Renew Your Lease: Major Changes in Lease Accounting. Sunday May 22, :30pm to 2:20pm 1 CPE Credit

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1 Renew Your Lease: Major Changes in Lease Accounting Sunday May 22, :30pm to 2:20pm 1 CPE Credit Moderator: Melanie Seale, Assistant Finance Director, City of San Antonio, TX Speaker: David R. Bean, Director of Research and Technical Activities, GASB Speaker: William Hall, Interim Director of Statewide Reporting, State of Vermont

2 Leases Proposed Accounting and Financial Reporting Guidance The views expressed in this presentation are those of Mr. Bean. Official positions of the GASB on accounting matters are determined only after extensive due process and deliberation. 2

3 Leases Project Background Objective reexamine issues associated with lease accounting - FASB project and IASB project - Issuance of GASB Concepts Statement on Elements in Evaluate standards that have been in effect for a sufficient length of time Research project initiated April 2011 Current agenda project added April Preliminary views issued November Exposure draft issued January 2016 Public hearing June

4 Definition and Scope Definition - A contract that conveys the right to use a nonfinancial asset (the underlying asset) for a period of time in an exchange or exchange-like transaction. Scope exclusions - Intangible assets (mineral rights, patents, software, copyrights) - Biological assets (timber) - Service concession arrangements (GASB Statement 60) - Assets financed with outstanding conduit debt unless both the asset and conduit debt are reported by lessor 4

5 Single Model No classification of leases into operating/capital or other categories Underlying assumption that leases are financings 5

6 Lease Term Includes noncancelable period, plus - Periods covered by a lessee s option to extend, if the option is reasonably certain of being exercised - Periods covered by a lessee s option to terminate, if the option is reasonably certain of NOT being exercised Excludes cancelable periods - Periods for which lessee and lessor each have the option to terminate - Periods for which only lessor has the option to terminate Fiscal funding/cancelation clauses should not be considered unless reasonably certain of being exercised 6

7 Short- term Leases Practicality exception - A short-term lease is one that, at the beginning of the lease, has a maximum possible term under the contract, including any options to extend, of 12 months or less - The maximum possible term for a cancellable lease defined as the noncancelable period, including any notice periods - Leases that transfer ownership do not qualify for the short-term lease exception, even if they meet the other criteria 7

8 Leasee 8

9 Recognition Liability for future payments Intangible asset for the right to use the underlying asset In governmental funds, - Payables when due - Do not report an asset 9

10 Liability Initial Measurement Fixed payments (less any lease incentives received from the lessor) Variable payments - Based on an index or rate, using the rate in effect at beginning of lease - Fixed in substance (For example, minimum usage) Residual value guarantees reasonably certain of being required Purchase options reasonably certain of being exercised Termination penalties, if lease term reflects lessee exercising termination options/fiscal funding clauses Any other reasonably certain payments Liability does not include lease payments that are dependent on a lessee s performance or usage of an underlying asset 10

11 Initial Measurement Discounting Lease liability payments be discounted using - Rate the lessor charges the lessee or, if that rate cannot be readily determined - Lessee s incremental borrowing rate 11

12 Initial Measurement of Lease Assets The value of the initial lease liability Any prepayments (amounts paid for the lease prior to measuring the lease liability) Initial direct costs - Capitalize ancillary charges to place the leased asset into use - Otherwise expense 12

13 Subsequent Recognition Lease liability reduced for actual payments less amortization of discount on lease liability (interest expense) Lease asset amortized (amortization expense) using a systematic and rational manner over the shorter of the useful life of the underlying asset or the lease term If the lease transfers ownership or if a purchase option is determined to be reasonably certain of being exercised, amortize as if the lessee owns the underlying asset, using the lessee s depreciation policy 13

14 Reassessments Reassessment of a lease liability when certain judgments change (and change is expected to be significant) - There is a change in lease term - Likelihood that a residual value guarantee or purchase option has changed from reasonably certain to not (or vice versa) - There is change in the estimated amounts for payments already included in the liability - There is a change in the rate the lessor charges the lease, if used in the initial discount rate If liability reassessed, also reassess index or rate used to determine variable lease payments and the discount rate Adjustments to the lease liability generally should adjust the lease asset by the same amount 14

15 Lessor 15

16 Recognition Recognize a lease receivable and deferred inflow of resources - Do not derecognize the underlying asset and do not recognize a residual asset for all leases Exceptions to recognition and measurement - Leases of assets that are investments - Certain regulated leases (for example, airport-airline agreements) Continue to report the leased asset Depreciate as normal, unless leased asset is required to be returned in its original or enhanced condition or leased asset has an indefinite useful life In governmental funds, report lease receivable and deferred inflow of resources 16

17 Initial Measurement Lease Receivable Fixed payments Variable payments that depend on an index or rate (for example, CPI) - Use the rate in effect at beginning of lease Variable payments that are fixed in substance - Exclude variable lease payments that are dependent on a lessee s performance or usage of an underlying asset Residual value guarantees that are fixed in substance Less provision for uncollectible amounts Discount the lease receivable using the rate the lessor charges the lessee - Interest rate may be implicit in the lease 17

18 Subsequent Recognition and Measurement Residual value guarantees that are not fixed in substance recognized as a receivable when: Payment is required, and Amount can be reasonably estimated - Purchase option payments or termination penalties recognized when exercised 18

19 Deferrals and Rent Revenue Initial measurement of the deferred inflow of resources includes: - Receivable amount - Any cash received up front that relates to future periods (for example, final month s rent) - Less provision for uncollectible amounts Recognize revenue over the lease term on a systematic and rational manner 19

20 Recognition of Interest Revenue Recognize amortization of the discount on the lease receivable (interest revenue) so as to produce a constant periodic rate of return on the receivable Lease payments allocated first to accrued interest receivable and then to the lease receivable 20

21 Subsequent Recognition and Measurement Remeasure the lease receivable and update the discount rate when the following occur and are expected to significantly affect the receivable amount: a) There is a change in lease term, or b) There is a change in the rate the lessor charges the lessee If remeasured for a) or b), also remeasure for changes in an index or rate used to determine variable lease payments The deferred inflow of resources generally adjusted by the same amount as the lease receivable If the discount rate is updated, the receivable should be discounted using the revised rate 21

22 Other Issues 22

23 Other Issues Terminations and modifications Leases with multiple components Contract combinations Subleases Related-party leases Leases with or between component units Sale and leaseback Lease and leaseback 23

24 Proposed Effective Date and Transition Effective Date - Effective for periods beginning after December 15, 2018 Two years after final standard expected to be issued Earlier application permitted Transition Provisions - Apply retroactively Restate if practicable, cumulative effect if not - Leases recognized and measured using the facts and circumstances that exist at the beginning of the period of implementation - Lessors would not restate the assets underlying their existing sales-type or direct financing leases Any residual assets for those leases would become the carrying values of the underlying assets 24

25 PUTTING THE STANDARD INTO PRACTICE: FIELD TEST ON LEASES PRELIMINARY VIEWS Government Finance Officers Association 110 th Annual Conference May 22, 2016 William Hall, Interim Director of Statewide Reporting, State of Vermont

26 GASB Leases Project Preliminary Views document issued November 11, 2014 As a part of their due process procedures, GASB also invited governments to participate in a field test of the PV document Discover issues practitioners might have in applying the provisions in the PV Better understand and evaluate the time and effort associated with implementation and ongoing application of the provisions Participants could perform the field test from the lessee perspective, the lessor perspective, or both Participants could apply the provisions to all of the leases, or a sample of the leases

27 State of Vermont June 30, 2014 Population of 626,562 Governmental Fund revenues totaled $5.3 billion Primary Government net position totaled $1.9 billion 6 capital leases, primarily building improvements Lease liability - $1,630,229 Gross value - $3,805,498, net value - $1,204,816 Annual lease payments - $392, operating leases, primarily real property leases Future minimum lease payments - $71,918,329 Annual rent payments - $16,276,117

28 Field Test Procedures How is information currently collected about leases for financial reporting purposes? If application was only to a sample, how was the sample chosen? Apply the provisions of the PV Apply the definition and scope did any agreements no longer meet the definition of a lease? Apply the recognition and measurement provisions what would the financial statements look like? Apply the disclosure provisions what would the note disclosures look like?

29 Field Test Procedures General information What problems were encountered in applying the provisions? What additional problems do you expect to encounter when you apply the provisions to the rest of the leases (beyond the sample chosen) What changes in processes and systems would need to be made in order to implement the provisions? What is the estimated time to implement the provisions? What other issues or observations were made?

30 Information Collection Vermont s financial reporting process is very decentralized Individual departments and agencies are responsible for maintaining financial transactions in the VISION accounting system, using a budgetary basis of reporting Finance and Management is responsible for making modified accrual and accrual adjustments Asset information on capital leases is entered into the Asset Management software in VISION by departments Information on leases (both capital and operating) is submitted by departments to Finance and Management Departments must determine whether a lease is a capital or operating lease The data request form F&M send to departments contains the formula to determine whether a lease is a capital lease or operating lease F&M compiles the information and prepares the appropriate entries and disclosures

31 Selecting the Sample Largest impact of change in the standard would be on property leases Large number of property leases (159) meant seriously limiting the number selected to a manageable amount Sample selected was based on factors such as multiple leases with the same lessor, the magnitude of the payment obligation, and renewal experience Equipment leases (18) required consideration of the capitalization threshold All land leases are cancellable which are not reported as lease obligations under the new standard

32 Field Test Sample Sample included five equipment leases One lease currently classified as a capital lease with a net asset value of $4,760 and a lease liability of $5,028 Three new leases were added under the new standard, with future minimum lease payments of $59,534 and annual rent expense of $32,361 The fifth lease was not included in the calculations as the asset value was below our capitalization threshold

33 Field Test Sample Sample included six property leases One lease was already classified as a capital lease, with a net asset value of $1,189,026 and a lease liability of $1,611,976 Five leases were classified as operating leases, with future minimum lease payments of $13,710,283, and rent expense of $686,626

34 Applying the Definition and Scope Right of way leases would no longer meet the definition of a lease as they are non-exchange transactions Land leases would no longer meet the definition of a lease as they are all cancellable leases

35 Applying the Recognition and Measurement Provisions Intangible lease assets - $12,425,415 Lease liability - $12,776,207 Interest expense for the year - $344,122 Amortization expense for the year - $1,520,400

36 Applying the Disclosure Provisions Note 4: CAPITAL ASSETS - Field Test Capital Assets activities for the fiscal year ended June 30, 2014 were as follows: Primary Government Beginning Reclassifications Ending Governmental Activities Balance Additions Deletions & Donations Balance Capital assets, not being depreciated: Land & land use rights and land imprv. 127,485, ,071, (182,600.00) - 128,374, Construction in process 525,204, ,320, (400,154,232.00) (10,742,120.00) 534,628, Works of Art 136, , Intangible Total capital assets, not being depreciated 652,825, ,392, (400,336,832.00) (10,742,120.00) 663,139, Capital assets, being depreciated: Buildings and improvements 457,754, ,928, (28,379,974.00) - 458,303, Leased Buildings and improvements 2,793, ,356, ,149, Machinery and equipment 184,530, ,230, (11,579,566.00) - 283,180, Leased Machinery and equipment 134, , (110,034.00) - 110, Infrastructure 1,859,793, ,554, (22,057,367.00) - 2,108,290, Total capital assets, being depreciated 2,505,006, ,155, (62,126,941.00) - 2,865,034, Less accumulated depreciation for: Buildings and improvements (212,884,174.00) (12,609,702.00) 18,040, (207,453,267.00) 2 Leased Buildings and improvements (1,327,553.00) (1,463,975.00) - - (2,791,528.00) Machinery and equipment (120,828,505.00) (23,425,440.00) 10,322, (133,931,025.00) 2 Leased Machinery and equipment (26,626.00) (56,425.00) 39, (43,391.00) Infrastructure (812,013,261.00) (86,306,582.00) 22,057, (876,262,476.00) Total accumulated depreciation (1,147,080,119.00) (123,862,124.00) 50,460, (1,220,481,687.00) Total capital assets, being depreciated, net 1,357,926, ,293, (11,666,385.00) - 1,644,552, Governmental activities capital assets, net 2,010,751, ,685, (412,003,217.00) (10,742,120.00) 2,307,691,985.00

37 Applying the Disclosure Provisions 5. Other Long-term Liabilities During the year ended June 30, 2014, the following changes occurred in long-term liabilities: PRIMARY GOVERNMENT Governmental activities: Bonds payable Total Liability July 1, 2013 Additions Reductions Total Liability June 30, 2014 Amounts due within one year Bonds $ 570,425,053 $ 97,964,947 $ 74,675,000 $ 593,715,000 $ 49,710,000 Bond premium 32,783,914 5,499,807 11,542,314 26,741,407 5,660,653 Bond discount (201,157) - (24,471.00) $ (176,686) $ (12,549) Total bonds payable 603,007, ,464,754 86,192,843 $ 620,279,721 $ 55,358,104 7 Capital leases payable 2,053,974 11,150, ,289 12,776,207 1,315,428 Compensated absences 31,954,659 39,541,142 38,097,646 33,398,155 22,937,221 Claims and judgments 45,603, ,276, ,026,588 50,853,215 13,742,176 Contingent liabilities 7,000, ,000,000 - Net pension obligations 215,447, ,910, ,151, ,205,956 - Net other postemployment obligations 552,894, ,822,091 24,272, ,444,006 - Other liabilities 81,375-81, Pollution remediation obligation... 10,258,892 2,789,551 7,284,835 5,763,608 1,346,000 Total governmental activities long-term liabilities $ 1,468,301,503 $ 532,808,503 $ 445,535,116 $ 1,555,574,890 $ 93,735,998

38 Effect of New Standard on Financial Statements Net asset value increased to $12,425,415 from $1,193,786, an increase of $11, Lease liabilities increased to $12,776,207 from $1,616,824, an increase of $11,159,383 Net position was a net increase of $72,246 Expenses under the new standard (interest expense and amortization expense) are $1,864,522 Expenses under the old standard (interest and depreciation of previously classified capital assets, plus lease expense) were $1,053,120 Expenses increased by $811,402 under the new standard

39 Problems Encountered Property space leases typically contain property services that are not broken out in the agreement Equipment leases typically contain maintenance services that are not broken out in the agreement Usually unable to determine if option to extend is probable or not probable Difficulty in obtaining interest rates from leasing companies on equipment leases

40 Anticipated Problems with Implementation Staff expended 60 plus hours of time applying the provisions to four equipment leases and six property leases Reassessment of liability for space leases when options are ultimately exercised Examination of statewide contracts for purchasing to determine if any now meet the scope of reporting Consideration of leases where the State is the lessor

41 Changes in Processes or Systems Statewide training for departments and agencies on new definition and scope More timely data entry of lease assets to reduce the need for corrections and adjustments Modification of contract software to allow for allocation of lease liability and interest payments Modification of fixed asset software to allow for intangible lease assets New procedures to more closely monitor changes in lease terms

42 Other Issues State uses operating leases frequently, and reclassification to a lease liability will impact the State s borrowing capacity Most space leases are in Internal Service Funds, which will make determination of the proper fees to member departments more problematic Estimated staff time for implementation 200+ hours for data entry, accounting transactions and disclosures Ongoing estimated staff time 100+ hours for new leases and monitor lease changes

43 William Hall Interim Director of Statewide Reporting State of Vermont

44 Thank-you!

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