iLeasePro Lease Accounting Business Considerations

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Business Considerations

Proposed Lease Accounting

Standard

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Background 3 Property Leases 4 Equipment Leases 6 Income Statement 8 Industry Considerations 9 Final Thoughts 15

Contents

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Background

But it is difficult to ignore completely the accounting results and business analytical metrics that result from changes in accounting treatment and certainly the changes in lease accounting currently being proposed in a Joint Project by the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) (collectively “the Boards”) will drive significantly different accounting results and metrics as compared to current accounting requirements. Therefore, let’s examine some of the business considerations that financial decision makers should take into account as they evaluate the impact of the proposed standard. As in the past, our focus will be on lessees since the proposed changes will have the greatest impact on their financial results. The issues will be considered separately for property and equipment leases but many of these issues will be relevant for both types of leases. Further, the impact will be much greater for those companies whose leases are currently categorized as operating leases, so we will limit our discussion to the effect of the change from current operating lease accounting versus the proposed standard. We will also consider how the proposed accounting standard might impact certain selected industries. Before thinking that we are being premature in dealing with these issues given that the proposed standard might not be effective until 2017, remember that a five year lease that is being finalized currently might well have to be transitioned into the proposed new accounting model at the effective date. Financial decision makers should be prepared to understand, at least in general, the terms of the future accounting ramifications of decisions that are being made currently.

I have heard it said many times that accounting results should not drive the basic economic decisions related to business. And I generally agree with that point of view.

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Property Leases

The initial measurement of the Lease Liability and the Right to Use asset will be based upon the discounted present value of the defined lease payment stream. For most companies, surveys have indicated that property leases will be fewer in number but have a higher Lease Liability amount as compared to equipment leases because property lease payments are generally higher dollar amounts and the lease terms are generally longer. Given the fact that most companies will be particularly concerned about adding additional debt on the balance sheet in the form of Lease Liability, one obvious way to limit the impact is to structure the lease with the shortest possible lease term. Of course, the accounting ramifications cannot be the only factor to be considered in this evaluation. Overall business considerations might dictate that a particular location is so important that it must be “locked up” for an extended period, the tradeoff being greater indebtedness on the balance sheet.

The complexity of the provisions contained in the lease agreement should also be taken into consideration. Option periods, lease incentives and residual value guarantees, among other provisions, will be subject to greater scrutiny to determine whether the lessee has a “significant economic incentive” to exercise these provisions.

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Property Leases

If so, the payments attributable to these provisions may have to be included in the payment stream that is used in the calculation of the initial measurement of the Lease Liability and the Right to Use asset. Variable lease payments will also be subject to greater scrutiny. Variable payments based upon performance or usages are not included in the initial discounted payment stream and would be accounted for as they are now (recognized when the obligation is incurred). However, variable payments based upon an index or rate would be included in the initial discounted payment stream and the payment stream would be subject to reassessment at every reporting period that the index or rate changes (a particularly burdensome requirement generating a completely new calculation). Based upon these factors alone, one would choose a simpler, less complex set of lease provisions. But, once again, business considerations might have to override accounting considerations. Having said that, given the potential for earnings fluctuation and a significant administrative burden, I would be reluctant to include index or rate based variable payment provisions in future lease transactions.

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Equipment Leases

Equipment leases represent a particular challenge in the implementation of the proposed standard. Surveys have indicated that equipment leases will generally be greater in number than property leases but will have a significantly lower dollar value. Therefore, given the fact that each contract must be evaluated separately, the cost benefit of the time and expense related to tracking all of this detail will be much lower than with property leases. Equipment lessees must be prepared administratively to deal with this burden. First and foremost, it may be challenging to determine whether the particular contract which has been executed falls within the scope of the proposed standard. • Is there a specific asset identified in the contract? • Does the supplier have the right to substitute the asset for

another similar asset? • Does the customer have the right to control and direct the use

of the asset during the term of the agreement or does the supplier retain a certain element of control?

• Is the contract based upon the partial usage or capacity of an asset?

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Equipment Leases

If there is not a specific asset, or the supplier has the right of substitution or the supplier retains some control over the asset or the customer does not have complete usage of the asset, then the contract may well not fit within the scope of the proposed standard. Therefore, the accounting treatment for these types of arrangements may not change. If it is determined that the contract does fall within the scope of the proposed standard and is a lease for accounting purposes, then the lessee must determine whether there are non-lease components within the contract and consider how those non-lease components should be accounted for.

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Income Statement Considerations

The objective of the Boards’ Joint Project was convergence on lease accounting, namely, an international standard for lease accounting applicable to all business entities. And the Boards have achieved the major guiding principle of the Joint Project – virtually all lease obligations must be recognized on the balance sheet of the lessee. However, there has been disagreement on some other aspects of the Joint Project that will make implementation particularly difficult, especially for those business entities that must comply with both US GAAP and IFRS. Most importantly, the Boards have agreed to disagree on the pattern of expense recognition in the income statement. The IASB is proposing only one accounting model for all leases resulting in accelerated expense recognition with the expense being recognized in two line items – interest expense and amortization expense. The FASB, however, will retain the distinction of Type A and Type a B lease that was originally proposed by the Boards in 2013. The FASB approach would use principles similar to what is now being used for operating and financing leases under current US GAAP. The FASB model would result in most leases having expense being recognized on a straight- line basis with the straight line expense being classified as lease expense.

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Industry Considerations

It is clear that all industries will be affected by the lease accounting changes being proposed but certain industries will be impacted more than others because of their relatively greater dependence on or preference for lease financing. Three industries that immediately come to mind are Banking, General Retail and Airlines.

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For Banks and Other Financial Institutions, increases in non-earning assets and indebtedness are a drag on financial performance and something to be avoided if possible. Therefore, it is preferable to enter into operating leases for equipment and particularly branch bank and ATM locations since these obligations can currently be accounted for “off balance sheet”. Requiring that these non-earning assets and indebtedness be recognized “on balance sheet” will decrease critical capital ratios at a time when many Financial Institutions are struggling with capital adequacy issues and regulatory bodies are poised to increase these capital requirements. The accounting change may have banks think twice before adding or renewing leases on branch facilities that are not performing at acceptable levels or may drive a smaller leasehold footprint (less space equals smaller lease expense equals smaller Lease Liability). Additionally, in their role as lenders, banks will face numerous instances where debt covenant violations will occur in commercial loan customer accounts, as the covenants relate to debt to equity, debt to assets or debt service coverage ratios. Should a waiver to these violations be provided? Or is there a need to scrutinize the credit more closely? This is just another byproduct of the proposed standard that must be addressed.

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For retailers such as CVS, Walgreens, Target and the other major retail chains, the effort to adopt the new lease accounting requirements for store locations currently under operating leases will be a major undertaking and will add significant new indebtedness. Most of these companies have the financial strength and accounting resources to deal with these issues. But many of the midsized and smaller retailers that have relatively significant lease obligations will not have that type of financial flexibility and resources.

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Companies such as this will have a major undertaking to transition to the new accounting requirements. They will also see a major deterioration in their debt to equity and debt service coverage ratios. To the extent that these companies have debt covenants that will be negatively impacted, it will be important to identify these issues early on. Then initiate discussions with banking relationships so that the banks can understand that, while the accounting has changed, the basic economics driving the business has not changed.

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Equipment leasing is an important financing strategy for the airline industry. Airplanes, jet ways, trucks and tow equipment are commonly leased by airlines, both small and large. Here, the issue of lease versus purchase may become a much more critical decision. If an asset and debt are going to be recognized on the balance sheet whether in a lease or a purchase, might it be more advantageous to purchase the equipment outright? This is an analysis that should certainly be performed and carefully considered. But in an industry such as the airline and other thinly capitalized industries where earnings and cash flow issues are challenging, the ability to purchase may not be financially feasible and leasing may be the only viable option.

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Early identification and planning will be crucial

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The FASB and IASB (“the Boards”) first formally proposed changes to lease accounting in 2010 and they have struggled with the negative reaction from various industry groups and other interested parties. The initial proposal has been modified to eliminate some of the earlier more complex provisions; however, reaction from financial statement preparers continues to be unenthusiastic. On the other hand, most financial analysts and other financial regulators, such as the Securities and Exchange Commission, support the proposed change because it contributes to financial statement transparency and puts “on balance sheet” a major obligation that is now accounted for “off balance sheet”. Where do we go from here?

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It is clear that lease obligations will eventually be recognized “on balance sheet” in the financial statements with the possible exception for short-term leases of terms not exceeding twelve months (including option periods). Lessees will have to face adoption of a new accounting model which will be challenging to implement. The current model is very prescriptive with bright line tests as to classification and balance sheet recognition. The new model will be more principles based with limited specific guidance to assist in the adoption. Subjective terms such as “significant economic incentive”, “major part of remaining economic life” and “insignificant in relation to fair value” will be left to the financial statements preparers and their advisors to sort through. What financial statement preparers should do at this point is monitor the final deliberations of the Boards over the next few months. Remember that all decisions made to date are tentative and can change. A final standard is expected to be issued in the second half of 2015. Preparation and planning will also be critically important.

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• Start early to identify what contracts will fall under the new standard and collect all of the relevant documentation supporting the arrangements.

• Remember that much of this documentation may be resident in various departments or divisions within the organization – it may be time consuming to collect a complete inventory.

• Consider whether it is worthwhile to have the overall lease administration function centralized in one location.

• Carefully evaluate the tools, particularly the technology tools, which may be required to capture and track the relevant leasing documentation and perform the required calculations.

• Prepare for the additional administrative burden that will be involved in the adoption and ongoing compliance with the new standard.

• Remember that the proposed standard does not provide for grandfathering of existing leases at the time of adoption. Leases that are being executed now may well have to be transitioned into the new accounting model.

Among other things, consider the following:

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Sean T. Egan, Managing Partner of iLease Management LLC, has been following and reporting on the FASB and IASB Lease Accounting Changes since 2010. Sean is responsible for the overall corporate governance and strategy of iLease Management LLC. Sean retired from the accounting and advisory firm of KPMG LLP in 2008 after having spent 35 years with the Firm. Among his responsibilities while at KPMG were Managing Partner of the Hartford, Connecticut office and Partner in Charge of the Firm’s Northeast Real Estate Practice. His client responsibilities were focused in the financial services area and his clients included numerous national and regional banking and real estate firms. From 2008 until 2010, Sean was Senior Vice President of a major technology company where he had overall responsibility for two of the company’s technology solutions for real estate managers and commercial and residential lenders. He holds a BA degree from Fordham College and he is a CPA.

About the Author

Contact Sean T. Egan

Managing Partner Tel: + 1 860 558 3294

[email protected]

An up-to-date summary and additional articles on the FASB and IASB Lease Accounting Changes can be found at: http://blog.iLeasePro.com

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About iLease Management LLC iLease Management LLC (iLease) was formed in 2012 and is a technology provider of a Lease Management and Lease Accounting Compliance solution, iLeasePro™. Our focus is on the global real estate and equipment lessee community. The iLeasePro solution offers enterprise or mid-sized firms comprehensive and portfolio level Lease Management and Lease Analysis features developed to reduce costs, mitigate risks and address the on-going compliance requirements of the proposed changes to lease accounting standards. iLeasePro™ is a scalable, cloud-based solution that firms will use throughout the entire lease lifecycle. Whether leases are currently on spreadsheets or in a solution, iLeasePro’s intuitive functionality allows companies to seamlessly transition its current lease operations from a single threaded process into a fully centralized and consolidated approach without having to realign its resources. iLease has leveraged its unique combination of practical experience, industry acumen, best practices, and in-depth knowledge of the changes to lease accounting standards proposed by the FASB and the IASB to produce publications explaining the technical and business issues that executive teams should be considering as they prepare for these changes. Learn more about iLease Management LLC and iLeasePro™ at http://www.iLeasePro.com or http://blog.iLeasePro.com. You can also follow iLease Management LLC on LinkedIn or on Facebook.

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