New Lease Accounting Standards FASB and IASB

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1 New Lease Accounting Standards FASB and IASB Session ID#: 2016JDE New Lease Accounting Standards with Implementation Strategies and Considerations Prepared and Presented by: David Kratzke, Director Dan Cherwin, Senior Manager Grant Thornton LLP #JDEINFOCUS

2 Polling Question: How familiar are you with the new lease accounting standards and their requirements? 1. I know the details well and could implement it 2. I understand the key differences from the current guidance, but not the details 3. I have a high-level understanding only 4. I'm just starting to learn about it

3 Agenda Lease accounting convergence US GAAP vs. IFRS Overview of ASC 842, Leases What could you be doing now to prepare for the changes? How might the new standards affect your real estate strategies?

4 ASC 842 vs. IFRS 16 ASC 842 IFRS 16 Lessee Accounting Lessor Accounting Measurement of RoU Asset Reassessment of variable lease payment Subleases Sale-leaseback Dual model for Profit and Loss: Finance lease (Interest/Amortization) Operating lease (Straight-line lease expense) Upfront profit recognition in sales-type leases only Two additional lessor classification criteria (Collectability & Amt. required to satisfy Residual Value Guarantee) Generally, Right of Use asset = Lease liability (subject to certain adjustments) In general, no reassessment (however required if lease is reassessed for other reasons, or contingency resolved such that some or all variable payments become fixed) Classification of sublease refers to an underlying asset Gain/loss on sale is accounted for consistently with guidance in ASC 606 Single model All leases (Interest/Amortization) Recognition/Measurement exemption for low-value assets ($5K or less) No distinction between sales-type and direct finance lease (allow upfront profit recognition for both) No additional lessor classification criteria Allows alternative measurement bases for Right of Use asset (e.g., IAS 40 or IAS 16) Required for variable lease payments that depend on an index/rate Classification of sublease refers to Right of Use asset arising from head lease Gain/loss limited to the amount that relates to the buyer-lessor s residual interest in underlying asset

5 Overview ASC 842, Leases Key Changes Scope Lessee Lessor Real Estate and Non-Real Estate Leases Recognize right-of-use asset and lease liability for almost all lease contracts; exemption provided for short-term leases (12 months or less) Accounting model stays substantially the same Effective January 1, 2019 for calendar-year public companies Improve and simplify the financial reporting for lessees Create a model that provides a faithful representation of leasing transactions for both lessees and lessors

6 Financial Statement Impact Snapshot Lessee Balance Sheet Income Statement Cash Flow Statement Finance Right-of-use asset Front loaded Amortization expense Interest expense Lease Liability Operating Lease Expense Operating Interest = Operating Principal = Financing Lessor Balance Sheet Income Statement Sales/ Direct Financing Lease receivable Unguaranteed residual Deferred profit Front loaded Interest income on receivable and residual Profit (immediateor deferred) Operating Cash Flow Statement Operating Underlying asset remains Lease income Operating

7 Lifecycle of Lease Accounting A lease is an arrangement that conveys a right to use an identified asset for a period of time. 1 Identifying a lease, term, components, lease payments 2 Lease classification Ongoing requirements 4 Recognition & measurement 3

8 Lease Identification Lease is present in a contract if a contract contains both: An Identifiable Asset Customers right to control use of the identified asset Is explicitly or implicitly specified Supplier has no practical ability to substitute or would not economically benefit from substituting Decision- Making authority over the use of the asset The ability to obtain substantially all economic benefits from the use of the asset

9 Separation of Lease & Nonlease Components Identify separate lease and nonlease components Allocate consideration to the separate lease and nonlease components on a relative standalone price basis Use observable standalone prices Use estimated standalone prices if observable not readily available (maximize the use of observable standalone prices) Residual estimation permitted if estimated standalone price for a component is highly variable or uncertain May elect to not separate lease and nonlease components by class of underlying assets and account for each separate lease component along with the associated nonlease component as a single lease component (accounting policy)

10 Real Estate Lease Contracts in Practice Net Leases Tenant pays their share of real estate taxes, insurance, and CAM Generally "variable" and will be excluded from lease payments and expensed as incurred Modified Gross or "Base Year" Leases Tenants pay their share of increases in real estate taxes, insurance and CAM over a base year amount Part fixed and part variable Fixed piece gets included in lease payments for real estate taxes and insurance Fixed piece for CAM is excluded from lease payments and is expensed as incurred Variable portions i.e., the excess amount over base year is excluded from lease payments and expensed as incurred Gross Leases Tenants pay a fixed amount which includes all components Fixed piece gets included in lease payments for real estate taxes and insurance Fixed piece for CAM is excluded from lease payments and is expensed as incurred

11 Separation & Allocation Example: Variable property tax & insurance payment Facts Lessee and Lessor enters into a 7-year net lease for a building The annual lease payments are fixed at $10,000 per year In addition, Lessee is required to separately pay property tax and insurance on the building as billed (these would be owed by Lessor regardless of the lease) Analysis Property taxes and insurance are not separate components; contract contains one component lease component Lessee s payment of property tax and insurance is reimbursement of Lessor s costs and not payment for goods or services $70,000 total lease payments ($10,000 per year x 7 years) are included in the measurement of lease liability Because property tax and insurance payments are variable and do not depend on an index or rate, they are: Excluded from measurement of initial lease liability Recognized in income statement if and when incurred

12 Separation & Allocation Example: Fixed property tax & insurance payment Facts Lessee and Lessor enters into a 7-year gross lease for a building Annual lease payments are fixed at $15,000 per year, itemized as follows: Rent: $12,000 Property tax: $2,000 Insurance: $1,000 Property tax and insurance would be owed by Lessor regardless of the lease Analysis Property taxes and insurance are not separate components; contract contains one component lease component Lessee s payment of property tax and insurance is reimbursement of Lessor s costs and not payment for goods or services Because property tax and insurance payments are fixed, $105,000 lease payments ($15,000 per year x 7 years) would be included in the measurement of the lease liability

13 Separation & Allocation Example: Common area maintenance Facts Lessee and Lessor enters into a 7-year lease for a space within a building Annual lease payments are fixed at $15,000 per year, which covers: Use of space Lessor s performance of common area maintenance (CAM) activities such as cleaning common areas, parking maintenance, etc. Analysis CAM activities are a separate component; the contract contains two components lease component and non-lease component (i.e., CAM services) Lessee receives a service from Lessor in the form of the CAM activities it would otherwise have to undertake itself or pay another party to provide Contract consideration of $105,000 ($15,000 per year x 7 years) would be allocated between lease and non-lease component (CAM)

14 Lease Classification Evaluate if any of the following criteria are met: Lease transfers ownership of asset to lessee Lease grants lessee a purchase option reasonably certain of being exercised Lease term is for major part of asset s remaining economic life PV of lease payments (incl. lessee RVG) is substantially all the asset's fair value Asset is so specialized it is expected to have no alternative use to lessor Yes Finance lease Operating lease No

15 Classification Considerations Commencement & Term Lease Commencement The date a lessor makes an underlying asset available for use to a lessee The date for classification and initial measurement Lease Term Non-cancellable period plus: Renewal periods reasonably certain of exercise Periods covered by a termination option reasonably certain not to be exercised Renewal periods (non-termination periods) controlled by lessor Consider all relevant factors that create an economic incentive to exercise an option to continue using the asset

16 Classification Considerations Lease Payments Fixed Payments (all lease components) Variable Payments (contingent rent) Include payments that depend on index or rate, using index or rate at commencement Include in-substance fixed payments Exclude payments that change due to factors after commencement (other than passage of time) Purchase or Termination Options Include payments for purchase, renewal or termination options consistent with lease term Residual Value Guarantees Include the full amount of the residual value guarantee Less Lessor-provided incentives Payments made to, or on behalf of, the lessee Loss incurred by lessor resulting from assuming a lessee s pre-existing lease from 3rd party

17 Classification Considerations Other Inputs Discount Rate Rate the lessor charges the lessee, when determinable; otherwise, the lessee s incremental borrowing rate Practical expedient for portfolio allocation or parent-subsidiary relationship Initial Direct Costs Incremental costs Only those costs incurred as a result of signing the lease Narrower definition than under prior guidance Practical expedient for prior conclusions

18 Impact on Lessee Balance Sheet At the commencement date, a lessee must record the following for all leases (except short-term leases): Lease Liability Right-of-use Asset PV of lease payments due over the lease term Discounted at lease implicit rate (if available), or lessee s incremental borrowing rate Initially equal to the lease liability, plus / minus +/- Prepaid / accrued rent - Lease incentives received + Initial direct costs - Impairment - Exit or disposal cost obligation (ASC 420)

19 Lease Classification Test Example Lessee McFly Corp. enters into a lease of a DeLorean with Lessor Brown Enterprises Term Economic life Purchase option Payments 4 years (no renewal option) 6 years None $100, paid in arrears, escalating $4 annually Rate 8% Fair value of asset $600 Residual value guarantee None How will lessee McFly Corp. classify the lease?

20 Lease Classification Test Example Lessee McFly Corp. enters into a lease of a DeLorean with Lessor Brown Enterprises Does ownership transfer? Is purchase option reasonably certain of exercise? Is lease term major part of economic life? Is present value of lease payments substantially all of asset fair value? Is asset specialized in nature? No, DeLorean reverts back to Brown Enterprises at lease termination. No, lease contains no purchase option. No, McFly leases DeLorean for only 67% (4 / 6 years) of asset's economic life. No, present value of lease payments is only 58% ($350 / $600) of asset's fair value. No, DeLorean can be used for any general corporate purpose. CLASSIFICATION = OPERATING LEASE

21 Operating Lease Accounting Treatment Journal Entry at Lease Commencement Right-of-useasset 350 Lease liability 350 Expense Liability Asset Cash Payment Interest Principal Reduction Amortization Year A B C D A C Total Year 1 Journal Entry for Operating Lease Lease expense 106 A Lease liability 72 D Cash Accumulated Amortization 100 B 78 (A C)

22 Finance Lease Accounting Treatment Change in Assumptions Assumethe same facts as in previous example except that DeLorean is retrofitted with flux capacitor, rendering it so specialized in nature that it can only be used for time travel purposes. Asset Liability Expense Amortization Cash Payment Interest Principal Reduction Year A B C D A+ C Total Year1 Journal Entry for Finance Lease Interest expense 28 C Amortization expense 88 A Lease liability 72 D Cash Accumulated Amortization 100 B 88 A

23 F/S Impact Comparison Lessee Operating Lease Finance Lease Balance Sheet, leasecommencement Right-of-use asset Lease liability (350) (350) Income Statement, Year 1 Lease expense 106 Amortizationexpense 88 Interest expense 28 Pre-tax income (106) (116) Statementof Cash Flows, Year 1 Operating activities (100) (28) Investing activities Financing activities (72) Balance Sheet, end of Year 1 Right-of-useasset, net of accumulated amortization Lease liability (278) (278)

24 Lessee Reassessment Requirements Cause Changes in assessment of renewal, termination, purchase options based on triggering events within lessee s control Change in amounts probable of being owed under a lessee provided residual value guarantee Contingency resolved such that some or all variable payments become fixed Reclassify the lease Remeasure liability using updated discount rate Do not reclassify the lease Remeasure liability using original discount rate Effect Remeasure & reallocate consideration to remaining lease & non-lease components Remeasure lease liability using appropriate rate above and revised lease payments (index or rate based variable lease payments are remeasured using index or rate at remeasurement date) Adjust the right-of-use asset (potential P&L impact)

25 Modifications Additional right-ofuse New Lease Standalone Price Assess modification as a separate contract or not If not a separate contract, reassess classification of modified lease Initial direct costs, incentives and any other payments are accounted for in a manner similar to a new lease Renewal or extension is considered a modification Lessee Liability Remeasured using discount rate at the date of the modification Increase in scope Corresponding adjustment to the ROU asset Decrease in scope Proportionate adjustment to the ROU asset and recognize resulting gain/loss Lessor Overall Multiple possible outcomes based on original vs. revised classification, resulting in updated characterization of the investment Modification of an operating lease is treated as a new lease for accounting purposes Gain or loss only recognized in cases where classification changes under modified terms

26 Other Subtopics Lessor Qualification for Sales-Type Lease Classification Lessee must obtain control in order to qualify as sales-type lease and recognize immediate profit Example of "substantially all" criterion satisfied due to third party residual value guarantee Leases classified as sales-type under prior guidance will be classified as direct financing under new guidance Asset Impairment Lessees have new long-lived assets (right-of-use intangible assets) to evaluate periodically (ASC 360) Lessor impairment model remains unchanged (ASC 310 & ASC 360) Sale-leaseback Transactions Sale-leaseback accounting guidance now also applicable to lessors (previously only lessees) Qualify as sales only if: Meets new revenue recognition criteria (ASC 606) Leaseback is an operating lease Repurchase options are at fair value, and similar alternative assets are available in the marketplace Gains recognized in full upon sale; "failed" sales treated as financings by both parties

27 Effective date and transition Adoption Date Effective January 1, 2019 for calendar-year public companies Other entities have an additional year for annual filings Early adoption permitted Transition Method Modified retrospective approach May apply hindsight to existing leases for lease term and asset impairment Change in classification (between operating and capital / finance) Relief Package At adoption do not reassess: Whether an arrangement is, or contains, a lease Lease classification Initial direct costs capitalization

28 Polling Question: Which stage of the lease accounting lifecycle presents the greatest challenge in transition & implementation? 1. Identification, separation and allocation of contracts 2. Classification, recognition & measurement of assets & liabilities 3. Ongoing requirements (reassessments, modification analyses) 4. Running parallel accounting models during the transition & implementation period

29 What could you be doing now to prepare for the changes?

30 Polling Question: What is your company doing now? 1. Beginning the process of understanding the new standard 2. Developing an implementation plan 3. Identifying and cataloging all leases 4. Evaluating new system solutions 5. Considering potential changes in leasing strategy

31 What could you be doing now to prepare for the changes? Find and Abstract ALL Leases Assess Systems & thirdparty provider readiness Identify internal stakeholders, includingreal estate, treasury, accounting, CFO etc. Implement controls to mitigate risk of incomplete or inaccurate lease accounting calculations Initiate dialog with your auditors Estimate Impact to balancesheet, ratios & debt covenants Centralize your lease process and data management Flowchart data collection and internal review/approval processes: Quantify operating expenses & variable lease payments Identify "Initial Direct Costs" Assess & reassess if renewal options are "reasonably certain" Confirm languages and translation requirements Safeguard that your lease abstract is capturing and reporting critical data elements

32 Impacts beyond accounting Procurement Master Data Mgmtand Business Analytics Lease Admin and Other Processes & Controls Systems Equipment & Real Estate Leasing Strategies Tax & Treasury

33 Lease Administration Considerations Properly structured lease administration can mitigate risk Proper alignment with Finance and Accounting is essential Lease Administration is a foundational element of the new lease standard A Lease Administration & Technology review may be required Early and full abstraction is vital

34 Lease Administration Systems Impacts Lead time for system RFPs, data migration and user acceptance testing, means you should start thinking about this element now: Easily accessible & indexed electronically stored supporting documentation Existing systems likely do not have sufficient functionality for remeasurement & disclosure Investigate whether systems require interface into Accounting / Finance platforms, and file layout Understand key event notifications functionality, like "what if" analyses, workflow management to support decision making

35 Lease Administration Process Impacts Need for a strong PMO with an effective governance structure Lease Administration team communication and training Reexamination of internal controls and processes Transactions, Lease Admin and CRE meeting cadence Exception/Status Reporting on key IASB / FASB fields

36 Polling Question: Which of the following best describes the primary system used by your company for tracking Non-Real Estate leases? 1. JD Edwards 2. Other Third Party Software 3. Internal customer-built system 4. Spreadsheet-based 5. None of the above

37 Consider your solution options Single or separate solution for RE/equipment? Systems Solutions Other features? Analytics or reporting? Consolidate solutions? Current leasing solutions? Upgrade or replace?

38 Roadmap to New Standard 1-6 months 6-12 months months Category Discovery/Planning Transition/Implementation Full Cutover to New Standard Database Define Business Requirements Issue RFP for Tech & Award UAT and Implement Interface Mapping Populate Transaction Module of system Lease Administration Locate all Leases Assess and Map Current Processes Abstraction and Query Resolution Process Update Current Lease Admin Processes and Procedures Business As Usual Lease Admin New Data Points Recorded Rent Management Assess and MapCurrent Rent Management Processes Refine processes forrent Management Lease Finance Rent ManagementProcedures Analysis & Strategy Obtain Data and Preliminary Modelling of Financial Impacts Deliver: ReportingRoad Map, Interface to Finance Team, Procedures and Best Practices, Program Mgmt Transition Schedule Refined Data Points for Financial Impacts Engage Auditors to Review Processes Embed thereassessments/strategy review

39 How might the new standards affect your real estate strategies?

40 How might the new standards affect real estate strategies? More options and analysis Minimizing balance sheet impact clashes with practical realities of leasing Own vs. Lease Sale/leaseback: Not much change New Priorities on-balance sheet lease financing Old structures rise synthetic leases Smart move: rationalize and right-size portfolios

41 Polling Question: Which of the following would be most helpful to facilitate implementation of the new guidance? 1. In person training/workshops 2. Webcasts 3. Publications with examples 4. Podcasts/videos

42 Additional Resources For additional material and resources on this topic please go to: 6/new-developments-summary/FASB-issues-new-leaseaccounting-standard.aspx

43 Contact information Dave Kratzke Dan Cherwin Director Real Estate Business Consulting and Technology Grant Thornton LLP Senior Manager Real Estate Audit Grant Thornton LLP

44 Please complete the session evaluation We appreciate your feedback and insight Session ID# 2016JDE