Lease Accounting: A Whole New Ballgame A critical perspective John Hepp

1. Lease Accounting:    A Whole New BallgameA critical perspectiveJohn Hepp

2. Disclaimer This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered. For additional information on matters covered in this presentation, contact your Grant Thornton LLP adviser.

3. A few words about the proposed leasing standard Complex Inconsistent Incomplete

4. Leasing and Revenue RecognitionThe new odd couple

5. The new lease accounting Step 1: Is the Arrangement a Lease? Step 2: Is the Lease Accounted for as a Sale or as a Lease? Step 3: What is a Lease and What is a Service? Step 4: What is the Lease Term? Step 5: Are There Any Contingent Rental Payments? Step 6: Have Initial Direct Costs Been Correctly Capitalized? Step 7: Have the Payments Been Discounted Correctly? Step 8: Are Systems in Place to Provide Information for Required Disclosures?

6. Scope: When is a lease a purchase  of a good or a service? Both lessors and lessees would be required to evaluate whether the lease payments should be allocated between service and lease components, considering all concurrently negotiated contracts with a third party.A lessor would be subject to the revenue recognition requirements regarding the identification of separate performance obligations within an arrangement. That is, if the service component is not considered distinct, total payments under the arrangement should be accounted for as the lease. If the service component is considered distinct, total payments under the arrangement should be allocated between the service and lease components using the same principles as those proposed in the revenue recognition project.The lessee�s identification of distinct components within an arrangement and measurement of the allocation between distinct service and lease components within an arrangement would be based on the same principles used by the lessor. The Boards noted that if the proposed revenue recognition guidance is incorporated into the proposed new leases guidance, some language changes would be necessary.If the lessor or lessee is unable to allocate the total payments among the service and lease components of an arrangement, the entire arrangement should be considered and accounted for as a lease.If the total payments under an arrangement that contains both lease and service components change after the inception of the lease (for example, term options or contingent rentals), an entity would first determine whether the entire change is directly attributable to either the lease or the service component. If it is unable to do so, then the change in total consideration should be allocated on a pro rata basis to the various contract components in the same proportion as determined at contract inception.Both lessors and lessees would be required to evaluate whether the lease payments should be allocated between service and lease components, considering all concurrently negotiated contracts with a third party.

7. Scope: When is a lease a sale  of a good or a service? Both lessors and lessees would be required to evaluate whether the lease payments should be allocated between service and lease components, considering all concurrently negotiated contracts with a third party.A lessor would be subject to the revenue recognition requirements regarding the identification of separate performance obligations within an arrangement. That is, if the service component is not considered distinct, total payments under the arrangement should be accounted for as the lease. If the service component is considered distinct, total payments under the arrangement should be allocated between the service and lease components using the same principles as those proposed in the revenue recognition project.The lessee�s identification of distinct components within an arrangement and measurement of the allocation between distinct service and lease components within an arrangement would be based on the same principles used by the lessor. The Boards noted that if the proposed revenue recognition guidance is incorporated into the proposed new leases guidance, some language changes would be necessary.If the lessor or lessee is unable to allocate the total payments among the service and lease components of an arrangement, the entire arrangement should be considered and accounted for as a lease.If the total payments under an arrangement that contains both lease and service components change after the inception of the lease (for example, term options or contingent rentals), an entity would first determine whether the entire change is directly attributable to either the lease or the service component. If it is unable to do so, then the change in total consideration should be allocated on a pro rata basis to the various contract components in the same proportion as determined at contract inception.Both lessors and lessees would be required to evaluate whether the lease payments should be allocated between service and lease components, considering all concurrently negotiated contracts with a third party.

8. A sale per the leasing ED: a contract that results in an entity transferring control of the underlying asset and all but a trivial amount of the associated risks and benefits to another entity (par 8a) A sale per revenue recognition ED: An entity shall recognize revenue when it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when the customer obtains control of that good or service A customer obtains control of a good or service when the customer has the ability to direct the use of, and receive the benefit from, the good or service. Control includes the ability to prevent other entities from directing the use of, and receiving the benefit from, a good or service. When is a lease a sale? A different definition of a sale If a lease qualifies as short-term, a lessee could elect, on a lease-by-lease basis, to measure the liability to make lease payments and the right-of-use asset using undiscounted amounts of lease payments. The lessee would recognize lease payments in the income statement over the lease term. A lessor entering into a short-term lease could also elect, on a lease-by-lease basis, not to recognize assets or liabilities arising from the lease, and not to derecognize any portion of the underlying asset. The lessor would recognize lease payments in the income statement over the lease term. If a lease qualifies as short-term, a lessee could elect, on a lease-by-lease basis, to measure the liability to make lease payments and the right-of-use asset using undiscounted amounts of lease payments. The lessee would recognize lease payments in the income statement over the lease term. A lessor entering into a short-term lease could also elect, on a lease-by-lease basis, not to recognize assets or liabilities arising from the lease, and not to derecognize any portion of the underlying asset. The lessor would recognize lease payments in the income statement over the lease term.

9. IG49. If an entity has an unconditional obligation or unconditional right to repurchase the asset (a forward or a call option), the customer is constrained in its ability to direct the use of, and receive the benefit from, the asset. Hence, the customer does not obtain control of the asset (even though the customer may have physical possession of the asset), and the entity shall account for the sale and repurchase agreement as: a right of use in accordance with Topic 840, if the entity repurchases the asset for an amount that is less than the original sales price of the asset; or a financing arrangement, if the entity repurchases the asset for an amount that is equal to or more than the original sales price of the asset. When is a sale a lease? From Revenue Recognition 

10. What is a lease?The line between services and a lease Lease: the contract conveys the right to control the use of a specified asset for an agreed period of time (paragraph B4) A contract with services could have an embedded lease A lease contract could have embedded services The proposed ASU provides a simplified method for lessees and lessors to account for short-term leases. The simplified method applies to leases that, on the lease commencement date, have a maximum possible lease term of 12 months or less, including options to renew or extend the lease. If a lease qualifies as short-term, a lessee could elect, on a lease-by-lease basis, to measure the liability to make lease payments and the right-of-use asset using undiscounted amounts of lease payments. The lessee would recognize lease payments in the income statement over the lease term. A lessor entering into a short-term lease could also elect, on a lease-by-lease basis, not to recognize assets or liabilities arising from the lease, and not to derecognize any portion of the underlying asset. The lessor would recognize lease payments in the income statement over the lease term.The proposed ASU provides a simplified method for lessees and lessors to account for short-term leases. The simplified method applies to leases that, on the lease commencement date, have a maximum possible lease term of 12 months or less, including options to renew or extend the lease. If a lease qualifies as short-term, a lessee could elect, on a lease-by-lease basis, to measure the liability to make lease payments and the right-of-use asset using undiscounted amounts of lease payments. The lessee would recognize lease payments in the income statement over the lease term. A lessor entering into a short-term lease could also elect, on a lease-by-lease basis, not to recognize assets or liabilities arising from the lease, and not to derecognize any portion of the underlying asset. The lessor would recognize lease payments in the income statement over the lease term.

11. Embedded leasesWhen is a service contract a lease? B1. At the date of inception of a contract, an entity shall determine whether the contract is, or contains, a lease on the basis of the substance of the contract, by assessing whether: the fulfilment of the contract depends on providing a specified asset or assets (the �underlying asset�) (paragraphs B2 and B3); and the contract conveys the right to control the use of a specified asset for an agreed period of time (paragraph B4).

12. Embedded leases Is a contract a lease or a service contract? The right is conveyed if any one of the following conditions is met: The entity has the ability or right to operate the asset or direct others to operate the asset �while obtaining or controlling more than an insignificant amount of the output or other utility of the asset The entity has the ability or right to control physical access tothe underlying asset while obtaining or controlling more than an insignificant amount of the output or other utility of the asset The entity will obtain all but an insignificant amount of the output or other utility of the asset during the term of the lease, and the price that the entity will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output.

13. Embedded services Bulk up or allocate? If the service component is considered distinct, total payments are allocated between the service and lease components If not distinct, account for total payments as a lease If not able to allocate the payments, account for total payments as a lease If the total payments change, first determine whether the entire change is directly attributable to either the lease or the service component If not able to do so, then allocate the change in total consideration pro rata in the same proportion as determined at contract inception

14. Distinct services Goods or services are distinct if: the entity, or another entity, sells an identical or similar good or service separately; or the entity could sell the good or service separately because the good or service meets both of the following conditions: it has a distinct function and it has a distinct profit margin (it is subject to distinct risks and the entity can separately identify the resources needed to provide the good or service)

15. What is the lease term? Recognize the longest possible lease term that is more likely than not to occur Consider all relevant factors Options to renew a lease that are priced at market value at the date of renewal would be considered when determining the lease term The lease term would be reassessed at each reporting date Detailed examination of every lease not required unless there is a change in facts or circumstances Any change to the obligation to pay rentals resulting from a reassessment of the lease term would be recorded as an adjustment to the right-of-use asset

16. Contingent rents The obligation to pay rentals (lessee) and the receivable (lessor) include contingent rent A lessor would recognize a receivable for amounts that could be measured reliably (from revenue recognition). Measured using an expected outcome technique. Not every possible scenario would need to be taken into account. Contingent rentals based on an index or rate measured using forward rates if readily-available. If not, use rates at inception. Reassess the carrying amount of the obligation/receivable at each reporting date if any new facts or circumstances indicate a material change in the obligation.

17. LeasesExample � lessee accounting 5 year lease of office space with 5 year renewal at market Initial monthly rent of $100,000 Rent increases by 2% each year Lessee's incremental borrowing rate is 9% If likely, assume 2% increases continue If re-evaluated year three, assume new base of $115,000

18. Income statementFrontloading of expense for lessees

19. Assume the option will be exercisedThe longer the lease term, the larger the difference

20. Re-evaluate the likelihood of the option periodAnd watch the expense spike

21. Summary The proposed standard will correct many of the abuses of the current model, but goes beyond booking obligations for minimum rentals Increases measurement complexity and raises conceptual issues Estimating future contingent rent payments Estimating future market rentals for option periods Introduces new bright lines Leases embedded in service contracts Services embedded in lease contracts Derecognition vs performance obligation approach Inconsistent with accounting for similar PPE

22. LeasesEffective date and transition No proposed effective date Comment period ends December 15, 2010 New model would apply to all leases within the scope of proposed guidance - no grandfathering Simplified retrospective transition method Adjust the right-of-use asset by the amount of any recognized prepaid or accrued lease payments on transition Carryover basis for plain vanilla capital leases The proposed ASU does not specify an effective date because the Boards plan to separately address the effective dates for all of their convergence projects. In the first financial statements in which entities would be required to apply the proposed guidance, they would apply the guidance as of the beginning of the first comparative period presented. Entities would be required to apply the new lease accounting model to all leases within the scope of the proposed guidance that are outstanding on the date of initial application, using a simplified retrospective method described in the proposed ASU.The proposed ASU does not specify an effective date because the Boards plan to separately address the effective dates for all of their convergence projects. In the first financial statements in which entities would be required to apply the proposed guidance, they would apply the guidance as of the beginning of the first comparative period presented. Entities would be required to apply the new lease accounting model to all leases within the scope of the proposed guidance that are outstanding on the date of initial application, using a simplified retrospective method described in the proposed ASU.

24. Additional resources available at Grant Thornton Lease Accounting Resource Centerwww.grantthornton.com/leases