Download - Lease Accounting Changes Primer
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8/7/2019 Lease Accounting Changes Primer
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Primer: Proposed Lease Accounting Changes
Background, Impact and Action
Thomas Ball
http://www.dealerbahn.com
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Proposed Lease Accounting Changes 2
Disclaimer
This presentation is 2010 DealerBahn LLC. All rights reserved. No part of this document maybe reproduced, transmitted or otherwise distributed in any form or by any means, electronic ormechanical, including by photocopying, facsimile transmission, recording, rekeying or using any
information storage and retrieval system, without written permission from DealerBahn LLC.DealerBahn LLC expressly disclaims any liability in connection with use of this presentation or itscontents by any third party. This information is provided "as is", with no guarantees ofcompleteness, accuracy or timeliness, and without warranties of any kind, express or implied.
This publication is general in nature and is not intended to answer specific questions or suggest
suitability of action in a particular circumstance.
Every effort has been made to offer current and accurate information. However, the informationherein should not be relied upon for your, or your companys, specific situation.
The information presented in this publication should not be construed as legal, tax or accounting
advice. You should consult with professional advisors familiar with your particular situation foradvice concerning specific matters before making any decisions.
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Proposed Lease Accounting Changes 3
Six Reasons Why Business Managers Should
Care About Proposed Lease Accounting Rules
1. Revised lease accounting islikely to have a drastic impacton your businesss financialstatements
2. Existing and future leasecontracts for real estate, officeequipment and productionequipment will be effected
3. Incentive compensation.Beware if your bonus plan(s)are based on financial metrics
4. Sale treatment could be atrisk for companies who useleasing to fund sales
5. Liquidity and fundingresources. Deteriorating debtcovenant ratios could restrictborrowing capacity
6. It is going to cost time andmoney to assess andimplement new rules
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Proposed Lease Accounting Changes 4
Global Conversion to Common Accounting Rules
Accounting standard setting organizations around the world have agoal to remove differences in accounting treatment betweencountries
Objectives:
Transparency
Consistent application
Comparable treatment and form
Lease accounting is one of the first standards to be addressed as aglobal standard
In2005, the SEC estimated the undiscounted amount of off-balance-sheetlease obligations at $1.25 trillion.
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Proposed Lease Accounting Changes 5
Scope of the Proposals
Contracts that do NOT meetlease definition
Contracts that meet lease definition
Intangible Assets
Natural Resource leases
Biological assets
Contracts that do not meetlease definition
In-substance sales orpurchases
Investment property leases
Service / Maintenance
Short-term leases (
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Proposed Lease Accounting Changes 6
Current Lease Accounting in the U.S.
Rules based approach
Two types of leases: Operating and Finance
Problems with current approach All leases are not required to be shown on the lessees (users) balance
sheet
Rules based approach leaves too much room for accounting
manipulation Does not fully consider impact of contingent payments or purchaseoptions on lessees financial position
Credit analyst and investor concerns:
Requires uniformed estimates and adjustments
Limits comparability between periods and peers
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Proposed Lease Accounting Changes 7
IFRS* Proposed Lease Accounting Standards
Principles based, Right of Use accounting
All current andfuture leases must be capitalized and presented on thebalance sheet
Capitalized amounts = Present value of most likely lease payments plus
contingent and guaranteed items
Short term leases (
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Proposed Lease Accounting Changes 8
IFRS Proposed Lease Accounting Standards
Requires reassessment of lease value at every reporting period
Considerations: Term, contingencies, guarantees, useful life
Service contracts and executory expenses must be capitalized if they arenot separated from lease terms
Excludes: Intangible assets, maintenance and security, taxes andinsurance, and mineral leases
Final Rule expected in 2011; Implementation expected as early as 2013(?)
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Proposed Lease Accounting Changes 9
Accounting Treatment
Lessee Accounting
Classify cash repayments and interest payments related to leases asfinancing activities. (Interest expense from leases is NOT included inoperating expenses) Equipment acquisition must be classified ininvesting.
Cash FlowStatement
Depreciation expense for right to use asset. Straight line depreciation is
default method.
Interest expense to recognize money costs. (Interest method)
Lessor will only be able apply sale treatment when applyingderecognition approach
Income Statement
Right of Use Asset (ROU) Equal to lease liability at inception.
Presented as separate component of property, plant and equipment.Payment Liability Equal to present value (at incremental borrowingrate) of most likely lease payments including contingent rents, purchaseoptions, and residual guarantees. Amortized using interest method.
Balance Sheet
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Accounting Treatment
Lessee Accounting: Front-end loaded expense pattern
Interest Expense
ROU Depreciation
Current Expense Pattern
Interest Expense
+ ROU Depreciation
New Standard
Total Expense
$
Time
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Proposed Lease Accounting Changes 11
Accounting Treatment
Lessee Accounting: Balance Sheet Pattern
Right to Use Asset
Current Method:
Deferred Tax Liability
$
Time
Lease Liability
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Lessee Example
Differences in depreciation andinterest amortization createsequity shortfall
Relative to current operating leaseaccounting, proposed accountingyields higher total expense in early
portion of the lease that is offset inlater periods.
Lease Term Assumptions
Commercial Equipment X Operating Lease to LesseeMonthly Lease Payments 10,000$ No contingent rentsLessee's incremental borrowing rate 6.00% No purchase option
Lease Term (Mos) 60 No residual value guarantees
Lease Inception Y1 Y2 Y3 Y4 Y5
Balance Sheet
Current Accounting $0 $0 $0 $0 $0 $0
Proposed Accounting
Right to Use Asset $519,842 $415,874 $311,905 $207,937 $103,968 $0
Lease Obligation $519,842 $425,803 $328,710 $225,629 $116,189 $0
Net Equity $0 ($9,930) ($16,805) ($17,692) ($12,221) $0
Income Statement
Current AccountingRent Expense 120,000$ 120,000$ 120,000$ 120,000$ 120,000$
Proposed Accounting
Depreciation on Right
to Use Asset$103,968 $103,968 $103,968 $103,968 $103,968
Interest Exp on LeaseObligation
25,961$ 22,907$ 16,918$ 10,561$ 3,811$
Total Prop Accounting Expense $129,930 $126,875 $120,887 $114,529 $107,779
Diff b/t Current and Proposed (9,930)$ (6,875)$ (887)$ 5,471$ 12,221$
Cumulative Difference (9,930)$ (16,805)$ (17,692)$ (12,221)$ 0$
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Proposed Lease Accounting Changes 13
Accounting Treatment
IncomeStatement
Balance Sheet
Lease Income
Depreciation Expense
Interest Income
Sales Revenue
Cost of Sales
Interest Income
+ Asset: Equipment
+ Asset: Lease Receivable
- Liability: Right of Use Liability
= Net Asset or Liability
Asset: Equipment Residual
Asset: Lease Receivable
Performance ApproachDerecognition Approach
Lessor Accounting
LessorAsset RiskTransfer
Lessee
NO sales treatment!
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Potential Impact of Proposed Standards
Changes to financial statements due to the proposed standards will alter keyfinancial ratios for many businesses. Businesses should consider the impacton common debt covenant ratios:
Net worth
Debt to EBITDA Interest coverage
Leverage (debt / assets)
Current fundingarrangements
Lessee expenses would be front loaded due to interest method amortizationof lease liability. Lessor earnings would also be front loaded but withsignificant declines during interim periods before lease termination.
Earnings Patterns
Lessees will be required to capitalize all existing and future leases. Lesseedebt covenants could be triggered after implementation of the new leasestandards. Lease liability must be reassessed at each reporting period andvalues adjusted to reflect most likely scenario.
All current andfuture leases mustbe capitalized
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Proposed Lease Accounting Changes 15
Potential Impact of Proposed Standards
For lessees, rent expense (an operating expense) will be replaced with interestand depreciation expense. To the extent that value calculations are confined
to EBITDA and constant multiples, then valuation metrics should rise. Theincrease is due to the removal of rent expense from the EBITDA equation.
Business Valuation
/ EBITDA
Current accounting rules classify expenses related to operating leases asrent. The proposed accounting will replace rent expense with the sum ofdepreciation of the right to use asset plus amortization of the lease paymentliability using the interest method.
The net effects are:
1. Higher EBITDA, as rent will be removed2. Lower interest coverage ratios
3. Different characterization of expense between accounting and taxrecords
Rent Expense vs.Depreciation andInterest Expense
Sales / Leaseback transactions will continue to be used where the primarypurpose is cash generation. However, sale leaseback will no longer be aviable tool to reduce demands on capital.
Sale / Leaseback
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Potential Impact of Proposed Standards
Businesses should plan for increased spending related to conversion to thenew accounting standards. IT systems will need to be designed, tested andimplemented to accommodate change in accounting treatment. Consulting
and technical assistance is likely to be required to properly establish controland IT systems. (General ledgers, sub ledgers, inventory systems)
Compliance / ITSystems
Businesses who use leases as selling tool will only be able recognize grossprofit on sales if they use the derecognition approach. Further, even ifderecognition approach is used, the profit on sale using the derecognitionapproach excludes the portion of gain attributed to residual asset.Transactions that do not qualify as sales will be treated as a financing
arrangements by both the lessor and the lessee.
Sale Recognition
Since cash rents will remain deductible by IRS, most lessees will book adeferred tax asset to recognize permanent timing difference.
Book / Tax TimingDifferences
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Business Impact
New rules require a greater reliance on management judgment toproperly apply correct accounting treatment and revenuerecognition methods
Changes limit the ability to financially engineer equipmentacquisitions
Accounting period assessment and adjustments could be
cumbersome and expensive to implement Performance metrics and management incentive programs
Probable negative effects on credit / debt covenant ratios
Leasing will remain a viable tool for acquiring new equipment forlessees desiring to limit cash outlays for capital expenditures
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Proposed Lease Accounting Changes 18
Business Impact
Customers likely to ask for:
Shorter lease terms
Separate billing for lease payments, services, taxes
Manufacturers likely to experience diminished accounting profitsfrom lease transactions
Banks and other credit providers will be required to carry morecapital. Will this limit supply or increase price?
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Recommended Actions
1. Invest time required to learn fundamentals of proposed leaseaccounting changes
2. Inventory all lease agreement
Documenting contingencies, residual guarantees, andpurchase options
3. Develop preliminary impact assessment:
Transition costs
Impact on financial statements and debt covenant ratios
Systems support needs
4. Develop a plan for addressing lease accounting changes
Strategy for future capital expenditures
Talking points for bankers and equity investors
Renegotiation of existing lease and debt agreements
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Contact:
Thomas [email protected]
http://www.dealerbahn.com
DealerBahn provides high value on-demand services todistributors and users of commercial equipment
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