Lease Accounting Deep Dive Staying ahead of the … › Orange County › IIA OC...What’s in and what’s out? Introducing the new standard Applies to leases of property, plant,

Lease Accounting Deep DiveStaying ahead of the risks

2 Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Summary

Summer TaylorAudit Managing [email protected]

Summer is a managing director in the Consumer Products, Retail & Distribution Practice where sheprovides auditing, financial reporting, accounting and consulting services to publicly traded and privatelyheld companies. She has 19+ years of direct experience assisting clients navigate the complexities inU.S. GAAP, SEC reporting and IPO's, public debt offerings, and private equity transactions. Summer isalso IFRS accredited.

Summer also leads our Accounting & Reporting Advisory services in Orange County, which helpscompanies implement accounting & reporting standards. In addition, she is a Master Facilitator forDeloitte's award winning Learning Group where she assists professionals learning to present andfacilitate, helping them gain confidence and executive presence.

As an award winning CalCPA Education Foundation instructor, Summer offers a wide range of programs,workshops, and classes designed to help CPA's achieve the highest level of quality by helpingparticipants understand and apply complex accounting and auditing guidance in a practical and fun way.

Overview of ASC 842 LeaseRequirements


Key takeaways:

The “Big Picture”

Most leases on balance sheet for lessees

Classification will drive expense profile

Lessor model largely unchangedMost changes result from alignment with ASC 606

FASB tried to make things easy

Classification, reassessment, transition

Effective 2020 for private entities but don’t wait to assess impact

Process and systems changes may be requiredPotential impact on debt covenants


Effective date• Public business entities — effective for calendar periods beginning after December 15,

2018 and interim periods therein• All other entities — effective for calendar periods beginning on January 1, 2020, and

interim periods thereafter• Early adoption will be permitted

• Lessees and lessors may use either:• a modified retrospective transition method for all existing leases• a cumulative-effect adjustment method for all existing leases

• Would apply the new model for the earliest year presented in the financial statements• Application of approach linked to current lease classification and new lease classification• An entity can use hindsight when evaluating lease term

Effective date and transition

Transition

TRANSITION RELIEF PACKAGELessees and lessors are not required to reassess the following upon transition:ü Whether any expired or existing contracts are leases or contain leasesü The lease classification for any expired or existing leasesü Initial direct costs for any existing leases

Identifying a Lease


Scope

What’s in and what’s out?

Introducing the new standard

Applies to leases of property, plant, or equipment

Does not apply to:q Leases of intangible assets

q Leases to explore for or use nonregenerative resources

q Leases of biological assets

q Leases of inventory

q Leases of assets under construction


A lease is a contract, or part of a contract, that conveys the rightto control the use of identified property, plant, or equipment for

a period of time in exchange for consideration

Consideration

Lessor LesseeControl the use of an

identified asset

What does the new definition look like?

Definition of a lease


For a contract tobe, or contain, a

lease it must

Depend on theuse of an

identified asset,and

Convey theright to control

the use

Right to obtainsubstantially all of the

economic benefits fromasset use

Right to obtainsubstantially all of the

economic benefits fromasset use

Right to direct the useof the asset over lease

term

Right to direct the useof the asset over lease

term

and

Definition of a lease


Understanding the criteria

Contract must depend on use of identified asset• Asset must be explicitly or implicitly identified• Physically distinct portion of a larger asset may be an identified asset• Capacity portion of a larger asset is generally not an identified asset

Right of substitution• Would result in the asset not being deemed a specified asset• Substitution would be considered substantive if . . .

o Lessor has the practical ability to substitute the asseto Lessor would benefit from exercising its right of substitution

Warranty or upgrade considerations• Supplier’s right or obligation to substitute an alternative asset due to

operational failure does not mean the asset is not an identified asset• Supplier’s right or obligation to upgrade the asset similarly does not mean the

asset is not an identified asset

Identified asset


IDENTIFIED ASSET— FACTSCompany A enters into a three-year contract with Vendor B, awarehouse operator, to store up to 1,000 pallets of overflowinventory• Vendor B’s warehouse has capacity to store up to 10,000 pallets of

inventory• During the contract period, Vendor B can use the remaining space in

its warehouse for other storage needs

Illustrative example

Identified asset

• Vendor B can relocate Company A’spallets within the warehouse any timewithout incurring significant costs.

• Vendor B only owns one warehouse


IDENTIFIED ASSET— ANALYSISArrangement does not contain an identified asset• Company A does not have exclusive use of a specified portion of the

warehouse• Portion being used is not substantially all of the warehouse capacity,

there is no identified asset• Although the contract specifies the number of pallets that will be

held, Vendor B can change the inventory’s location within itswarehouse at any time

Illustrative example (cont’d)

Identified asset

Would the answer change if thewarehouse only has a capacity

to hold 1,100 pallets?


Benefits related to the ownership of an asset should not be included in theassessment of whether an arrangement contains a lease

Can obtain economic benefits from the use of an assetdirectly or indirectly in many ways

Economic benefits from the use of an asset includeits primary output and by-products, includingpotential cash flows derived from these items

RIGHT TO OBTAIN SUBSTANTIALLY ALL OF THE ECONOMIC BENEFITS FROM USE

Obtain substantially all of the economic benefits from use

Right to control the use


Protective rights, while defining the scope of the asset use, generally do not, inisolation, prevent the customer from being able to direct the use of the asset

• Right to direct “how and for what purpose” asset is usedthroughout the period of use; or

• Relevant decisions about “how and for what purpose” asset isused are predetermined before the period of use, andü Customer has the right to operate asset without supplier having

the right to change operating instructions; orü Customer designed the asset in a way that predetermines the

most relevant decisions about how and for what purpose the assetwill be used during the period of use

RIGHT TO DIRECT THE USE OF THE ASSET


Right to direct the use


CONTRACT FOR THE USE OF A TRUCK— FACTSCustomer A enters into a contract with Supplier B for the use of aspecific truck for a two-year period• Supplier B is not permitted to substitute the truck during the contract term• Customer A decides whether and what cargo will be transported and when

and to which cities the truck will deliver to during the contract period• During the lease term, Customer A is required to provide a properly licensed

driver and is responsible for the safe delivery of the cargo that is carried



• Certain restrictions prohibit Customer A’sdrivers from using the truck beyond themaximum hours permitted by law or fromcarrying hazardous materials as cargo

• During the contract period, Supplier B isrequired to maintain the truck


CONTRACT FOR THE USE OF A TRUCK — ANALYSISIn this scenario, A has the right to control the use of thetruck throughout the two-year contract period• Customer A has the right to obtain substantially all of the economic benefits

from the use of the truck during the contract period through its exclusive useof the truck

• Customer A has the right to direct activities related to the use of the truckbecause it decides where and when the truck will travel, what cargo it willcarry, or whether it will be transporting cargoat any given time

• While there are contractual restrictions aboutwhen the truck can be driven and what cargocan be transported, these are protectiverights and do not prevent Customer A fromhaving the right to direct the use of the asset

Illustrative example (cont’d)



Key ingredients of theleases model


Lease would be classified as a finance lease (lessee) or a sales-typelease (lessor) when . . .ü Lease transfers ownership of the underlying asset to lessee by the end of the lease

termü Lease grants the lessee an option to purchase the underlying asset that the lessee is

reasonably certain to exerciseü Lease term is for a major part of the remaining economic life of the underlying assetü Present value of the lease payments and any residual value guaranteed by the

lessee equals or exceeds substantially all of the fair value of the underlying assetü Leased asset is so specialized in nature that it is expected to have no alternative use

to the lessor at the end of the lease term

Overview of the criteria

Lease classification

CLASSIFICATION CRITERIA

The standard states that the bright-line thresholds that exist under ASC 840 could be areasonable approach to evaluate whether a lease would be classified as a finance lease


Initial determination and reassessment

Lease term

LEASE TERMNoncancelable period, plus…ü Renewal options that are reasonably certain to be exercised by a lesseeü Termination options that are reasonably certain not to be exercised by a lesseeü Options to extend (or not to terminate) that are controlled by the lessor

REASSESSMENT REQUIREMENTSLessees are required to reassess lease term whenü A significant event or change in circumstances occurs that is in the control of the

lesseeü A contract term obliges the lessee to exercise (or not exercise) a renewal or

termination optionü Lessee elects to exercise or not exercise a renewal or termination option that was

not previously deemed reasonably certain of being or not being exercisedü Would reassess when there is a modification that does not result in a separate

contractLessors would not be required to reassess lease term, unless there is amodification that does not result in a separate contract


What amounts are included in lease payments?

Lease payments

• Payments specified in the lease agreement

• In-substance fixed paymentsFixed leasepayments

• Payments that depend on an index or a rate• Excludes payments based on usage or performance• Reassessment required under certain circumstances

Variablepayments

• Lessees — amount that it is probable will be owed underthe RVG at the end of the lease term

• Lessors — the full amount at which the residual asset isguaranteed by the lessee or third party

Residualvalue

guarantees

• Treated in a manner consistent with the accounting forrenewal options

• Include options that a lessee is reasonably certain toexercise

Purchase andtermination

options


Overview of the coreaccounting models


What does the lessee model look like?

Lessee accounting model

InitialMeasurement

Most* leases are recorded on the balance sheet using a right-of-useasset approach:

SubsequentMeasurement

• Lease obligation — PV of lease payments not yet paid• ROU asset — lease obligation + initial direct costs –

lease incentives + prepaid lease payments

• Lease obligation — amortized using the effectiveinterest method

• ROU asset — depends upon lease classification• Expense recognition pattern:

o Finance lease — front-loadedo Operating lease — generally straight-line

Short-term leases: A lessee can elect, by asset class, not to record on its balancesheet a lease with a lease term of 12 months or less and which does not include apurchase option that the lessee is reasonably certain to exercise

*



Lessee accounting model

Finance lease Operating lease

This table highlights the differences in accounting for the lease under the finance lease and operating lease models:


Journal Entries

24

Financing LeaseYear one:

Dr. Interest Expense $3,038Dr. Lease Liability 6,962

Cr. Cash $10,000

Dr. Amortization Expense $12,666Cr. ROU Asset $12,666

Initial Entry:Dr. Right of Use Asset $38,000

Cr. Lease Liability $38,000

Operating LeaseYear one:

Dr. Lease Expense $15,000 (*)Dr. Lease Liability 6,962

Cr. ROU Asset $11,962Cr. Cash 10,000

(*) Interest of $3,038 plus ROUamortization of $11,962= annualStraight line Expense of $15,000


What does the lessor model look like?

Lessor accounting model

• Existing lessor accounting retained with minimal changes• Classification depends on an assessment of control of the underlying

assetSales-type Direct financing Operating

• Lessee gains control ofthe underlying asset

• Underlying asset isderecognized

• Net investment in a lease isrecognized

• Selling profit or lossrecognized at leasecommencement

• Initial direct costsrecognized at leasecommencement unless noselling profit or loss

• Lessee does not obtaincontrol of the asset, butthe lessor relinquishescontrol

• Underlying asset isderecognized

• Net investment in a lease isrecognized

• Profit deferred andamortized into income overthe lease term

• Initial direct costs deferredand amortized into incomeover the lease term

• Lessor retains control ofthe underlying asset

• Underlying asset remainson the lessor’s balancesheet

• Income recognized on astraight-line basis unlessanother systematic basis ismore appropriate

• Initial direct costs deferredand expensed over thelease term in a mannerconsistent with income


ROU assetLease liability

AmortizationexpenseInterestexpense

Principal(Financing)

Interest(Operating)

ROU assetLease liability

Lease expense(single line onstraight-line

basis)

Leasepayments

(Operating)

Balance Sheet Income Statement Cash Flow Statement

FinancingLease

OperatingLease

Presentation requirements

Lessee model

Presentation consistent with current lessor model:• Balance sheet — presentation depends on lease classification• Income statement — profit or loss recognized in a manner consistent with business model• Cash flow statement — recognized as cash inflows from operating activities

Lessor model


Disclosure requirements

DISCLOSURE OBJECTIVEEnable financial statement users to assess the amount, timing, and uncertainty

of cash flows arising from leases

LESSEE DISCLOSURESq Nature of its leasesq Information about leases that have not

yet commencedq Related-party lease transactionsq Accounting policy election regarding

short-term leasesq Finance and operating lease costsq Short-term and variable lease costsq Sublease incomeq Gain or loss from sale-and-leasebackq Maturity analysis for lease obligationsq Weighted-average remaining lease

termq Weighted-average discount rate

LESSOR DISCLOSURESq Nature of its leasesq Significant assumptions and

judgments usedq Related-party leases transactionsq Tabular disclosure of lease-related

incomeq Components of the net investment in

a leaseq Information on the management of

risk associated with residual assetq Maturity analysis of operating lease

payments and lease receivableq Information required by ASC 360


Tax implications ofASC 842


Lease characterization for federal income taxpurposes has not changed (e.g., true lease vs. sale) as aresult of Topic 842. For tax, the focus remains on whichparty bears the benefits and burdens of ownership.

Topic 842 will create book/tax differences consistent withcurrent GAAP. However, since the new standard may resultin the recognition of more assets and liabilities, ASC 842may require entities to record new or adjust existingDTAs and DTLs.

Overview of income tax implications from ASC 842

Topic 842 may also impact the computation of stateand local income-based taxes as a result of changes tothe apportionment formula.

Topic 842 does not contain tax accounting guidanceand only includes minor, conforming amendments to ASCTopic 740, “Accounting for Income Taxes”, that do notchange the basic requirements of current accounting.

Implementationconsiderations for ASC 842


Application of Judgment and Estimation

• Judgment is often required in the assessment of a lease’s term, which would impact whether thelease qualifies for the short-term exemption and therefore for off-balance-sheet treatment

• Since almost all leases will be recognized on the balance sheet, an entity’s judgment indistinguishing between leases and services becomes more critical under the new guidance

• Lease classification without bright line classification tests• Determining whether the customer has the right or not to direct the use of the identified asset

Potential operational challengesThe following are examples of additional challenges you may experience:

Internal Controls and Business Process Environment

• With increased relevance of leasing to the financial statements, entities may face additionalscrutiny from auditors and regulators regarding the design and effectiveness of associatedcontrols under Sarbanes-Oxley

• Entities may consider examining internal controls related to their processes for capturing,calculating, and accounting for their leases

• Entities may also need to issue organizational communications and establish change managementand employee training programs


Debt Covenants

• Careful examination of the effects of increased leverage and potential debt covenant violationswill likely be required

• This may depend in part on how various debt agreements define and limit indebtedness, as wellas on whether the debt agreements use “frozen GAAP“ covenants.

• ASC 842 requires entities to present operating lease liabilities outside of traditional debt, whichmay provide relief to some entities. Nevertheless, it is recommended entities determine ASC842’s potential effects on debt covenants.

Income Taxes

• Potential tax implications are situational requiring involvement of entities’ tax department

Potential operational challenges (cont’d)


Typical initial stepsThe following summarizes several of the key steps that companies may considerperforming in the near term to achieve the desired future state.

We recommend forming across-functional project teamand begin to determine amethod by which you willinventory, organize and gatherdata from lease contracts

Understand the accountingrequirements

Understand the lease population

Assess capabilities of existingtechnology

Perform a data gap analysis

Develop an implementation roadmap

Establish project leadership,milestones, governance andresource requirements

The new revenue standard—a consumer business perspectiveCopyright © 2016 Deloitte Development LLC. All rights reserved. 34

Deloitte Tool Suite

The new revenue recognition standard—How ready are you?Copyright © 2017 Deloitte Development LLC. All rights reserved. 35

A variety of technologies are available

Abstractionsoftware

LeaseController

• Software that automates theprocess of reading and extractingcritical data from documents andcontracts

• Combines machine learningalgorithm with human knowledge(contract provisions “trained” byDeloitte domain specialists)

• Increases productivity and deliveryspeed making it faster, easier, andcheaper to abstract required leasedata

AMERICAS

EMEA

ASIAPACIFIC

• The lease tool is focused primarilyon the new lease accountingstandard

• The lease tool comes bundled withDeloitte services

• Flexible and customizable for allindustries

• Covers all types of leases (e.g.,drilling rigs, equipment, vehicles,real estates, etc.)

• Use the lease tool for reportingunder current and future rules

Need help analyzingand abstracting lease

contracts?

Need a solution for leaseaccounting calculations to

facilitate ASC 842 adoption?

These technology accelerators and solutions may be customized to meet your specific lease accounting andlease administration needs.

.


Questions?


Thank you!

This presentation contains general information only and Deloitte is not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. Thispresentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any actionthat may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this presentation.

About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of memberfirms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as“Deloitte Global”) does not provide services to clients. Please see www.deloitte.com/about for a detailed description of DTTL and its member firms.Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may notbe available to attest clients under the rules and regulations of public accounting.

Copyright © 2016 Deloitte Development LLC. All rights reserved.36 USC 220506Member of Deloitte Touche Tohmatsu Limited

Documents

Lease Accounting Deep Dive Staying ahead of the … › Orange County › IIA OC...What’s in and what’s out? Introducing the new standard Applies to leases of property, plant,