BECKER GEARTY CONTINUING PROFESSIONAL EDUCATION

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1 Now & Next (ASC 840 f/k/asfas 13) Learning Objectives: To review recent developments in lease accounting and demonstrate how they have affected accounting for leases as prescribed under SFAS 13, Accounting for Leases. Program Prerequisites: None Program/Course Level: Overview Program Content: Lease accounting has been one of the most controversial accounting topics for nearly two decades. This program will begin with a quick overview of the current accounting for leases within ASC 840 (SFAS 13). The focus of the program will be to address the current exposure draft on Leases, the significant rule changes, the impact on both the lessee and lessor, impact on preexisting leases and comment letters associated with this topic. Advanced Preparation: None Type of Delivery Method: Live & Group Internet Based CPE Credits: 2011 DeVry/Becker Educational Development Corp. All rights reserved. 2 1

2 2011 DeVry/Becker Educational Development Corp. All rights reserved. 3 Developments in Lease Accounting FASB Proposed ASU 2011 DeVry/Becker Educational Development Corp. All rights reserved. 4 2

3 Developments in Lease Accounting FASB Proposed ASU 2011 DeVry/Becker Educational Development Corp. All rights reserved. 5 I. Overview A lease is a contractual agreement between a lessor, who conveys the right to use real or personal property (an asset), and a lessee, who agrees to pay periodic rents over a specified time. Rental Sale Lessee Operating Lease Capital Lease Lessor Operating Lease Sales Type or Direct Financing Type 2011 DeVry/Becker Educational Development Corp. All rights reserved. 6 3

4 II. Operating Leases A. Definition An operating lease includes a lessor, who collects rent, and a lessee, who uses the leased asset and pays periodic rent for such use. The lessee merely uses the asset; there is no transfer of ownership, or of any risk or benefit of ownership DeVry/Becker Educational Development Corp. All rights reserved. 7 B. Accounting for Operating Leases 1. Lessee Accounting a. Lease Rent Expense The lessee records rent expense over the lease term, usually on a straight-line basis unless other methods are warranted (for example, lease expense can be tied to sales, to the Consumer Price Index, or to the prime interest rate). DR Rent expense $XXX CR Cash/rent payable $XXX 2011 DeVry/Becker Educational Development Corp. All rights reserved. 8 4

5 b. Lease Bonus (Prepayment) Lease bonus (prepayment) for future expenses should be classified as an asset (deferred charge) and amortized using the straight-line method over the life of the lease. c. Leasehold Improvements A leasehold ld improvement is one that t is permanently affixed to the property and reverts back to the lessor at the termination of the lease. In general, if the property is not moveable from the premises by the tenant, it is a leasehold improvement. Air conditioning ducts would be considered a leasehold improvement, while a painting hanging on a wall would not. 1) Capitalize Leasehold Improvements The value of leasehold improvements should be capitalized and added to the property, plant, and equipment section or the intangible assets section of the balance sheet. 2) Depreciation Useful Life or Lease Term Leasehold improvements should be depreciated (amortized) over the lesser of: a) Lease life b) Asset/improvement life d. Rent Kicker A premium rent payment required for specific events. 1) Period expense e. Refundable Security Deposit Is reported as an asset until refunded by the lessor DeVry/Becker Educational Development Corp. All rights reserved. 9 f. Free or Reduced Rent Consideration If consideration (free rental months or reduced rental charge at beginning) is part of the package, lessee must take total rent expense to be paid for the entire lease term and divide it evenly over each period (matching principle). XAMPLE EX 5 years (60 $1,000 *First 6 months are free Net cost for five years Total months rented Monthly rental expense First 6 months ( Mo. 1 6) Rental-Agreement $60,000 <6,000> $54, mo. $ 900 DR Rent expense $900 CR Rent payable $900 Next 54 months (Mo. 7 60) DR Rent expense $900 DR Accrued rent payable 100 CR Cash/rent payable $1, DeVry/Becker Educational Development Corp. All rights reserved. 10 5

6 C. Leasing Issues 1. Background and evolution a. Restatements b. SEC Staff Letter 2. Primary issues a. Amortization of leasehold improvements b. Rent holidays c. Lease incentives d. Disclosures 2011 DeVry/Becker Educational Development Corp. All rights reserved. 11 Issue 1: Amortization of Leasehold Improvements Amortized by lessee over the shorter of: Their economic lives Lease term (as defined in ASC 840, f/k/a SFAS 13) Amortization of LHIs over a term that includes renewals is appropriate only when renewals have been determined to be "reasonably assured" A lease that is cancelable only upon the occurrence of some remote contingency, only with the permission of the lessor, only if the lessee enters into a new lease with the same lessor, or only if the lessee incurs a penalty in such amount that continuation of the lease appears, at inception, reasonably assured... is considered non-cancelable KEY POINT Leasehold improvements cause renewal option to be "reasonably assured: when: 1. LHIs are expected to have significant value at end of initial period such that lessee is not willing to abandon these assets (i.e. effectively incur a penalty) 2. Renewal option reasonably assured of exercise 3. Add the renewal period to the initial term to determine appropriate term for accounting purposes 2011 DeVry/Becker Educational Development Corp. All rights reserved. 12 6

7 Issue 2: Rent Holidays Apply ASC ; 25; f/k/a/ FASB Technical Bulletin 85-3, "Accounting for Operating Leases with Scheduled Rent Increases" Operating leases with rent holidays should be recognized: 1. On a straight-line basis 2. Over the lease term 3. Including the rent holiday period: lease term for accounting purposes includes all periods lessee has access to and control over leased space. Straight-line applies unless another systematic or rational allocation is more representative of the time pattern in which the leased property is physically employed DeVry/Becker Educational Development Corp. All rights reserved. 13 Issue 3: Lease Incentives Landlord incentives for Leasehold Improvements: 1. Acquisition of LHI is capitalized asset 2. Incentive received recorded as a deferred rent by lessee 3. Amortize incentive as reduction to lease expense over the lease term 4. Cash Flow Statement a. Acquisition of the leasehold improvement in "investing activities" b. Proceeds of incentive as "operating activities" 2011 DeVry/Becker Educational Development Corp. All rights reserved. 14 7

8 Issue 4: Disclosures Amortization Period For LHIs Material Lease Agreements Disclosures: Footnotes, MD&A Critical Accounting Policies Accounting Policies for Leases Basis for Contingent Rents Provisions of Material Leases original term, renewal periods, reasonably assured rent escalations, rent holidays, contingent rent, rent concessions, LHI incentives and other unusual provisions 2011 DeVry/Becker Educational Development Corp. All rights reserved Lessor Accounting a. Fixed Asset The cost of the property is included in the lessor's s property, plant and equipment. 1) Depreciation over the asset's useful life b. Rental Income Rental income is reported on either the straight-line or other systematic method. DR Cash/rent receivable $XXX CR Rental income $XXX 2011 DeVry/Becker Educational Development Corp. All rights reserved. 16 8

9 c. Security Deposits Security deposits required by the lease may be either refundable or nonrefundable: 1) Nonrefundable deferred by the lessor (unearned revenue) and capitalized by the lessee (prepaid rent expense) until the lessor considers the deposit earned. 2) Refundable treat as a receivable by the lessee and a liability by the lessor until the deposit is refunded d to the lessee. DR Cash $XXX CR Refundable deposit $XXX 2011 DeVry/Becker Educational Development Corp. All rights reserved. 17 KEY POINT Do not recognize security deposits as revenue in advance of their being earned (violation of the Rule of Conservatism). Remember, revenue is only recognized when the earning process is complete; we never anticipate revenue. d. Temporary Difference 1) GAAP Rule report prepaid rental income when earned 2) Tax Rule report prepaid rental income when received e. Lease Bonus The lease bonus is deferred (unearned income) and amortized (into income) over the life of the lease DeVry/Becker Educational Development Corp. All rights reserved. 18 9

10 f. Free or Reduced Rent Consideration If consideration (free rental months or reduced rental charge at beginning) is part of package, lessor must take total rental income to be paid for the entire lease term and divide it evenly over each period (matching principle/revenue recognition principle). EXAM MPLE Rental-Agreement 5 years (60 $1,000 *First 6 months are free Net rental income for five years Total months rented $60,000 <6,000> $54, mo. Monthly rental income $ 900 First 6 months ( Mo. 1 6) DR Accrued rent receivable $900 CR Accrued rental income $900 Next 54 months (Mo. 7 60) DR Cash $1,000 CR Rental income $900 CR Rent receivable DeVry/Becker Educational Development Corp. All rights reserved. 19 III. Capital Lease A capital lease transfers substantially all of the benefits and risks inherent in ownership of property p to the lessee. i. This is an accounting transaction, which is, in substance, an installment purchase in the form of a leasing arrangement. ii. The lessee accounts for this type of lease as the acquisition of both an asset (leased asset under capital lease) and a related liability (obligation under capital lease). iii. The lessor accounts for such a lease as a sales-type or a direct financing lease. A sales-type lease results in a dealer's or manufacturer's profit or loss to the lessor. A direct financing lease does not result in a dealer's or manufacturer's profit or loss DeVry/Becker Educational Development Corp. All rights reserved

11 A. Lessee Capital Lease Criteria 1. Must meet just one condition to capitalize. DR Fixed asset leased property $XXX CR Liability obligation under capital lease $XXX Ownership transfers at end of lease (upon final payment or required buyout) Written option for bargain purchase Ninety (90%) percent of leased property F.V. <= P.V. of lease payments Seventy-five y (75%) percent of asset economic life is being committed in lease term 2. Criteria (N) and (S) cannot be used for a lease that begins within the last 25% of the original estimated economic life of the leased property DeVry/Becker Educational Development Corp. All rights reserved. 21 EXAMPLE Equipment FV is $3,500, lease payments are $1,000 per year, on lease term is four years, asset life is ten years. Incremental borrowing rate is 10% No ownership No written bargain FV P.V. Cost $3,500 x 90% $3,150 $ $3,170 $1,000 $1,000 $1,000 $1, DeVry/Becker Educational Development Corp. All rights reserved

12 B. Lessor: Sales-Type/Direct Financing Type Criteria 1. If a lease, at inception, meets all three of the following conditions, it shall be classified by the lessor as a sales- type or direct financing lease, whichever is appropriate. Lessee "owns" the leased property (meets any one of the four lessee's criteria) Uncertainties do not exist regarding any unreimburseable costs to be incurred by the lessor. Collectibility of the lease payments is reasonably predictable DeVry/Becker Educational Development Corp. All rights reserved. 23 IV. Lessee (Capital Lease) Accounting A. Calculation of Leased Asset and Liability Amounts The lessee treats the capital lease as if an asset were being purchased over time; that is, it is a financing transaction in which an asset is acquired and a corresponding obligation (liability) is created. DR Fixed asset leased property $XXX CR Liability obligation under capital lease $XXX 2011 DeVry/Becker Educational Development Corp. All rights reserved

13 1. Recording the Lease a. Capitalized Amount The lessee records the lease as an asset and a liability at the lower (lesser) of: 1) Fair value of the asset at the inception of the lease, or 2) Cost = present value of the minimum lease payments DeVry/Becker Educational Development Corp. All rights reserved. 25 a) Includes (all payments that the lessee is obligated to make): 1) Required Payments 2) Bargain Purchase Option When the lease contains a bargain purchase option, the lease obligation includes the present value of the payment required to exercise the bargain purchase option in addition to the present value of the minimum lease payments. 3) Guaranteed Residual Value The guaranteed residual value is the amount guaranteed by the lessee to the lessor for the estimated residual value of the asset at the end of the lease term. b) Exclude: 1) Executory Costs Insurance, maintenance, and taxes can be paid by the lessor or lessee. If the lessor pays them, a portion of each lease payment representing executory costs is excluded from the calculation of minimum lease payments. If the lessee pays these costs directly, they are not included in the minimum lease payments. 2) Optional Buyout (not required and not a bargain) 2011 DeVry/Becker Educational Development Corp. All rights reserved

14 Periodic payment KEY POINT Bargain OR PV of $1 Guaranteed residual Beginning = PV of an annuity due Ending = PV of an annuity (in arrears/ordinary) 2011 DeVry/Becker Educational Development Corp. All rights reserved. 27 b. Interest Rate The lessee uses the incremental borrowing rate, determined d as the lower (lesser) of: 1) Rate implicit in the lease (if known) 2) Rate available in market to lessee (not prime) 2011 DeVry/Becker Educational Development Corp. All rights reserved

15 c. Summary Capitalized Cost (remember, lower of this cost or market): O wnership = PV of payments and required buyout (if any) W ritten = PV of payments and bargain buyout N inety % FV = PV of payments (not option buyout) S eventy five % life = PV of payments (not option buyout) 2011 DeVry/Becker Educational Development Corp. All rights reserved. 29 B. Term to Use in Computing Depreciation of the Asset 1. Formula for Depreciation Capitalized lease assets < Salvage value> Depreciable Basis Periods of benefit Depreciation Expense (per period) 2011 DeVry/Becker Educational Development Corp. All rights reserved

16 2. Period of Benefit (Depreciable Life) a. Ownership Transfer and Written Bargain 1) Estimated economic life of the asset if the lessee takes ownership of the leased asset by the end of the lease or if there is a bargain purchase option as part of the agreement. The asset is depreciated in a manner consistent with the lessee's normal policies. b. Ninety % FV and Seventy-five % Life 1) The lessee uses the lease term if the lessee does not take ownership of the asset by the end of the lease or if there is not a bargain purchase option DeVry/Becker Educational Development Corp. All rights reserved Summary Depreciation Rules: (Capitalized "lease" asset salvage salvage value): Ownership = Depreciate over asset life (legal form) Written = Depreciate over asset life (legal form) Ninety % FV = Depreciate over lease life (substance over form) Seventy five % life = Depreciate over lease life (substance over form) 2011 DeVry/Becker Educational Development Corp. All rights reserved

17 E. Summary of Lessee Capitalization Rules 1. Capitalize As PP&E on the balance sheet, the leased asset at the lower LESSER of: a. Cost PV of future lease payments Include: Guaranteed Residual Value by Lessee, Bargain Purchase Option (if applicable) Exclude: "Executory Cost" = Insurance, Taxes, and Repair & Maintenance 1) Discount Rate: Incremental borrowing rate is the lower (LESSER) of: a) Rate implicit in the lease (if known) b) Rate available in market to lessee (not prime) b. Fair Value Capitalize Depr. Life Ownership = PV of payments and required buyout Asset life Written = PV of payments and bargain buyout Asset life Ninety % FV = PV of payments (ignore option) Lease life Seventy-five % life = PV of payments (ignore option) Lease life 2011 DeVry/Becker Educational Development Corp. All rights reserved. 33 KEY POINT If a lease meets more than one of the criteria, then the order of priority for applying the rules is the exact way they are spelled: O W N S 2011 DeVry/Becker Educational Development Corp. All rights reserved

18 V. Lessor Accounting 2011 DeVry/Becker Educational Development Corp. All rights reserved. 35 A. Recording a Sales-Type Lease Following are the terms which are important to know for sales-type leases: 2011 DeVry/Becker Educational Development Corp. All rights reserved

19 1. Gross Investment (lease receivable) The minimum lease payments plus any unguaranteed residual value accruing to the benefit of the lessor. This is recorded as Lease Payments Receivable on the lessor's books. Lease payment + Unguaranteed residual value Gross investment 2011 DeVry/Becker Educational Development Corp. All rights reserved Net Investment This is computed as the sum of the present value of the minimum lease payments and the present value of any unguaranteed residual value accruing to the benefit of the lessor, using the interest rate implicit in the lease. Lease payments + Unguaranteed residual value Gross investment x PV Net investment 2011 DeVry/Becker Educational Development Corp. All rights reserved

20 3. Unearned Interest Revenue (Contra-Lease Receivable) The gross investment less unearned interest revenue equals net investment. This is amortized over the life of the lease by the effective interest method and is included in the balance sheet as a deduction from the gross investment to report the net investment. Gross investment < Net investment > Unearned interest revenue 2011 DeVry/Becker Educational Development Corp. All rights reserved Cost of Goods Sold The cost of the leased asset plus any initial direct costs, such as legal fees or commissions to the lessor, minus the present value of any unguaranteed residual value accruing to the lessor's benefit. This is charged against income in the period in which the corresponding sale is recorded. Cost of Asset < PV Unguaranteed Residual > Cost of Goods Sold 2011 DeVry/Becker Educational Development Corp. All rights reserved

21 5. Sales Revenue The present value of the minimum lease payments is recorded as sales revenue. This does include the present value of any guaranteed residual value but does not include the present value of any unguaranteed residual value DeVry/Becker Educational Development Corp. All rights reserved. 41 EXAMPLE Recording a Sale-Type Lease with Unguaranteed Residual Value (Lessor Lessor) Assume that a lease with a ten-year term requires rental payments of $5,000 on January 1 of each year. The lessor's cost for the leased asset is $35,000. The estimated fair value at the end of the lease (unguaranteed residual value) is $4,000, and the lessor retains ownership at the end of the lease. The implicit interest rate is 10 percent (P.V. of annuity due is and PV of $1 is.386). Compute the information necessary to record this sales-type lease DeVry/Becker Educational Development Corp. All rights reserved

22 EXAMPLE (continued) 1. Gross investment = Minimum lease payments + Unguaranteed residual value = ($5,000 x 10 yrs) + $4,000 = $54, DeVry/Becker Educational Development Corp. All rights reserved. 43 EXAMPLE (continued) 2. Net investment = Lease payments x PV of annuity due of $1, 10 periods, 10% + Unguaranteed residual value x PV of $1, 10 periods, 10% = ($5,000 x 6.759) + ($4,000 x.386) = $35,339 (The present value of the minimum lease payments, but not the unguaranteed residual value, is recorded as sales, $5,000 x = $33,795) 2011 DeVry/Becker Educational Development Corp. All rights reserved

23 EXAMPLE (continued) 3. Unearned interest revenue = Gross investment Net investment = $54,000 $35,339 = $18, DeVry/Becker Educational Development Corp. All rights reserved. 45 EXAMPLE (continued) 4. Cost of goods sold = Lessor s cost of leased asset + Initial direct costs PV of unguaranteed residual value = $35, ($4,000 x PV of $1, 10 periods, 10%) = $35,000 (4,000 x.386) = $33, DeVry/Becker Educational Development Corp. All rights reserved

24 EXAMPLE (continued) 5. Present value of lease payments (sale) = $5,000 x = $33, DeVry/Becker Educational Development Corp. All rights reserved. 47 EXAMPLE (continued) Journal Entry: To record this sales-type lease DR Lease payments receivable $54,000 DR Cost of goods sold 33,456 CR Sales $33,795 CR Equipment 35,000 CR Unearned interest revenue (contra-lease receivable) 18,661 Note: The lessor s profit on sale is $33,795 $33,456 = $339, which is recognized at the lease s inception DeVry/Becker Educational Development Corp. All rights reserved

25 B. Recording a Direct Financing Since no manufacturer's or dealer's profit is realized in a direct financing lease, the fair value of the leased property p equals the cost or carrying value at the inception of the lease. The information necessary to record this type of lease is: 2011 DeVry/Becker Educational Development Corp. All rights reserved Gross Investment (Lease Receivable) Gross investment equals the minimum lease payments plus the unguaranteed residual value and is recorded as Lease Payments Receivable. Lease payments + Unguaranteed residual value Gross investment 2011 DeVry/Becker Educational Development Corp. All rights reserved

26 2. Net Investment Net investment equals the gross investment plus any unamortized initial direct costs less the unearned income. The initial direct costs are amortized over the lease term by the effective interest method. + x Lease receivable Unguaranteed residual Gross investment PV Net investment 2011 DeVry/Becker Educational Development Corp. All rights reserved Unearned Interest Revenue This is the gross investment less the cost of the leased property p yplus any initial direct costs. It is amortized over the lease term by the effective interest method. Gross investment < Net investment > Unearned interest revenue Journal Entry: To record a direct financing lease DR Lease receivable (gross investment) $54,000 CR Unearned interest revenue (contra-lease receivable $18,661 CR Asset (at cost or FMV) (Cost + nonrecorded profit) 35, DeVry/Becker Educational Development Corp. All rights reserved

27 VI. Sale-Leaseback 2011 DeVry/Becker Educational Development Corp. All rights reserved. 53 A. Introduction In a sale-leaseback transaction, the owner of a property (seller-lessee) sells the property and simultaneously leases it back from the purchaser-lessor. Usually there is no visible interruption in the use of the property. Sale-leaseback transactions are treated as single financing transactions where, in general, any profit or loss is deferred and amortized. In general, two questions are involved in determining the treatment of any profits: 1. Is the lease a capital or operating lease? And 2. What portion of the rights to the leaseback property are retained? 2011 DeVry/Becker Educational Development Corp. All rights reserved

28 B. Terminology 1. Selling Price Selling price is the negotiated t price in the saleleaseback agreement. It may be less than, equal to, or greater than the fair value of the property, depending on the negotiated terms of the sale-leaseback. 2. Profit or Loss on Sale Profit or loss on the sale is the amount which would have been recognized by the seller-lessee assuming there was no leaseback. It is calculated by subtracting book value from fair value (sale price) DeVry/Becker Educational Development Corp. All rights reserved Excess Profit on Sale-Leaseback a. Operating Lease Excess Profit The amount of profit on the sale which exceeds the present value of the minimum lease payments. Sale price < Asset NBV> Tentative ti gain < PV min. lease payments> Excess gain 2011 DeVry/Becker Educational Development Corp. All rights reserved

29 b. Capital Lease Excess Profit The amount of profit on sale that exceeds the recorded amount of the asset. Note that this amount will be the same as in an operating lease unless the leaseback asset is recorded at the lower fair value. The recorded amount of the leaseback asset is the lesser of i. The fair value of the leased property, or ii. The present value of the minimum lease payments DeVry/Becker Educational Development Corp. All rights reserved Rights to Remaining Use of Property Retained by Seller- Lessee The rights to the remaining use of the property are determined by the present value of rent payments paid by the seller-lessee. The seller-lessee's rights may be categorized as follows: a. "Substantially All" Rights Retained (Greater than 90%) The present value of the rent payments is equal to or greater than 90% of the fair value of the property. These leases are usually accounted for as capital leases. b. Rights Retained Are Less Than "Substantially All" but Greater than "Minor" (Between 90% - 10%) The present value of the rent payments is less than 90% of the fair value, but greater than 10% of the fair value of property at the lease inception. These leases are accounted for as either capital or operating leases, depending on the criteria. c. "Minor" Portion of Rights Retained by Seller-Lessee (Less than 10%) The present value of the rent payments is 10% or less of the fair value of the property at lease inception or the lease (back) period is 10% or less of the asset's remaining life. These leases are usually accounted for as operating leases. Note: To determine whether any sales-leaseback transaction should be accounted for as operating or capital, use the "OWNS" test DeVry/Becker Educational Development Corp. All rights reserved

30 Sale-Leaseback: Summary Gain Major Middle Minor 90% or More 90% 10% 10% or Less (Life or Sales Price) Defer All (Amortize over leaseback) Defer (up to PV of leaseback) (Amortize over leaseback) No Deferral Loss (NBV > FMV) (real economic losses) Recognize Immediately Recognize Immediately Recognize Immediately Other Losses (artificial loss) Defer All (Amortize over leaseback) Defer All (Amortize over leaseback) Recognize Immediately 2011 DeVry/Becker Educational Development Corp. All rights reserved. 59 EXAMPLE Leaseback Less Than "Substantially All" but More Than "Minor" On January 1, Year 1, Carlson Company sold an airplane with an estimated useful life of ten years. Carlson simultaneously leased back the airplane for three years. The lease is classified as an operating lease. Applicable data follow: Sale price, fair value $500,000 Book value of airplane 100,000 Monthly rental 5,100 Present value of lease rentals 153,000 Calculate the amount of Carlson s profit recognized on January 1, Year 1, and rent expense on December 31, Year DeVry/Becker Educational Development Corp. All rights reserved

31 EXAMPLE (continued) The present value of lease rentals exceeds 10% of the fair value ($50,000) but is less than 90% of the fair market value ($450,000). 000) Therefore, the amount of profit recognized is the amount in excess of the present value of the minimum lease payments. The calculation follows: Sale price $500,000 Less book value (100,000) Total profit 400,000 Less present value of lease payments (deferred amount) (153,000) Profit recognized at lease inception 1/1/Yr 1 (excess profit on sale leaseback) $247,000 Carlson s rent expense for the year is calculated as follows: Annual rent payments ($5,100 x 12 months) $ 61,200 Less one year recognition of deferred profit ($153,000 3 years) (51,000) Rent expense 12/31/Yr 1 $ 10, DeVry/Becker Educational Development Corp. All rights reserved. 61 Developments in Lease Accounting FASB Proposed ASU 2011 DeVry/Becker Educational Development Corp. All rights reserved

32 SEC Staff Report to Congress I. July 2005 SEC Staff Issued Report to Congress A. Required under 401 (c) of Sarbanes-Oxley Act B. The extent of Off-Balance Sheet Arrangements C. Whether current financial statements transparently reflect the economics of off-balance sheet arrangements D. Among many topics, Lease Accounting is discussed 2011 DeVry/Becker Educational Development Corp. All rights reserved. 63 Improving Financial Transparency Objectives-Oriented Standards II. III. SEC recommends: Accounting standards that are principle-based or "objectives-oriented": Clearly l state t the accounting objective Minimize the use of exceptions in a standard Avoid use of percentage tests ("bright lines") to evade intent Based on an approved and consistently applied conceptual framework Provide sufficient detail and structure to operationalize and consistently apply Rules-based standards: "further a need and demand for voluminously detailed implementation guidance creating complexity and uncertainty in the standard." 2011 DeVry/Becker Educational Development Corp. All rights reserved

33 SEC Standard Setting Recommendations Leases IV. Reconsider A. Repeatedly identified as an area to be reexamined by the FASB. B. Current "all or nothing" approach not designed to reflect the wide variety of lease structures. C. Transparency and consistency in reporting is not achieved. D. A project on lease accounting would be consistent with several of the key initiatives identified in achieving transparency in reporting DeVry/Becker Educational Development Corp. All rights reserved. 65 SEC Standard Setting Recommendations Leases Reconsider (continued) E. Currently uses "bright-lines" 1. Increases potential for similar arrangements to be portrayed differently F. Bright-line tests facilitate structuring leases by form over substance 1. Seek desired accounting treatment vs. principle-based approach 2011 DeVry/Becker Educational Development Corp. All rights reserved

34 SEC Standard Setting Recommendations Leases V. The lease project is complex and controversial VI. Leases have many different terms including: contingent rents optional extensions penalty clauses purchase options 2011 DeVry/Becker Educational Development Corp. All rights reserved. 67 Developments in Lease Accounting FASB Proposed ASU 2011 DeVry/Becker Educational Development Corp. All rights reserved

35 Proposed FASB ASU on Leases Developments in Lease Accounting FASB Proposed ASU General Provisions of Lease Accounting Lessee Accounting Lessor Accounting Other Lease Accounting Topics Effects on Financial Reporting Transition and Effective Date 2011 DeVry/Becker Educational Development Corp. All rights reserved. 69 Leases General Provisions I. Corporate Behavior Why Enter into a Lease? A. Avoid large initial cash outlays B. Features and options offered by lessor C. Financial flexibility D. Off-balance sheet financing E. Tax Advantages of capital lease deductions for: 1. Depreciation 2. Interest Expense 3. Synthetic Leases F. Start-up company may lack credit to borrow from bank G. Restaurants and Retailers: 1. No need for lease vs. buy decision (shopping malls) 2. Embedded in business model 3. Prime Location 2011 DeVry/Becker Educational Development Corp. All rights reserved

36 Leases 2010 Exposure Draft II. Leases 2010 Exposure Draft A. On August 17, 2010, the ISAB and the FASB issued an exposure draft on Leases that proposes p that a new standard on lease accounting for lessees and that lessors would replace U.S. GAAP under SFAS 13 and IFRS under IAS 17 Leases, IFRC 4 Determining whether an arrangement contains a Lease, SIC-15 Operating Leases Incentives, and SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease. Source: Aug Exposure Draft 2011 DeVry/Becker Educational Development Corp. All rights reserved. 71 Leases General Provision III. IV. Definition A. Lease a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration. Scope A. The proposed standard will apply to all leases including subleases of right-to-use assets. Some arrangements that are specifically stated to not be within the scope of the exposure draft are: 1. Leases of intangible assets 2. Leases to explore for or use minerals, oil, natural gas, and other nonregenerative resources; 3. Leases of biological assets; and 4. Leases that meet the definition of onerous contracts prior to the date of the commencement of the lease. 5. Contracts that represent the purchase or sale of the underlying asset would be excluded from the scope. A contract constitutes a purchase or a sale if, at the end of the contract, the contract transfers both of the following: a. Control of the underlying asset. b. All but a trivial amount of the risk and benefits associated with the underlying asset DeVry/Becker Educational Development Corp. All rights reserved

37 Leases General Provision INVESTMENT PROPERTY KEY POINT The boards agreed to retain the scope exemption for investment property if measured at fair value, which currently only exists internationally under IAS 40, Investment Property. Under U.S. GAAP, a similar exemption is expected for those entities that qualify for fair value accounting pursuant to the Investment Property Company Project, which is expected to be released for exposure in the third quarter of DeVry/Becker Educational Development Corp. All rights reserved. 73 Leases General Provision IV. Scope B. Includes: 1. Combined services and lease contracts (bifurcate lease) 2. Short term leases 3. Sale-leasebacks 4. Subleases 5. Leveraged leases (tentatively added at the July 13, 2011 meeting) C. Excludes immaterial items. 1. If material in the aggregate, consider a policy similar to PP&E capitalization policy DeVry/Becker Educational Development Corp. All rights reserved

38 Leases 2010 Exposure Draft. KEY POINT Topics pending Board decision on whether they will be included in scope: 1. Leases of internal-use software in accordance with Subtopic , Intangibles Goodwill and Other Internal-Use Software, of the FASB Accounting Standards Codification. 2. Leases of inventory DeVry/Becker Educational Development Corp. All rights reserved. 75 Leases 2010 Exposure Draft. KEY POINT DEFINITION OF A LEASE AS UPDATED BY THE BOARDS ON APRIL 12, An entity would determine whether a contract contains a lease by assessing whether: a. The fulfillment of the contract depends on the use of a specified asset; and b. The contract conveys the right to control the use of a specified asset for a period of time. 2. A contract would convey that right to control the use if the customer has the ability to direct the use, and receive the benefit from use, of a specified asset throughout the lease term. Guidance on separating the use of a specified asset from other services should be aligned with the boards tentative decisions in March 2011 relating to the separation of lease and non-lease components. 3. A specified asset refers to an asset that is explicitly or implicitly identifiable. 4. A physically distinct portion of a larger asset of which a customer has exclusive use is a specified asset. A capacity portion of a larger asset that is not physically distinct (for example, a capacity portion of a pipeline) is not a specified asset DeVry/Becker Educational Development Corp. All rights reserved

39 Leases General Provision V. Types of Leases A. At the Feb 17 th meeting the boards tentatively decided to identify a principle for identifying two types of leases for both lessees and lessors, with different profit and loss effects, as follows: 1. A finance lease with a profit or loss recognition pattern consistent with the proposals in the exposure draft. 2. An other-than-finance lease with a profit or loss recognition pattern consistent with an operating lease under existing IFRSs/U.S. GAAP. B. The boards tentatively decided to establish indicators to distinguish a finance lease from an other-than-finance lease C. The boards asked the staff to use these tentative decisions to perform targeted outreach to determine if stakeholders concerns about the profit and loss recognition pattern proposed in the exposure draft would be addressed. KEY POINT To date no subsequent decisions on this topic have been noted DeVry/Becker Educational Development Corp. All rights reserved. 77 Leases General Provision 2010 Exposure Draft Lessor Accounting: Original Exposure Draft Contracts that represent the purchase or sale of the underlying asset would be excluded from the scope of the Exposure Draft. The Exposure Draft states that a contract constitutes a purchase or a sale if, at the end of the contract, the contract transfers both of the following: 1. Control of the underlying asset. 2. All but a trivial amount of the risk and benefits associated with the underlying asset. KEY POINT The scope of the Exposure Draft is similar to the scope of the existing lease accounting standards set forth in ASC 840 (and previously included in EITF Issue Thus, most contracts that are currently accounted for as leases would be subject to the new guidance DeVry/Becker Educational Development Corp. All rights reserved

40 Leases 2010 Exposure Draft Note: A contract would normally meet both of these criteria when it transfers title of the underlying asset automatically at the end of the contract or includes a bargain purchase option in which it is reasonably certain, at the inception of the lease, that the lessee will exercise the option. But, all facts and circumstances should be considered, not just how the transaction is described in the contract. KEY POINT The determination about whether a contract is a purchase or sale is made at the time of inception and is not subsequently reassessed. Transfer of the title of the asset alone is insufficient i for an entity to decide that the transaction should be treated as a purchase or sale. For purchase or sale treatment, all but a trivial amount of the risks and benefits must also be transferred to the lessee DeVry/Becker Educational Development Corp. All rights reserved. 79 Leases General Provision KEY POINT Ownership transfers at end of lease (upon final payment or required buyout) Written option for bargain purchase Ninety (90%) percent of leased property F.V. <= P.V. of lease payments Seventy-five (75%) percent of asset economic life is being committed in lease term Operating Leases 2011 DeVry/Becker Educational Development Corp. All rights reserved

41 Developments in Lease Accounting FASB Proposed ASU General Provisions of Lease Accounting Lessee Accounting Lessor Accounting Other Lease Accounting Topics Effects on Financial Reporting Transition and Effective Date 2011 DeVry/Becker Educational Development Corp. All rights reserved. 81 Lessee Accounting - General General A lessee s s rights and obligations under all leases, existing and new, would be recognized on the balance sheet. Removes the concept of capital leases and operating lease classifications. Straight-line rent expense will be replaced with amortization of the right-of-use asset and interest expense on the lease obligation Lessee Recognizes on Balance Sheet Right-of- Liability to use Asset make Lease Payments Amortization Expense Income Statement Interest Expense 2011 DeVry/Becker Educational Development Corp. All rights reserved

42 Lessee Accounting Initial Measurement I. Initial Measurement A. Initially recognize asset and liability at present value of lease payments to be made. B. The right-of-use asset is measured at the amount of the lease obligations plus any initial direct costs incurred. 1. Initial direct costs: Incremental costs directly attributable to negotiating and arranging the lease that would not have been incurred had the lease transaction not been made (commissions, legal fees). C. Present value uses the rate charged by lessor if available or lessee s incremental borrowing rate. D. It also includes: 1. Options (renewal and termination) in lease term 2. Contingent rentals, residual value guarantees and termination payments 2011 DeVry/Becker Educational Development Corp. All rights reserved. 83 Lessee Accounting Initial Measurement E. Measurement Date 1. The initial measurement of the lease asset and liability as well as the date to determine the discount rate is to be the commencement date of the lease rather than the inception date. a) Inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. b) Commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. 2. The lease standard will also include guidance regarding: a) The treatment of costs incurred between the inception and commencement dates. b) Lease payments made prior to the commencement date DeVry/Becker Educational Development Corp. All rights reserved

43 Lessee Accounting Lease Term II. Lease Term A. The lease term is now the same for lessee and lessor. It is defined as the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease. Lessees would be required to estimate the ultimate expected lease term and periodically reassess such estimate. B. The boards are to publish indicators of what defines a clear economic incentive. C. The lease term will be reassessed by both parties only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease DeVry/Becker Educational Development Corp. All rights reserved. 85 Lessee Accounting Lease Payments III. Lease Payments A. Concept of minimum lease payments is gone. B. Lease payments will include contractual payments plus estimated contingent rentals. 1. Percentage rent. 2. Payments which depend on an index or rate updated at the July 20 meeting. a. Initial measurement at date of commencement of lease. 1) Leases with payments based upon LIBOR would use a current spot rate. 2) Leases with payments based upon CPI would use the absolute index at commencement and not the expected rate of change in that index DeVry/Becker Educational Development Corp. All rights reserved

44 Lessee Accounting Lease Payments KEY POINT A lease with a fixed rental increase of 2% per year as a proxy for inflation will include such adjustments in the initial measurement. A lease with rental increases based on changes to CPI (which may be expected to increase at the same 2% per year rate) will not include these expected rate changes. b. Reassessment required as rates and indices change at the end of each reporting period. c. Accounting for changes: 1) Relates to past period = income statement 2) Relates to current period = income statement 3) Relates to future period = adjust right to use asset 3. Termination penalties should be consistent with the accounting for options to extend or terminate a lease. 4. Guaranteed residual values except for amount guaranteed by unrelated third parties DeVry/Becker Educational Development Corp. All rights reserved. 87 Lessee Accounting Lease Payments C. Contingent Rentals and Residual Value Guarantees 1. The exposure draft provides that contingent rentals and residual value guarantees a must be estimated and accounted for using an expected outcome approach, based on a probability-weighted average for a reasonable number of potential outcomes. Contingent rentals based on interest rate changes would be estimated using spot rates. a. Amounts payable under purchase options would be excluded from the present value of lease payments calculation DeVry/Becker Educational Development Corp. All rights reserved

45 Lessee Accounting Lease Payments b. When determining the present value of lease payments, the lessee must include contingent rents, residual value guarantees, and expected payments under termination penalties. KEY POINT This represents a major change from the current lease accounting guidance under GAAP and IAS that call for the exclusion of contingent rents from the minimum lease payment calculation regardless of their probability of occurrence. 2. Initial Measurement: The underlying asset would be initially measured at the amount of the liability and adjusted for any prepaid lease rentals and any recoverable initial direct costs that the lessee incurs DeVry/Becker Educational Development Corp. All rights reserved. 89 Lessee Accounting Lease Payments 3. Timing of Recognition: The asset and liability would be measured at the inception of the lease, but neither would be recognized until the date that the lessor makes the underlying asset available to the lessee for use. KEY POINT Under the exposure draft, contingent rents are required to be estimated and included in the minimum lease payment calculation that is recorded at the commencement of the lease. The current guidance under GAAP calls for the exclusion of contingent rents from the minimum calculation regardless of their probability of occurrence DeVry/Becker Educational Development Corp. All rights reserved

46 Lessee Accounting Subsequent Measurement V. Subsequent Measurement A. Reassess the carrying amount of the lease payment obligation if there is a significant change B. Accounting for Subsequent Measurement 1. Changes in lease terms: Adjust the right-of-use asset and the obligation to make rental payments 2. Changes to assumptions (contingent rents, GRV and termination penalties): Reflected in earnings if change arises from current or prior reporting periods 3. Changes related to future reporting periods: Adjust the right-ofuse asset and the obligation to make rental payments KEY POINT No changes required for the incremental borrowing rate. The discount rate is locked in at initial measurement 2011 DeVry/Becker Educational Development Corp. All rights reserved. 91 Lessee Accounting Financial Reporting VI. Presentation A. Balance Sheet 1. Right of use assets presented with PP&E but separate from non- lease assets. a. Amortization term of LHIs to coincide with lease term. 2. Lease obligation presented separate from other liabilities. a. Could affect leverage covenants. B. Income Statement 1. Straight-line expense replaced with amortization and interest expense. 2. Foreign exchange differences related to the liability to make lease payments. C. Statement of Cash Flows 1. Cash payments shown as financing activity DeVry/Becker Educational Development Corp. All rights reserved

47 Lessee Accounting Financial Reporting D. Updated Requirements Tentative Decisions as of July 21, Statement of Financial Position - Lessees may separately present or disclose the values related to right of use assets and liabilities. a. If they do not separately present they must disclose in what account the values are included. b. The right of use assets should be presented as if they are owned assets DeVry/Becker Educational Development Corp. All rights reserved. 93 Lessee Accounting Financial Reporting 2. Statement of Cash Flows: a. Cash paid for leases payments is classified in financing activities. t b. Classify or disclose the cash paid relating to interest using U.S. GAAP or IFRS. c. Classify cash paid for variable lease payments not included in the measurement of the liability to make lease payments as operating activities. (FASB: 4 to 3; IASB: 13 IASB to 2). d. Cash paid for short-term leases not included in the lease liability value are treated as operating activities DeVry/Becker Educational Development Corp. All rights reserved

48 Lessee Accounting Financial Reporting 2011 DeVry/Becker Educational Development Corp. All rights reserved. 95 Lessee Accounting Financial Reporting 2011 DeVry/Becker Educational Development Corp. All rights reserved

49 Lessee Accounting Financial Reporting VII. Disclosure A. As of the July 21 st meeting the boards tentatively decided on the following disclosure requirements: 1. A reconciliation of the opening and closing balance of right-of-use assets, disaggregated by class of underlying asset. 2. A reconciliation of the opening and closing balance of the liability to make lease payments disaggregation is not required as it was in the ED. 3. Maturity analysis of the undiscounted cash flows that are included in the liability to make lease payments. The maturity analysis should show, at a minimum, the undiscounted cash flows to be paid in each of the first five years after the reporting date and a total of the amounts for the years thereafter. The analysis should reconcile to the liability to make lease payments DeVry/Becker Educational Development Corp. All rights reserved. 97 Lessee Accounting Financial Reporting 4. Information about the principal terms of any lease that has not yet commenced if the lease creates significant rights and obligations for the lessee. 5. Information required in paragraphs 73(a)(ii)-73(a)(iii) of the exposure draft (additional guidance pending on this item.) 6. All expenses relating to leases recognized in the reporting period, in a tabular format, disaggregated into (a) amortization expense, (b) interest expense, (c) expense relating to variable lease payments not included in the liability to make lease payments, and (d) expense for those leases for which the short-term practical expedient is elected, to be followed by the principal and interest paid on the liability to make lease payments DeVry/Becker Educational Development Corp. All rights reserved