MHM Executive Education Series
Overview of the Proposed Changes for
Lease Accounting
September 27, 2011
About the Presenters
James 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 Presenters
Tim 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 reexposure.
Background of the Lease Project (Joint Project)
Lessee Perspective
Current GAAP
Operating Lease
Balance Sheet
•Straight-line rent
adjustments
Income Statement •Rent Expense
Statement of
Cash Flows
Current GAAP
Capital Lease
Proposal
All Leases
•Leased Asset
•Liability
•Right of Use
Asset
•Liability
•Depreciation
•Interest Expense
•Amortization
•Interest Expense
•Operating Activity •Financing Activity •Financing Activity
Background of the Lease Project (Joint Project)
Lessor Perspective
Balance Sheet
Current GAAP
Operating Lease
Current GAAP
Capital Lease
Proposal
All Leases
•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)
•Interest Income
•Potential upfront
profit
•Interest Income
•Potential upfront
profit
Income Statement •Rent Income
•Depreciation
Statement of
Cash Flows
•Operating Activity •Financing Activity •Financing Activity
Scope
A 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 Asset
In 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 Control
The 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 assets
4. Contracts that are purchases/sales of underlying asset
5. 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 lease
B. 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 shortterm 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 Example
An 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 Example
An 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 Example
Some examples of significant economic
incentives that might impact the lease term:
1. periods containing bargain renewal options
2. periods where a penalty is avoided, such as loss
of leasehold improvements
3. 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
paid
All 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 performancebased (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 insubstance fixed lease payments
Lessee Accounting - Discount Rate
The 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 rent
Incentives
• 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 Measurement
Real 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 Measurement
Real 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 Accounting
One 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 Accounting
One 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 Accounting
One 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-ofuse 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???