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This overview provides information on the FASB Lease Accounting Project, including the timing, issues, impacts, and action plans. It also addresses questions such as lease classification, lease term, lease payments, and more.
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The FASB Lease Accounting Project Overview, Issues and Status May 30, 2013
Agenda • Timing • What is the Project? • Issues and Impacts • Lessees • Lessors • Summary impacts and action plans • Q&A
Project Timeline ED Issued August 2010 Comment Letters Due 9/13/13 Comment Letters Dec 2011 New ED To Issued 5/16/2013 Draft New ED Now Re-deliberate 4 QTR 2013 & into 2014 Final Standard 2014 Redeliberations Jan 2011 – September 2012 Outreach • Timeline is not fixed • Dependent upon number of comment letters and extent of re-deliberations • We expect a high volume of negative comment letters • Effective date uncertain – likely to be 2017
Questions addressed by the Boards How does a lessee allocate cost? What is a lease? What is the lease term? What are the lease payments? How does a lessor recognize income? How to account for short term leases?
Definition of a lease • A contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration • Specified asset (PP&E plus certain types of inventory like spare parts) • Right to control the use of a specified asset (different from current GAAP) • No guidance on purchase vs. lease
Lease term • Recognized lease term would include non-cancellable period, plus any optional periods where there is a significant economic incentive to extend (or not terminate) the lease (virtually same as current GAAP) • Purchase options – include on a basis consistent with renewal options • Assume exercise if significant economic incentive to exercise exists • Consider all factors (contract, asset, market and entity based)
Lease payments • Lease payments include: • Fixed payments (bundled services must be bifurcated) • Variable payments based on index or rate (e.g., CPI or LIBOR) • Termination penalties (if term is assumed not to be renewed) • Residual value guarantees, at the amount expected to be paid, if any (lessee only); lessor does NOT include all types of them • Exercise price of purchase option included in lease term • Contingent rents based on performance or usage would be excluded: • Recognized as incurred/accrued • Contingent rents must be truly variable to be excluded (aka not “disguised min lease pmts”)
Lease Models “Right to use” leased property LessorModels LesseeModels Lease payments Short term leases - use op lease method Receivable & Residual approach Short term leases - use op lease method Right of use model* Operating Lease Recognize “right of use” asset Recognize receivables and residuals Recognize liability to make lease payments Derecognize leased property *2 lease types: SLE (Type B) vs.I&A (Type A) leases with different P&L cost patterns Most TRALA leases will be classified Type A for lessees & R&R for lessors
Lease Classification – ROU Model Lessees: • 2 new lessee types and approaches (except for short term leases) • Interest & Amortization (I&A) (Type A) • The lease is capitalized and the asset is amortized straight line and interest is imputed on the liability. • The result is a front ended expense pattern. • Single Lease Expense (SLE) (Type B) • The lease asset and liability are capitalized, then adjusted each month With inoerest imputed on the liability and plugged amortization on the asset to create a single (straight line) lease expense Lessors: • Receivable & Residual (R&R) (Type A) • Record a PV receivable & residual asset, recognize finance income • Operating Lease (OL) (Type B) • Same as FAS 13 method
Lease Classification – ROU Model Lessees: • Real estate and equipment leases are treated drastically differently. • For equipment leases – including most vehicle leases • It is presumed that the lease is an I&A lease for lessees (bad news!) and an R&R lease for lessors (good news!) • Unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the lease payments is insignificant relative to the fair value of the asset • These criteria are radically different for lessees than under existing FAS 13 GAAP so that most equipment leases will have front ended lease costs • For real estate leases • It is presumed the lease is a SLE lease for lessees and operating leases for lessors • Unless the lease term is for the major part of the economic life of the underlying asset; or the present value of fixed lease payments accounts for substantially all of the fair value of the asset. • These criteria are virtually the same as the line under existing FAS 13 GAAP so that most real estate leases will have straight line rent expense • Net result: balance sheet amounts for equipment capital & operating leases are jumbled & analysts won’t be able to adjust to get what they need!!!
Determining lease type So, the million $$$ question – What is insignificant??? • FASB/IASB – no bright lines; joint webinar examples (lease term versus life) Property Commercial real estate (10 yr/40 Yr) I&A SLE Commercial real estate (30 yr/40 Yr) Other Than Property Truck (4 Yr/10 Yr) Vessel (20 Yr/40 Yr) SLE I&A Airplane (8 Yr/25 Yr) Car Fleet (3 Yr/6 Yr) Vessel (5 Yr/40 Yr) Re the PV test 10% has traditionally been the “insignificant” bright line
Lessee Project Summary Lessees: • Capitalizes lease assets & liabilities via complex calculations & adjustments ignoring lease economics • Short term leases can use existing operating lease accounting (off balance sheet) • Estimate lease term & payments (include only bargain/compelling renewals, bargain POs, “rate & index based” contingent rents & value of residual guarantees) and capitalize at incremental borrowing rate with continual adjustments to estimates • Unbundle full service lease payment or else capitalize the whole payment – lease portion should be capitalized, service portion should be expensed as paid • New classification tests – different for real estate and equipment • Real estate lease get straight line rent expense (SLE or single lease expense method) • Equipment lease costs front ended – amortization & imputed interest (I&A or interest and amortization method) • Deferred tax accounting needed for all equipment leases
Front Ending of Lessee Lease Cost Imputed Interest Expense + Depreciation Book Expense Str LineRent Exp Imputed Int Exp Depreciation of ROU Asset Mid Point Expiry Lease Term
What is SLE accounting?Example A company enters into a three-year lease for new office space and agrees to pay the following: $10,000 in year 1, $12,000 in year 2 and $14,000 in year 3. The present value of lease payments is $32,500 (using a discount rate of 5%). * Consists of
What is I&A accounting?Example A company enters into a three-year lease for new $1,000 (list price) PC and agrees to pay the following: $339 per year in arrears. The present value of lease payments is $890 (using a discount rate of 7%).
What is the Project? TRALA Lessee Issues & Impact
Lessee Analysis TRALA Product Offerings
What might the numbers look like? Truck lease example: Vehicle cost $89,000.00 Lease term 84 months Basic rent payment $1,101.51 Lessee incremental borrowing rate 7.00% PV of basic rent $72,983 Percent capitalized vs. truck cost 82% Capitalization Journal Entry: Right to Use Leased Asset $72,983 Capitalized Lease Obligation $72,983 To record lease at inception (PV of lease rents) • Issues with bundled billed full service leases: • Lessee must bifurcate service portion or capitalize whole payment (results in well over 100% of vehicle cost capitalized!) • Lessee will ask for break out of lease and service portions of payment
Implications for Lessees • The PV of the lease rents will be recorded by the lessee as an asset and liability. As an example, assume a 5 year $100,000 truck, where the PV rents are capitalized at $89,517 or 89% of cost assuming a 8% discount rate (incremental borrowing rate). • The P&L pattern will not represent the economic nature of a rental agreement as it will be front-ended as level rent expense is replaced by imputed interest on the liability at 8% and straight line depreciation of the capitalized asset. For a 5 yr lease with monthly rents of $1,815 the increase in first year expense is $2,333 or 11% higher than straight line. • P&L Pattern YR 1 YR 2 YR 3 YR 4 YR 5 TOTAL • Current GAAP 21,781 21,781 21,781 21,781 21,781 108,905 • Proposed GAAP 24,114 23,026 21,863 20,618 19,286 108.905 • Difference (2,333) (1,245) (82) 1,163 2,495 0 • Difference -11% -6% -6% 11% 0.0% • The lessee will have to include contractual rents, bargain POs, bargain/compelling renewals & estimated payments under residual guarantees. Non bargain renewals and POs ignored in TRACs. Estimates to be reviewed & adjusted at each reporting date with complex calculations & catch-up adjustments to be made. • The P&L pattern will not match the IRS tax treatment triggering deferred tax accounting.
Customer Talking Points New rules will capitalize lease payments on balance sheet Amount capitalized will be less than if you borrow to buy P&L cost will be front loaded for most vehicle leases Not logical - rent should be the expense The leasing industry & lessees will fight through comment letters % of front loading may not be material The front ending “turns around” so the reported cost is the same as total rents Reasons for leasing remain Service/outsourcing/convenient Capitalized payments less than cost to buy Additional source of financing 100% financing/level payments Low financing costs/tax benefits/residual Right to return equipment/transfer residual risk
What is the Project? - Lessor Details • Lessor classification same as for lessees • There are 2 methods as proposed • The Receivable & Residual (R&R) method for most vehicle leases (Type A leases) • The Operating Lease method (for lease terms of one year or less – without renewal options & most RE leases(Type B leases)) • Lessors rebook virtually all leases except short term leases on transition
Lessor accounting - receivable and residual(most equipment leases) • Record a lease receivable • Allocate a portion of the carrying value of the underlying asset to the right-of-use asset “sold” • Recognize “sales type” profit (or loss) for the difference between the PV of lease payments and the carrying value allocated to right-of-use asset “sold” • Record a residual asset as an allocation of the carrying amount of the underlying asset • “Sales type” profit associated with the residual asset would be deferred until the asset is subsequently sold or re-leased Right-of-use “sold” Underlying asset Residual asset
Assumptions: A lessor manufactures a machine for $7,500 with a fair value of $10,000 = $2,500 gross profit Enters into a three-year lease with annual lease payments of $2,400 paid at end of each year Expected fair value of the residual asset at the end of the lease term is $4,770 Interest rate implicit in the lease is approximately 7.87% Lease receivable (PV of annual lease payments of $2,400 at 7.87%) = $6,200 (rounded) Carrying value of asset allocated to right-of-use asset “sold”: $7,500 x $6,200/$10,000 = $4,650 Profit recognized at lease commencement: $6,200 – $4,650 = $1,550 (or 62% of $2,500 gross profit) Gross residual (PV of the estimated FV of residual asset of $4,770 at 7.87%) = $3,800 (rounded) Carrying value of asset allocated to residual asset (net residual): $7,500 x $3,800/$10,000 = $2,850 Deferred profit: $3,800 – $2,850 = $950 Interest income on gross residual: $3,800 x 7.87% = $299 (rounded) Illustrative example – Receivable & ResidualLessor Commencement Subsequent (year 1) Lease receivable $6,200 Gross residual $3,800* Cost of sales $4,650 Deferred profit $950* Asset $7,500 Revenue $6,200 *Presented as net residual: $2,850 Cash $2,400 Interest income – receivable $ 488 Lease receivable $1,912 Gross residual $ 299 Interest income – residual $ 299
Illustrative example – Receivable & ResidualProposed standard vs. current standard
Lessor presentation – Receivable & Residual Balance sheet • Lease receivable and residual asset presented separately (summing to a total “lease assets”) or shown as one “lease assets” with two amounts disclosed in notes • Present gross residual and deferred profit together as a net residual asset Income statement • Lease income and expense (e.g., revenue and cost of sales) in separate line items or net in a single line item (lease income), depending upon lessor’s business model • Income and expense from lease transactions presented separately in income statement or disclosed in the notes • Accretion of residual asset in interest income • Amortization of initial direct costs as an offset to interest income
Possible Strategies/Tactics Monitor the project – TRALA website, Leasing-101 website, IASB/FASB/ELFA websites, articles Comment to the FASB Sales training Understand proposed rules Talking points Dealing with objections Review products Accounting driven products will change – no longer 100% off balance sheet Customer will know PV of rents Focus on FMV tax leases, TRACs and synthetics with low PVs Interim rents & certain contingent rents will be capitalized New products/offerings Use more TRAC-type structures Develop a “residual guarantee” product Provide accounting info to customers as a service Lease Accounting Project
What is the Industry Doing? TRALA issued a comment letter to the FASB/IASB citing major issues re the first ED: Estimating payments and adjusting continuously makes compliance costly and burdensome Immaterial leases (cost =/< $250,000) and short term leases should be exempt from capitalization Lease cost should be straight line Different leases should be accounted for differently Contingent rent and non-bargain renewals are not liabilities to be capitalized Full service leases should not be unbundled – should be service contracts Results: They changed positions on renewals, mileage based contingent rents, short term leases & revised lessor methods
What is the Industry Doing? TRALA & the NPTC issued an unsolicited comment letter to the FASB/IASB citing major issues re their final decisions: Classification tests S/B the same for equipment and real estate leases & S/B based on FAS 13 & same as tax & legal view Lease cost for former operating leases S/B straight line to preserve capital Capitalized op lease liability should not be called “debt” to avoid covenant breaches/preserve borrowing capacity Rules are too complex – most lease customers are small companies
What is the Industry Doing? TRALA, ELFA & worldwide leasing trade organizations jointly interacting with the FASB & IASB providing industry input & expertise Influencing the process to: Lessee accounting should reflect lease economics SL recognition of lease expense Operating lease liability not “debt” Avoid burdensome compliance for our lessee customers Save DFL, leveraged & sales-type lease accounting and get tax effected DFL-like income recognition for true leases PR campaign Engage lessees & manufacturers/lessors encouraging comment letters Meetings, articles & webcasts Results: Got them to change position on renewals, mileage contingent rents and short term leases Got them to reconsider lessor accounting model
WE NEED COMMENT LETTERS!!! • Read the Exposure Draft dated May 16, 2013 • Comment on the Exposure Draft • Deadline for comments will be September 13, 2013 • Get your customers and their parents to comment • There is an unofficial hierarchy of comment letters: • User/lender comment letters carry the most weight • Preparers are next in importance • Lessor trade associations letters are viewed as self serving – sotrade associations alone cannot change their views
