An Update on the FASBs Lease Project

September 25, 2012 Douglas Boedeker, CPA, CMA Dboedeker@tatetryon.com 202-419-5106

Course Outline

Why is the FASB doing this?

FASB timeline

Project scope

Recording by lessees

Recording by lessors

Transition
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The FASB/IASB Lease Project WHY?

Leases are an important source of finance more information required. Concern over lack of comparability. Concern over bright-line test for operating vs. capital lease.

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FASB Timeline
Exposure Draft Issued August 17, 2010 Public Comment Period Ended December 15, 2010, 786 comment letters were received

Numerous redeliberations have taken place in 2011 and 2012 A New & Improved Exposure Draft is anticipated in 4th Quarter of 2012 (they might extend the public comment period past 120 days) Additional outreach and public comments in 2013 Final standard to be issued - ?????

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A Key Fact to Remember This Morning

Everything we talk about today is TENTATIVE!!!

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What is a lease?

A contract contains a lease if: The fulfillment of the contract depends on the use of a specified asset; and the contract conveys the right to control the use of the specified asset for a period of time. Important note: A physically distinct portion of a larger asset can be a specified asset.
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Scope of the proposed standard

Simple ALL Leases

Except : Leases of intangible assets Leases of mineral rights, etc. Leases of biological assets FASB is still considering whether leases of internal use software should be accounted for under the new rules.

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What about service components?

Each contract must be analyzed for lease and non-lease components. Contract payments are then allocated between the components based on observable purchase prices. If there are no observable purchase prices, all payments under the contract would be accounted for like a lease. Lessors would allocate payments in accordance with revenue recognition guidance. Question: Are items such as property taxes, insurance, and maintenance a service or part of a lease?
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Important Exception for Short-Term Leases

Leases with a maximum possible lease term of 12 months or less can be accounted for the old way. No lease asset or liability is recognized. Any renewal options are considered in the determination of the 12 month maximum period. Thus, month-to-month leases will likely not qualify as a short-term lease!

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Lessee Accounting

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There will be two types of leases.

Interest & Amortization Approach

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Lessee consumes more than an insignificant portion of leased asset. Essentially similar to todays capital lease. Will generally apply to equipment leases.

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There will be two types of leases

Straight-Line Expense Approach

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Lessee does not consume more than an insignificant portion of leased assets. Essentially similar to todays operating lease coupled with a balance sheet gross-up. Will generally apply to land/building (property) leases.

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Initial Recording by a Lessee

1. Determine the lease liability (Future anticipated cash payments discounted to present value at either the lessees incremental borrowing rate or, if known, the rate implicit in the contract.)

2. Determine the right of use asset (Lease liability plus initial direct costs of acquiring the lease.)

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Lessee Subsequent Recording Interest & Amortization Approach 1. Amortize the right of use asset. (Probably on a straight-line basis.) 2. Adjust the lease liability using the effective interest rate method. (Essentially treated like a note payable.) 3. Reassess significant assumptions and adjust for current facts and circumstances. Thus, the P&L reflects amortization expense and interest expense. Total expense under the lease gets front loaded.

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Lessee Subsequent Recording Straight-Line Expense Approach 1. Figure out what the monthly straight-line expense under the lease would be just like the FAS 13 calc. done today. 2. Adjust the lease liability balance sheet account as if it were amortized like a loan payable. (Each lease payment has a principal and interest component.) 3. The right of use asset gets debited or credited in order to make the cash, lease expense, & lease liability adjustment balance. In other words, the right of use asset becomes a balancing account. Or, it gets plugged.

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Lessor Accounting

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There will be two types of leases

Receivable & Residual Approach

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Lessee consumes more than an insignificant portion of leased asset. Profit on sale is recognized with periodic interest income. Will generally apply to equipment leases.

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There will be two types of leases

Straight-Line Revenue Approach

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Lessee does not consume more than an insignificant portion of leased assets. Essentially similar to todays operating lease rental income is recognized on a straight-line basis. Will generally apply to land/building (property) leases.

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Receivable & Residual Approach The Basic Steps

1. Leased asset is removed from the books. Profit on sale gets recognized here based on what % of total FV is getting leased. Receivable is booked for the right to receive lease payments. (Calculated as the PV of the future anticipated lease payments using the discount rate implicit in the lease.) A residual asset is recorded essentially the unconsumed portion of the leased asset. It is booked at the current present value, and then accreted up to gross value by the end of the lease term. Subsequent income is recognized in the form of interest income on the lease receivable and accretion income on the residual asset.

2.

3.

4.

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Straight-Line Revenue Approach The Basic Steps

1. Leased asset stays on the books. It continues to be amortized in its usual manner. 2. Rental income would be recognized on a straightline basis over the life of the lease. (Thus, well still need some kind of accrued rent receivable balance sheet account.) Does this sound familiar?

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Calculation Quirks

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Asset Consumption Heres something directly from the FASB/IASB staff

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Slide from Leases: Project Update, July 2012 by FASB & IASB

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Figuring out the Lease Term

Heres the latest proposed definition: The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.

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Figuring out the Lease Term

Factors to weigh when considering the presence of significant economic incentive: Contract-based: Bargain renewal options, commitments to restore asset at end of term. Asset-based: Lessee installs significant leasehold improvements or unique location. Entity-specific: The historical practice of the entity, managements intent, and common industry practice. The lease term should be reassessed when there are significant changes in the relevant factors.

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Determining Future Lease Payments

The calculation of future lease payments includes: Fixed increases specified in the contract; Variable payments that are based on an index or rate; (The Spot Rate is to be used to measure the future anticipated lease payments.) Purchase options with significant economic incentive to exercise. This is a dramatic simplification from the original ideas in the exposure draft that would have required a probability-weighted calculation of all contingent lease payments! The revised standard will include guidance on how to account for lease incentives provided by the lessor to the lessee.
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Example - Determining the lease term

Assume a tenant enters into a five year lease with two five-year renewal options. The tenant is installing a state of the art research laboratory in the facility. The laboratory is very expensive and is considered a major investment by the tenant. Common industry practice is to completely replace laboratory facilities every ten years. There appears to be significant economic incentive for the tenant to exercise the first renewal option. A 10 year term will be used when initially recording the lease.

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Example - Calculation of Lease Payments

Lets assume that our lease has an initial base rent of $1,000,000 with a 3% annual escalation. Our tenants incremental borrowing rate is 8%.
Year 1 2 3 4 5 6 7 8 9 10 Payment $ 1,000,000 1,030,000 1,060,900 1,092,727 1,125,509 1,159,274 1,194,052 1,229,874 1,266,770 1,304,773 $ 11,463,879 PV @ 8% Average Rent $ 7,550,134 $ 1,146,388

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Example - Calculating the Liability and Asset

Legal fees of $265,000 were incurred as part of the review of the lease document. Based on the lease term and rental payments analysis performed, the liability and asset are calculated as follows.

"LEASE LIABILITY" (PV for 10 years at 8%) Add, direct costs (legal review) "RIGHT TO USE ASSET"

$ 7,550,134 265,000 $ 7,815,134

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Example - Entries for year one

Debit Year 1 Entry to record lease payment Cash Lease expense Lease liability Right of use asset $ 1,000,000 $ 1,146,388 $ 395,990 (A) $ 542,378 Credit

To record straight-line lease expense and corresponding reduction in lease liability. 1 Year 1 Entry to record direct cost amortization Amortization expense (??) Right of use asset $ 26,500 $ 26,500

To record amortization expense related to capitalized direct lease costs

(A) - This is the "principal" portion of the annual cash payment.

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Items to consider each year Lease term: Have factors changed regarding economic incentives to exercise or not exercise renewal options. (Discount rate would also change.) Payments tied to an index: Recalculate future payments based on the current year-ends spot rate. Right of Use Asset: Assess for impairment.

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Transition
Early adoption will likely be permitted. Generally a retrospective approach, with a number of modifications designed to make the initial application less onerous. However, full retrospective adoption will be permitted. Nonpublic entities will likely get more time.

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Good Luck!
You might want to sneak away sometime before this all goes final......

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Speaker Biography
Douglas Boedeker, is a partner within Tate & Tryons Audit and Assurance Services unit and is also actively involved in the Firm's exempt organization tax services group. He has 20 years of experience providing an array of audit, tax, and consulting services to a variety of nonprofit organizations and employee benefit plans. He takes particular pride that his family has contained at least one CPA every year since 1923. Doug graduated summa cum laude from Susquehanna University in Selinsgrove, Pennsylvania with a Bachelor of Science degree in accounting while simultaneously completing the coursework for a second major in arts administration. Doug is a frequent speaker on a variety of exempt organization accounting and tax issues. He recently lead a session on presenting the Form 990 & audited financial statements to a nonprofits board of directors at the 2012 AICPA Not for Profit Industry Conference. Doug is a coauthor to Guide to the Newest IRS Form 990: Interpreting and Complying with the New Tax Reporting Requirements for Transparency and Accountability, (published by ASAE).
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Doug Boedeker, CPA, CMA Audit Partner Tate & Tryon Direct: 202-419-5106 dboedeker@tatetryon.com

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