Lessee Accounting for Leases

July 29, 2010

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Agenda

Topics to be Covered:

• Lease Classification – Operating– Direct Financing

• Accounting and Reporting for Leases– Operating– Direct Financing

• Nonlevel Rents• Leasehold Improvement Amortization• Tenant Incentives• Our Audit Approach• Other Lease Issues and Current Developments

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Capital Leases (ASC 840—30)

• A capital lease is defined as a lease that meets one or more of the following criteria (ASC 840-10-25-1):

– The lease transfers ownership of the property to the lessee by the end of the lease term.

– The lease contains a bargain purchase option.

– The lease term is equal to 75 percent or more of the remaining estimated economic life of the lease property.

– The present value at the beginning of the lease term of the minimum lease payments

equals or exceeds 90 percent of the excess of the fair value of the leased property.

– If a lease does not meet one of the above criterion it is classified as an operating lease.

Bargain Purchase Option

• A provision allowing the lessee, at his option, to purchase the leased property for a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable and exercise of the option appears, at the inception of the lease, to be reasonably assured.

Situation

• Moss Adams OC Construction and Real Estate group leases a Citation X twin engine jet for five years in order to better serve their clients in Baton Rouge, Louisiana. The original purchase price for this aircraft would be $19 million. The estimated fair price for this aircraft after five years is $11 million. The purchase option at the end of the lease is for $5.5 million.

POLLING QUESTION 1

Is the purchase option considered a bargain purchase?a) Yesb) Definitely notc) Maybe?d) What is a Po’ boy?

75% Test

•If the lease term is equal to 75 percent or more of the estimated economic life of the leased property then the lease should be classified as a Capital Lease.

•Exception: If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

75% Test

– Lease Term - The fixed noncancelable term of the lease plus any of the following:

• covered by bargain renewal options• all periods, if any, for which failure to renew the lease imposes an

economic penalty• all periods, if any, covered by ordinary renewal options during which

there is a guarantee by the lessee of the lessor’s debt• all periods, if any, covered by ordinary renewal options preceding the

date as of which a bargain purchase option is exercisable.• all periods, if any, representing renewals or extensions of the lease at

the lessor’s option

– Estimated economic life:• The estimated remaining period during which the property is

expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at the inception of the lease, without limitation by the lease term.

POLLING QUESTION 2

• Which of the following should be considered in determining the term of a lease?

a) All periods during which the lessee reasonably expects to lease the property

b) A renewal period where an economic penalty is imposed on the lessee if the lessee does not renew under the renewal option

c) All renewal periods prior to the period a bargain purchase option is exercisable

d) All of the abovee) Items 1 and 3f) Items 2 and 3

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90 % Test

• If the present value at the beginning of the lease term of the minimum lease payments to be paid by the lessor equals or exceeds 90 percent of the fair value of the leased property to the lessor at the inception of the lease the lease is a Capital Lease.

• Exception: If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

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90% Test – Minimum Lease Payment Calculation

• Minimum rental payment include the following:

– The minimum rental payments called for by the lease over the lease term.

– Any guarantee by the lessee of the residual value at the expiration of the lease term.

– Any payment that the lessee must make or can be required to make upon failure to renew or extend the lease at the expiration of the lease term

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90% Test – Minimum Lease Payment Calculation

• The Present Value of the Minimum Lease Payment is determined by using the lower of :

– The lessee’s incremental borrowing rate; or– The implicit rate in the lease, if it is practicable for the lessee to learn

the implicit rate; plus– the guaranteed residual value

• (Hint: This is NOT always explicitly stated!)– Contingent rentals

POLLING QUESTION 3

• QUESTION: What best describes a company’s incremental borrowing rate?

a) The rate of interest charged on the Company’s only loanb) LIBOR plus a spread of 100 to 500 basis pointsc) The rate included in a loan for equipment the Company is

considering buying

Capital vs. Operating

• HANDOUT 1 – Key Equipment Finance dated11/20/2007

Additional Information:Asset Useful Life – 7 years

– DETERMINE IF THIS IS A CAPITAL OR OPERATING LEASE

POLLING QUESTION 4

• Is the lease a capital or operating lease?

a) Capitalb) Operating

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Accounting for Capital and Operating Leases by Lessee

• Capital Leases– Accounting

• Record an asset (leased equipment) and a liability (lease obligation) equal to the present value of the rental payments

• Record depreciation for the asset over the economic life of the asset– Disclosures

• Include the gross amount of the asset, future minimum lease payments, total noncancelable minimum sublease rentals, total contingent rentals, and a general description of the lessee’s arrangements

• Operating Leases– Accounting

• Do not record an asset or liability• Record rental expense as rental payments are made to lessor

– Disclosures• For leases in excess of one year include future minimum lease payments and total

minimum rentals• Include rental expense and a general description of the lessee’s arrangements

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Nonlevel Rents

• ASC 840-20-25-2 (Nonlevel Rents)

– When is the inception of these lease?

– What qualifies as a scheduled rent increase?

– The period between the lease agreement and completion of construction may be a rent holiday

– Straight-line recognition of lease expense

• Exceptions to the straight-line method

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Non-level (escalated) Rents

• Case Study• Smith, a pharmaceutical company, leased office space from Jones. Smith took

possession and began to use the building on July 1, 2009. Rent was due the first day of each month. Monthly lease payments escalated over the 5 year period of the lease as follows:

Period Lease Payment• 7/1/09-9/30/09 $0- rent abatement during move-

in/construction• 10/1/09-6/30/10 $17,500• 7/1/10-6/30/11 $19,000• 7/1/11-6/30/12 $20,500• 7/1/12-6/30/13 $23,000• 7/1/13-6/30/14 $24,500

• What amount of deferred rent would Smith show in balance sheet at 12/31/12?

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Leasehold Improvement Amortization/Lease Terms

• ASC 840-10-35-6

• Leasehold improvements should be amortized over the shorter of the assets useful life or the lease term– Lease term is defined as:

• Fixed non cancelable term of the lease plus:– Periods covered by bargain renewal options– Lease imposes an economic penalty such that renewal appears reasonably

assured– Renewal periods under which there is a guarantee by the lessee of the lessors

debt.

– Include reasonably assured renewal periods

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Tenant Incentives

• ASC 840-20-25

• Payments made to or on behalf of the lessee represent incentives that should be considered reductions of rental expenses

• Leasehold improvements funded by the landlord under allowances should be recorded as leasehold improvements and amortized over the life of the lease

• The incentives should be recorded as deferred rent and amortized as reductions to the lease expense over the lease term

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Sale-Leaseback Transactions

• ASC 840-20

• What is a sale leaseback?

– Sale of property by the owner and a lease of the property back to the seller

– The same criteria are applied to determining whether or not the lease should be classified as a capital or operating lease

– There is generally a gain or loss that should be recognized (deferred, with some exceptions for “excess” gain).

– Guaranteed residual value should be considered for deferring any gain on the sale-leaseback

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Sale-Leaseback Transactions, (Continued)

Recognition of Gain or Loss

• Defer gain or loss and amortize over amortization period of leased asset if a capital lease, or in proportion to the gross rentals charged to expense over the lease term EXCEPT in the following situations:

– The seller-lessee retains the rights to only a minor portion of the remaining use of the property sold.

– The seller-lessee retains the rights to more than a minor portion but less than substantially all of the remaining use of the property sold.

– The fair value of the property at the time of the transaction is less than its undepreciated cost. In that event, a loss should be recognized equal to the difference between undepreciated cost and fair value.

(FROM PPC GAAP GUIDE)

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Polling Question 5

• Under which situation is a sale of property NOT recorded as stipulated by sale-leaseback accounting?

a) The seller-lessee retains, through a leaseback, retains substantially all of the benefits and risks incident to the ownership of the property sold.

b) The seller-lessee relinquishes the right to substantially all of the remaining use of the property sold retaining only a minor portion of such use.

c) The seller-lessee retains more than a minor part but less than substantially all of the use of the property through the leaseback.

d) Both b and c

e) All of the above

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Sale-Leaseback Transactions, (Continued)

• On December 31, 2009, XYZ Corp sold ABC Corp two airplanes and simultaneously leased them back. Additional information pertaining to the sale-leasebacks follows:

Plane 1 Plane 2• Sales Price $600,000 $1,000,000• Carrying Amt (12/31/09) $100,000 $550,000• Remaining Useful Life 10 years 35 years• Lease Term 8 years 3 years• Annual lease pmts $100K $200K

At 12/31/09 what amount should XYZ record as deferred gain on the transaction?

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Lease Amendments

• ASC 840-10-35-4 – Any change to provisions of the lease other than renewing or extending its term, in a manner that would have changed the classification of the lease had the changed terms been in effect at inception of the lease, are to be treated as a new agreement– Evaluate new agreement for classification of

lease (Capital v. Operating)

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Lease Amendments (Continued)

Asset and obligation are adjusted by the difference between the PV of the new minimum lease payments and the present balance of the obligation

• The PV of the minimum lease payments under the revised agreement is calculated using the interest rate used to record the lease initially.

– Change results in a new agreement and a change in classification from capital to operating

• Asset and obligation are removed, gain or loss recognized, and new lease is accounted for as an operating lease

– Early lease termination

• Asset and obligation are removed and gain or loss is recognized

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Sub-Lease Accounting

• If the nature of a sublease is such that the original lessee is not relieved of the primary obligation under the original operating lease, the original lessee(as sublessor) shall account for both the original lease and the new lease as operating leases.

• If costs expected to be incurred under an operating sublease (that is, executory costs and either amortization of the leased asset or rental payments on an operating lease, whichever is applicable) exceed anticipated revenue on the operating sublease, a loss shall be recognized by the sublessor.

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Our Audit Approach – Operating Leases

• Perform directed testing on selected leases utilizing section AS222 -224 to determine appropriate method for determining testing selections.

• Obtain and read copies of selected leases and any applicable amendments keeping in mind the issues, scan the leases, bookmark and highlight pertinent sections including lease terms, payments, etc. Include in the perm file with a summary of the lease and associated terms and determination of lease classification in the current year file or perm file.

• Obtain and test clients capital v. operating lease analysis

• Prepare (PFX template) or have client prepare the operating lease analysis

• Reconcile amortization expense and deferred rent to the general ledger

• Include special reps in representation letter

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Our Audit Approach – Capital Leases

• Obtain and read copies of selected leases and any applicable amendments keeping in mind the issues

• If new lease during the year– Test clients capital v. operating lease analysis– Confirm lease terms (you will generally not be able to confirm the present value– For leases selected for testing, obtain and test clients amortization schedule

• Does number of total payments and payments remaining agree to confirmation• Is interest rate reasonable and consistent with other obligations of the Company• Is term consistent with confirmation• Is monthly payment consistent with confirmation

– Obtain and test clients capital lease roll forward• For lease selected for testing, agree balances, interest paid, principal payments, to the

amortization schedule• Reconcile total interest to the general ledger

– Obtain and test clients capital lease payout• For leases selected for testing, agree future amounts to the amortization schedule

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Polling Question 7

• Is using a detailed schedule of leases showing annual rent payments to agree lease expense per the schedule to the client’s trial balance a SAP or test of details?

a) SAPb) TODc) OPEN FOR DISCUSSION?

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Current Developments

• FASB released a discussion paper on March 19, 2009

– Summary version:

»Most of what we just covered will become irrelevant!

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Current Developments

• The Board has proposed an accounting model that will require the lessee to recognize an asset (the lessee’s right to use the leased item for the lease term) and liability (the obligation to pay the rental amount) in all lease contracts. The result will be a significant change: the elimination of off-balance sheet reporting of operating leases. The Boards believe this change will increase the transparency and comparability of lease accounting.

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Current Developments

• What’s in scope? Deliberations are ongoing, but currently all leases will be in scope, except the following:– Leases of intangible assets, – Leases to explore or use natural resources, – Leases of biological assets. – Contracts that represent the sale or purchase of an asset.

• Tentative concession made for short-term leases (such as for copiers and laptops) defined as having a maximum possible lease term less than 12 months. The lessee would recognize the gross amounts payable and a corresponding right-of-use asset under a short-term lease in the statement of financial position. The concession for short-term leases would be optional for lessors.

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Current Developments

• Measurement: The lessee’s asset and the liability initially would be recorded “at cost”,

Cost = present value of the lease payments, discounted at the lessee’s incremental borrowing rate or implicit rate if easily determinable.

• Subsequent measurement of the lessee’s asset would be at amortized cost – Account description would be amortization rather than

rental expense. – Impairment consideration under existing guidance

would also be applied.

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Current Developments

• The lessor, using a performance obligation approach, would recognize an asset representing its right to receive rental payments from the lessee( a lease receivable) and a liability representing its performance obligations under the lease (i.e., its obligation to permit the lessee to use the leased item). Revenue would be recognized over the lease term, as the performance obligation is met. Subsequent measurement of the performance obligation would be at amortized cost using the effective interest method.

• Complex leases can have multiple components, such as renewal options, early terminations, purchase options, contingent rentals, and residual value guarantees. All the components of a lease would be looked at as a whole and not valued as individual components.

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Current Developments

• Timing and Transition: Assets and liabilities arise and would be recorded when a contract is signed. In addition, a company would provide disclosures about the assets and liabilities that arose upon contract signing. At the effective date of the new guidance, a lessee would apply the new lease standard by recognizing an obligation to pay rentals and an asset for the right of use for all outstanding leases at the transition date.

No grandfathering of existing leases is expected to be allowed.

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Current Developments

Potential Impact:

• Changing the fundamental basis of lease accounting will impact certain of our clients’ core operating decisions, such as lease versus buy and how to structure transactions.

• The change in accounting may drive changes in their capital planning and budgeting processes. And, the financial statement effects will certainly create a need to reconsider performance measures, key ratios, and financial covenants.

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Current Developments

• Next Steps: The proposal is under discussion with an Exposure Draft for public comment expected in Q3 2010, and a final standard expected in 2011.

• Many of our clients will be impacted by this proposed change, and would benefit from understanding it early. To facilitate an early discussion, get up to speed on this issue by visiting the lease project page on the FASB project pages, updated monthly.