A Global Reach with a Local Perspective University of North Alabama 19th Annual Decosimo Accounting Forum July 22, 2011 www.decosimo.comLeases – The Winding Road AheadA Review of Current and Proposed Lease TreatmentKEN CONNER, CPAPrincipal
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 lessees implicit or incremental borrowing rate, is 90% or more of the fair market value of the asset. Operating leases - All other leases
Leases – Current GAAP 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.
Leases – Current GAAP 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
Case Study- Capital or Operating 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%)
Case Study- Capital or Operating 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
Case Study- Capital or OperatingImplicit 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%
Case Study- Capital or Operating 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
Case Study- Capital or Operating 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 LeaseAccounting 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 FASBPresentation April 2011 Complexity and cost Definition of a lease Estimation and judgment Variable payments, renewal options P/L pattern Lessor accounting Investment properties • SOURCE: FASB LEASE UPDATES APRIL 2011
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 • SOURCE: FASB LEASE UPDATES APRIL 2011
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 • SOURCE: FASB LEASE UPDATES APRIL 2011
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 • SOURCE: FASB LEASE UPDATES APRIL 2011
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 firstname.lastname@example.org 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.