Lease Accounting - The New Exposure Draft

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UNIVERSITY OF NORTH ALABAMA
2013 ACCOUNTING SEMINAR
LEASES – THE NEW EXPOSURE
DRAFT
ROBERT BELCHER | July 19, 2013

 Leasing is an important source of finance and the FASB objective
is to provide greater transparency around a company’s leasing
transactions
 Current standards omit relevant information about rights and
obligations that meet the definitions of assets and liabilities –
users currently adjust financial statements to recognize assets
and liabilities arising from operating leases
 Complexity of the current standard because of the “bright-line”
distinction between capital leases and operating leases
 Part of the Convergence Project – this is a joint project of the IASB
and FASB
Why a Leases Project

 For the lessee – other than some short term leases, would feature a right to use model
that would require all leases to be on the balance sheet
 Short term lease
 At date of commencement has a maximum possible term, including any options to renew, of 12
months
 Need not recognize lease assets or liabilities
 Recognize payments on a straight-line basis
 Changes to both balance sheet and income statement
 Could impact key ratios and covenant calculations
 Could impact EBITDA calculations
 Could impact incentive compensation plans
 Changes accounting treatment when lease contains non-lease components such as
services
 Leases would be classified into two types (Type A and Type B) and the classification
would be used principally for determining the method and timing for recognizing lease
revenue and expense
Key Impacts

 For lessee – two types of leases
 Type A lease – (Accelerated expense) – Assets other than real property
(e.g. equipment, vehicles)
 Type B lease – (Straight line expense) – Primarily land and/or building
leases
 For lessor –
 Type A leases – Approach similar to today’s accounting for sales-type
leases
 Type B leases – Would be accounted for using a method similar to current
operating lease accounting
Key Impacts

 Estimated leases coming on balance sheet ($1.25 trillion for SEC
registrants)
 Approximately 70% related to real estate
 All companies with lease obligations will be affected
 Industries that could be significantly impacted
 Industries with multiple locations (retail operations)
 Industries with significant investment in PPE (transportation companies)
Key Impacts

 Discussion paper was issued in March 2009
 Exposure draft was issued in August 2010
 New exposure draft issued in May 2013 – comment period ends September 2013
 Redeliberations beginning fourth quarter 2013
 Final standard and effective date - TBD
 Likely effective date no earlier than January 1, 2017
 Will also have to be aligned with the new revenue recognition standard
 Companies will be required to restate comparative periods – so if standard
becomes effective in 2017, a restatement of 2016 and 2015 could be required
 Proposed standard has created a lot of discussion – hundreds of comment letters
were received, numerous roundtable discussions were held
Current Status

 Definition of a lease
 Contract in which the right to use a specified asset is conveyed for a period
of time in exchange for consideration, as determined based on the
substance of the contract, by assessing whether both of the following
conditions are met:
 The fulfillment of the contract depends on the use of an explicitly or implicitly
specified asset or assets
 The contract conveys the right to control the use of the specified asset or assets
for a period of time
Recap of Some Key Concepts
for Lessee and Lessor

 Lease determination dependent on the substance of the contract
 Fulfillment of the contract depends on the use of a specified asset
 Specified asset is an asset that is explicitly or implicitly identifiable
 A physically distinct portion of a larger asset is a specified asset (one floor in a 20 story
office building would be included – where as a non physically distinct portion of an
asset such as a specified percentage of the capacity of a pipeline would be excluded)
 Customer controls the use of the specified asset throughout the term of the
arrangement
 Customer has the ability to direct the use (make decisions that impact how the
asset is used)
 Receive substantially all of the benefits
 Contracts excluded would include those where the lessor can substitute the
asset without the lessee’s consent or the customer cannot use the asset on its
own – contracts where the right to use the asset and the services are not
negotiated separately

 The proposed definition of a lease would be similar in scope but in some
respects has a little bit of broader scope than the existing definition.
Today’s standard applies only to property, plant and equipment. The
definition in the exposure draft would apply to leases of all assets except
the following:
 Excludes leases of
 Biological assets, including timber
 Right to explore for or use minerals, oil, and/or gas
 Intangible assets are not required to be treated as leases
 Short term leases (at the date of commencement has a maximum possible term,
including any options to renew, of 12 months or less)
 Scope would include
 Subleases
 Leases involving assets other than property, plant and equipment – however such
arrangements (e.g. assets often treated like inventory – spare parts, supplies) would
not likely meet the definition of a lease
Scope

 Lease Term
 Determined at lease commencement date based on the noncancellable
period for which the lessee has the right to use the underlying asset
plus
 Any period covered by an option to extend the lease if the lessee has an
economic incentive to extend the option
 Period covered by an option to terminate the lease if the lessee has a
significant economic incentive not to exercise the option

 Lease Payments
 Present value of the lease payments over the lease term would be
recognized as a lease liability for lessees or a lease receivable for
lessors of a Type A lease – Payments would include
 Fixed lease payments
 Variable payments that depend on an index or rate such as CPI or LIBOR
 Purchase options if lessee has a significant incentive to exercise a purchase
option
 Any variable rents not based on an index or rate (based on performance or
usage) would be excluded and recognized as accrued/incurred

 Discount Rate
 Would be determined on a lease by lease basis and used to determine
present value of the lease payments
 If lessee can determine the rate charged by lessee then that rate should
be used – when that rate is not known the lessee would use its own
incremental borrowing rate
 The lessee’s incremental borrowing rate would be the interest rate that
the lessee would have to pay to borrow over a similar term to purchase
an asset of a similar value for the right to use the asset in a similar
economic environment

 Lease Classification
 The principle for determining between the two lease types would be
based on the portion of the economic benefits of the underlying asset
expected to be consumed by the lessee over the lease term
 Leases of assets that are not property (e.g. equipment, vehicles) would
be classified as Type A leases – An exception to classifying these
leases as Type A leases would be
 Lease term is for an insignificant part of the life of the asset
 Present value of the lease payments is insignificant relative to the fair value
of the underlying asset

 Lease Classification
 Leases of property (building or part of building) would be classified as a
Type B lease unless the lease term is for a significant portion of the
economic life of the asset or the present value of the lease payments is
for substantially all of the fair value of the leased asset
 If the lessee has a significant economic incentive to exercise an option
to purchase the underlying asset then the lease would be classified as a
Type A lease
 Many of the leases classified as operating leases today would probably
be Type A leases under the proposal

 What is significant – no bright lines
 The proposed standard does not provide a definition of “insignificant”
for purposes of assessing the exception criteria for classifying leases
of assets other than property
 For Type A leases some examples given were as follows:
 More than insignificant
 2 year lease of an asset with an expected life of 12 years
 Present value of lease payments is $16,700 compared to fair market value of
equipment of $60,000
 For Type B leases:
 Insignificant
 15 year lease of an office building with a 40 year life
 Present value of lease payments of $300,000 compared to fair market value of
property of $400,000
 Lease term and present value of lease payments considered insignificant

 Would recognize an asset representing its “right-of-use” of an underlying
asset during the lease term and a liability representing its obligations to
make lease payments during the lease term at the commencement of the
lease
 Liability would be recognized at the present value of the lease payments
including expectations about the lease term, variable payments that
depend on an index or rate, purchase options where the lessee has
significant economic incentive to exercise, etc.
 Right-of-use asset would be measured initially at cost
 Amount of the liability
 Plus: Direct costs incurred – costs directly attributable to negotiations and arranging a
lease that would not have been incurred had the transaction not been made
 Less: Any lease incentives received
 Initial recognition of the right to use asset and the lease liability would be
the same for a Type A lease and a Type B lease
Lessee – Right-to-Use Model

 Expense Recognition
 Two approaches
 (Type A) Accelerated method – non property leases (equipment, vehicles)
 (Type B) Straight Line method – property leases – building and real estate
 Type A (Accelerated Method)
 Amortize the right-of-use asset on a systematic basis that reflects the usage
of the asset – generally on a straight line basis
 Interest expense would be calculated on the effective interest method
 Combined amortization expense and interest expense on the lease liability
result in generally front-loaded pattern of total lease expense
 Recognize interest and amortization expense separately in the income
statement

 Type B (Straight Line Method)
 Interest expense calculated under the effective interest method
 Measure the right-of-use asset each period as a balancing figure such that
lease expense would be recognized on a straight line basis, regardless of
timing of lease payments
 Recognize lease expense as one amount in the income statement

Lessee Accounting (Type A)
Example
A company enters into a three-year lease for equipment that has an
economic life of six years and agrees to pay the following: $12,000 in
year 1, $14,000 in year 2 and $16,000 in year 3. The present value of
lease payments is $37,220 (using a discount rate of 6%).
At lease commencement the lessee would recognize the lease-related
asset and liability:
Right-of-use asset $37,220
Liability to make lease payments $37,220
To initially recognize the lease-related asset and liability

Example
The following journal entries would be recorded in the first year:
Interest Expense $2,233
To record interest on the liability to make lease payments using the
interest method ($37,220 *6%)
Amortization expense $12,407
Right-of-use asset $12,407
To record amortization of the right-of-use asset ($37,220/3 years)
Cash $12,000
To record cash paid

Example
A company enters into a three-year lease for equipment that has an
economic life of six years and agrees to pay the following: $12,000 in year 1,
$14,000 in year 2 and $16,000 in year 3. The present value of lease payments
is $37,220 (using a discount rate of 6%).
Initial Year 1 Year 2 Year 3
Lease expense recognized
(consists of):
Interest expense $ 2,233 $ 1,647 $ 900
Amortization expense $ 12,407 $ 12,407 $ 12,406
Total $ 14,640 $ 14,054 $ 13,306
Balance sheet
Right-of-use asset $ 37,220 $ 25,533 $ 12,766 $ -
Liability to make lease payments $ 37,220 $ 27,453 $ 15,100 $ -

Lessee Accounting (Type B)
Example
Initial Year 1 Year 2 Year 3
Lease expense presented on I/S
(consists of):
Interest expense $ 2,233 $ 1,647 $ 900
Amortization expense $ 11,767 $ 12,353 $ 13,100
Total lease expense presented on I/S $ 14,000 $ 14,000 $ 14,000
Balance sheet
Right-of-use asset $ 37,220 $ 25,453 $ 13,100 $ -
Liability to make lease payments $ 37,220 $ 27,453 $ 15,100 $ -
A company enters into a three-year lease for new office space and agrees to
pay the following: $12,000 in year 1, $14,000 in year 2 and $16,000 in year 3.
The present value of lease payments is $37,220 (using a discount rate of 6%).

Lessee Accounting
Presentation
Financial
Statement
Lessee Presentation
Balance
Sheet
• Right-of-use assets and liabilities to make lease payments for each type of lease presented
separately or disclosed in notes along with the line item in the balance sheet
• Whether presented separately or together with other assets, right-of-use assets presented as if
the underlying asset were owned
Income
Statement
• Type A leases: lease-related amortization and interest expense presented separately from other
amortization and interest expense or disclosed. Lease-related amortization and interest
expense cannot be combined
• Type B leases: lease-related expense presented as a single line item (e.g., lease or rent
expense)
Statement of
Cash Flows
• Type A leases: cash payments for principal presented as financing activities and cash payments
for interest presented as operating activities
• Type B leases: cash payments for lease payments presented as operating activities
• Both types of leases: cash payments for variable lease payments not included in the liability
presented as operating activities
• Cash payments for short-term leases presented as operating activities
The following table summarizes how lease-related activity would be presented
on the financial statements of lessees:

 Two Models for the Balance Sheet and Income Statement
 Receivable/Residual Approach
 Used for most equipment leases – leases which consume more than an
insignificant portion of the underlying asset over the lease term
 Record a lease receivable for the right to receive payments at the present value
of the lease payments
 At the discount rate using the rate charged to lessee
 Derecognize the underlying asset
 Profit recognition
 Gain or loss on the transfer of the right-to-use asset – calculated as the difference
between the present value of the lease payments to be received and the carrying value
allocated to the right-to-use asset sold
 Interest income and profit from the accretion of the residual asset recognized over the
lease term
Lessor Accounting

 Operating Lease Approach
 Most land and building leases
 Lessor would keep property, plant and equipment on balance sheet
 Rental income would be recognized over the lease term generally on the straight
line basis
 Balance Sheet and Income Statement Presentation
 Lease receivable and residual assets (including deferred profit), as, or totaling to,
a single caption (e.g. leased assets) or disclose separately in the notes if not
separately presented
 Lease income and expense (i.e., revenue and cost of sales) in separate line
items or net in a single line item (lease income)
Lessor Accounting

 Transition
 Option for modified retrospective approach or full retrospective approach
 At date of initial application (beginning of earliest comparative period presented)
recognize and measure a liability to make estimated lease payments and a right
of use asset
 Liability measured as the present value of the remaining lease payments
discounted using the lessee’s incremental borrowing rate
 For Type A leases, right-of-use assets based on the liability to make lease
payments at the lease commencement prorated for the remaining lease term
 For Type B leases, right-of-use assets measured at the related liability
 Difference between the liability to make lease payments and the right-of-use
asset would be a cumulative adjustment to opening retained earnings
 Discount rate based on the incremental borrowing rate on the effective date
 Not required to adjust carrying amounts for existing capital leases
Lessee Accounting

 Should a right of use asset and obligation to make lease
payments be recognized for a related party lease?
 The FASB decided to eliminate the guidance that requires entities to
evaluate related party leases on the basis of their substance. The
exposure draft requires entities to evaluate related party leases on the
basis of its legal terms and conditions, acknowledging that some related
party leases are not documented or at arm’s length. The FASB also
discussed whether related party leases would be considered cancelable
or non cancelable leases. FASB decided against a presumption that
related party leases would be considered noncancellable.
Related Party Leases

Sale-leaseback transactions would no longer provide off-balance sheet financing
because lessees would recognize all leases (other than short term leases) on the
balance sheet. A sale and leaseback of the underlying asset would be recognized if the
requirements for sale recognition in the revenue recognition standard are met;
otherwise, the transaction would be accounted for as a financing transaction. There
would be no special criteria for assessing sale-leaseback transactions.
For a seller-lessee – if the transaction qualifies as a sale
 Derecognize the leased property
 Recognize a right-of-use asset
 Recognize a liability to make estimated future lease payments
For a buyer-lessor – if the transaction qualifies as a sale
 Recognize a lease receivable for estimated future lease payments
 Recognize a residual asset
If no sale, account for the entire transaction as a financing transaction by the seller-
lessee.
If sale and leaseback are at fair value, gains and losses should be recognized when the
sale occurs and should not be deferred. If the consideration is not at fair value, the
assets, liabilities, gain or loss would be adjusted to reflect current market rentals.
Sale-Leaseback Transactions

 Financial metrics, key performance indicators and capital structure
 Grossed up balance sheet
 Changes to timing of income/expense
 Financial ratios – return on assets, EBITDA
 Debt covenants, interest coverage ratios, debt to equity ratios
 Compensation arrangements
 Lease procurement and strategy
 Understand effect of lessee’s behavior
 Lease vs. buy strategy
 IT and systems, processes and controls
 Need to understand any modifications or new software necessary to capture
information
 Tax accounting issues
 Adjustments to deferred taxes
Overview of Implications

ROBERT BELCHER, CPA
Assurance Principal | robertbelcher@decosimo.com
Robert Belcher has provided audit and accounting
services for public and privately-held businesses, as well
as governmental entities, for 30 years.
Robert is a trusted assurance principal providing audit, attest
and due diligence services to clients in a wide range of
industries. His clientele includes manufacturers in the textile,
food, furniture, construction, printing, portrait studios and carpet
sectors, as well as brokerage and investment firms, government
contractors and governmental entities. Robert provides clients
with industry-specialized assistance related to cost accounting
and other inventory issues, revenue recognition and internal
control framework, as well as merger and acquisition services.

Lease Accounting - The New Exposure Draft

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