Coming Changes to Lease Accounting

1. Coming Changes to Lease Accounting Joint Project IASB & FASBDiscussion Paper 2009Exposure Draft Planned 2010Final Standard Planned 2011

2. This presentation is based on the discussion paper Comments were due July 16, 2009 This document focused on accounting for lessees with some very sketchy thoughts on how lessor accounting would change Examples are from comment letter of Teresa Gordon

3. No more operating leases • The exposure draft focused on lessee accounting • All leases would be capitalized (finance leases) • Capitalized value would be based on present value of expected lease payments including renewal periods, contingent rentals, guarantees, etc. • Incremental borrowing rate would be used • When the projected lease term changes, journal entries get fairly complicated • No exception for short-term leases

4. Some key differences Current Proposed • Capitalize leases (that meet criteria) at PVMLP • Contingent rentals are not included in lease payments (with an exception for those based on price index, etc.) • Lease term always ends at date of bargain purchase option • Capitalize ALL leases at PV of expected lease payments (PVELP) • Contingent rentals must be estimated and included in the present value of the lease payments • Purchase option is just a variation of a renewal option

5. Some key differences Current Proposed • FASB: use lower of incremental borrowing rate or implicit rate if known • IASB: use implicit rate if practicable to determine, otherwise incremental borrowing rate • Lessees would always use incremental borrowing rate • Apparently some disagreements between IASB and FASB initial opinions as to whether one should use current incremental borrowing rates instead of the original rate when assumptions about lease term change

6. Some key differences Current Proposed • Lease term:very specific rules under FASB with similar but more generalized guidance under IASB • Liability is not re-evaluated at each balance sheet date • Use “most likely” lease term • Appears that the new lease standard will be less rule based and require more judgment • Lease term would be re-evaluated at each balance sheet date and the liability and asset accounts would be adjusted if necessary

7. Some key differences Current Proposed • Contingent rentals are generally not projected. • Even when based on an index, the PVMLP is based on the rental payments at the current index (that’s why it is “minimum” lease payment computation) • Guaranteed residual values stay on books at “maximum” value • IASB proposes using a weighted probability expected value for contingent rents and guaranteed residual values • FASB is leaning toward a simpler “most likely” amount for contingent rentals and guaranteed residual values • Guaranteed residual value would be difference between guarantee and the asset’s expected value at end of lease

8. An example (a variation of Example 3 in the DP) • A machine is leased for a fixed term of five years with an option to extend for two additional years; the expected life of the machine is 10 years. The lease is noncancellable, and there are no rights to purchase the machine at the end of the term and no guarantees of its value at any point. Lease payments of CU 35,000 are due each year. No maintenance or other arrangements are entered into. • At the start of the lease, the lessee intends to exercise the renewal option. • The present value of the lease payments over the seven-year period discounted at the lessee’s incremental borrowing rate of 8 per cent is CU 182,223.

9. Schedule based on intentions at inception of lease:

10. What happens if after 3 years they decide to NOT renew?

11. You must adjust the liability to match PV of remaining estimated cash flows • Entry for catch-up method Lease obligation 53,510 Right-to-use asset 53,510 • In other words, the liability suddenly got smaller • “Right to use asset” is the name for “Leased Asset” account – some debate as to whether it is PP&E or an intangible asset • Depreciation “jumps” to $52,064 for the last two years of the lease

12. You must adjust the liability to match PV of remaining estimated cash flows • Entry for alternate catch-up method (my own recommentation)Lease obligation 53,510 Interest expense 11,032 Right-to-use asset 42,478 • Depreciation expense 5,751 Accumulated depreciation 5,751 • Depreciation “jumps” only a little to $27,949 for the last two years of the lease. This method ends with the PVELP based on 5 year lease term in the asset and acc’d depreciation accounts.

13. FASB’s example 3Page 30 in the Discussion Paper • Same except the lessee does NOT initially plan to renew the lease so the initial PVELP is CU 139,700 • (5 years of CU 35,000 payments at 8%). • At the end of the third year, the lessee decides the lease term will be 7 years

14. Schedule based on intentions at inception of lease:

15. Revised schedule to reflect change from 5 to 7 yr lease term

16. You must adjust the liability to match PV of remaining estimated cash flows • Entry for catch-up method Right-to-use asset 53,510 Lease obligation 53,510 • In other words, the liability just got higher. • One could debit Acc'dDepreciation instead of the “right to use asset” account for the same net effect on the balance sheet • Depreciation decreases slightly from $27,949 to $27,352 for the last four years of the lease

17. The capitalized value • Notice that in both the increased and decreased lease term situations, the originally anticipated “value” of the leased asset changes abruptly by a substantial amount • Is this logical? • Whether or not this makes sense, the liability balance MUST change!

18. Worst Case Scenario • For those wanting to cook the books: • Instead of the example lease, write the contract for seven one-year renewal options at CU 35,000 per year • Each year, decide that the remaining lease term is just one more year • Use the highest possible incremental borrowing rate to keep the liability at the lowest possible number • In the example on next slide, I left it at 8% but if one could argue for 9% or 10%, the liability would be even smaller!

19. Worst Case Version • Liability would always be CU 32,407 (PV of 35,000 in one year at 8%)

20. Worst Case Version • Depreciation expense would always be CU 32,407 (PV of 35,000 in one year at 8%) and combined impact of interest and depreciation would equal cash flow

21. Too complicated? • Think about a typical rent situation for retail space. Rent is a fixed amount PLUS a percentage of sales. • Since it is impossible to predict the future with accuracy, it is likely that the liability account would have to be revised EVERY reporting date! • This is quite complicated because it theoretically affects depreciation expense • The other issue is whether to run the difference in liability (gain or loss) through the income statement or use some other technique