MHM Executive Education SeriesOverview of the Proposed Changes for

Lease Accounting

September 27, 2011

About the PresentersJames Comito, CPA• Shareholder• Subject Matter Expert for Mayer Hoffman McCann P.C.’s

Professional Standards Group• Big Four experience

Mike Loritz, CPA• Shareholder• Subject Matter Expert for Mayer Hoffman McCann P.C.’s

Professional Standards Group• Big Four experience

About the PresentersTim Woods, CPA• Shareholder• Subject Matter Expert for Mayer Hoffman McCann P.C.’s

Professional Standards Group• Big Four experience

Hal Hunt, CPA• Shareholder• Subject Matter Expert for Mayer Hoffman McCann P.C.’s

Professional Standards Group• Local Attest Practice Leader: Kansas City office

Agenda• Background: Exposure Draft on Leases• Scope: What is a lease?• Critical Terms• Lessee Accounting• Lessor Accounting• Presentation and disclosure• Business implications• Q & A

Background of the Lease Project (Joint Project)• Part of joint FASB/IASB Convergence Project• Lease Project addressing shortfalls in the current model

(SFAS 13, Issued November 1976)• Objective: record lease contracts on balance sheets• Accounting for leases to address perspectives of lessees

and lessors• Lessee Model: “right-of-use” asset and “obligation to pay

rent” liability• Lessor Model: receivable for PV of lease payments and

residual asset and potential upfront profit recognition• Will be applied to all leases (limited exceptions)

Background of the Lease Project (Joint Project)

“One of my main goals in life is to one day fly on an airplane that actually appears on the balance sheet of an airline.”

Quote by Sir David Tweedie, IASB Chair

Background of the Lease Project (Joint Project)• Original Exposure Draft was issued in August 2010

and comment period ended December 2010• Received > 750 comment letters on the Exposure

Draft• Joint Roundtable Meetings held throughout the year• Re-deliberations and tentative conclusions reached in

July and August 2011—discussions are expected to conclude in Fall 2011

• New Exposure Draft expected 4th Quarter 2011• Final Standard expected to be issued Mid/Late

2012• Effective Date expected to be no sooner than 2015

Background of the Lease Project (Joint Project)Key Re-deliberation Issues:• Scope (leases of inventory or of internal-use software)• Definition of a lease• Measurement (both initial & subsequent)• Accounting for:

– modifications & extinguishments– subleases– leasehold improvements– lease incentives– sale/leaseback– build-to-suit

Background of the Lease Project (Joint Project)Significant Open Topics:

• Transition and Effective Date

• Lessor Presentation and Disclosure

Background of the Lease Project (Joint Project)

WARNING – MATERIAL SUBJECT TO CHANGE

Today’s presentation will focus on the tentative decisions reached during July and August 2011.

The Boards’ decisions are subject to change--they will have to deal with another round of comments made during re-

exposure.

Background of the Lease Project (Joint Project)Lessee Perspective

Current GAAPOperating Lease

Current GAAPCapital Lease

ProposalAll Leases

Balance Sheet •Straight-line rent adjustments

•Leased Asset•Liability

•Right of Use Asset•Liability

Income Statement •Rent Expense •Depreciation•Interest Expense

•Amortization•Interest Expense

Statement of Cash Flows

•Operating Activity •Financing Activity •Financing Activity

Background of the Lease Project (Joint Project)Lessor Perspective

Current GAAPOperating Lease

Current GAAPCapital Lease

ProposalAll Leases

Balance Sheet •Property & Equipment held for leasing•Straight-line rent adjustments

•Receivable (PV of lease payments)•Residual Value(Derecognize underlying asset)

•Receivable (PV of lease payments)•Residual Value(Derecognize underlying asset)

Income Statement •Rent Income•Depreciation

•Interest Income•Potential upfront profit

•Interest Income•Potential upfront profit

Statement of Cash Flows

•Operating Activity •Financing Activity •Financing Activity

ScopeA lease is a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration requires two components.

1. Fulfillment of the contract depends on providing a specified asset

2. Contract conveys the right to control the use of a specified asset for an agreed upon period of time

Scope – Specific AssetIn order for a transaction to qualify as a lease, the fulfillment of the contract must be dependent on a specified asset. The asset can be either explicitly or implicitly identified and performance is dependent on the specified asset .

An asset is “Implicitly Specified” if it meets one of the following:– Infeasible or impractical for a lessor to provide alternative assets in

place of the underlying asset during the lease term, or– A lessor can substitute another asset for the underlying asset but rarely

does so in practice.

Scope - Right to Control• A contract conveys the right to control the use of an

underlying asset if the Reporting Entity has the ability to direct the use of, and receive substantially all of the potential economic benefits from the asset throughout the term of the arrangement.

• The boards tentatively revised the definition of control to conform to guidance in the proposed revenue recognition standard – Focus on inseparable service criteria (asset and service component)– Original ED evaluated control based on possession and rights to an

assets outputs during the lease term

Scope - Right to ControlThe Boards agreed to provide indicators in the final standard to assist in the determination of whether the Reporting Entity has the right to control an asset. These indicators, to be considered together and not in isolation, include:1. Physical access: The customer is able to control physical

access to the specified asset.2. Customization: The asset is customer-specific and the

customer is involved in its design.3. Controlling benefits: The customer controls the right to obtain

substantially all of the benefits from the asset during the contract term.

Scope Other Scope Changes:• The definition of a lease would be changed to exclude a right of

use asset (explicit or implicit) that is inseparable from the provisions of a service– Previously included in the scope of the original ED

• Leases of intangible assets other than right to use assets are not required to be accounted for under the leases standard – Previously excluded from the scope in the original ED

• A substantial modification to the contractual terms of a contract result in the modified contract being accounted for as a new contract– Previously unaddressed in the ED

Lease Project Scope Exceptions

1. Leases involving intangible assets (other than right to use)2. Leases to explore for, or use minerals, oil, natural gas and

similar non-regenerative resources (with the exception of long term leases for land)

3. Leases of biological assets4. Contracts that are purchases/sales of underlying asset5. Board to research status of internal use software and

inventory leases.6. Board to research status of leasee involvement with asset

construction.

Lease Project - Critical Terms

• Lease Term • Lease Payments • Discount Rate • Inception/Commencement Date • Lease Incentives

Lessee Accounting

General Principle: All leases are recognized on the lessee’s balance sheet!

• Lessee will recognize a right-of-use asset representing the lessee’s right to use the leased asset.– Amount of the liability to make lease payments, plus any

initial direct costs incurred by the lessee.

• Lessee will recognize a liability for its obligation to make lease payments.

Lessee Accounting• Initial measurement and recognition of the right to use

asset and liability at the present value of the lease payments to be made over the lease term (excluding indirect costs)

• The right to use asset will be amortized (most likely straight line) and the liability will be measured using the effective interest rate method.– The different models have been an issue of concern expressed in

many comment letters.– Generally results in front loading of expense as compared to

previous model (interest expense)

Lessee accounting - Lease Term

Recognized lease term would be the non-cancellable period plus any optional periods for which a significant economic incentive to exercise an option to extend the lease, or to terminate the lease. A. Identify each possible lease term taking into account the effect of

any options to extend or terminate the leaseB. The following should be considered:

• Contractual factors • Non-contractual factors • Business factors • Other lessee-specific factors, including leasee intentions and

past practice.

Lessee accounting - Lease Term

• Lease term is reassessed if economic factors affecting the decisions to extend or terminate change significantly – Consider same factors as considered at lease assessment– Lease term reassessments result in changes in total estimated

payments• Discount rate is revised as of date of reassessment• Adjust the right-to-use asset and liability

• Original ED required reassessment if facts and circumstances indicated a significant change in the liability

• Purchase options (non-bargain purchase) are only accounted for when they are exercised.

Lessee Accounting - Short-term leases

For leases with a maximum possible term (including all extension options) of 12 months or less, a lessee will be permitted to account for short-term leases in a manner consistent with the current requirements for operating leases.– Election is available based on class of underlying asset (previously a

lease-by-lease basis).– Disclosure requirements include rental expense incurred under short-

term leases and the existence of any circumstances in which such lease practices could change in the next reporting period

– Significant implementation Issues for month-to-month leases.– Additional complexity if the month-to-month lease is a related party

lease.

Lessee Accounting – Lease Term

Practice Pointer - Entities assessment of the lease term takes into account the effect of any options to renew/extend or terminate the lease and considers significant economic incentives to renew/extend.

Lease Term ExampleAn equipment lease has a 6 month term with two 6 month renewal options. The lessee concludes that the lease term is 6 months because there is not a significant economic incentive to renew.

Is this a short-term lease?

Lease Term ExampleAn equipment lease has a 6 month term with two 6 month renewal options. The lessee concludes that the lease term is 6 months because there is not a significant economic incentive to renew.

Yes, it is a short term lease.How could the answer change?

Lease Term ExampleSome examples of significant economic incentives that might impact the lease term:

1.periods containing bargain renewal options2.periods where a penalty is avoided, such as loss

of leasehold improvements3.periods containing a bargain purchase option.

Lease Payments

The present value of any contractual lease payments plus any variable lease payments.

– Variable lease payments based on an index or rate– Residual value guarantees

• Difference between Residual Value Guarantees (RVG) and expected residual value

– Termination penalty requirements• If expected to be incurred (i.e. significant economic disincentive

does not exist)– Purchase options

• Included if significant economic incentive exists. • Useful life would be the estimated life of the asset (not lease

term)

Variable or Uncertain Lease Payments • Original ED required that variable or uncertain lease

payments, including those based on an index or rate, would be included in the determination of the right to use asset as well as the liability – Determined using a probability weighted expected outcomes

technique– Re-measurement was required if facts and circumstances

indicated a significant change in the lease liability– Included guidance on the use of an index or other rate

Variable or Uncertain Lease Payments The Boards tentatively decided that the following variable lease payments should be included in the measurement of lease obligations and assets:

– All contingencies that are based on a rate or an index (must be reassessed each reporting period)

– Any contingency that is a "disguised" minimum lease payment (i.e., an anti-abuse provision to include lease payments for which the variability lacks economic substance and the payments are reasonably certain)

– Any portion of residual value guarantees that are expected to be paidAll other variable or uncertain lease payments are excluded from

the measurement of the right to use asset and liability (recognized when incurred)!

Variable or Uncertain Lease Payments • The boards tentatively decided that any contingent

amounts would be included using a best estimate approach rather than the probability-weighted approach proposed in the original Exposure Draft.

• Variable lease payments that are usage or performance-based (e.g., based on tenant sales) would not be included in measuring the lease asset and liability unless the variable lease payments are "disguised" or in-substance fixed lease payments

Lessee Accounting - Discount RateThe discount rate used by the lessee to determine the present value of lease payments is either:

A. The lessee‘s incremental borrowing rate, or B. The rate that the lessor charges the lessee (if it can be readily

determined).The discount rate that causes the sum of the present value of cash flows and the present value of the residual value of the underlying asset at the end of the lease to be equal to the fair value of the underlying asset, or some other appropriate approach.

Practice Pointer - The discount rate will need to be determined and evaluated for each lease.

Lessee Accounting – Other Issues

Inception Date• All initial measurements are based on information at

lease commencement (vs. lease inception date)• Payments before lease commencement are treated as

prepaid rentIncentives• All lease incentives received by the lessee are recorded

as a reduction of the lessee’s right-of-use asset

Lessee Accounting - Other Services

• How to separate a lease, service and other components Exposure Draft had distinguished between

distinct and non-distinct Tentative decision is to separate components

by lease and non-lease and account for separately

Non-lease components include both services and executory costs

Lessee Accounting - Other Services

• How are payments allocated? Lessee: based on relative purchase price of

individual components (if purchase price is observable)

If there are no observable purchase prices, all payments accounted for as a lease

Lessor: allocate in accordance with Revenue Recognition Project

Lessee Accounting – Initial Measurement

• Liability is measured initially at the present value of the lease payments.

• Right-of-use asset - Amount of the liability to make lease payments, plus any initial direct costs incurred by the lessee.

Lessee Accounting – Initial MeasurementReal Estate Lease Example: Lessee

• Company executes a real estate lease• Lease term: 10 year non-cancellable with 5 year

renewal option.• Annual lease payments:

– Year 1 to 5: $2 million per year– Year 6 to 10: $2.5 million per year– Year 11 to 15: $3 million per year

• Company’s incremental borrowing rate at commencement is 7 %. Rate lessor charges lessee is not known.

• No purchase option or residual value guarantee

Lessee Accounting – Initial MeasurementReal Estate Lease Example: Lessee

• Company concludes there is no significant economic incentive to exercise renewal option.

• Company records:– Right of use asset $15.5 million (debit)– Lease liability $15.5 million (credit)

(To record lease asset and liability at commencement date at PV of lease payments at lessee’ incremental borrowing rate of 7%.)

Lessee Accounting – Subsequent Measurement• Right-of-use asset - amortized over shorter of the lease term or

economic life of the leased asset and subject to impairment– Right-of-use asset adjusted for changes in liabilities resulting from

changes in the lease term or changes in uncertain lease payments related to future periods.

• Liability - Interest expense recognized using the interest method and lease payments reduce the liability.

• Reassess lease liability each reporting period if facts or circumstances indicate that there would be a significant change.– Re-measure the liability at present value of lease payments using revised

assumptions.– The discount rate is not revised unless contingent rents are based on

variable reference interest rates.– Changes in liabilities resulting from changes in uncertain lease

payments related to current or prior periods recognized in income

Lessee Accounting - Financial Statement Presentation

Balance Sheet Right-of-use assets presented within property, plant and equipment, separately from assets not leased.Liabilities presented separately from other financial liabilities.

Income statement Amortization and interest expense presented separately from

other amortization expense and other interest expense

Statement of cash flows Cash payments for leases would be classified as financing

activities and shown separately

Lessor AccountingOne Approach to Lessor Accounting.

The Boards agreed that lessors should account for leases using a "receivable and residual" approach (previously called the "derecognition" approach).

• Under this approach, a lessor would derecognize the underlying asset and record a lease receivable and residual asset.

• The lessor would allocate the carrying value of the underlying asset being leased between the portion related to the lessee's right-of-use asset and the portion retained by the lessor (the residual).

Lessor AccountingOne Approach to Lessor Accounting.

The approach allows for a lessor to recognize profit on the leased asset at lease commencement if it is "reasonably assured.”

Open Questions:How will reasonably assured profit assessment be

evaluated?Two approaches may be an incentive to “structure” a

desired result.

Lessor AccountingOne Approach to Lessor Accounting.

Profit would be recognized for the difference between the lease receivable recognized and the portion of the carrying amount of the underlying asset derecognized. – Residual Asset is subject to accretion to an amount

at the end of the lease term.When not "reasonably assured," the timing and recognition pattern of profit would extend over the life of the asset. The Boards will continue to develop application guidance on this new approach, including the assessment of "reasonably assured."

Presentation and Disclosure• General description of lease arrangements• Basis and terms on which contingent rentals are

determined• Existence and terms of options: renewal and

termination– Including options recognized as part of right-of-

use asset and those that were not• Existence and principal terms of any options to

purchase

Presentation and Disclosure• Information about assumptions and judgments

relating to amortization methods and any changes• Existence and terms of residual value guarantees• Initial direct costs incurred during the reporting

period and included in the right-of-use asset• Significant restrictions imposed by the lease• Information about significant leases that have not

commenced

Presentation and Disclosure• Nature and amount of significant subleases• A reconciliation of opening and closing balances,

disaggregated by class of underlying asset, which separately shows total cash lease payments for the period

• Maturity analysis of liabilities to make lease payments showing undiscounted cash flows for the first five years and total for remaining years

Business Implications• Critical Path to Implementation:

– Planning– identification of resources needed– data gathering and analysis– implementation for existing leases– handling of new or modified leases– monitoring

Business Implications

• Considerations for existing and future business decisions:– new leases– renewal of existing leases– modifications of existing leases– Required re-evaluation of lease agreements

resulting in revision

Business Implications• Determine impact on:

– financial statements: upon implementation and re-evaluation

– Comparability with historical financial statements and ratios

– loan covenants, compensation, regulatory and/or other agreements (e.g. cost plus contracts)

– Deferred income tax reporting

Questions???