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Coming Changes to Lease Accounting Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

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Page 1: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Coming Changes to Lease Accounting

Joint Project IASB & FASBDiscussion Paper 2009

Exposure Draft Planned 2010Final Standard Planned 2011

Page 2: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

This presentation is based on the discussion paperComments 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

Page 3: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

No more operating leasesThe exposure draft focused on lessee

accountingAll 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

Page 4: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Some key differencesCurrent 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

Page 5: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Some key differencesCurrent 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 rateApparently 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

Page 6: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Some key differencesCurrent 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 termAppears 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

Page 7: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Some key differencesCurrent 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

Page 8: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

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.

Page 9: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Schedule based on intentions at inception of lease:

Period Payment Interest Principal Balance Depr 0 182,223 1 35,000 14,578 20,422 161,801 26,032 2 35,000 12,944 22,056 139,745 26,032 3 35,000 11,180 23,820 115,924 26,032 4 35,000 9,274 25,726 90,198 26,032 5 35,000 7,216 27,784 62,414 26,032 6 35,000 4,993 30,007 32,407 26,032 7 35,000 2,593 32,407 0 26,032

245,000 62,777 182,223 182,223

Page 10: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

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

Period Payment Interest PrincipalAdj for

Renewal BalanceDepr

Expense0 182,223 1 35,000 14,578 20,422 161,801 26,032 2 35,000 12,944 22,056 139,745 26,032 3 35,000 11,180 23,820 115,924 26,032 4 35,000 9,274 25,726 57,791 32,407 52,064 5 35,000 2,593 32,407 - 0 52,064 6 0 (0) 0 7 0 (0) 0

TRUE 175,000 50,568 124,432 182,223

Page 11: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

You must adjust the liability to match PV of remaining estimated cash flowsEntry for catch-up method

Lease obligation 53,510 Right-to-use asset 53,510In 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

Page 12: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

You must adjust the liability to match PV of remaining estimated cash flowsEntry for alternate catch-up method (my own

recommentation)Lease obligation 53,510

Interest expense 11,032 Right-to-use asset 42,478

Depreciation expense 5,751Accumulated 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.

Page 13: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

FASB’s example 3Page 30 in the Discussion PaperSame 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

Page 14: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Period Payment Interest Principal Balance Depr 0 139,745 1 35,000 11,180 23,820 115,924 27,949 2 35,000 9,274 25,726 90,198 27,949 3 35,000 7,216 27,784 62,414 27,949 4 35,000 4,993 30,007 32,407 27,949 5 35,000 2,593 32,407 0 27,949 6 0 (0) 0 7 0 (0) 0

175,000 35,255 139,745 139,745

Schedule based on intentions at inception of lease:

Page 15: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

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

Period Payment Interest Principal Adj for

Renewal Balance Depr

Expense 0 139,745 1 35,000 11,180 23,820 115,924 27,949 2 35,000 9,274 25,726 90,198 27,949 3 35,000 7,216 27,784 (53,510) 115,924 27,949 4 35,000 9,274 25,726 90,198 27,352 5 35,000 7,216 27,784 62,414 27,352 6 35,000 4,993 30,007 32,407 27,352 7 35,000 2,593 32,407 0 27,352

245,000 51,745 193,255 193,255

Page 16: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

You must adjust the liability to match PV of remaining estimated cash flowsEntry for catch-up methodRight-to-use asset 53,510

Lease obligation 53,510In other words, the liability just got higher. One could debit Acc'd Depreciation 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

Page 17: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

The capitalized valueNotice that in both the increased and

decreased lease term situations, the originally anticipated “value” of the leased asset changes abruptly by a substantial amountIs this logical? Whether or not this makes sense, the liability

balance MUST change!

Page 18: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Worst Case ScenarioFor 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!

Page 19: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

Worst Case Version

Liability would always be CU 32,407 (PV of 35,000 in one year at 8%)

Period Payment Interest Principal Adj for

Renewal Balance Rate used

0 32,407 1 35,000 2,593 32,407 (32,407) 32,407 8%2 35,000 2,593 32,407 (32,407) 32,407 8%3 35,000 2,593 32,407 (32,407) 32,407 8%4 35,000 2,593 32,407 (32,407) 32,407 8%5 35,000 2,593 32,407 (32,407) 32,407 8%6 35,000 2,593 32,407 (32,407) 32,407 8%7 35,000 2,593 32,407 0 8%

245,000 62,777 62,777

Page 20: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

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

Period Depr

Expense Acc'd Depr

Adj asset

Right-to-use Asset

Book value of

Asset

Impact on P&L (depr +

int)0 32,407 32,407 1 32,407 32,407 32,407 64,815 32,407 35,000 2 32,407 64,815 32,407 97,222 32,407 35,000 3 32,407 97,222 32,407 129,630 32,407 35,000 4 32,407 129,630 32,407 162,037 32,407 35,000 5 32,407 162,037 32,407 194,444 32,407 35,000 6 32,407 194,444 32,407 226,852 32,407 35,000 7 32,407 226,852 - 226,852 - 35,000

226,852 245,000

Page 21: Joint Project IASB & FASB Discussion Paper 2009 Exposure Draft Planned 2010 Final Standard Planned 2011

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 expenseThe other issue is whether to run the difference

in liability (gain or loss) through the income statement or use some other technique