IMA MIDATLANTIC COUNCIL ACCOUNTING for LEASES November 17, 2016 KARL G IMA MIDATLANTIC COUNCIL ACCOUNTING for LEASES November 17, 2016 KARL G. FASSNACHT, CPA CBIZ-MHM

ASU 2016-02 - LEASES Overview Key changes Similar concepts Most leases will be recorded on the balance sheet New presentation and disclosure requirements Eliminated: Real estate-specific provisions Leverage leases (prospectively) Alignment with Topic 606, Revenue from Contracts with Customers: Sale and leaseback Sales-type Direct financing lease Similar concepts Expense recognition for lessees Classification criteria for operating vs. capital Operating leases for lessors Key definitions Issued in February 2016 to increase transparency and comparability and to disclose key information about leasing arrangements

Definition of a Lease A contract contains a lease if it conveys the right to control the use of an identified asset (property, plant or equipment) for a period of time in exchange for consideration Control means the right to Obtain substantially all of the economic benefits, and Direct the use of the identified asset Customer can direct how and for what purpose the asset is used, or Relevant decisions are predetermined and (1) customer was involved in the design or (2) customer can operate the asset without the supplier having the right to change the operating instructions Identified assets can be A portion of a larger asset if physically distinct Explicitly-specified Implicit Related party transactions are evaluated based on their legally enforceable terms and conditions This is the critical question (Topic 840 was classification). Lease term may be only for a portion of the contract term. Related parties need to make the necessary related party disclosures Talk about unwritten agreements

What is Excluded? Leases of Short-term leases Intangible assets Exploration for or use of natural resources Biological assets Inventory Assets under construction Short-term leases Leases with a lease term of 12 months or less that do not have an option to purchase the underlying asset that the lessee is reasonably certain to exercise Lessees can make a policy election (by class of underlying asset) not to recognize a lease asset or liability Contracts with a substantive right to substitute another asset Short-term leases would be recognized like current operating leases, recognizing rent on a straight-line basis over the lease term and variable lease payments as incurred

Substantive Right of Substitution A right is substantive if The supplier has the practical ability to substitute alternative assets, and The supplier would benefit economically from the substitution Factors to consider Cost of substitution Location of the asset Restriction to substitute only on or after a particular date or event Repairs and maintenance Protective rights

Example 1: Does this Contract Contain a Lease? A contract between Customer and a freight carrier (Supplier) provides Customer with the use of 10 specific rail cars of a particular type for 5 years. Customer determines when, where, and which goods are to be transported using the cars. When the cars are not in use, they are kept at Customer’s premises. Customer can use the cars for another purpose (for example, storage) if it so chooses. However, the contract specifies that Customer cannot transport particular types of cargo (for example, explosives). If a particular car needs to be serviced or repaired, Supplier is required to substitute a car of the same type. Otherwise, Supplier cannot retrieve the cars during the five-year period. The contract also requires Supplier to provide an engine and a driver when requested by Customer. Supplier keeps the engines at its premises and provides instructions to the driver detailing Customer’s requests to transport goods. Supplier can choose to use any one of a number of engines to fulfill each of Customer’s requests, as well as the goods of other customers (for example, if other customers require the transport of goods to destinations close to the destination requested by Customer and within a similar timeframe, Supplier can choose to attach up to 100 rail cars to a single engine). 842-10-55-42

Example 1: Does this Contract Contain a Lease? Rail cars Yes, the contract contains a lease of 10 rail cars for 5 years. The rail cars are identified assets that are explicitly stated and can only be substituted for needed servicing or repairs. Customer has the right to obtain substantially all of the economic benefits of the cars over the lease term. Customer has the right to direct the use of the cars. Engine No, the contract does not contain a lease of the engine. The engine is not an identified asset. 842-10-55-44

Components of a Contract Components of a contract include only those items or activities that transfer a good or service to the lessee Lease and nonlease components should be separated For lessees, consideration is allocated based on a relative standalone price basis For lessors, consideration is allocated based on Topic 606 Nonlease components should be separately accounted for under other applicable GAAP (generally accepted accounting principles) Lessees may make an accounting policy election (by class of underlying asset) to account for each lease component and its related nonlease components as a single lease component Reimbursement of a lessor’s costs is not a component of a contract. Maintenance activities are considered to be nonlease components. Executory costs (taxes and insurance) do not transfer a good or service and are, therefore, not a separate component. (example at 842-10-55-141) Land and building should be separate lease components unless the accounting effect is insignificant (842-40-15-29) The accounting election will cause bigger assets and liabilities to be recognized

Components of a Contract The right to use an underlying asset should be a considered a separate lease component (from other lease components) if The lessee can benefit from the right of use either on its own or together with other resources that are readily available, and The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract

Lease Term and Related Payments Noncancellable period plus optional periods in which it is reasonably certain that the lessee will exercise the option or that the lessor controls whether the option will be exercised Lease payments Fixed payments, including in-substance fixed payments, less incentives paid Variable lease payments dependent upon an index or rate Other variable lease payments are recognized in the period they incur If the lease term includes the lessee exercising these options: Exercise price of an option to purchase the underlying asset Payments for penalties to terminate the lease Fees paid by the lessee to owners of a special purpose entity for structuring the transaction For lessees only, amounts probable of being owed under residual value guarantees Reasonably certain = today’s reasonably assured and is a high threshold Lease payments exclude guarantees of the lessor’s debt and amounts allocated to nonlease components

Initial Direct Costs and Discount Rate Initial direct costs are incremental costs that would not have been incurred if the lease had not been executed Discount rate is the rate implicit in the lease If the rate implicit in the lease cannot be readily determined, then lessees can use the incremental borrowing rate (borrowing a similar amount for a fixed rate for the same term with similar collateral) Nonpublic lessees can make an accounting policy election (for all leases) to use a risk-free discount rate The rate implicit in the lease causes the aggregate present value of the sum of The lease payments and The amount the lessor expects to derive from the underlying asset following the end of the lease term To equal the sum of The fair value of the underlying asset at lease commencement (less any tax credit retained and expected to be realized by the lessor) and Any deferred initial direct costs (excluded for sales-type leases with selling profit or loss) Commissions are initial direct costs while legal fees and staff time are not.

Lease Classification Criteria The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Evaluated at lease commencement The bright lines (75% of remaining life and 90% of fair value and last 25% of life) are removed but included in the implementation guidance as one reasonable approach. #5 is new.

Which Type of Lease Do I Have? Lessee Finance = At least one of the five criteria is met Operating = None of the five criteria are met Lessor Sales-type = At least one of the five criteria is met Direct financing = None of the five criteria are met, and The present value of the sum of the lease payments and any residual value guaranteed by the lessee and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset, and It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee. Operating = Not a sales-type or direct financing lease Next we will go through the accounting and presentation for each of these types of leases

Example 2 - Fact Pattern Lessee enters into a 10-year lease of an asset, with an option to extend for an additional 5 years. Lease payments are $50,000 per year during the initial term and $55,000 per year during the optional period, all payable at the beginning of each year. Lessee incurs initial direct costs of $15,000. Lessee concludes that it is not reasonably certain to exercise the option to extend the lease (so the lease term is 10 years). The rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 5.87%. 842-20-55-22

Lessee - Finance Lease - Initial Measurement and Recognition The lease liability (LL) is initially measured at the present value of the lease payments not yet paid using the discount rate for the lease LL at commencement = $342,017 (Present value 9 annual payments of $50,000 payments at a 5.87% discount rate) The right-of-use (ROU) asset equals the lease liability plus initial direct costs and prepayments to the lessor, less lease incentives received from the lessor ROU at commencement = $407,017 ($342,017 LL + $50,000 initial lease payment + $15,000 initial direct costs) At least 1 criteria on slide 21 was met

Lessee - Finance Lease - Subsequent Measurement The LL is increased based on the interest method using the discount rate determined at lease commencement, unless a reassessment occurs, and reduced by the payments made LL at end of Year 1 = $362,093 (Interest expense = $342,017 LL x 5.87% = $20,076) (End of period LL = $342,017 beginning of period LL + $20,076 interest expense - $0 lease payment) The ROU is amortized, generally on a straight line basis over the shorter of the lease term or useful life of the ROU asset, adjusted for any impairment loss recorded ROU at end of Year 1 = $366,315 (Amortization expense = $407,017 initial ROU / 10 yrs = $40,702) (End of period ROU = $407,017 beginning of period ROU - $40,702 amortization expense) The LL for finance is amortized like a loan. No lease payment until the beginning of year 2. Finance lease has $60,778 total expense in year 1.

Lessee - Operating Lease - Initial Measurement and Recognition The lease liability (LL) is initially measured at the present value of the lease payments not yet paid using the discount rate for the lease LL at commencement = $342,017 (Present value 9 annual payments of $50,000 payments at a 5.87% discount rate) The right-of-use (ROU) asset equals the lease liability plus initial direct costs and prepayments to the lessor, less lease incentives received from the lessor ROU at commencement = $407,017 ($342,017 LL + $50,000 initial lease payment + $15,000 initial direct costs) No criteria on slide 21 was met This is the same calculation as a finance lease

Lessee - Operating Lease - Subsequent Measurement The LL is measured at the present value of the lease payments not yet paid using the discount rate determined at lease commencement, unless a reassessment occurs LL at end of Year 1 = $362,093 (End of period LL = Present value 8 annual payments of $50,000 payments at a 5.87% discount rate + $50,000 payment due at the beginning of year 2) (Lease expense allocated to LL = $362,093 end of period LL - $342,017 beginning of period LL = $20,076) The ROU is the amount of the LL and adjusted for cumulative prepaid or accrued lease payments, the remaining balance of lease incentives received (gross lease incentives received net of amounts previously recognized as part of the lease expense), unamortized initial direct costs and any impairment loss recorded ROU at end of Year 1 = $375,593 (Total lease cost = $50,000 payments x 10 years = $500,000 + $15,000 initial direct costs = $515,000) (Lease expense = $515,000 total lease cost / 10 years = $51,500) (End of period ROU = $362,093 end of period LL + $13,500 remaining initial direct costs) Finance lease has $60,778 total expense in year 1 compared to $51,500 for the operating lease.

Lessee - Comparison - Subsequent Measurement Finance Operating The LL is increased based on the interest method using the discount rate* and reduced by the payments made. The LL is measured at the present value of the lease payments not yet paid using the discount rate*. The ROU is amortized, generally on a straight line basis over the shorter of the lease term or useful life of the ROU asset, adjusted for any impairment recorded. The ROU is the LL adjusted for prepaid or accrued rent, the remaining balance of lease incentives received, unamortized initial direct costs and any impairment. Finance Operating End of Year 1 LL = $362,093 ($342,017 LL + $20,076 interest expense) (Interest expense = $342,017 LL x 5.87% = $20,076) (Present value 8 annual payments of $50,000 payments at a 5.87% discount rate + $50,000) End of Year 1 ROU = $366,315 ($407,017 ROU - $40,702 amortization expense) (Amort expense = $407,017 ROU / 10 yrs = $40,702) End of Year 1 ROU = $375,593 ($362,093 end of period LL + $13,500 remaining initial direct costs) Total Expense = $60,778 Total Expense = $51,500 The LL for finance is amortized like a loan. No lease payment until the beginning of year 2. Finance lease has $60,778 total expense in year 1 compared to $51,500 for the operating lease.

Lease Accounting Effective Date/Transition December 31 year ends – December 31, 2020 June 30 year ends – June 30, 2021 Use modified retrospective transition approach; leases will be recognized beginning in the earliest period presented within the financial statements. Example: 12/31/20 comparative statements of net assets – apply as of 1/1/19 Review existing leases and determine ROU (right of use) and lease liability (LL) as of 1/1/19.

Lease Accounting – What To Do Now Inventory all leases (data from lease footnote disclosures) Coordinate with facility and other departments Practical expedient – can maintain existing lease classification Calculate ROU and RL at day 1 of earliest statement of financial position presented Assess the impact on contractual and regulatory obligations Consider/reassess leasing strategies Assess if any change need to be made to accounting/operating systems

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