LEASE ACCOUNTING:Changes are coming

November 16, 2016

FOCUS ON WHAT COUNTS

[ENTREPRENEURIAL]

[PROGRESSIVE]

[SOLUTIONS]

PRESENTED BY:

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Mike SabatiniAudit Partner &

Managing Partner, Long Island Office

Joseph TurkewitzAudit Partner

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OVERVIEW

Effective Date:

• Private Companies – Fiscal years beginning after December 15, 2019, and interim periods with fiscal years beginning after December 15, 2020

• Public Companies - Fiscal years beginning after December 15, 2018, including interim periods within those fiscal years

• Comparative statements must be restated using a modified retrospective transition method

Comparison of GAAP

Existing New

Balance Sheet• Leases are classified as either capital or operating lease • Only capital leases are recognized on balance sheet as asset and related liabilities

Lessees will recognize almost every lease or balance sheet

Income & Cash Flow Substantially retains concept of operating versus capital (finance) leases

The accounting for lessors is largely unchanged

CERTAIN SCOPE EXCEPTIONS

• No scope exception permitted for “low value” assets (i.e. computers, copiers, etc.)

• Scope exception for arrangements with a lease term of 12 months or less and doesnot include option to purchase underlying asset that the lessee is reasonablycertain to exercise

Caution: The definition of lease term

may include renewal options included

in the arrangement

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WHY SHOULD YOU CARE?

Covenant Compliance

• Potential impact on debt service coverage ratio

• Other financial covenants may be impacted • Potential impact on working capital• Compensation arrangements may also be

impacted

Accounting and Reporting Matters

• Significant judgment and estimates• New processes and controls to be

implemented• New or enhanced disclosures• New asset required to be evaluated for

impairment

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PROCESS FLOW

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Determine if contract contains

a lease

• Separate lease & non-lease

components

• Identify other key terms

Determination of appropriate classification

Initial and subsequent

recognition and measurement

WHAT IS A LEASE?

A contract is (or contains) a lease when two criteria are met:

1. The contract explicitly or implicitly specifies the use of an identifiable asset

a) Asset is explicitly or implicitly identified

b) Physically distinct

c) Supplier does not have substitution right

2. The customer controls the use of the asset for

that period of use

a) The right to obtain substantially all of the economic benefits from using the asset

b) The right to direct the use of the asset

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“A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time

in exchange for consideration”

LEASE AND NON-LEASE COMPONENTS

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OPTIONAL ELECTION

In certain circumstances, an accounting policy election can be made to bundle a non-lease component with its related lease component

Lease component can be used on its own AND not dependent with other rights

Separation

Goods and services provided to lessee that are separate from the assetExamples: Cleaning, security, waste removal and other such common area maintenance charges

Non-leaseComponents

AllocationArrangement consideration should be allocated between the lease and non-lease components based on their respective relative stand-alone pricing

KEY TERMS IN A LEASE

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Lease Term

• Contractual non-cancellable period• Lessee options reasonably certain to exercise• Lessor renewal options are assumed to be exercised• If lessee subsequently changes lease term assessment, triggers re-

measurement

Lease Payments

Discount Rate

• Rate implicit in lease• If not readily determinable, use lessee’s incremental borrowing rate• Nonpublic entities may elect to use risk-free rate for all leases

Fixed payments

Variable lease payments that depend on an index or rate

Lease incentives provided by lessor

The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to do so

Penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease

Amounts probable of being owed by the lessee under a residual value guarantee

LEASE CLASSIFICATION

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Five criteria: If any of the following apply, the lease is classified as finance; otherwise classified as operating

1. Ownership of the underlying asset transfers to the lessee at end of lease term

2. An option exists under which the lessee may purchase the underlying asset and exercise of that option is reasonably certain

3. When the lease does not comment at or near the end of the underlyingasset's economic life, the lease term makes up a major part of the underlying asset’s remaining economic life

4. The sum of the present value of the lease payments and any residual value guaranteed by the lessee that is not already included in the lease payments is equal to or exceeds substantially all of the underlying asset’s fair value

5. NEW: The underlying assets specialized nature is expected to result in it not having an alternative use to the lessor at the end of the lease term

INITIAL RECOGNITION AND MEASUREMENT

ALL LEASES

On Day 1, recognize the following:

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Right-of-Use Asset Lease Liability

Lease liability recognized Present value of future lease payments

Any lease payments rendered prior to commencement date

Use discount rate previously determined

Direct costs incurred by lessee

Any landlord incentives received

INITIAL RECOGNITION AND MEASUREMENT

Initial direct costs are:

• Incremental costs of a lease that would not have been incurred had the lease not been executed.

• Costs directly or indirectly attributable to negotiating and arranging the lease are not

considered initial direct costs.

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Included Excluded

Commissions Employee salaries

Legal fees resulting from the execution of the lease Internal engineering costs

Lease document preparation costs incurred after the execution of the lease

Negotiating lease term and conditions

Certain payments to existing tenants to move out Advertising

Consideration paid for a guarantee of a residual asset by an unrelated third party

Depreciation

SUBSEQUENT MEASUREMENT

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Finance Operating

Right-of-Use Asset

Amortize a straight-line basis over lease term

• Calculate straight-line lease expenses (similar to current GAAP)

• Amortize asset of lease term by difference between straight-line lease expense and interest expense

Lease Liability

• Record interest expense on the carrying value of the lease liability• Reduce lease liability as lessee makes lease payments• Record variable lease payments in period incurred

EXAMPLE FACTS

Lease term is for 3 years

Payment schedule

• $200,000 at the end of Year 1

• $300,000 at the end of Year 2

• $400,000 at the end of Year 3

Discount rate is 5%

Present value of lease payments is $808,120

Lessee’s initial direct costs are $30,000

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FINANCE LEASE EXAMPLE

Using the example facts (assume no variable lease payments):

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Year Right-of-Use Asset Lease Liability

BeginningBalance Amortization

Ending Balance

BeginningBalance

Interest @5% Payments

Ending Balance

1 838,120 279,373 558,747 808,120 40,406 200,000 648,526

2 558,747 279,373 279,373 648,526 32,426 300,000 380,952

3 279,373 279,373 - 380,952 19,048 400,000 -

FINANCE LEASE EXAMPLE - SUMMARY

Year 1 Year 2 Year 3 Total

Interest 40,406 32,426 19,048 91,880

Amortization 279,373 279,373 279,373 838,120

Total Expense 319,779 311,800 298,421 930,000

Year 1 Year 2 Year 3 Total

Operating CashFlow

70,406 32,426 19,048 121,880

Financing Cash Flow

159,594 267,574 380,952 808,120

Total Cash Flow 230,000 300,000 400,000 930,000

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OPERATING LEASE EXAMPLE

Compute straight-line lease expense

= ($200,000 + $300,000 + $400,000 lease payments + $30,000 IDC / 3 years

= $310,000

See next slide for interest expense calculations

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OPERATING LEASE EXAMPLE

Compute ROU amortization

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Year Lease Liability Right-of-Use Asset

Beginning Balance

Interest @ 5% Payments

Ending Balance

Beginning Balance

Straight-line Expense Interest Amortization

Ending Balance

1 808,120 40,406 200,000 648,526 838,120 310,000 40,406 269,594 568,526

2 648,526 32,426 300,000 380,952 568,526 310,000 32,426 277,574 290,952

3 380,952 19,048 400,000 - 290,952 310,000 19,048 290,952 -

Compute interest expense

OPERATING LEASE EXAMPLE - SUMMARY

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Year 1 Year 2 Year 3 Total

Interest 40,406 32,426 19,048 91,880

Amortization 269,594 277,574 290,952 838,120

Total Expense 310,000 310,000 310,000 930,000

Year 1 Year 2 Year 3 Total

Operating CashFlow

230,000 300,000 400,000 930,000

Financing Cash Flow

- - - -

Total Cash Flow 230,000 300,000 400,000 930,000

PRESENTATION

Balance Sheet Income Statement

Right-of-use assets are always noncurrent

Finance lease• Interest expense (typically below

the line)• Amortization expense (typically

above the line)

Lease liabilities are classified as current or noncurrent

Operating lease• Single operating lease expense

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In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach.

The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply:

An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified

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MODIFIED RETROSPECTIVE TRANSITION

• identification and classification of leases that commenced before the effective date

• initial direct costs for leases that commenced before the effective date

• the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset.

DISCLOSURE REQUIREMENTS

HIGHLIGHTS OF WHAT IS NEW

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Qualitative

• Significant assumptions and judgments- Determination of whether a contract contains a lease- Allocation between lease components- Determination of discount rate

• Policy election to not recognize short-term leases

• Policy election to bundle lease components for allocation purposes

DISCLOSURE REQUIREMENTS – CONTINUED

HIGHLIGHTS OF WHAT IS NEW

* The disclosed expense items should include any amounts that were capitalized as part of the cost of another asset, such as inventory, software development costs, and equipment.

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Quantitative• For Finance leases, amortization of right-to-use (ROU) assets and interest on lease liabilities (including

capitalized interest)*

• Operating lease expense (including capitalized costs)*

• Short-term lease expense, when term > 30 days*

• Variable lease expense*

• Sublease income

• Gains and losses on sale-leaseback transactions

• Cash paid for amounts included in measurement of lease liabilities, segregated by Finance and Operating leases and between operating and financing cash flows

• Supplemental noncash information on ROU assets obtained in exchange for new lease liabilities, separately for Finance and Operating leases

• Supplemental noncash information on ROU assets obtained in exchange for new lease liabilities, separately for Finance and Operating leases

• Weighted-average remaining lease term, presented separately by Finance and Operating leases

• Weighted-average discount rate for Operating and Finance leases as of the balance sheet date

Any questions?

Thank You