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REVISED LEASING EXPOSURE DRAFT

REVISED LEASING EXPOSURE DRAFT. REVISED EXPOSURE DRAFT ON LEASING (ED2) ISSUED MAY 16, 2013 DEVELOPED AND PRESENTED BY: JOHN C. FUSCO, JR. CPA MACE OCTOBER 17, 2013. AT THIS POINT THE NEW METHODS ARE LIKELY TO BECOME AN ACCOUNTING STANDARD UPDATE (ASU) ARE THERE ARGUMENTS AGAINST IT?

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REVISED LEASING EXPOSURE DRAFT

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  1. REVISED LEASING EXPOSURE DRAFT REVISED EXPOSURE DRAFT ON LEASING (ED2) ISSUED MAY 16, 2013 DEVELOPED AND PRESENTED BY: JOHN C. FUSCO, JR. CPA MACE OCTOBER 17, 2013 LEASING JOHN C. FUSCO, JR. CPA, MT

  2. AT THIS POINT THE NEW METHODS ARE LIKELY TO BECOME AN ACCOUNTING STANDARD UPDATE (ASU) ARE THERE ARGUMENTS AGAINST IT? Yes, but the economists and non-accountants have won the battle accountants have fought for years. STATED OBJECTIVE OF THE ED Establish principles that Lessees and Lessors should apply to report useful information to users of financial statements about the amount, timing and uncertainty of cash flows arising from a lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  3. WHY IS THE NEW METHODOLOGY IMPORTANT? Most businesses of some size, and not too large either, have leases. Some companies have many leases on their books. Think about it, most companies have: • Office/Building lease(s) • Vehicle leases (cars and trucks) • Computer leases • Phone equipment lease • Other equipment leases LEASING JOHN C. FUSCO, JR. CPA, MT

  4. APLICABILITY OF NEW RULES Any entity that enters into a lease and reports in accordance with GAAP, is subject to the new accounting for leases, except: • Short Term leases – leases of less than 12 months total. • Leases of intangible assets • Leases of minerals etc. (non-regenerative resources) • Leases of Biological assets including timber LEASING JOHN C. FUSCO, JR. CPA, MT

  5. WHAT IS THE NEW MODEL? The core principle involved is that an entity should recognize assets and liabilities arising from a lease. Lessee accounting requires reporting a “Right-of-Use asset and a lease obligation Lessor accounting requires application of the “receivable and residual” method LEASING JOHN C. FUSCO, JR. CPA, MT

  6. WHY THE CHANGE? Many users of financial statements (mostly analysts) say that the bright line classification of lease as capital and operating fails to meet the users needs because they do not always provide a faithful representation of leasing transactions because they do not require lessees to recognize assets and liabilities arising from operating leases. LEASING JOHN C. FUSCO, JR. CPA, MT

  7. QUESTION • When we are finished with today’s presentation ask yourself: WHAT ARE WE GAINING WITH THE NEW MODEL AS TO INFORMNG USERS OF THE FINANCIAL STATEMENTS ABOUT THE AMOUNT, TIMING AND UNCERTAINTY OF CASH FLOWS ARISING FROM LEASES? LEASING JOHN C. FUSCO, JR. CPA, MT

  8. EXAMPLES 3 YEAR COPIER LEASE $400/MONTH OPERATING LEASE UNDER CURRENT RULES TWO COMPANIES COMPANY J AND COMPANY F SAME LEASE TERMS/ SAME EQUIPMENT/ FROM THE SAME LESSOR RESULT RENT EXPENSE $4,800/YEAR FOR THREE YEARS FOR BOTH COMPANIES LEASING JOHN C. FUSCO, JR. CPA, MT

  9. NEW METHOD LEASING JOHN C. FUSCO, JR. CPA, MT

  10. INCOME STATEMENT EFFECT LEASING JOHN C. FUSCO, JR. CPA, MT

  11. WHAT WE HAVE TO DO We need to classify our leases as: • TYPE A LEASES – a lease that is expected to consume MORE than an INSIGNIFICANT portion of the economic benefits embedded in the underlying asset. (things like equipment, aircraft, cars and trucks); so in plain English the lease is for a significant part of the assets useful life. • Notwithstanding the above requirements, if a lessee has a significant economic incentive to exercise an option to purchase the underlying asset, it is classified as a Type A lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  12. TYPE B LEASES – leases are classified as TYPE B if either of the following criteria are met: • Lease term is for an insignificant portion of the total economic life of the underlying asset. OR • Present value of lease payments is insignificant relative to the Fair Value of the underlying asset at commencement date. LEASING JOHN C. FUSCO, JR. CPA, MT

  13. TYPE B EXCEPTION If the underlying asset is property it is classified as Type B property unless one of the following criteria are met: • The lease term is for the major part of the remaining economic life of the underlying asset. OR • The present value of the lease payments accounts for substantially all of the Fair Value of the underlying asset at commencement date. LEASING JOHN C. FUSCO, JR. CPA, MT

  14. ED 2 Example of type –b exception • Lessee enters into a 15-year lease of an office building, which has a remaining economic life of 40 years at the commencement date. • The lease calls for payments of $30,000 per year, the present value of which is $300,000 using the lessee incremental borrowing rate. • The fair value of the property at the commencement date is $400,000. Lessee determines the lease is a Type-B lease because: • The underlying asset is property • Lease term is not for a major part of the remaining economic life of the property (37.5% ) • The PV of the lease payments does not account for substantially all of the Fair value of the property. (75% - 300,000/400,000) Your thoughts on the above? LEASING JOHN C. FUSCO, JR. CPA, MT

  15. RECOGNITION – TYPE A LEASE BY LEASEE Lessee would : • Recognize a right-of-use asset and a lease liability at the present value of lease payments. • Recognize the unwinding of the discount on the lease liability as interest separately from the amortization of the right-of-use asset. LEASING JOHN C. FUSCO, JR. CPA, MT

  16. REGONITION OF TYPE B LEASES BY LESSEE For most leases of property (that is land and/or building or part of a building) the lessee would: • Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments. • Recognize a single lease cost, combining the unwinding of the discount on the lease liability with the amortization of the right-of-use asset, on a straight-line basis. LEASING JOHN C. FUSCO, JR. CPA, MT

  17. LESSORS MEASUREMENT OF TYPE A LEASES For most leases of assets other than property, a lessor would classify the lease as a Type A Lease and do the following: • Derecognized the underlying asset and recognize a right to receive lease payments (the lease receivable) and a residual asset representing the rights the lessor retains relating to the underlying asset. • Recognize the unwinding of the discount on both the receivable and the residual asset as interest income over the lease term. • Recognize any profit relating to the lease at the commencement date. LEASING JOHN C. FUSCO, JR. CPA, MT

  18. LESSOR REOGNITION OF TYPE B LEASES For most leases of property, lessor would apply an approach similar to existing operating lease accounting in which the lessor would: • Continue to recognize the underlying asset. • Recognize lease income over the lease term typically on a straight-line basis. LEASING JOHN C. FUSCO, JR. CPA, MT

  19. WHAT IS IN THE LEASE PAYMENTS Both lessee and lessor would: • Exclude most variable lease payments • Include payments to be made in optional periods only if the lessee has a significant economic incentive to exercise an option to extend or not to exercise an option to terminate. LEASING JOHN C. FUSCO, JR. CPA, MT

  20. SIGNIFICANT ECONOMIC INCENTIVE At commencement date an entity assesses whether the lessee has a significant economic incentive to exercise an option considering all relevant factors, such as: • Contractual terms and conditions of the optional periods compared with current market rates such as: • The amount of lease payments in any optional period • The amount of any variable lease payments or other contingent payments. • The terms and conditions of any options that are exercisable after initial optional period such as a purchase option. LEASING JOHN C. FUSCO, JR. CPA, MT

  21. Significant economic incentive (continued) b. Significant leasehold improvements that are expected to have significant economic value for the lessee when the option to extend or terminate the lease or purchase the asset becomes exercisable. c. Costs relating to the termination of the lease and signing a new lease. d. The importance of that underlying asset to the lessee’s operations. LEASING JOHN C. FUSCO, JR. CPA, MT

  22. IDENTIFYING A LEASE Basic definition: a contract that conveys the right to use an asset (the underlying asset) for a period of time for consideration. At inception of a contract, an entity shall determine whether the contract is or contains a lease by addressing both of the following: • Whether fulfillment of the contract depends on the use of an identified asset • Whether the contract conveys the right to control the use of the identified asset for a period of time. LEASING JOHN C. FUSCO, JR. CPA, MT

  23. FULFILLMENT • Asset would usually be specifically identified in the contract. • However, even the asset is specifically identified fulfillment does not depend on the use of an identified asset, if the lessor has the substantive right to substitute the asset throughout the term of the contract. LEASING JOHN C. FUSCO, JR. CPA, MT

  24. CONTROLLING THE USE Contract gives lessee the right to control the use of the identified asset if throughout the term of the contract the lessee has the right to do both of the following: • Direct the use of the identified asset. • Derive the benefits from the use of the identified asset. Let’s look at some examples from ED2 of using the criteria to determine if a contract contains a lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  25. IDENTIFYING A LEASECONTRACT FOR RAIL CARS-EXAMPLE 1 • Contract between the lessee (Customer) and a freight carrier (Carrier) for use of 10 rail cars of a particular specification that are owned by the carrier and contracted for 5 years. • Contract specifies the type of car. Customer determines when, where and which goods are transported using the cars. • When cars are not in use, they are kept at Customer’s premises and Customer can use them for any purpose (such as storage) if it so chooses. • If a particular car needs service or repair Carrier is required to substitute an equivalent car of the same type. Except in case of default, Carrier can not retrieve the cars during the 5 years of the contract. LEASING JOHN C. FUSCO, JR. CPA, MT

  26. CONTRACT FOR RAIL CARS-EXAMPLE 1 (CONTINUED) • Carrier is required to provide and engine and driver when requested by Customer. If Carrier is unable to provide Customer can use another Carrier’s service. • Carrier can transport Customer’s goods along with other Customer’s goods on trains up to 100 cars.. • RESULT: The contract contains a lease, Customer had the right to use 10 cars for 5 years. Contract also contains a nonlease service component that relates to the use of an engine and driver. Contract does not convey the right to use an identified engine. LEASING JOHN C. FUSCO, JR. CPA, MT

  27. CONTRACT FOR RAIL CARS-EXAMPLE 1 (CONTINUED) ANALYSIS • Customer has the right to control use of the cars because of both of the following: • A. Customer has the ability to drive the use of the cars. Customer determines how, when, and for what purpose the cars are used, not only when they are being used to transport Customer’s goods but throughout the term of the contract. • B. Customer has the ability to derive the benefit from use of the cars. The cars are available for Customer’s use throughout the term of the contract, including when they are not being used to transport Customer’s goods. LEASING JOHN C. FUSCO, JR. CPA, MT

  28. CONTRACT FOR RAIL CARS-EXAMPLE 1A • Contract between Customer and carrier requires carrier to transport a specified quantity of goods in accordance with a stated timetable for a period of five years. • The timetable and quantity of goods specified is the equivalent of the Customer having the use of 10 rail cars for 5 years. • Contract states the nature and quantitiy of goods to be transported but does not include specific details of the cars or engine to be used. • Carrier had a large pool of similar cars and can choose which cars to use and engines to use to fulfill Customer’s requests. • RESULT: The contract does NOT contain a lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  29. CONTRACT FOR RAIL CARS-EXAMPLE 1A ANALYSIS • The contract does not contain a lease because: • Fulfillment of the contract does not depend on the use of 10 identified rail cars or an identified engine. • Carrier has substantive substitution rights, • Carrier can choose any cars without Customer’s consent. • There are no economic barriers that prevent Carrier from using any cars and engines in fulfillment of the contract. LEASING JOHN C. FUSCO, JR. CPA, MT

  30. CONTRACT FOR COFFEE SERVICE • Customer (the lessee) enters into a contract for coffee services for two years with Suplier (lessor) • Supplier puts 25 coffee machines in customer’s premise that are tailored for use with consumables provided by Supplier. The coffee machines function only with consumables provided by Supplier and have no use to Customer other than when they are used in conjunction with those consumables. • Supplier is responsible for repairs and maintenance of the coffee machines. • Customers staff operate the machines, selecting the coffee they wish to drink and the machines deliver the coffee. • RESULT: The contract does not contain a lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  31. CONTRACT FOR COFFEE SERVICE (ANALYSIS) • Although fulfillment of the contract may depend on the use of the machines, the contract does not give the Customer the right to control the use of the machines. • Customer does not have ability to derive benefits from the use of the machines on their own; the machines function only with the consumables supplies by Supplier. Machines are incidental to the delivery of coffee services to the Customer over the two year term of the contract. Developer’s Note: Most of these type contracts require a certain quantity of consumables to be purchased by the Customer or the Supplier pulls the machines out. For instance , typical machine today would be a Keurig that uses K-cups that are available from many sources. The Supplier will insist on purchase only from them and remove the machines if they even suspect the Customer has used consumables from another source. So, you have a service contract not a lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  32. CONTRACT FOR FIBER-OPTIC CABLE – PART A • Customer (lessee) enters into a 15 year contract to use 3 specified, physically distinct dark fibers withina larger cable connecting Hong Kong to Tokyo. • Customer makes all the decisions about the use of the fibers by connecting each end of the fibers to its electronic equipment (that is the Customer “lights’ the fibers). • If the fibers are damaged, Supplier is responsible for repairs and maintenance. • RESULT: The contract contains a lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  33. CONTRACT FOR FIBER-OPTIC CABLE – PART A (ANALYSIS) • Why does this contract contain a lease? One reason is that fulfillment depends on use of the fibers that are explicitly specified in the contract and are physically distinct from other fibers within the cable. • The Customer has the right to control the use of the dark fibers because of the following: • Customer has the ability to direct the use of the dark fibers. Customer determines how, when and to what purpose the fibers are used. Accordingly, Customer makes the decisions about the use of the fibers that most significantly affect the economic benefits derived from use throughout the term of the contract. • Customer has the ability to derive the benefit from use of the dark fibers. The fibers are available for Customer’s use throughout the 15 year term of the contract, they can not be used by any other party unless Customer agrees to such use. The contract also contains a non-lease service component for repairs and maintenance of the fibers. LEASING JOHN C. FUSCO, JR. CPA, MT

  34. CONTRACT FOR FIBER-OPTIC CABLE – PART B • Customer enters into a 15 year contract for the right to use a specified amount of capacity within a cable connecting Hong Kong to Tokyo. • The specified amoutisequivant to Customer having the use of the full capacityof 3 fiber strands within the cable (the cable contains 15 fibers with similar capacities) • Supplies makes decisions about the transmission of data (that is, Supplier lights the fibers and makes decisions about which fibers are used to transmit Customer’s traffic). • RESULT: the contract does not contain a lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  35. CONTRACT FOR FIBER-OPTIC CABLE – PART B (ANALYSIS) • The contract does not contain a lease because: • Supplier makes all the decisions about transmission of Customer’s data, which requires only a portion of the capacity of the cable. • That capacity portion ids not physically distinct from the remaining capacity of the cable. • Customer has contracted for the right to capacity within a cable. It does not have the right to use an identified asset. LEASING JOHN C. FUSCO, JR. CPA, MT

  36. COMMENCEMENT DATE OF THE LEASE Date on which the lessor makes an underlying asset available for use by a lessee. LEASING JOHN C. FUSCO, JR. CPA, MT

  37. LEASE TERM • The noncancellable period of the lease, together with both of the following: • Periods covered by an option to extend the lease if the lessee has a significant economic incentive to exercise that option. • Periods covered by an option to terminate the lease if the lessee has a significant economic incentive not to exercise the option. LEASING JOHN C. FUSCO, JR. CPA, MT

  38. LEASE PAYMENTS Payments made by lessee to a lessor relating to the right to use the underlying asset during the lease term, consisting of the following: • Fixed payments, less any lease incentives received or receivable from the lessor. • Variable lease payments that depend on an index or rate or are in substance a fixed payment • The exercise price of a purchase option if the lessee has significant economic incentive to exercise that option. • Payments for penalties for terminating the lease if the lease term reflects the lessee exercising the option to terminate. • Non lease components are not included • Residual value guarantees are included. LEASING JOHN C. FUSCO, JR. CPA, MT

  39. LESSEE’S INCREMENTAL BORROWING RATE The rate of interest that the lessee would have to pay to borrow over a similar term, and with similar security, the funds necessary to obtain an asset of similar value in a similar economic environment. NOTE: Private companies can elect to use the risk-free rate. Some treasury rates recently: 2year – 0.27%; 5 year – 0.77%; 10 year- 1.86% LEASING JOHN C. FUSCO, JR. CPA, MT

  40. INITIAL DIRECT COSTS Lessors have always needed to record “initial direct costs” and amortize them over the life of the lease. Now lessees must also include initial direct costs in the right-of-use asset at commencement of the lease. Initial direct costs are defines as: Costs that are directly attributable to negotiating and arranging a lease and would not have been incurred without entering into the lease. LEASING JOHN C. FUSCO, JR. CPA, MT

  41. COSTS INCLUDED IN INITIAL DIRECT COSTS For both lessees and lessors such items as: • Commissions • Legal fees • Evaluating the prospective lessee’s financial condition • Evaluating and recording guarantees, collateral, and other security contracts • Negotiating lease terms and conditions • Payments made to existing tenants to obtain the lease LEASING JOHN C. FUSCO, JR. CPA, MT

  42. COSTS THAT ARE NOT INITIAL DIRECT COSTS • General overhead, including for example depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time • Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities. Question: What about the controllers time reviewing, negotiating and setting up the lease on the books? LEASING JOHN C. FUSCO, JR. CPA, MT

  43. NON-LEASE COMPONENTS If there are “observable” standalone prices for each component of the contract, lessee shall allocate the consideration to each component on the basis of the relative standalone price of each. Standalone price is the price at which a lessee would purchase the component separately. After that allocation the remaining amounts are considered lease components. This is likely in a maintenance contract included with your lease payment. LEASING JOHN C. FUSCO, JR. CPA, MT

  44. RECORDING LEASESLESSEE Facts: 10 yr. lease, option for 5 more yrs. No incentive to exercise so use 10 yr. as term. Borrowing rate 5.87% Initial direct costs $15,000 Lease payments $50,000/yr initial term; $55,000/yr extended term Paid beginning of year PV of 10, $50,000 payments at 5.87% $342,017 Pays first year at commencement At commencement record DR Right-of-use (342,017+50,000+15,000) = 407,017 CR Lease Liability 342,017 CR Cash (50,000+15,000) 65,000 LEASING JOHN C. FUSCO, JR. CPA, MT

  45. End of first year Type A lease: Interest (5.87*342,017) 20,076 Lease liability 20,076 Amortization (402,017/10) 40,702 Right-of-use 40,702 Balances end of first year Right-of-use (407017-40,702) = 366,315 Lease liability (342,017+20,076) = 362,093 LEASING JOHN C. FUSCO, JR. CPA, MT

  46. SAME FACTS TYPE B LEASE • Total lease cost: • 10x50,000 = 500,000 + 15,000 = 515,000 • Lease expense per year = 51,500 (515,000/10) • Entry: Lease expense 51,500 Lease liability 20,076 Right-of-use (51,500-20,076) 31,424 Next years payment beginning of year: Lease liability 50,000 Cash 50,000 LEASING JOHN C. FUSCO, JR. CPA, MT

  47. PURCHASE OPTION Lessee enters into a 5-year lease of equipment with annual end of year lease payments of $59,000, no initial direct costs, option to purchase for $5,000 at end of fifth year. Residual value of equipment at end of 5 years is $75,000, therefore, significant economic incentive to exercise the option. The fair value of the equipment at commencement date is $250,000. The rate implicit in the lease, that is the rate that makes the PV of payments including the option to equal the FV is 6.33%. LEASING JOHN C. FUSCO, JR. CPA, MT

  48. ACCOUN TING FOR THIS LEASE Commencement date: Right-of-use 250,000 Lease liability 250,000 Right-of-use amortized over life of equipment 7yrs rather than shorter life of lease. First year entry: Interest expense (250,000*6.33%) 15,825 Lease liability 15,825 Amortization (250,000/7) 35,714 Right-of-use 35,714 LEASING JOHN C. FUSCO, JR. CPA, MT

  49. END OF FIRST YEAR Right-of-use asset (250,000-35,714)= 214,286 Lease liability (250,000+15,825 – 59,000) = 206,825 The $59,000 is the payment that was recoded as debiting Lease Liability and crediting cash at end of year. LEASING JOHN C. FUSCO, JR. CPA, MT

  50. END OF YEAR 5 Right of use asset (250,000-35417X5) = 71,430 Liability remaining is $5,000 the purchase option which is then paid. The Right-of-use asset gets reclassified to Property, Plant & equipment as follows: PP&E 71,430 Right-of-use 71,430 Then the lessee depreciates this amount over the remaining two years. LEASING JOHN C. FUSCO, JR. CPA, MT

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