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An Update on the FASB’s Lease
Project

September 25, 2012
                     Douglas Boedeker, CPA, CMA
                     Dboedeker@tatetryon.com
                     202-419-5106
Course Outline

   Why is the FASB doing this?


   FASB timeline


   Project scope


   Recording by lessees


   Recording by lessors


   Transition

      1
                                  © Copyright Tate & Tryon 2012
The FASB/IASB Lease Project – WHY?

 Leases are an important source of finance – more information required.

 Concern over lack of comparability.

 Concern over “bright-line” test for operating vs. capital lease.




       2
                                                                     © Copyright Tate & Tryon 2012
FASB Timeline

 Exposure Draft Issued – August 17, 2010

 Public Comment Period Ended – December 15, 2010, 786 comment letters
  were received

 Numerous redeliberations have taken place in 2011 and 2012

 A “New & Improved” Exposure Draft is anticipated in 4th Quarter of
  2012 (they might extend the public comment period past 120 days)

 Additional outreach and public comments in 2013

 Final standard to be issued - ?????


        3
                                                                © Copyright Tate & Tryon 2012
A Key Fact to Remember This Morning




Everything we talk about today is TENTATIVE!!!




     4
                                       © Copyright Tate & Tryon 2012
What is a “lease”?

A contract contains a lease if:

The fulfillment of the contract depends on the use of a
 specified asset; and

the contract conveys the right to control the use of the
  specified asset for a period of time.

Important note:
A physically distinct portion of a larger asset can be a
 “specified asset”.

     5
                                                      © Copyright Tate & Tryon 2012
Scope of the proposed standard

                         Simple – ALL Leases

Except :
           Leases of intangible assets
           Leases of mineral rights, etc.
           Leases of biological assets

FASB is still considering whether leases of internal use software should
be accounted for under the new rules.




      6
                                                               © Copyright Tate & Tryon 2012
What about service components?

 Each contract must be analyzed for lease and non-lease components.

 Contract payments are then allocated between the components based on
 observable purchase prices.

 If there are no observable purchase prices, all payments under the contract
 would be accounted for like a lease.

 Lessors would allocate payments in accordance with revenue recognition
 guidance.

 Question:
 Are items such as property taxes, insurance, and maintenance a
 “service” or part of a “lease”?

      7
                                                                    © Copyright Tate & Tryon 2012
Important Exception for Short-Term Leases

 Leases with a maximum possible lease term of 12 months or less can
  be accounted for the “old way”. No lease asset or liability is
  recognized.

 Any renewal options are considered in the determination of the 12
  month maximum period.

 Thus, month-to-month leases will likely not qualify as a short-term
  lease!




      8
                                                               © Copyright Tate & Tryon 2012
Lessee Accounting



 9
                    © Copyright Tate & Tryon 2012
There will be two types of leases….

 Interest & Amortization Approach
  -   Lessee consumes more than an insignificant portion of leased
      asset.

  -   Essentially similar to today’s “capital lease”.

  -   Will generally apply to equipment leases.




        10
                                                        © Copyright Tate & Tryon 2012
There will be two types of leases…

 Straight-Line Expense Approach

  -   Lessee does not consume more than an insignificant portion
      of leased assets.

  -   Essentially similar to today’s “operating lease” coupled with a
      balance sheet gross-up.

  -   Will generally apply to land/building (property) leases.




        11
                                                            © Copyright Tate & Tryon 2012
Initial Recording by a Lessee

1. Determine the “lease liability”
  (Future anticipated cash payments discounted to present value at
   either the lessee’s incremental borrowing rate or, if known, the rate
   implicit in the contract.)



2. Determine the “right of use asset”
  (Lease liability plus initial direct costs of acquiring the lease.)




      12
                                                                   © Copyright Tate & Tryon 2012
Lessee Subsequent Recording
Interest & Amortization Approach

1. Amortize the “right of use asset”. (Probably on a straight-line
   basis.)

2. Adjust the lease liability using the effective interest rate method.
   (Essentially treated like a note payable.)

3. Reassess significant assumptions and adjust for current facts and
   circumstances.

 Thus, the P&L reflects amortization expense and interest expense.

 Total expense under the lease gets “front loaded”.


      13
                                                                © Copyright Tate & Tryon 2012
Lessee Subsequent Recording
Straight-Line Expense Approach

1. Figure out what the monthly straight-line expense under the lease
   would be – just like the “FAS 13” calc. done today.

2. Adjust the lease liability balance sheet account as if it were
   amortized like a loan payable. (Each lease payment has a
   “principal” and “interest” component.)

3. The right of use asset gets debited or credited in order to make the
   cash, lease expense, & lease liability adjustment balance.

 In other words, the right of use asset becomes a “balancing account”.
  Or, it gets “plugged”.


      14
                                                               © Copyright Tate & Tryon 2012
Lessor Accounting



 15
                    © Copyright Tate & Tryon 2012
There will be two types of leases…

 Receivable & Residual Approach
  -   Lessee consumes more than an insignificant portion of leased
      asset.

  -   Profit on “sale” is recognized with periodic interest income.

  -   Will generally apply to equipment leases.




        16
                                                            © Copyright Tate & Tryon 2012
There will be two types of leases…

 Straight-Line Revenue Approach

  -   Lessee does not consume more than an insignificant portion
      of leased assets.

  -   Essentially similar to today’s “operating lease” – rental income
      is recognized on a straight-line basis.

  -   Will generally apply to land/building (property) leases.




        17
                                                            © Copyright Tate & Tryon 2012
Receivable & Residual Approach – The Basic Steps

1.   Leased asset is removed from the books. Profit on sale gets
     recognized here – based on what % of total FV is getting leased.

2.   Receivable is booked for the “right to receive lease payments”.
     (Calculated as the PV of the future anticipated lease payments
     using the discount rate implicit in the lease.)

3.   A “residual asset” is recorded – essentially the unconsumed portion
     of the leased asset. It is booked at the current present value, and
     then accreted up to gross value by the end of the lease term.

4.   Subsequent income is recognized in the form of interest income on
     the lease receivable and accretion income on the residual asset.




      18
                                                              © Copyright Tate & Tryon 2012
Straight-Line Revenue Approach – The Basic Steps

1. Leased asset stays on the books. It continues to be
   amortized in its usual manner.

2. Rental income would be recognized on a straight-
   line basis over the life of the lease. (Thus, we’ll still
   need some kind of “accrued rent receivable”
   balance sheet account.)

 Does this sound familiar?




     19
                                                   © Copyright Tate & Tryon 2012
Calculation Quirks



 20
                     © Copyright Tate & Tryon 2012
“Asset Consumption”
Here’s something directly from the FASB/IASB staff……




     21   Slide from Leases: Project Update, July 2012 by FASB & IASB
                                                                        © Copyright Tate & Tryon 2012
Figuring out the “Lease Term”


Here’s the latest proposed definition:

“The lease term is the non-cancellable period for which the lessee has
  contracted with the lessor to lease the underlying asset, together with
  any options to extend or terminate the lease when there is a significant
  economic incentive for an entity to exercise an option to extend the
  lease, or for an entity not to exercise an option to terminate the lease.”




      22
                                                                © Copyright Tate & Tryon 2012
Figuring out the “Lease Term”

Factors to weigh when considering the presence of significant economic
 incentive:

    Contract-based: Bargain renewal options, commitments to restore asset at
      end of term.

    Asset-based: Lessee installs significant leasehold improvements or unique
      location.

    Entity-specific: The historical practice of the entity, management’s intent,
      and common industry practice.

The lease term should be reassessed when there are significant changes in the
 relevant factors.


      23
                                                                     © Copyright Tate & Tryon 2012
Determining Future Lease Payments
  The calculation of future lease payments includes:

      Fixed increases specified in the contract;

      Variable payments that are based on an index or rate; (The Spot Rate is
      to be used to measure the future anticipated lease payments.)

      Purchase options with significant economic incentive to exercise.

  This is a dramatic simplification from the original ideas in the exposure
     draft that would have required a probability-weighted calculation of
     all contingent lease payments!

The revised standard will include guidance on how to account for lease
 incentives provided by the lessor to the lessee.
      24
                                                                    © Copyright Tate & Tryon 2012
Example - Determining the “lease term”

Assume a tenant enters into a five year lease with two five-year renewal
options.

The tenant is installing a state of the art research laboratory in the facility.
The laboratory is very expensive and is considered a major investment by
the tenant.

Common industry practice is to completely replace laboratory facilities every
ten years.

There appears to be significant economic incentive for the tenant to
exercise the first renewal option.

A 10 year term will be used when initially recording the lease.


       25
                                                                      © Copyright Tate & Tryon 2012
Example - Calculation of Lease Payments
Let’s assume that our lease has an initial base rent of $1,000,000 with a 3% annual
escalation. Our tenant’s incremental borrowing rate is 8%.
                                   Year          Payment
                                     1          $ 1,000,000
                                     2            1,030,000
                                     3            1,060,900
                                     4            1,092,727
                                     5            1,125,509
                                     6            1,159,274
                                     7            1,194,052
                                     8            1,229,874
                                     9            1,266,770
                                    10            1,304,773
                                                $ 11,463,879


                                 PV @ 8%        $ 7,550,134


                                 Average Rent   $ 1,146,388




       26
                                                                             © Copyright Tate & Tryon 2012
Example - Calculating the Liability and Asset
Legal fees of $265,000 were incurred as part of the review of the lease document.

Based on the lease term and rental payments analysis performed, the liability and asset
are calculated as follows…….


        "LEASE LIABILITY" (PV for 10 years at 8%)                   $ 7,550,134

        Add, direct costs (legal review)                                265,000


        "RIGHT TO USE ASSET"                                        $ 7,815,134




       27
                                                                            © Copyright Tate & Tryon 2012
Example - Entries for year one…

                                                     Debit                 Credit

          Year 1 Entry to record lease payment

          Cash                                                         $ 1,000,000
          Lease expense                          $ 1,146,388
          Lease liability                        $ 395,990 (A)
          Right of use asset                                           $   542,378

                   To record straight-line lease expense and corresponding reduction in lease liability.

                                                                                                  1
          Year 1 Entry to record direct cost amortization

          Amortization expense (??)              $    26,500
          Right of use asset                                           $    26,500

                   To record amortization expense related to capitalized direct lease costs




          (A) - This is the "principal" portion of the annual cash payment.



     28
                                                                                                           © Copyright Tate & Tryon 2012
Items to consider each year
Lease term: Have factors changed regarding economic incentives to
exercise or not exercise renewal options. (Discount rate would also
change.)

Payments tied to an index: Recalculate future payments based on the
current year-end’s spot rate.

Right of Use Asset: Assess for impairment.




      29
                                                           © Copyright Tate & Tryon 2012
Transition

 Early adoption will likely be permitted.

 Generally a retrospective approach, with a number of modifications designed
  to make the initial application less onerous.

 However, full retrospective adoption will be permitted.

 Nonpublic entities will likely get more time.




       30
                                                                   © Copyright Tate & Tryon 2012
Good Luck!

 You might want to sneak away sometime before this all goes final......




       31
                                                                     © Copyright Tate & Tryon 2012
Speaker Biography
Douglas Boedeker, is a partner within Tate & Tryon’s Audit and
Assurance Services unit and is also actively involved in the Firm's
exempt organization tax services group. He has 20 years of
experience providing an array of audit, tax, and consulting
services to a variety of nonprofit organizations and employee
benefit plans. He takes particular pride that his family has
contained at least one CPA every year since 1923. Doug
graduated summa cum laude from Susquehanna University in
Selinsgrove, Pennsylvania with a Bachelor of Science degree in
accounting while simultaneously completing the coursework for a
second major in arts administration.                                  Doug Boedeker, CPA, CMA
                                                                      Audit Partner
                                                                      Tate & Tryon
Doug is a frequent speaker on a variety of exempt organization
                                                                      Direct: 202-419-5106
accounting and tax issues. He recently lead a session on              dboedeker@tatetryon.com
presenting the Form 990 & audited financial statements to a
nonprofit’s board of directors at the 2012 AICPA Not for Profit
Industry Conference. Doug is a coauthor to Guide to the Newest
IRS Form 990: Interpreting and Complying with the New Tax
Reporting Requirements for Transparency and Accountability,
(published by ASAE).
        w
                                                                       32   © Copyright Tate & Tryon 2012
        w

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Update on FASB Lease Project

  • 1. An Update on the FASB’s Lease Project September 25, 2012 Douglas Boedeker, CPA, CMA Dboedeker@tatetryon.com 202-419-5106
  • 2. Course Outline  Why is the FASB doing this?  FASB timeline  Project scope  Recording by lessees  Recording by lessors  Transition 1 © Copyright Tate & Tryon 2012
  • 3. The FASB/IASB Lease Project – WHY?  Leases are an important source of finance – more information required.  Concern over lack of comparability.  Concern over “bright-line” test for operating vs. capital lease. 2 © Copyright Tate & Tryon 2012
  • 4. FASB Timeline  Exposure Draft Issued – August 17, 2010  Public Comment Period Ended – December 15, 2010, 786 comment letters were received  Numerous redeliberations have taken place in 2011 and 2012  A “New & Improved” Exposure Draft is anticipated in 4th Quarter of 2012 (they might extend the public comment period past 120 days)  Additional outreach and public comments in 2013  Final standard to be issued - ????? 3 © Copyright Tate & Tryon 2012
  • 5. A Key Fact to Remember This Morning Everything we talk about today is TENTATIVE!!! 4 © Copyright Tate & Tryon 2012
  • 6. What is a “lease”? A contract contains a lease if: The fulfillment of the contract depends on the use of a specified asset; and the contract conveys the right to control the use of the specified asset for a period of time. Important note: A physically distinct portion of a larger asset can be a “specified asset”. 5 © Copyright Tate & Tryon 2012
  • 7. Scope of the proposed standard Simple – ALL Leases Except : Leases of intangible assets Leases of mineral rights, etc. Leases of biological assets FASB is still considering whether leases of internal use software should be accounted for under the new rules. 6 © Copyright Tate & Tryon 2012
  • 8. What about service components? Each contract must be analyzed for lease and non-lease components. Contract payments are then allocated between the components based on observable purchase prices. If there are no observable purchase prices, all payments under the contract would be accounted for like a lease. Lessors would allocate payments in accordance with revenue recognition guidance. Question: Are items such as property taxes, insurance, and maintenance a “service” or part of a “lease”? 7 © Copyright Tate & Tryon 2012
  • 9. Important Exception for Short-Term Leases  Leases with a maximum possible lease term of 12 months or less can be accounted for the “old way”. No lease asset or liability is recognized.  Any renewal options are considered in the determination of the 12 month maximum period.  Thus, month-to-month leases will likely not qualify as a short-term lease! 8 © Copyright Tate & Tryon 2012
  • 10. Lessee Accounting 9 © Copyright Tate & Tryon 2012
  • 11. There will be two types of leases….  Interest & Amortization Approach - Lessee consumes more than an insignificant portion of leased asset. - Essentially similar to today’s “capital lease”. - Will generally apply to equipment leases. 10 © Copyright Tate & Tryon 2012
  • 12. There will be two types of leases…  Straight-Line Expense Approach - Lessee does not consume more than an insignificant portion of leased assets. - Essentially similar to today’s “operating lease” coupled with a balance sheet gross-up. - Will generally apply to land/building (property) leases. 11 © Copyright Tate & Tryon 2012
  • 13. Initial Recording by a Lessee 1. Determine the “lease liability” (Future anticipated cash payments discounted to present value at either the lessee’s incremental borrowing rate or, if known, the rate implicit in the contract.) 2. Determine the “right of use asset” (Lease liability plus initial direct costs of acquiring the lease.) 12 © Copyright Tate & Tryon 2012
  • 14. Lessee Subsequent Recording Interest & Amortization Approach 1. Amortize the “right of use asset”. (Probably on a straight-line basis.) 2. Adjust the lease liability using the effective interest rate method. (Essentially treated like a note payable.) 3. Reassess significant assumptions and adjust for current facts and circumstances.  Thus, the P&L reflects amortization expense and interest expense.  Total expense under the lease gets “front loaded”. 13 © Copyright Tate & Tryon 2012
  • 15. Lessee Subsequent Recording Straight-Line Expense Approach 1. Figure out what the monthly straight-line expense under the lease would be – just like the “FAS 13” calc. done today. 2. Adjust the lease liability balance sheet account as if it were amortized like a loan payable. (Each lease payment has a “principal” and “interest” component.) 3. The right of use asset gets debited or credited in order to make the cash, lease expense, & lease liability adjustment balance.  In other words, the right of use asset becomes a “balancing account”. Or, it gets “plugged”. 14 © Copyright Tate & Tryon 2012
  • 16. Lessor Accounting 15 © Copyright Tate & Tryon 2012
  • 17. There will be two types of leases…  Receivable & Residual Approach - Lessee consumes more than an insignificant portion of leased asset. - Profit on “sale” is recognized with periodic interest income. - Will generally apply to equipment leases. 16 © Copyright Tate & Tryon 2012
  • 18. There will be two types of leases…  Straight-Line Revenue Approach - Lessee does not consume more than an insignificant portion of leased assets. - Essentially similar to today’s “operating lease” – rental income is recognized on a straight-line basis. - Will generally apply to land/building (property) leases. 17 © Copyright Tate & Tryon 2012
  • 19. Receivable & Residual Approach – The Basic Steps 1. Leased asset is removed from the books. Profit on sale gets recognized here – based on what % of total FV is getting leased. 2. Receivable is booked for the “right to receive lease payments”. (Calculated as the PV of the future anticipated lease payments using the discount rate implicit in the lease.) 3. A “residual asset” is recorded – essentially the unconsumed portion of the leased asset. It is booked at the current present value, and then accreted up to gross value by the end of the lease term. 4. Subsequent income is recognized in the form of interest income on the lease receivable and accretion income on the residual asset. 18 © Copyright Tate & Tryon 2012
  • 20. Straight-Line Revenue Approach – The Basic Steps 1. Leased asset stays on the books. It continues to be amortized in its usual manner. 2. Rental income would be recognized on a straight- line basis over the life of the lease. (Thus, we’ll still need some kind of “accrued rent receivable” balance sheet account.)  Does this sound familiar? 19 © Copyright Tate & Tryon 2012
  • 21. Calculation Quirks 20 © Copyright Tate & Tryon 2012
  • 22. “Asset Consumption” Here’s something directly from the FASB/IASB staff…… 21 Slide from Leases: Project Update, July 2012 by FASB & IASB © Copyright Tate & Tryon 2012
  • 23. Figuring out the “Lease Term” Here’s the latest proposed definition: “The lease term is the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.” 22 © Copyright Tate & Tryon 2012
  • 24. Figuring out the “Lease Term” Factors to weigh when considering the presence of significant economic incentive: Contract-based: Bargain renewal options, commitments to restore asset at end of term. Asset-based: Lessee installs significant leasehold improvements or unique location. Entity-specific: The historical practice of the entity, management’s intent, and common industry practice. The lease term should be reassessed when there are significant changes in the relevant factors. 23 © Copyright Tate & Tryon 2012
  • 25. Determining Future Lease Payments The calculation of future lease payments includes: Fixed increases specified in the contract; Variable payments that are based on an index or rate; (The Spot Rate is to be used to measure the future anticipated lease payments.) Purchase options with significant economic incentive to exercise. This is a dramatic simplification from the original ideas in the exposure draft that would have required a probability-weighted calculation of all contingent lease payments! The revised standard will include guidance on how to account for lease incentives provided by the lessor to the lessee. 24 © Copyright Tate & Tryon 2012
  • 26. Example - Determining the “lease term” Assume a tenant enters into a five year lease with two five-year renewal options. The tenant is installing a state of the art research laboratory in the facility. The laboratory is very expensive and is considered a major investment by the tenant. Common industry practice is to completely replace laboratory facilities every ten years. There appears to be significant economic incentive for the tenant to exercise the first renewal option. A 10 year term will be used when initially recording the lease. 25 © Copyright Tate & Tryon 2012
  • 27. Example - Calculation of Lease Payments Let’s assume that our lease has an initial base rent of $1,000,000 with a 3% annual escalation. Our tenant’s incremental borrowing rate is 8%. Year Payment 1 $ 1,000,000 2 1,030,000 3 1,060,900 4 1,092,727 5 1,125,509 6 1,159,274 7 1,194,052 8 1,229,874 9 1,266,770 10 1,304,773 $ 11,463,879 PV @ 8% $ 7,550,134 Average Rent $ 1,146,388 26 © Copyright Tate & Tryon 2012
  • 28. Example - Calculating the Liability and Asset Legal fees of $265,000 were incurred as part of the review of the lease document. Based on the lease term and rental payments analysis performed, the liability and asset are calculated as follows……. "LEASE LIABILITY" (PV for 10 years at 8%) $ 7,550,134 Add, direct costs (legal review) 265,000 "RIGHT TO USE ASSET" $ 7,815,134 27 © Copyright Tate & Tryon 2012
  • 29. Example - Entries for year one… Debit Credit Year 1 Entry to record lease payment Cash $ 1,000,000 Lease expense $ 1,146,388 Lease liability $ 395,990 (A) Right of use asset $ 542,378 To record straight-line lease expense and corresponding reduction in lease liability. 1 Year 1 Entry to record direct cost amortization Amortization expense (??) $ 26,500 Right of use asset $ 26,500 To record amortization expense related to capitalized direct lease costs (A) - This is the "principal" portion of the annual cash payment. 28 © Copyright Tate & Tryon 2012
  • 30. Items to consider each year Lease term: Have factors changed regarding economic incentives to exercise or not exercise renewal options. (Discount rate would also change.) Payments tied to an index: Recalculate future payments based on the current year-end’s spot rate. Right of Use Asset: Assess for impairment. 29 © Copyright Tate & Tryon 2012
  • 31. Transition  Early adoption will likely be permitted.  Generally a retrospective approach, with a number of modifications designed to make the initial application less onerous.  However, full retrospective adoption will be permitted.  Nonpublic entities will likely get more time. 30 © Copyright Tate & Tryon 2012
  • 32. Good Luck!  You might want to sneak away sometime before this all goes final...... 31 © Copyright Tate & Tryon 2012
  • 33. Speaker Biography Douglas Boedeker, is a partner within Tate & Tryon’s Audit and Assurance Services unit and is also actively involved in the Firm's exempt organization tax services group. He has 20 years of experience providing an array of audit, tax, and consulting services to a variety of nonprofit organizations and employee benefit plans. He takes particular pride that his family has contained at least one CPA every year since 1923. Doug graduated summa cum laude from Susquehanna University in Selinsgrove, Pennsylvania with a Bachelor of Science degree in accounting while simultaneously completing the coursework for a second major in arts administration. Doug Boedeker, CPA, CMA Audit Partner Tate & Tryon Doug is a frequent speaker on a variety of exempt organization Direct: 202-419-5106 accounting and tax issues. He recently lead a session on dboedeker@tatetryon.com presenting the Form 990 & audited financial statements to a nonprofit’s board of directors at the 2012 AICPA Not for Profit Industry Conference. Doug is a coauthor to Guide to the Newest IRS Form 990: Interpreting and Complying with the New Tax Reporting Requirements for Transparency and Accountability, (published by ASAE). w 32 © Copyright Tate & Tryon 2012 w