Proposed Accounting Standards Update to Lease Accounting

1. Proposed Accounting Standards Update to Lease Accounting February 22, 2011

2. Presenters Today’s presenters: Paul Anderson, CPADirector of AssuranceGBQ Partners LLC panderson@gbq.com 614.947.5203 Jeff Alton, CPAAssurance ManagerGBQ Partners LLC jalton@gbq.com 614.947.5202

3. Overview • The core principle is that lease contracts give rise to assets and liabilities that should be reflected in the balance sheets of lessees and lessors. • All lessees would use a single method of accounting for all leases. • The accounting by a lessor would reflect its exposure to the risks or benefits of the underlying leased asset. • Users of financial statements would have more timely information about variable features such as renewal options and contingent rentals. • A simplified approach would apply to short-term leases. • The proposal does not change the current definition of a lease contract.

4. Proposed Accounting Standards Update: Leases (Topic 840) • Released August 2010/Joint project with IASB • Significant change to existing lease accounting model • Would impact both lessees and lessors • Eliminates off-balance sheet (i.e., operating) leases • Retrospective application on adoption, thus no grandfathering of existing leases is expected • Comment period ended: December 15, 2010 • Final standard issuance: June 2011 (expected) • Effective date: ?

5. Key Term Definitions

6. Key Term Definitions (continued)

7. Scope • Applies to all entities • Includes leases of property, plant, and equipment • Excludes: • Leases of intangible assets • Leases to explore for or use natural resources (i.e., minerals, oil and gas) • Leases of biological assets • Contracts that represent the purchase or sale of the underlying asset • Includes contracts with both service and lease components, with certain exceptions • Most contracts viewed as leases under current GAAP will be subject to the new guidance

8. Lessee Accounting Model - Recognition • Right-of-use (“ROU”) approach • Right to use an asset for a specified period of time • Gives rise to both an asset and a liability • Asset = right to use item for lease term • Recognized and carried at amortized cost • Liability = obligation to pay rentals • Present value of payments • One accounting model replaces current two model approach (capital and operating leases)

9. Lessee Accounting Model - Recognition • Right of use asset and liability recognized on statement of financial position on date of commencement of lease (“DCL”) • The following will be subsequently recognized in the income statement: • Interest expense on the liability • Amortization expense of the asset • Changes in the liability resulting from reassessment of contingent rentals, residual value guarantee, or term option penalties • Any impairment losses on the right of use asset

10. Measurement of Asset and Liability • Initially done as of date of inception of lease • Present value of lease payments • Discounted at either: • Lessee’s incremental borrowing rate, or • Rate charged by lessor, if known • At inception, asset will be the same as the liability plus any initial direct costs, such as: • Commissions • Legal fees • Costs incurred in evaluating lessee, guarantees, and collateral • Closing costs • Note: the following costs are notconsidered initial direct costs: general overhead expense, advertising or soliciting expense, costs associated with servicing an existing lease.

11. Measurement - Lease Term • “Longest possible term that is more likely than not to occur” • Include optional renewal periods that are more likely than not to be exercised • Different than “old’ accounting where optional renewal periods were ignored • Continually reassessed based on significant changes • Renewal periods and early termination options • Estimates adjusted in period that facts and circumstances change • Assessment should consider both contractual and non-contractual factors

12. Example - Lease Term • Non-cancellable 10-year term • Option to renew for 5 years at the end of 10 years and an option to renew for an additional 5 years at the end of 15 years • The lessee estimates the probability for each term as follows: 40% for 10-year term, 30% for 15-year term and 30% for 20-year term • Under these scenarios, the term would be at least 10 years, with a 60% chance that the term would be 15 years or longer, but only a 30% chance that the term would be 20 years. Therefore, there is a 60% chance that the term would be 15 years, which is the longest possible term more likely than not to occur. As such, the lease term would be 15 years. • This example is adapted from Paragraph B17 of the Exposure Draft.

13. Measurement - Lease Payments • Initially used to measure asset and liability • “Expected outcome approach” • Present value of the probability-weighted average of the cash flows for a reasonable number of outcomes • Estimating expected outcome involves: • Identifying each reasonably possible outcome. An entity need not assess every possible outcome to identify the reasonably possible outcomes included in the expected PV of the cash flows. • Estimating the amount and timing of the cash flows for each reasonably possible outcome • Determining the present value of those cash flows • Estimating the probability of each outcome • Include contingent amounts • Continually reassess

14. Expected Outcome Approach – Contingent Rents Example The Facts: A retailer enters into a 5 year lease which, in addition to fixed monthly payments, calls for contingent rents to be paid at a rate of 1% of annual sales in excess of $1M. Contingent rents are to be paid at the end of each year of the lease. Based on past performance and future projections, management prepares the following analysis related to estimated forecasted sales. The retailer’s incremental borrowing rate is 10%. As a result of the foregoing analysis, the retailer would include contingent rent of $39,221 in its estimate of lease payments. The present value of estimated yearly payments is $7,844 ($39,221/5).

15. Expected Outcome Approach – Contingent Rents Example (Continued) • Carrying on with the example on the previous slide, assume fixed monthly payments of $5,000. Further assume the retailer incurred $20,000 in initial direct costs. The present value of the lease payments, including the contingent rent determined above, is $274,548. The recognized right of use asset at lease inception is $294,548; the lease liability is $274,548. Assume actual sales in Year 1 were $2M; contingent rent due is $10,000. • During the first year of the lease, the retailer will record the following: • Amortization of the right of use asset of $58,910 ($294,548/5) • Interest expense on the lease liability of $25,450 (based on a lease amortization schedule using interest method) • Reduction of the lease liability for cash payments of $70,000 ($60,000 + $10,000) • Additional expense of $2,156 would need to also be recorded to "true up" contingent rent ($10,000 - $7,844) • Effect in first year of lease of adopting the exposure draft: • Revised (ED) accounting model  total expense of $86,516 ($58,910 + $25,450 + $2,156) • Current accounting model  total expense of $74,000 ($60,000 + $4,000 + $10,000)

16. Subsequent Measurement • Right of Use Asset: • Amortized on a systematic basis over the shorter of the lease term or useful life of the underlying asset • Subject to impairment analysis under ASC 350 • Liability: • Amortized cost using the using the interest method • Subject to periodic reassessments “…if facts or circumstances indicate that there would be a significant change” • Discount rate is not reassessed unless specifically based on an index

17. Presentation • Right of use asset: • Presented as a tangible asset within PP&E • Segregated from non-leased assets • Liability: • Separately from other financial liabilities • Interest and amortization expense presented separately from other interest/amortization expense (either on P&L or in the footnotes) • Principal and interest cash payments will be a financing activity in the Statement of Cash Flows

18. Recognition/Presentation – Financial Statement Impact • Income Statement • Current GAAP • Rent expense classification • Included in Operating Income/Loss • Proposed GAAP • Interest and amortization expense classification; no rent expense • Amortization expense included in Operating Income/Loss; Interest excluded • Statement of Financial Position • The addition of lease liability on the balance sheet may impact debt ratios and possibly covenant calculations • Note: Change in classification may impact EBITDA

19. Lessor Accounting Model - Recognition • Dual model approach • Performance obligation or • Derecognition • Centers on whether significant risks or benefits of the leased asset are retained • Exposure to risk/benefits can occur during and after the lease term • If retained = performance obligation model • If transferred = derecognition • Model determined at Date of Inception and not reassessed • Both models require estimates of lease term and contingent rentals

20. Recognition – Performance Obligation Approach • Underlying asset stays on the lessor’s books • As of date of commencement of the lease, lessor will recognize: • Asset for the right to receive lease payments • Liability at the present value of the lease payments • Subsequently, lessor will recognize: • Interest income on right to receive lease payments • Lease income as lease liability is satisfied • Changes in lease liability resulting from reassessment of contingent rentals, residual value guarantee or term option penalties • Potential for impairment losses on right to receive lease payments

21. Measurement – Performance Obligation Approach • Lease liability measured as the sum of the PV of lease payments, discounted using the rate lessor charges the lessee • Right to receive asset measured as the sum of lease liability and any initial direct costs • Initial measurement based on longest possible lease term that is more likely than not to occur • Measured at date of inception of the lease • Expected outcome approach • PV of the probability-weighted average of the cash flows for a reasonable number of outcomes • Asymmetrical amounts for lessor/lessee are probable

22. Subsequent Measurement – Performance Obligation Approach • Right to receive asset is carried at amortized cost using the interest method • Subject to impairment testing under ASC 310-10 (loan impairment) • Remaining lease liability measured based on pattern of use of the underlying asset by the lessee, if pattern can be reliably determined using either inputs or outputs • If not reliably determinable, use straight-line method • Underlying asset is depreciated over its expected useful life • Systematic and rational approach • If none based on pattern of use, straight-line method should be used • Asset subject to ASC 360 impairment testing (long lived assets impairment)

23. Recognition - Derecognition Approach • Apply if performance obligation criteria not met • As of date of commencement of lease, lessor will: • Recognize a receivable for the right to receive rental payments with the offset to lease income • Remove portion of the carrying amount of underlying leased asset from books which represents the lessee’s right to use the asset during the lease term • Residual asset for the portion of the carrying amount of the leased asset that represents the lessor’s non-transferred rights in that asset • Portion of the carrying value of leased asset removed from balance sheet and recorded as cost of sale

24. Recognition - Derecognition Approach • Recognized in the income statement: • Lease income = PV of lease payments • Lease expense = cost of underlying asset derecognized • Interest income on right to return asset • Lease impact of any reassessments in right to return asset due to change in estimates of contingent amounts • Impairment losses on right to return asset • If lessor’s ongoing, major, or central activities involve leasing activities, lease income is reported as revenue and lease expense as cost of revenue

25. Measurement - Derecognition Approach • Allocation: • Amount to be derecognized computed as: • (FV of right to receive lease payments/FV of the underlying leased asset) X Carrying amount of the underlying leased asset • Residual asset is computed as the remaining amount of the carrying amount of the underlying leased asset • Reassess when facts and circumstances indicate that there could be a significant change

26. Subsequent Measurement - Derecognition Approach • Right to receive asset at amortized using interest method • No remeasurement of residual asset unless: • Terms change • Asset is impaired • ASC 310 used to assess impairment of right to receive asset • ASC 350 or 360 used to assess impairment of residual asset

27. Lessor Accounting Model - Presentation

28. Disclosure – Lessors and Lessees • Quantitative and qualitative information relative to lease arrangements • User should be able to understand amount and timing of expected cash flows; disaggregation of information to the appropriate level • Significant NEW disclosure requirements: • Reconciliation of opening and closing balances of right-of-use assets and liabilities to make lease payments, disaggregated by class of underlying asset • Narrative disclosure about the options that were recognized as part of the right-of-use asset and those that were not • Assumptions and judgments relating to amortization methods and changes to those assumptions and judgments • Initial direct costs incurred during the reporting period and included in the measurement of the right-of-use asset or right to receive lease payments • Basis and terms on which contingent rentals are determined

29. Income Tax Considerations • New model will create temporary differences • Assets/liabilities created for book purposes not reflected for tax purposes • ASC 740 requires gross basis recognition – no offsetting of deferred tax asset and deferred tax liability arising from lease items • State and local taxes may be impacted

30. Short Term Leases • Maximum possible term (including all extension options) of 12 months or less • Lessee measurement: • At date of inception of lease, accounting election on a lease-by-lease basis: • Measure similarly to long term lease; or • Measure using simplified approach • Right of use asset and liability equal to undiscounted lease payments • Lease payment recognized in income statement over lease term • Lessor measurement: • At date of inception of lease, accounting election on a lease-by-lease basis: • Measure similarly to long term lease; or • Measure using simplified approach • No recognition of right-to-receive asset and lease liability; no derecognition of underlying asset • Lease payments recognized in income statement over lease term

31. Short Term Leases Simplified Approach – Example The Facts: A lessee enters into a 12 month lease for storage space; the lease requires monthly payments of $1,000. The lessee elects to account for the lease using the simplified approach. Based on the fact pattern, the lessee would record the following entries:

32. Adoption/Transition • All outstanding leases as of the date of initial application will be subject to the new accounting • No grandfathering of leases in existence as of the adoption date • Date of initial application - the beginning of the first comparative period presented in the first financial statements in which the lessee applies the new guidance • Recognize and measure all outstanding contracts within scope of guidance • Simplified retrospective approach • No specific effective date in exposure draft

33. Sale and Leaseback Transactions • Scope • If an asset is transferred and leased back, transaction to be accounted for under the proposed ASU if the contracts are: • Entered into at or near the same time • Negotiated as a package with a single commercial objective • Performed either concurrently or consecutively • Sale Criteria - at end of contract, seller-lessee transfers control and all but a trivial amount of risks/benefits

34. Sale and Leaseback Transactions • Seller-Lessee • If sale criteria are met: • Record sale pursuant to other GAAP • Record lease asset and obligation pursuant to lease standard • Buyer-Lessor • If purchase criteria are met: • Account for purchase pursuant to other GAAP • Account for lease using the performance obligation approach

35. Questions?

36. Thank you!