The FASB Lease Accounting ProjectOverview, 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 Issue

dAugus

t 2010

Redeliberations Jan 2011 – September

2012

Comment LettersDec 2011

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

Outreach

Final Standard

2014

Comment

Letters Due

9/13/13

New ED To Issued 5/16/2013

Draft New EDNow

Re-deliberate4 QTR 2013 & into 2014

Questions addressed by the Boards

What is a lease?

What is the lease

term?

What are the lease payments

?

How to account for short

term leases?

How does a lessee allocate cost?

How does a lessor

recognize income?

4

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

5

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)

6

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”)

7

Lease Models

LessorModels

LesseeModels

Short term leases - use op

lease method

Short term leases - use op

lease method

Right of use model*

Right of use model*

“Right to use” leased property

Lease payments

Short term leases - use op

lease method

Short term leases - use op

lease method

Recognize receivables and

residuals

Recognize receivables and

residuals

Derecognize leased

property

Derecognize leased

property

Receivable & Residual approach

Receivable & Residual approach

Recognize “right of use”

asset

Recognize “right of use”

asset

Recognize liability to

make lease payments

Recognize liability to

make lease payments

Operating Lease

Operating Lease

*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

Other Than Property

Commercial real estate (10 yr/40 Yr)

Commercial real estate (30 yr/40 Yr)SLE I&A

SLE I&A

So, the million $$$ question – What is insignificant???• FASB/IASB – no bright lines; joint webinar examples (lease term versus life)

Car Fleet (3 Yr/6 Yr)

Vessel (20 Yr/40 Yr)

Airplane (8 Yr/25 Yr)Vessel (5 Yr/40 Yr)

Truck (4 Yr/10 Yr)

Property

1111

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

Boo

k E

xpen

se

Lease Term

Str LineRent Exp

Imputed Interest Expense + Depreciation

Depreciation of ROU Asset

Front Ending of Lessee Lease Cost

Mid PointExpiry

Imputed Int Exp

What is the Project?

The Effect of Front Ending Lease Costs

Lease Term First Year Increase in Lease Cost – proposed rules vs. current GAAP

3 Years 7%

5 Years 11%

7 Years 16%

10 Years 21%

20 Years 28%

What is SLE accounting?Example

Initial Year 1 Year 2 Year 3

Income statement*: $12,000 $12,000 $12,000

Lease expense $12,000 $12,000 $12,000

Balance sheet

Right-of-use asset $32,500 $22,125 $11,333 $ –

Liability to make lease payments $(32,500) $(24,125) $(13,333) $ –

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

Initial Year 1 Year 2 Year 3

Interest expense $ 1,625 $ 1,208 $ 667

Amortization expense $10,375 $10,792 $11,333

Total $12,000 $12,000 $12,000

15

What is I&A accounting?Example

Initial Year 1 Year 2 Year 3 Total

Income statement:

Interest expense $ 62 $ 43 $ 22

Amortization expense $297 $296 $ 297

Lease expense $359 $339 $319 $1,017

Balance sheet

Right-of-use asset $890 $593 $297 $ 0

Liability to make lease pmts

$(890) $(613) $(317) $ 0

Average rent paid $339 $339 $339 $1,017

% Lease exp B/(W) average rent

(6%) 0 6%

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%).

16

What is the Project?

Issue Impact

New ROU asset & lease liability capitalized – but not broken out

Same as calculation S&P and Fitch, less than Moody’s capitalizes

Lease costs front ended for equipment leases

Up to 16% higher than today in year of transition, 3 to 8 years to turn around

Cash rent paid still the IRS tax deduction

New deferred tax assets on B/S

Bundled payment Must break out service to avoid capitalization

Lease cost more evident Capitalize interim rents, CFO involved

Lease treated as capital item No longer in operating budget, tougher internal approval process

Simple short-term lease method Good news for terms of 12 mos or less with no option to renew

Compliance costs Transition, ongoing process, complex

TRALA Lessee Issues & Impact

Lessee Analysis

Product Impact

Short Term Rental (1 yr or less with no option to renew)

Exempt from new rules – election to continue to use operating lease method (off balance sheet)

Full Service Lease “Lease” portion of pmt capitalized - lessee must break out the “service” portion or else the whole payment amount is capitalized

Operating (Tax) Lease Capitalized, but PV lower than equipment cost

Synthetic Lease/TRAC Capitalize only contractual rents, compelling renewal rents & estimated residual guarantee payments – capitalizes far less than expected

Capital lease Capitalized as under current rules

TRALA Product Offerings

Impact by Lessee Type

Lessee type Potential impactInvestment grade/large companies

Some negative impact as leases often accounting focused, have more sources of capital, more analytical staff, loss of leveraged lease product increases lease costs

Non-investment grade/small & medium sized

Less impact as source of capital is prime reason for leasing, fewer sources of capital, level payments & 100% financing conserves cash, less concerned about balance sheet optics, less staff to analyze lease and less analytical

Municipal/tax exempt No change in municipal market as GASB, not FASB, issues rules and operating leasing appears to be retained by GASB, tax exempt leasing offers lowest cost, leasing avoids issuing debt with all its constraints

Truck lease example:Vehicle cost $89,000.00 Lease term 84 monthsBasic rent payment $1,101.51Lessee incremental borrowing rate 7.00%PV of basic rent $72,983Percent capitalized vs. truck cost 82%

What might the numbers look like?

Capitalization Journal Entry:

Right to Use Leased Asset $72,983Capitalized Lease Obligation

$72,983To 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.

Lessee TRAC Lease ExampleAssumptions Open end lease - level rent vehicle cost $20,000.00 lease term in mos 36 rent pmt $/% of cost $364.00 1.82% TRAC $10,000.00 50% delivery date 1/1 Lessee incr bor rate 7.50% TRAC = FMV Options accounted for at fair value % of cost Capitalized value under proposed rule $11,701.84 58.51% Lessee Financials Year end Year end Year end inception 1 2 3 totals Assets $11,701.84 $7,801.23 $3,900.61 $0.00 Liability $11,701.84 $8,088.96 $4,195.61 ($0.00) depreciation $3,900.61 $3,900.61 $3,900.61 $11,701.84 interest cost $755.12 $474.64 $172.39 $1,402.16 total expenses $4,655.74 $4,375.26 $4,073.01 $13,104.00 Annual rents $4,368.00 $4,368.00 $4,368.00 $13,104.00 Rents paid vs. book expense ($287.74) ($7.26) $294.99 $0.00 tax timing difference ($287.74) ($7.26) $294.99 $0.00 Tax rate 35.00% 35.00% 35.00% deferred tax amount ($100.71) ($2.54) $103.25

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

Business Reasons for Leasing Reason for Leasing

Details Status After Proposed New Rules

Raise Capital Additional capital source, 100% financing, fixed rate, level payments, longer terms

Still a major benefit versus a bank loan especially for SME & non-investment grade lessees with limited sources of capital

Low cost capital Low payments/rate due to tax benefits, residual & lessor low cost of funds

Still a benefit versus a bank loan

Tax benefits Lessee can’t use tax benefits & lease vs. buy shows lease option has lowest after tax PV cost

Still a benefit

Manage assets/residual risk transfer

Lessee has flexibility to return asset

Still a benefit

Service Outsource servicing of the leased assets.

Still a benefit

Convenience Quick & easy financing process often available at point-of-sale

Still a benefit

Regulatory Capital issues Partial benefit if the PV < cost of the asset, S/B true for hi residual assets w tax benefits

Accounting Off balance sheet Partial benefit if the PV < cost of the asset, S/B true for hi residual assets w tax benefits

• 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

What is the Project? - Lessor Details

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

Underlying asset

Residual asset

Right-of-use “sold”

26

Illustrative example – Receivable & ResidualLessor

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 = $4,650Profit 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 = $2,850Deferred profit: $3,800 – $2,850 = $950

Interest income on gross residual: $3,800 x 7.87% = $299 (rounded)

Commencement

Lease receivable $6,200Gross residual $3,800*Cost of sales $4,650

Deferred profit $950*Asset $7,500Revenue $6,200

*Presented as net residual: $2,850

Subsequent (year 1)

Cash $2,400Interest income – receivable $ 488Lease receivable $1,912

Gross residual $ 299Interest income – residual $ 299

27

Illustrative example – Receivable & ResidualProposed standard vs. current standard

Proposed standard Current standard

Period ReceivableGross residual Deferred profit Net residual Profit

Profit(sales-type lease)

Initial $6,200 $3,800 $ (950) $2,850 $1,550 $2,500

Year 1 $4,288 $4,099 $ (950) $3,149 $ 787 $ 787

Year 2 $2,225 $4,422 $ (950) $3,472 $ 660 $ 660

Year 3 $ $4,770 $ (950) $3,820 $ 523 $ 523

Total prior to sale of residual $3,520 $4,470

28

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

29

Lessor Issues & Impact

Issue Impact

Short term leases exempt Elect to keep using operating lease method

New Receivable & Residual (R&R) method

Almost identical to current direct finance method – earnings @ implicit rate

Sales-type gross profits Recognized on all R&R leases but residual portion deferred until residual resolved

Residual value insurance Need for RVI?? No operating lease accounting, may change residual to a financial asset?

FAS 166 receivable sales Receivables under former operating may be financed as asset sales – works best for synthetic leases (non-tax leases)

Transition Virtually all leases rebooked, huge project, revise systems

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 – so trade associations alone cannot change their views

Remaining Advocacy Issues – Lessee

Issue Desired outcome Basis for request

Lessee cost pattern for equipment leases

•Maintain current straight line average rent expense for all operating leases as they are executory contracts

•Reflects economics of an executory contract•Asset = liability reflects value of the contract•Matches revenue with costs in rent reimbursement scenarios•Matches tax and legal view

Lessee balance sheet presentation

Lease liability re capitalized operating leases should be separately reported and not labeled as debt

•Legally not the same as debt in bankruptcy•Intent of debt limits is to limit more debt having same legal claims on assets•Avoids debt covenant limits

Sale leasebacks with any PO not considered sales per Rev Rec

A non bargain purchase option should not negate sale treatment

All the risks and most of the rewards in the asset’s residual value have transferred to the buyer indicating that a sale has taken place

Renewals that rise to a significant economic incentive are booked at inception & costs are front ended

Renewals should be booked at commencement & the cost pattern should be straight line

•New leases are booked at commencement•Front ending costs creates a saw toothed pattern•Costs of the renewal are accelerated into the remaining term of the base lease

Ease requirements for bundled lease payments

Estimates s/b allowed if no rates available to lessee

•Elements of pricing proprietary•Full capitalization onerous/incorrect

Remaining Lease Project Advocacy Issues - Lessor

Issue Desired outcome Basis for request

Gross profits deferred in proportion to residual risk

RVI & RVGs to be considered in the profit calculation

A guarantee/insurance changes the residual’s nature to a financial asset

Required symmetry in lease classification with the lessee tests

•Lessor business model should be the basis for lease classification•Lessors in the “operating lease” business should get operating lease treatment as real estate lessors do

•For financial lessors, the R&R method best reflects the economics for their business•For operating lessors, operating lease accounting best reflects the economics of their business

Tax benefits should be factored into the revenue recognition of leases

•The after tax yield on the net cash invested should be the pattern of revenue recognized in R&R leases•ITC should be a revenue item

•Tax benefits are as much a part of revenue as rents and residual sales•Some transactions have significant tax benefits & ignoring them distorts revenue recognition

Leveraged leases •Grandfather existing deals•Retain some form of leveraged lease accounting

•Reflects economics of the transaction•Avoids capital adequacy issues•Reduces lease rates

Questions ?