical attributes 100% of output does not dictate a lease Page 6 Multiple elements Contracts that contain lease and non-lease (services, supplies, etc.) components Both lessors and lessees would be required to separately account for lease and non-lease components Lessors would allocate payments in accordance with revenue recognition standard (separate criteria) Lessees would generally use observable prices to allocate payments on a relative purchase price basis Lessees can apply a residual method. Items that cannot be separated based on observable prices are included with lease payments on balance sheet. Page 7

5 Overview of right-of-use model Lessee will recognize A right-of-use asset representing the lessee s right to use the leased asset A liability for its obligation to make lease payments Lessor will recognize (if not investment property) A receivable representing the lessor s right to receive lease payments A residual asset for the portion of the underlying asset retained Initially measure lessee ss liability and the lessor s s receivable at the present value of lease payments to be made over the lease term Page 8 Lease term Recognized lease term would include non-cancellable period, plus any optional periods where there is a significant economic incentive to extend (or not terminate) the lease Purchase options include on a basis consistent with renewal options Assume exercise if significant economic incentive to exercise exists Similar to current GAAP, though some reassessment required throughout term Page 9

6 Lease payments Lease payments include: Fixed payments Variable payments based on index or rate (e.g., CPI or LIBOR) Termination penalties (if term is assumed not to be renewed) Residual value guarantees, at the amount expected to be paid, if any (lessees only) Exercise price of purchase options that are included in lease term Contingent rents based on performance or usage would be excluded Recognized as incurred/accrued Contingent rents must be truly variable to be excluded Page 10 Lessee accounting Initial recognition and measurement Lease-related assets and liabilities initially recognized and measured as of lease commencement date Liability initially iti measured at the present value of the lease payments Discounted using rate the lessor charges the lessee (when available) or the lessee s incremental borrowing rate Right-of-use asset is measured initially at cost Amount of the liability Plus: any initial direct costs incurred Less: any lease incentives received Page 11

7 Lessee accounting Subsequent measurement Still up in the air ED Approach A (current tentative proposal): Right-of-use asset amortized generally on a straight-line basis over either the lease term or economic life of the leased asset Interest expense recognized using the interest method, and lease payments reduce the liability Accelerated expense recognition pattern Interest-based amortization ( Approach B FASB) Underlying asset ( Approach C IASB) Page 12 Lessee accounting (ED; Approach A) Example A company enters into a three-year lease for office space and agrees to pay the following: $10,000 in year 1, $12,000 in year 2 and $14,000 in year 3. The present value of lease payments is $32,500 (using a discount rate of 5%). Initial Year 1 Year 2 Year 3 Lease expense recognized Interest expense 1,625 1, Amortization expense 10,833 10,833 10,834 Total 12,458 12,041 11,501 Balance sheet Right-of-use asset 32,500 21,667 10,834 Liability to make lease payments (32,500) (24,125) (13,333) Page 13

8 Lessee accounting Subsequent measurement Approach B Interest-based amortization (two types of leases) Finance/capital type leases straight-line amortization of right-of-use asset Same as ED Operating type method allocates more amortization expense to later periods smoothes out total lease expense when combined with interest method for liability The ROU asset at the beginning of each reporting period is equal to PV of the estimated remaining economic benefits under the lease as estimated at lease commencement discounted at the rate used to PV liability initially. When rents are due in equal monthly amounts, pattern of total expense recognition approximates straight-line. Page 14 Lessee accounting Subsequent measurement Approach C Underlying asset approach Amortization based on consumption of underlying asset over term Estimate decrease in value of asset at end of term If decrease is small (e.g., real estate), higher amortization toward end When combined with interest expense, closer to straight-line total expense If decrease is significant (e.g., equipment), closer to straight-line asset amortization Front loaded total expense when combined with interest expense Page 15

9 Lessee accounting Reassessment Consideration Indicator to reassess Accounting treatment Lease term and A significant change in factors (except purchase options market factors) relevant to determining whether a significant economic incentive exists Adjust right-of-use asset Discount rate Residual value guarantees Lease payments that depend on an index or rate Change in lease payments due to a change in lease term Events or circumstances indicate that there has been a significant change in the amounts expected to be payable When the rate changes Amounts relating to current or prior periods net income; Amounts relating to future periods adjust right-of-use asset Page 16 Lessee accounting Presentation and disclosure Balance sheet Income statement Cash flow statement Right-of-use asset Present separately in Amortization Supplementary balance sheet or disclose in notes (if in notes disclose line item in balance sheet) expense not combined with interest expense non-cash disclosure of acquisition Liability to make lease payments Separately present or disclose interest expense Principal payments financing Interest payments operating Variable lease payments Not recognized Disclose expense Operating Page 17

10 Lessee transition May choose full retrospective approach or modified retrospective approach Under modified retrospective approach: Liability to make lease payments measured at the present value of the remaining lease payments Right-of-use asset calculated based on the liability to make lease payments at lease commencement prorated for the remaining lease term Differences between the liability to make lease payments and right-of-use asset would be a cumulative adjustment to opening retained earnings Discount rate based on incremental borrowing rate on effective date May be determined at a portfolio level for leases with similar characteristics Adjust right-of-use asset by prepaid/accrued rents, subject to impairment review May elect to use hindsight when preparing comparative information and not evaluate initial direct costs for leases that began before the effective date Not required to adjust carrying amounts for existing capital leases Page 18 Lessor accounting (for now) Scope of lease same as lessees except: Leases of investment property (would include most real estate property, including integral equipment) If lessor is an investment property entity out of scope Apply the FASB s investment property ED account at fair value and recognize lease revenue when contractually due If lessor is not an investment property entity in scope Apply current operating lease accounting Further consideration of cell tower assets? All other leases would be subject to the receivable and residual approach Eliminates special accounting for leveraged leases Page 19

11 Receivable and residual approach Record a lease receivable Underlying asset Right-ofuse sold Allocate a portion of the carrying value of the underlying asset to the right-of-use asset sold Recognize profit (or loss) for the difference between the PV of lease payments and the carrying value allocated to right-of-use asset sold Record a residual asset for the carrying value not allocated to the leased asset that is sold Residual asset Profit associated with the residual asset would be deferred until the asset is subsequently sold or re-leased Page 20 Receivable and residual approach Initial and subsequent measurement Initial measurement: Lessor lease term same as lessee Lessor receivable = PV of lease payments similar to lessee but does not include any amounts for residual value guarantees (considered in impairment assessment only) Lessor discount rate as of the lease commencement date using the rate the lessor charges the lessee Subsequent measurement: Lease payments received by lessor allocated as a reduction of the lease receivable and interest income using the interest method Recognize interest income to accrete the residual asset to its estimated fair value at the end of the lease (less deferred profit) Page 21

12 Illustrative example Lessor Assumptions: A lessor manufactures a machine for $7,500 with a fair value of $10,000 Enters into a three-year lease with annual lease payments of $2,400 paid at end of each year Expected fair value of the residual asset at the end of the lease term is $4,770 Interest rate implicit in the lease is approximately 7.9% Commencement Lease receivable $6,200 Gross residual $3,800* Cost of sales $4,650 Deferred profit $950* Asset $7,500 Revenue $6,200 *Presented as net residual: $2,850 Subsequent (year 1) Cash $2,400 Interest income receivable $ 488 Lease receivable $1,912 Residual $ 299 Interest income residual $ 299 Lease receivable (PV of annual lease payments of $2,400 at 7.9%) = $6,200 (rounded) Carrying value of asset allocated to right-of-use asset sold : $7,500 x $6,200/$10,000 = $4,650 Profit recognized at lease commencement: $6,200 $4,650 = $1,550 Gross residual (PV of the estimated FV of residual asset of $4,770 at 7.9%) = $3,800 (rounded) Carrying value of asset allocated to residual asset (net residual): $7,500 $4,650 = $2,850 Deferred profit: $3,800 $2,850 = $950 Interest income on gross residual: $3,800 x 7.9% = $299 (rounded) Page 22 Illustrative example Proposed standard vs. current standard lessor Proposed standard Current standard Period Receivable Gross residual Deferred profit Net residual Profit Profit (sales-type lease) Initial $6,200 $3,800 $ (950) $2,850 $1,550 $2,500 Year 1 $4,288 $4,099 $ (950) $3,149 $ 787 $ 787 Year 2 $2,225 $4,422 $ (950) $3,472 $ 660 $ 660 Year 3 $ $4,770 $ (950) $3,820 $ 523 $ 523 Total prior to sale of residual $3,520 $4,470 Page 23

13 Lessor presentation Balance sheet Lease receivable and residual asset presented separately (summing to a total lease assets ) or shown as one lease assets with two amounts disclosed in notes Present gross residual and deferred profit together as a net residual asset Income statement Lease income and expense (i.e., profit and cost of sales) in separate line items or net in a single line item (interest income), depending upon lessor s business model Income and expense from lease transactions presented separately in income statement or disclosed in the notes Accretion of residual asset in interest income Amortization of initial direct costs as an offset to interest income Page 24 Lessor transition Similar to lessees, may choose full retrospective approach or modified retrospective approach Under modified retrospective approach: Lease receivable measured at the present value of the remaining lease payments subject to any adjustments required to reflect impairment Allocate the carrying value of the underlying asset between the right-of-use asset sold and the residual asset using the estimated fair value of the leased asset at the beginning of the earliest comparative period presented Discount rate based on the rate charged in the lease determined at the date of commencement Adjust cost basis of underlying asset derecognized by prepaid/accrued rents May elect to use hindsight when preparing comparative information and not evaluate initial direct costs for leases that began before the effective date Not required to adjust carrying values for existing direct finance or sales-type leases Page 25

14 Sale-leaseback transactions No difference between real estate and equipment No lessee involvement in asset construction guidance Apply control criteria described in revenue recognition project to determine whether a sale has occurred If a sale has occurred, seller-lessee would derecognize the leased asset and recognize a right-of-use asset and a liability to make lease payments for the leaseback Gain/loss would be recognized at transaction date If a sale has not occurred, seller-lessee would account for as a financing Page 26 Implications and considerations What is potentially affected? Financial metrics, key performance indicators and capital structure Changes to timing and characterization of income/expense Will changes in characterization of income impact income tax deductibility of lease payments? Return on assets; EBITDA/EBIT levels and multiples; accretion and dilution; impairment Debt covenants; interest coverage ratios; debt to equity ratios; liquidity Market and leasing strategy Lease vs. buy strategy Unbundling of services (warranty, maintenance, etc.) Length of lease term, amount of lease payments, residual value guarantees, lease incentives or other lease options Page 27

15 Implications and considerations What is potentially affected Infrastructure, process and control changes Resources (people, systems, input knowledge); controls; data capture; procurement and technical accounting, internal controls IT and systems New lease data requirements will result in IT system modifications and changes to financial reporting requirements Tax accounting issues Initial adjustments to deferred taxes Tracking book/tax differences related to amortization expense, rent and interest deductions Page 28 What are companies doing now? Example activities Understanding the magnitude of the changes to the company to minimize the effect on financial metrics and make informed decisions in current negotiations Establishing project management and planning activities (timeline, tasks, resources) Determining training requirements for individuals responsible for lease accounting and related judgments Determining the population of lease arrangements that would be in scope under the proposal Identifying lease data to be accumulated based on the requirements of the proposal Does the lease contain any non-lease components? What should be included in the lease term and payments? What is the fair value of the leased asset at lease commencement and the estimated residual value at the end of the lease term? What information would be needed upon transition? Page 29

16 What are companies doing now? Example activities Establishing a process for gathering and analyzing lease data Where is the lease data maintained? Is it readily available? How will you evaluate whether you have the most up-to-date lease agreement or the existence of side agreements? Will the review of lease arrangements be performed locally or by a centralized team to maintain consistency in corporate approach? How will management document its judgments and estimates to maintain an audit trail? Establish protocols for summarizing shortfalls in available information necessary to adopt the proposed lease standards Perform impact assessment on a sample of lease arrangements or entire lease portfolio to understand the magnitude of the changes to the company Considering requirements for maintaining multiple sets of lease data for comparative periods, as well as book/tax differences upon adoption Will IT systems be able to manage both sets of data? Will the company need separate systems to accumulate data for book and tax? Page 30 What are companies doing now? Technology options Existing lease management software and database-type solutions Develop workarounds using existing software Create a database to compile the required ed data fields and calculate cu ate the lease- related assets and liabilities, along with the related income statement impact More advanced solutions include interface with document workflow tool with scanned copy of the lease and data tagging of key terms Lease specific vendor solutions Work with existing lease accounting software vendors to understand their plans and timing for upgrading packages, which is in part pending definitive guidance ERP-based solution Determine whether SAP and Oracle are working on modules that will interface with existing systems, although the timing is uncertain and likely pending definitive guidance Page 31

17 Lease accounting proposal Disclaimer The views expressed by presenter(s) are not necessarily those of Ernst & Young LLP. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 33

18 Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US Ernst & Young LLP. All Rights Reserved This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLP nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.

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