Leases- The Winding Road Ahead

A Global Reach with a Local Perspective

University of North Alabama
19th Annual Decosimo Accounting Forum
July 22, 2011

www.decosimo.com

Leases – The Winding Road Ahead
A Review of Current and Proposed Lease Treatment

KEN CONNER, CPA
Principal

Objectives
 Review of current GAAP related to leases
 Case study on Capital versus Operating Leases
 Current Exposure Draft for Leases –
 What is the objective
 What are they proposing
 How will it work
 Examples of calculations

Leases – Current GAAP
 Capital leases meet one or more of the following
criteria:
 1) The lease conveys ownership to the lessee at the
end of the lease term.
 2) The lessee has an option to purchase the asset at
a bargain price at the end of the lease term.
 3) The term of the lease is 75% or more of the
economic life of the asset.
 4) The present value of the rents, using the lessee's
implicit or incremental borrowing rate, is 90% or more
of the fair market value of the asset.
 Operating leases - All other leases

 Lease term - The fixed noncancelable term of the
lease that does not include lessee options to renew
with financial obligation on the lessee to continue.
 Minimum lease payments - The minimum rental
payments called for by the lease over the lease term,
certain guarantees of residual value, penalties or
other payments for failure to renew or extend.

 Lessee’s incremental borrowing rate - The rate that, at the
inception of the lease, the lessee would have incurred to
borrow over a similar term the funds necessary to purchase
the leased asset.
 Interest rate implicit in the lease - The discount rate
that, when applied to (i) the minimum lease payments,
excluding that portion of the payments representing executory costs to be
paid by the lessor, together with any profit thereon, and (ii) the
unguaranteed residual value accruing to the benefit of the lessor,
causes the aggregate present value at the
beginning of the lease term to be equal to the
fair value of the leased property to the lessor at the inception of the lease,
minus any investment tax credit retained by the lessor and expected to be realized by
him.

Straight-Line Operating Leases
 Normally, rental on an operating lease shall be charged to
expense over the lease term as it becomes payable. If
rental payments are not made on a straight-line basis,
rental expense nevertheless shall be recognized on a
straight-line basis… unless
 Example –
 A ten year lease with payments of $10,000 per year for five
years and $12,000 per year for the second five years
 Straight line of 11,000 per year
 First year –
 Cash – ($10,000)
 Deferred Lease Liability – ($1,000)
 Lease Expense – $11,000

Current Disclosures
 For capital leases:
 The gross amount of assets recorded under capital leases.
 Future minimum lease payments as of the date of the
latest balance sheet presented, in the aggregate and for
each of the five succeeding fiscal years.
 Total contingent rentals actually incurred for each period
for which an income statement is presented.
 For operating leases having initial or remaining
noncancelable lease terms in excess of one year:
 Future minimum rental payments required in the aggregate
and for each of the five succeeding fiscal years.
 Rental expense for each period for which an income
statement is presented, with separate amounts for
minimum rentals, contingent rentals, and sublease rentals.

Current Disclosures
 A general description of the lessee‟s leasing
arrangements including, but not limited to, the
following:
 The basis on which contingent rental payments are
determined.
 The existence and terms of renewal or purchase
options and escalation clauses.
 Restrictions imposed by lease agreements, such as
those concerning dividends, additional debt, and
further leasing.

Case Study- Capital or Operating
 Company enters into a five year lease for equipment
with a useful life of seven years (70% of useful life)
 Payment Terms –
 $128,900 per month
 Due in advance the first of each month
 Original cost of the equipment - $6,760,000
 Stated residual value in the lease - $1,000,000
 Option to purchase is at FMV

 Interest Rate
 Company claims an incremental borrowing rate of
10.25%
 New company
 High debt load
 Call to bank loan executive by prior auditor
 Yields a present value of 89.9804% (@ 10.24%, the present
value is 90.0004%)

 New auditor finds:
 Short term variable debt interest rate on the equipment prior
to execution of lease of 7.9%
 Other unsecured debt with a short term rate of 8.0%
 Lease secured by equipment
 Attempts to reconfirm the rate with the bank failed –
 Bank officer no longer at the bank
 His immediate supervisor states that it is NOT bank policy to
give an ‘incremental’ rate outside of a formal term sheet or loan
document which would stand alone
 Capital Lease would have required the approval of senior
lender

Implicit Interest Rate – GAAP requires the use
of the implicit interest rate if information is
available to determine the interest rate used
in establishing the lease. The following
information was available:
 Monthly payment amount
 Original cost
 Residual value
 Term of the lease
 Based on facts in the lease, the auditor is able to calculate the
implicit interest rate was in fact 9.5%
 The present value at the implicit rate was 91.5020%

 Converting to Capital Lease
 Adds debt at the end of year one to the balance sheet of $4.8
million
 Increases EBITDA by $1.55 million ( At 4 times EBITDA, the
capital lease treatment reduces the cash to the seller. At 5
times EBITDA, it increases the cash to the seller.)
 Decreases GAAP net income by $207,000 in year 1,
variance declines in years 2 and 3 (annual depreciation is
higher in the early years than the amortization of principal in
the lease) and turns negative in years 4 and 5
 Cash flow is unchanged

 Advantages to the Company of an operating lease
were:
 No associated debt on the balance sheet
 No approval required by senior lender
 Higher net cash from a sale
 How would the senior lender view the obligation or
the annual lease payments of $1.3 million?

Capital or Operating – what is important?
 When does the reader of the financial statements
really care about lease obligations of any type? What
is material?
 15 year building lease that qualifies as operating
 Five year equipment lease that has a NPV of 75%, 80%,
89%
 How is a three year lease obligation different from a
three year note payable?

Why are FASB and IASB Looking at Lease
Accounting
 Leasing is an important source of finance.
 Provides users of financial statements with a
complete and understandable picture of an entity‟s
leasing activities.
 The models also lead to a lack of comparability and
undue complexity because of the sharp „bright-line‟
distinction between capital leases and operating
leases.
 A new approach to lease accounting that would
ensure that assets and liabilities arising under
leases are recognized in the statement of financial
position.

From FASB Exposure Draft Leases - August 17, 2010

General rules

 The right-to-use model,
what today we would term
a Capital Lease, – any lease
greater than a year
 Use of the old “Operating
lease model”– all other
leases

Two types of leases
 In response to feedback, the Boards discussed two models for
both lessees and lessors at the April 13th Board meeting
 Boards decided that there should be two accounting
approaches for leases for both lessees and lessors
 Tentatively termed ‘other-than-finance’ and ‘finance’ leases
 Existing guidance in IAS 17 should be used to make that
distinction for both lessees and lessors
 For both lessee accounting approaches, the Boards affirmed
their proposals in the Leases ED that a lessee should:
 Initially recognize a liability to make lease payments and a right-
of-use asset, both measured at the present value of lease
payments.
 Subsequently measure the liability to make lease payments
using the effective interest method.
• SOURCE: FASB LEASE UPDATES APRIL 2011

Lessee Accounting - General
“A lessee would recognize an asset (the right-of-use
asset) representing its right to use an underlying
asset during the lease term, and a liability to make
lease payments. The lessee would amortize the right-
of-use asset over the expected lease term or the
useful life of the underlying asset if shorter. The
lessee would incur interest expense on the liability
to make lease payments.”

• SOURCE: Exposure Draft and FASB LEASE UPDATES
APRIL 2011

Lessor Accounting -

A lessor would apply either a performance obligation
approach or a derecognition approach to account for
the assets and liabilities arising from a lease,
depending on whether the lessor retains exposure to
significant risks or benefits associated with the
underlying asset during or after the expected term of
the lease.

SOURCE: Exposure Draft

Does not apply to -
 Short term leases – defined by FASB at its meeting of June 23,
2011 as, “A lease that, at the date of commencement of the
lease, has a maximum possible term, including any options to
renew, of 12 months or less.” (Emphasis added)
 An entity can elect to treat short term leases on a right-to-use
basis on a case-by-case basis
 “Leases” covered elsewhere in GAAP
 Leases with the right to explore for oil and minerals
 Leases for intangibles
 Leases for biological assets (i.e. timber or agricultural products)

 SOURCE: Exposure Draft, minutes of June 23, 2011 FASB meeting

What would it do?
 (a) A lessee would recognize an asset representing its right to
use the leased („underlying‟) asset for the lease term (the „right-
of-use‟ asset) and a liability to make lease payments.
 (b) A lessor would recognize an asset representing its right to
receive lease payments and, depending on its exposure to risks
or benefits associated with the underlying asset, would either:
 (i) recognize a lease liability while continuing to recognize the
underlying asset (a performance obligation approach); or
 (ii) derecognize the rights in the underlying asset that it transfers
to the lessee and continue to recognize a residual asset
representing its rights to the underlying asset at the end of the
lease term (a derecognition approach).

 SOURCE: Exposure Draft and FASB LEASE UPDATES APRIL 2011

Key Components to Measurement
 Assets and liabilities recognized by lessees and lessors would
be measured on a basis that:
 (a) assumes the initial term of the lease and options to renew if
there is an economic incentive to extend the lease term. (Origin
Exposure Draft included option to renew, “that is more likely than not to occur”, taking into
account the effect of any options to extend or terminate the lease).
 (b) included fixed lease payments, variable payments that are
effectively fixed payment and variable payments tied to a rate or
index. (Original Exposure Draft included contingent payment based on an expected outcome
technique to reflect the lease payments, including contingent rentals and expected payments under
term option penalties and residual value guarantees, specified by the lease).
 (c) is updated when changes in facts or circumstances indicate
that there would be a significant change in those assets or
liabilities since the previous reporting period.
• SOURCE: Exposure Draft and FASB LEASE
UPDATES APRIL 2011

Key Components to Measurement
 Other measurement notes
 Don’t change the interest rate on the original measurement
unless there has been a significant change
 Election of option to renew
 Renegotiation of key lease terms
 The lessee should allocate payments as follows:
 If the purchase price of each component is observable, the
lessee would allocate the payments on the basis of the
relative purchase prices of individual components;
 If the purchase price of one or more, but not all, of the
components is observable, the lessee would allocate the
payments on the basis of a residual method; or
 If there are no observable purchase prices, the lessee
would account for all the payments required by the
contract as a lease.

Example A
 Terms of the Lease –
 Five year triple net operating lease at $48,000 in year
one due on the first day of the month
 Lease payments escalate at 3% per year with no
contingent payments
 Incremental borrowing rate is 7%

Example A
 Record lease value –
 Lease Rights $218,042
 Lease Obligation $218,042
 Entry to record payment in month two –
 Lease Obligation $2,752
 Interest Expense $1,248
 Cash $4,000
 Entry to record „use‟ of lease property
 Lease Amortization - $3,634
 Accumulated Amortization $3,634

What we (FASB) heard – From FASB
Presentation April 2011
 Complexity and cost
 Definition of a lease
 Estimation and judgment
 Variable payments, renewal options
 P/L pattern
 Lessor accounting
 Investment properties


Renewal Options
 ED: longest possible term that is more likely than not
to occur
 Changes:
 Options to extend or terminate when there is a
significant economic incentive to extend, or not to
terminate the lease
 Reassess only when there is a significant change in
relevant factors


Lessor Accounting
 FASB is evaluating the use of two options for lessor
accounting based on the transfer of risk to the
lessee.
 Staff is to evaluate the implications of two different
methods.
 Interest rate used in calculations is the rate that the
lessor is charging the lessee.

 “The Boards discussed a single approach to lessor accounting
whereby the lessor would recognize a lease receivable and a
residual asset at lease commencement. The Boards will
discuss at a future meeting whether and when, under such an
approach, it is appropriate for a lessor to recognize profit at
lease commencement. The Boards will also discuss at a future
meeting whether there should be different lessor models for (1)
a lease of a portion of an asset and (2) a lease of an entire
asset.
The Boards did not make any decisions about lessor
accounting at this meeting.”

FASB update on lessor accounting from board meeting of June
23, 2011

Lessor – At Risk
 Performance obligation approach – lessor exposed to significant
risks or benefits associated with the underlying asset
 Initial measurement
 Lease receivable = PV of estimated lease payments plus any initial direct
costs - Debit
 Performance obligation - Credit
 Subsequent measurement
 Systematic and rational approach to amortize to lease income
 Debit Lease Obligation
 Credit Lease Income
 Recognize interest income using the interest method
 Debit Cash for lease payment
 Credit Lease Receivable
 Credit Interest Income
 Asset
 Debit Depreciation
 Credit Accumulated Depreciation

Lessor – Transfers Risk to Lessee
 Initial measurement
 Lease receivable = PV of estimated lease payments plus any
initial direct costs
 Residual asset
 Derecognize the underlying asset
 Debit Lease Receivable
 Credit Assets
 Subsequent measurement
 Amortize the receivable and recognize interest income using the
interest method
 Debit Cash
 Credit Lease Receivable
 Credit Interest Income
 Asset
 No depreciation related to the derecognized asset

Presentation
 Separate accounting for assets and liabilities –
 Do not net lease rights and lease obligations
 Report total lease payment – amortized portion and
interest component reported separately from other
interest and depreciation
 Cash payments for leases are treated as financing
activities on a separate line in the Statement of Cash
Flows
 Impairment – always an issue

Disclosure Lessee – Key Requirements

 A general description of those lease arrangements.
 The basis and terms on which contingent rentals are
determined.
 The existence and terms of options, including for renewal
and termination. A lessee shall provide narrative
disclosure about the options that were recognized as part
of the right-of-use asset and those that were not.
 The existence and principal terms of any options for the
lessee to purchase the underlying asset.
 Information about assumptions and judgments relating to
amortization methods and changes to those assumptions
and judgments.

Disclosure Lessee – Key Requirements
 Amounts of short term leases.
 A lessee shall disclose a reconciliation of opening
and closing balances of right-of-use assets and
liabilities to make lease payments, disaggregated by
class of underlying asset. The reconciliation shall
separately show the total cash lease payments paid
during the period.

Transition
 There is no grandfather clause.
 Speculation is that there will be a long lead time to
the effective date.
 Interest rate determined at the date of application.
 Any prepaid or deferred rent at the date of
application included in the amortization of lease
rights.
 Capital leases with no economic incentives to renew
will use the carrying value established under capital
lease treatment.

Consequences
 How will lenders view the change in the short term?
In the long term?
 Raises EBITDA
 Raises „debt‟ obligation and debt to equity ratio
 If we know what the numbers are, do the bankers
and lawyers know what the documents say?
 Will it make as much sense to use debt as leases in
the future?

Consequences
 Lowers debt service coverage – increases „debt‟
payments and money available for debt service by
same amount, raising the denominator by a greater
percentage
Existing - Old New Lease Revised Debt
Rule Amounts Service
Available for Debt
Service $4,000,000 $500,000 $4,500,000
Debt Service
Requirement $2,000,000 $500,000 $2,500,000
Debt Coverage
Ratio 2.00 1.80

What is next -
 Expectation that the final rule will be released before
the end of 2011
 FASB – intends to release another exposure draft for
public comment before the final
 Implementation – pending final

Reference Sources
 Lease Update – June 23 Board meeting
 http://www.fasb.org/jsp/FASB/Page/SectionPage&cid
=1218220137074 – Click on Leases
 Original Exposure Draft
 http://www.fasb.org/cs/BlobServer?blobcol=urldata&bl
obtable=MungoBlobs&blobkey=id&blobwhere=11758
21125393&blobheader=application%2Fpdf

Connect with me

H. Kennedy (Ken) Conner, CPA
Assurance Principal
423.756.7100
kenconner@decosimo.com

On LinkedIn:
http://www.linkedin.com/in/kenconner

Disclaimer: The contents of this presentation are for informational purposes only. The information is not intended to be a substitute for
professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have
regarding your financial goals or specific situations.

Leases- The Winding Road Ahead

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