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1 July 21, 2015 NDS New Developments Summary An accounting makeover for lessees Looking ahead toward a new standard for leases Introduction The FASB and IASB have nearly finished redeliberating the latest proposed lease accounting standard issued in May of The FASB staff is currently drafting major revisions to lease accounting that will have a wide-ranging impact when effective on both lessees and lessors. This bulletin briefly describes some of the main proposed changes to lessee accounting. For a discussion of the main issues that would affect a lessor, see NDS , Leasing industry update: Looking ahead toward a new standard for lessor accounting. For a discussion of the potential impact on sale and leaseback transactions, see NDS , Sale and leaseback redefined: The impact of new leasing and revenue recognition standards. As the standard is not yet final, the comments herein are tentative and subject to change. The FASB staff is expected to finish drafting the standard by the end of the summer, and the Board expects to issue the final standard by the end of the year. We expect the FASB to align the effective date of the leasing standard with the effective date of the guidance in ASU , Revenue from Contracts with Customers. The FASB recently decided to defer the new revenue model s effective date by one year, meaning the guidance will be effective for public entities in annual reporting periods beginning after December 15, 2017 and for all other entities in annual reporting periods beginning after December 15, Contents A. Type A and Type B leases... 2 B. Lease classification... 2 Optional renewal periods and purchase options... 3 Variable lease payments... 3 Residual value guarantees... 3 C. Practical expedient for short-term leases... 3 D. Nonlease elements... 3 E. Type A lease accounting... 4 Initial measurement... 4 Subsequent measurement... 5

2 New Developments Summary 2 F. Type B accounting... 5 Initial measurement... 5 Subsequent measurement... 5 G. Other issues... 6 Impairment... 6 Income taxes... 6 Foreign currency... 6 H. Transition... 6 Type A leases... 7 Type B leases... 7 I. Next steps... 7 A. Type A and Type B leases The FASB elected to retain two models for lessee accounting, diverging from the IASB s one-size-fits-all proposal. The proposed Type A accounting model is similar to the current accounting for a capital lease. A lessee would recognize a right-of-use asset and a lease obligation on commencement of the lease. The right-ofuse asset would be amortized/depreciated over the term of the lease. The obligation would be accounted for similar to debt, amortized using the effective interest rate method. The proposed Type B accounting model is a compromise solution that requires entities to record a rightof-use asset and lease obligation on the statement of financial position while retaining many of the mechanics of straight-line rent recognition on the statement of comprehensive income. Those mechanics are explained in the sections below. B. Lease classification Lease classification for a lessee under the proposed leasing guidance would be similar but not identical to current guidance. Rather than retain the familiar classification guidance in ASC 840, Leases, the FASB proposal would adopt the classification model in IAS 17, Leases, into U.S. GAAP. According to IAS 17, a lease that transfers substantially all the risks and rewards incidental to ownership is classified as a finance lease (Type A lease in the proposed terminology). A lease that does not transfer substantially all the risks and rewards of ownership is an operating lease (Type B lease). The main lease classification provisions in IAS 17 are similar to those in U.S. GAAP, but less explicit: The lease transfers ownership of the asset to the lessee by the end of the lease term. The lessee has a bargain purchase option. The lease term is for the major part of the economic life of the asset. The present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset at lease inception. IAS 17 also has a fifth provision that is not currently found in U.S. GAAP: A lease of specialized assets may be a finance lease when only the lessee can use them without major modifications. Another difference is that there is no exception to the useful life provision in IAS 17 when classifying leases that commence in the last 25 percent of the useful life of an asset.

3 New Developments Summary 3 Under IAS 17, the classification provisions for leases are viewed as indicators rather than hard and fast criteria. That is not expected to be the case under the new leasing standard. Optional renewal periods and purchase options Optional renewal periods and purchase options are important factors in classifying a lease under current U.S. GAAP. The FASB decided to more or less retain the current guidance on whether to include optional renewal periods (or consider termination options). The terminology, however, would change under the proposed guidance. The phrase reasonably assured would be replaced with reasonably certain, although the FASB indicated that the meaning has not changed. In addition to economic factors such as bargain renewals, termination penalties, and residual value guarantees, the analysis of whether exercise is reasonably certain would also consider factors such as significant customization, the importance of the asset to the lessee s operation, and any sublease agreements. The reasonably certain standard would apply to purchase options as well. If exercise of a purchase option is reasonably certain, then the option price would be included in the lease payments. Variable lease payments The proposed accounting for variable lease payments would differ, depending on the nature of the variability. Payments that vary based on an index or rate would be included in lease payments for classification and measurement purposes based on the prevailing index or rate at the measurement date. This differs from current practice where future changes in inflation are often not included in minimum lease payments. Payments that vary based on future usage of the leased asset would not be included in lease payments for classification and measurement purposes. Similar to current practice, the proposal would require variable payments that are in-substance fixed payments to be included in the lease payments. Residual value guarantees When classifying a lease, the entire amount of any residual value guarantee would be included in the lease payments, similar to current U.S. GAAP. However, only the expected payments under a residual value guarantee would be included when measuring the right-of-use asset. C. Practical expedient for short-term leases During redeliberations, the FASB liberalized the proposed provisions for accounting for short-term leases. Previously, the FASB had indicated that only leases of 12 months or less with no possibility of renewal would qualify for a practical expedient of nonrecognition on the statement of financial position. As revised, leases of 12 months or less with renewal options would be eligible for the short-term exclusion provision unless exercise of the renewal options is reasonably certain. D. Nonlease elements Although existing guidance in U.S. GAAP requires entities to evaluate multiple-element arrangements to identify lease and nonlease components, as a practical matter, lessees may not separate the lease and nonlease elements for accounting purposes because both operating leases and the related service elements are considered to be executory contracts. That is about to change. Under the proposed model, lessees would be required to recognize a right-ofuse asset and a lease liability for the lease element, but not for service elements within a full-service

4 New Developments Summary 4 lease contract. Therefore, lessees with leases that contain both lease and nonlease elements might need to account separately for those elements. Lessees would be required to allocate consideration to lease and nonlease components on a relative stand-alone price basis. Therefore, entities would no longer include lease-related executory costs and related profits as part of the consideration associated with the lease component of an arrangement. Instead, entities would determine whether they receive additional goods or services in exchange for the executory costs, and if so, whether those costs are associated with a lease or nonlease component of the contract. The proposed guidance includes a practical expedient that would allow lessees to make an accounting policy election to treat lease and nonlease elements as a single lease component. This would simplify the accounting for the contract but increase the amount of assets and liabilities recognized. It also could have implications for impairment. E. Type A lease accounting For lessees, Type A accounting would not represent a major change compared to the current accounting for capital leases. There would be some changes at the margins, the most significant of which is the replacement of the current lease classification criteria with the IAS 17 model. Other changes and practical expedients that affect all leases could modify measurement and recognition at the margins, but the overall model would remain substantially the same. Initial measurement A lessee would initially measure the lease liability for a Type A lease at the present value of the lease payments, including the following items: Fixed payments, less any lease incentives receivable from the lessor Variable lease payments that depend on an index or rate, initially measured using the index or rate on the lease commencement date, or that are in-substance fixed payments Amounts expected to be payable under residual value guarantees The exercise price of a purchase option that the lessee has a significant incentive to exercise Termination penalties, if the lease term implies that the lessee will incur them The guidance on determining an appropriate discount rate would be generally consistent with existing U.S. GAAP, that is, the rate implicit in the lease, if readily determinable, or the lessee s incremental borrowing rate. The incremental borrowing rate should reflect similar terms and security for a loan to purchase a similar asset. Private companies could elect to use a risk-free rate as a practical expedient, but at the cost of recognizing a larger lease obligation and right-of-use asset. The lease obligation would be the starting point for recognition of the right-of-use asset. The lessee would adjust that amount for any lease payments made before the lease commencement date, any lease incentives received from the lessor, and the amount of any capitalized initial direct costs. The proposed standard would limit capitalization of initial direct costs to those costs that would not have been incurred if the lease had not been executed. Internal cost allocations and other costs incurred prior to execution of the lease that are not incremental to obtaining the lease would not qualify for capitalization. A lessee would include initial direct costs in the initial measurement of the right-of-use asset and amortize those costs over the lease term.

5 New Developments Summary 5 Subsequent measurement In subsequent periods, the accounting for a Type A lease would be similar to the accounting for a purchased asset and debt, much the same as the current accounting for a capital lease. The Type A right-of-use asset would be depreciated and the lease payments would be recognized as interest expense and a reduction of the lease obligation. F. Type B accounting Type B accounting would represent a major change compared to the current accounting for operating leases. When a lease or lease element is classified as a Type B lease, the proposed accounting would recognize an obligation on the balance sheet and a corresponding right-of-use asset. The right-of-use asset for a Type B lease is a new type of asset that would be accounted for similar to a fixed asset, including potential testing for impairment. Although the assets and liabilities from both Type A and Type B leases would be presented on the statement of financial position, a Type B lease liability would not be considered debt or accounted for like debt. Instead of interest expense, a lessee would recognize rental expense over the lease term in a manner that should approximate straight-line rent expense in the absence of other events, such as an impairment loss or exercise of a renewal option. Initial measurement The initial measurement of a Type B lease would be substantially the same as the initial measurement of a Type A lease. The difference between the two models lies in subsequent measurement and expense recognition. Subsequent measurement The subsequent accounting for a Type B lease would be more in the nature of a remeasurement than a traditional amortization of a loan or Type A lease. The remaining lease obligation would be remeasured using the original assumptions, with a corresponding credit to the right-of-use asset. The lease expense would then be calculated independently of the change in the obligation. A lessee would recognize rental expense each period as the greater of The remaining cost of the lease (recalculated each period), divided by the remaining lease term The difference between the lease liability at the beginning of the period and the end of the period (a situation that could occur during a period of negative amortization or a rent holiday) The net result should approximate straight-line rent expense in the absence of other events such as an impairment loss or exercise of a renewal option. When rents are uneven due to future increases in rental payments, current U.S. GAAP recognizes a deferred rent credit in the early periods of a lease that reverses in subsequent periods. Under the new leasing model, the credits would be accounted for as accrued rent, that is, recognized as a reduction to the right-of-use asset. Any debits would be similarly recorded as prepaid rent, but as a component of the right-of-use asset. Therefore, when rents increase over time, the right-of-use asset would differ from the recognized lease obligation. This accounting model is unconventional in that measurement of the amounts recognized on the statement of financial position and the statement of comprehensive income are measured independently. In accounting jargon, the financial statements do not articulate as they typically would in classical double-entry bookkeeping. This feature permits measurement of the lease obligation as if it were debt while rental expense more closely resembles the accounting for an executory contract.

6 New Developments Summary 6 G. Other issues Because the proposed accounting model would require all lessees to recognize a right-of-use asset and a lease liability, provisions related to recognized assets and liabilities in various sections of the Codification that are not a consideration when accounting for most operating leases today could impact lease accounting in the future. Impairment Under the proposed guidance, a lessee would be required to evaluate its right-of-use asset for impairment under the guidance in ASC 360, Property, Plant, and Equipment. Under ASC 360, if any impairment indicators are present, an entity must determine whether the undiscounted future cash flows associated with the asset are sufficient to recover its carrying amount. If an entity fails this recoverability test, then it must recognize an impairment loss equal to the difference between the carrying amount and the fair value of the right-of-use asset. Income taxes The proposed model s requirement for lessees to recognize a right-of-use asset and a lease liability, as well as its changes to the expense recognition pattern associated with the existing model, will likely affect lessees accounting for deferred tax assets and liabilities. Foreign currency Under the proposed model, lease liabilities denominated in a foreign currency would be remeasured using the guidance in ASC 830, Foreign Currency Matters. Any change in the liability would be recognized in net income for the period. As a nonmonetary asset, right-of-use assets denominated in a foreign currency would not be remeasured using the current exchange rate, creating another potential measurement difference between lease assets and liabilities. H. Transition Lessees would be required to apply the proposed guidance to all leases existing at, or entered into after, the beginning of the earliest comparative period presented in the period of initial application. To ease the initial burden of applying the proposed guidance, the FASB has decided to permit a lessee to elect three specific reliefs during transition. A lessee would not be required to go back and reassess Whether any expired or existing contracts are or contain leases The classification of any expired or existing lease Whether the initial direct costs capitalized for existing leases would have qualified for capitalization under the new leases standard All three provisions must be elected as a package and applied to all leases. Separately, lessees could also elect to use hindsight when evaluating lease renewals and purchase options for existing leases. The election also would apply to all leases. If the lease is subsequently modified or remeasured for any reason, the new provisions would apply.

7 New Developments Summary 7 Type A leases Because the proposed Type A lease accounting is not significantly different from current U.S. GAAP, lessees would not remeasure capital leases on transition, except to recognize the impact of the change in the guidance for capitalizing initial direct costs. Any remaining initial direct costs that are not eligible for capitalization would be adjusted to equity, unless the relief package is adopted as a policy election. Type B leases On transition, a lessee would initially recognize a right-of-use asset and lease liability at the present value of the sum of The remaining minimum rental payments (as currently defined) Expected payments under residual value guarantees (discounted according to the provisions of the new standard) Any remaining initial direct costs not eligible for capitalization would be adjusted to equity, unless the relief package is adopted as a policy election. I. Next steps Although the final standard is not expected until the end of the year, there are several actions that entities should take to prepare for implementing the new lease accounting model: Evaluate both the recognition and disclosure requirements to determine how the information will be accumulated. Consider whether to adopt any of the practical expedients and policy choices that will impact the type of information that must be accumulated to prepare for transition. Compile information about existing leases to gauge the impact of the new lease accounting model. Design and prepare to implement new controls over the recording of right-of-use lease assets and liabilities, including transition, initial measurement, modifications, and impairment testing. Review loan covenants and other agreements that incorporate financial ratios and metrics, such as compensation arrangements, that could be affected by the new leasing model. Review capitalization policies for initial direct costs and determine the likely impact of a change in the standard Grant Thornton LLP, U.S. member firm of Grant Thornton International Ltd. All rights reserved. This Grant Thornton LLP bulletin provides information and comments on current accounting issues and developments. It is not a comprehensive analysis of the subject matter covered and is not intended to provide accounting or other advice or guidance with respect to the matters addressed in the bulletin. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this bulletin. For additional information on topics covered in this bulletin, contact your Grant Thornton LLP professional.