ASC Topic 842: “Leases”

1. ASC Topic 842: “Leases” Danny Lanier, Jr., Ph.D. Assistant Professor of Accounting dlanier2@elon.edu

2. ASC 842 Overview Issued February 25, 2016 Per FASB, “[t]he new guidance establishes the principles to report transparent and economically neutral information about the assets and liabilities that arise from leases.”

3. ASC 842 Overview (cont.) Results in more faithful representation of the rights and obligations arising from leases; Results in fewer opportunities to structure leasing transactions to achieve a particular financial reporting outcome; Improves understanding and comparability of lessees’ financial commitments regardless of financing decisions pertaining to assets

4. Overview (cont.) Provides users of financial statements with additional information about lessors’leasing activities and lessors’exposure to credit and asset risk as a result of leasing

5. Effective Dates Public entities, non-profits engaged in securities, benefit plans that file with SEC – December 15, 2018 All others – December 15, 2019

6. Summary of Changes Definition of a lease under ASC 842 New classifications for lessee and lessor; Revisions to classification criteria (increased judgement); Elimination of (nearly all) off-balance sheet financing; Disclosure requirements Special topics

7. Definition of a Lease ASC 842 defines a lease as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”

8. Definition of a Lease (cont.) An entity has the right to control the use of the identified asset if the entity has both: • The right to obtain substantially all of the economic benefits from use of the identified asset; and • The right to direct the use of the identified asset.

9. Definition of a Lease (cont.) What about a contract specifying the use of a portion of an asset? It depends… • If the portion is physically distinct and/or functionally independent  likely a lease; • If the portion represents substantially all of the capacity of the asset (thereby providing customer with right to obtain substantially all of the economic benefits)  likely a lease; • Shared use arrangements  not likely

10. Current Lease Classifications (ASC 840)

11. New Lease Classifications (ASC 842-10-25)

12. New Classification Criteria (ASC 842-10-25) A lease is classified as a finance lease (lessee) and as a sales-type lease (lessor) when the lease meets any of the following criteria: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. The lease term is for the major part of the remaining economic life of the underlying asset. The present value of the lease payments equals or exceeds substantially all of the fair value of the underlying asset. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

13. New Classification Criteria (cont.) If none of the 5 criteria are met: Both Lessee and lessor shall classify lease as an operating lease

14. Example 1: Finance/Sales-type lease (no seller profit)

15. Example 1: Finance/Sales-type Lease (no profit) On 1/1/19, Wren leased equipment from Polk Leasing. Polk purchased the equipment from MicroTekfor $208,493. The lease specifies five annual payments of $50,000, with payments due on 1/1/19 and each December 31, thereafter. The 5-year lease term equals the asset’s economic life. Polk routinely acquires equipment for lease to other firms. The rate implicit in this lease is 10% (known to lessee).

16. Example 1 (cont.) Classification Criteria Lease term (5 years) equals or exceeds a major part of underlying asset’s economic life (5 years); PV of lease payments ($208,493) equals or exceeds substantially all of FV of underlying asset; Therefore, lessee shall classify as a finance lease; lessor shall classify as sales-type lease without profit (cost = FV)

17. Example 1 (cont.) Lessee At commencement, lessee shall record a right-of-use asset (ROU) and lease payable, measured as PV of lease payments using appropriate discount rate; After commencement: • ROU reported at cost less accumulated amortization; • Lease liability reported at net carrying value.

18. Example 1 (cont.) Wren (lessee) 1/1/19 Right-of-use asset 208,493 Lease payable 208,493 Lease payable 50,000 Cash 50,000 12/31/19 Lease payable 34,151 Interest expense 15,849 [(208,493-50,000)*10%] Cash 50,000 Amortization expense 41,699 ROU 41,699

19. Example 1 (cont.) Lessor At commencement, lessor shall derecognize underlying asset and recognize: • Net investment in lease – sum of lease receivable and unguaranteed residual (if any); and • Any profit or loss arising from lease

20. Example 1 (cont.) Polk (lessor) 1/1/19 Lease receivable 208,493 Equipment 208,493 Cash 50,000 Lease receivable 50,000 12/31/19 Cash 50,000 Lease receivable 34,151 Interest revenue 15,849

21. Example 2: Sales-type lease (with seller profit)

22. Example 2: Sales-Type (with Profit) On 1/1/19, Wren leased equipment from MicroTek (manufacturer). The lease specifies five annual payments of $50,000, with payments due on 1/1/19 and each December 31, thereafter. The 5-year lease term equals the asset’s economic life. MicroTek manufactures the equipment at a cost of $150,000. The rate implicit in this lease is 10% (known to lessee).

23. Example 2 (cont.) Classification Criteria Lease term (5 years) equals or exceeds a major part of underlying asset’s economic life (5 years); PV of lease payments ($208,493) equals or exceeds substantially all of FV of underlying asset; Lessee shall classify as a finance lease; Lessor shall classify as sales-type lease with seller profit since FV ($208,493) > lessor’s cost ($150,000)

24. Example 2 (cont.) Wren (Lessee) Wren’s (lessee) entries would be same as Example 1 MicroTek (Lessor) 1/1/19 Lease receivable 208,493 Cost of goods sold 150,000 Sales revenue 208,493 Equipment 150,000 (all remaining entries same as sales-type without profit)

25. Example 3: Operating lease

26. Example 3: Operating Lease On 1/1/19, Wren leased equipment from Polk Leasing. Polk purchased the equipment from MicroTek for $208,493. The lease specifies three annual payments of $50,000, with payments due on 1/1/19 and each December 31, thereafter. The asset’s economic life is 5 years. Polk routinely acquires equipment for lease to other firms. The rate implicit in this lease is 10% (known to lessee).

27. Example 3 (cont.) Classification Criteria Lease term (3 years) does not equal or exceed a major part of underlying asset’s economic life (5 years); PV of lease payments ($136,777) does not equal or exceed substantially all of FV of underlying asset ($208,493); Lessee and lessor shall both classify as an operating lease

28. Example 3 (cont.) Operating Leases (Lessee) No off-balance sheet financing! • At commencement lessee shall record a right-of-use asset and lease liabilitymeasured as PV of lease payments using appropriate discount rate; • Lease liability classified as a non-debt liability, reported separately on face of balance sheet or in footnote disclosures

29. Example 3 (cont.) Operating Lease (Lessee) After commencement: • ROU reported at cost, less accumulated amortization; • Lease liability reported at net carrying value Lessee will record a single lease expense on income statement, equal to sum of interest and amortization; Amortization is plugged such that lease expense equals amount of lease payments (mirroring straight-line rental)

30. Example 3 (cont.) Wren (lessee) 1/1/19 Right-of-use asset (ROU) 136,777 Lease payable (non-debt) 136,777 Lease payable 50,000 Cash 50,000 12/31/19 Interest expense [10% x (136,777-50,000)] 8,678 Lease payable (difference) 41,322 Cash 50,000 Amort expense (50,000 – 8,678) 41,322 ROU 41,322

31. Example 3 (cont.)

32. Example 3 (cont.) Operating Lease (lessor) At commencement, no derecognition of underlying asset; Rent revenue recorded on straight-line basis over lease term

33. Example 3 (cont.) Polk (lessor) 1/1/19 Cash 50,000 Deferred lease revenue 50,000 12/31/19 Deferred lease revenue 50,000 Lease revenue 50,000 Cash 50,000 Deferred lease revenue 50,000 Depreciation expense [208,493÷5] 41,699 Accum. Depr 41,699

34. Key Differences Finance/Sales-type leases: Front-loading of expenses for lessee and revenues for lessor; Operating leases Avoids front-loading, defers expense recognition, resulting in higher net income in early years.

35. Short-term Leases Lease term (including renewal options) 12 months or less; and No purchase option that lessee is likely to exercise, which would extend term beyond 12 months If both criteria met, lessee may elect not torecord asset and liability, and instead record lease payments as rent expense

36. Lessee Disclosure Requirements Qualitative Nature of lease; Information about leases yet to commence, but create significant rights and obligations; Information about significant assumptions and judgements

37. Lessee Disclosures (cont) Quantitative Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities. Operating lease cost determined in accordance with ASC 842 Other special lease items

38. Lessor Disclosure Requirements Qualitative Nature of leases Significant assumptions Management of risk associated with residual values Quantitative Maturity analysis of lease receivables

39. Special topics

40. Sale-Leaseback Transactions Under ASC 842, A sale and leaseback transaction will qualify as a sale only if: • It meets the revenue recognition criteria under ASC 606; • Leaseback is not a finance lease; and • There is a repurchase option Sale and leaseback accounting now applies to both lessee and lessor

41. IFRS Differences Under IFRS No. 16, lessees use a one-model approach, classifying all leases as finance leases; only lessors distinguish between finance and operating leases

42. Questions?

43. Thank you!