Leases 101 An Overview and Perspectives on the New Leases Standard

Transcription

1 Leases 101 An Overview and Perspectives on the New Leases Standard May 17, 2016 Houston, TX John Vickers, Director Tim Kolber, Senior Manager Deloitte & Touche LLP

2 Agenda The Big Picture Identifying a lease Key ingredients of the leases model Overview of the core accounting models Other provisions, effective date, and transition Operational considerations Question and answer 1

3 The Big Picture Key takeaways from this presentation 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 2

4 Identifying a lease 3

5 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 4

6 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 5

7 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 6

8 Identified asset Understanding the 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 7

9 Identified asset Illustrative example IDENTIFIED ASSET FACTS Company A enters into a three-year contract with Supplier B, a storage terminal operator, to store up to 25,000 barrels of oil at any given time Supplier B s storage terminal has capacity to store up to 200,000 barrels of oil During the contract period, Supplier B can contract the remaining storage capacity in its terminal to other third parties 8 Supplier B is required to give back to Company A an equivalent volume of oil that was originally stored when A calls for it Supplier B it is not required to give back the same molecules

10 Identified asset Illustrative example (cont d) IDENTIFIED ASSET ANALYSIS Arrangement does not contain an identified asset Company A does not have exclusive use of a specified portion of the storage terminal Portion being used is not substantially all of the storage terminal capacity, therefore there is no identified asset Although the contract specifies the number of barrels of oil that will be stored, Supplier B is permitted to comingle the volumes stored with oil that is stored for other customers Would the answer change if the storage terminal only has a capacity to hold 27,500 barrels? 9

11 Right to control the use Obtain substantially all of the economic benefits from 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 10

12 Right to control the use Right to direct the use 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 11

13 Right to control the use 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 when and to which ports the ship and even whether cargo will be transported 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 12

14 Right to control the use 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, 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 13

15 Key ingredients of the leases model 14

16 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

17 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

18 Lease term Initial determination and reassessment LEASE TERM Noncancelable period, plus 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

19 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

20 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

21 Overview of the core accounting models 20

22 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 21

23 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 22

24 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 23

25 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

26 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 25

27 Disclosure requirements DISCLOSURE OBJECTIVE Enable financial statement users to assess the amount, timing, and uncertainty of cash flows arising from leases LESSEE 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 LESSOR DISCLOSURES 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 Information required by ASC

28 Other provisions, effective date, and transition

29 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 28

30 Other key provisions Subleases Head lease and sublease accounted for as two separate leases Sublease classification based on underlying asset Offsetting generally prohibited Related-party leases Accounted for on the basis of legally enforceable terms and conditions (versus substance) Subject to ASC Topic 850 disclosure requirements Leasehold improvements Generally capitalized and amortized over the shorter of their useful life or remaining lease term unless: o Lease transfers ownership at the end of lease term or o It is reasonably certain that lessee will exercise purchase option 29

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 30

32 Other key provisions and resources But wait, there s more Lease modifications Contract combinations Leveraged lease accounting Accounting for leases at a portfolio level Leases in a business combination Impairment considerations U.S. GAAP to IFRS comparison 31

33 Industry considerations 32

34 Industry considerations Drilling contracts Identified asset Specific versus implicit identification of a drilling rig Ability of a supplier to substitute the rig is a consideration Control Extent of the operator s control will differ on the basis of the contract Day-work, turnkey, and footage contracts could result in differing accounting Customer s involvement in the design of the underlying asset for use in a unique drilling program needs to be considered Right to direct the use of the specified asset would take into account whether the customer has the right to determine or predetermine how and for what purpose the asset is used

35 Industry considerations Alternative commodity transportation contracts Vessels Shipping contracts may be a lease depending on the contract terms Bareboat, time, and voyage charters may have different accounting Railcars Contracts involving railcars may be considered a lease or may constitute a service agreement Specified asset criteria may be impacted by supplier s ability to substitute asset Control depends on the customer s involvement in directing the use of the asset

36 Industry considerations Joint operating agreements Control considerations Operators that are legally obligated to counterparties named in arrangement would generally exhibit control of the underlying asset Nonoperators listed as additional parties in an arrangement typically would not exhibit control Income statement recognition Operators of a joint-interest asset accounted for as a finance lease lease will recognize frontloaded expense Nonoperators are billed net on an as-incurred basis for their pro rata proportion of expenses Cash flow statement presentation Operators will record cash outflows for a finance lease in financing and operating sections Nonoperators will record its cash outflows from the arrangement within the operating or investing section

37 Industry considerations Recapitalization of lease costs Implications of new model Presentation lease payments capitalized as part of the cost of another asset would generally be classified as cash flows from investing activities Disclosure lessee is to disclose certain amounts related to a lessee s total lease cost including those amounts capitalized as part of the cost of another asset

38 Operational considerations 37

39 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 38

40 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 39

41 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 40

42 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 41

43 Getting started Initial steps to understand and plan the road ahead Understand Understand Assess the accounting requirements the lease population capabilities of existing technology 4 5 Perform a data Develop an gap analysis implementation roadmap 42

44 Question and answer

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