1. New Lease Accounting Standard
15th Annual IMA Michigan Fall Conference
October 31, 2016
Jim Hannan
Scott Sachs

2. Meet the Presenters… Jim Hannan Managing Director Chicago, Illinois
Scott Sachs
Assurance Practice Senior Manager
Sacramento, California

3. Agenda Background Scope Effective dates & transition requirements
Lessee accounting model
Implementation framework
Other practical considerations
The purpose of this presentation is to provide an overview of the new lease accounting standard and specifically, to highlight changes we believe are most important for financial executives and financial statement preparers to be aware of. There may be some details within the standard that simply cannot be covered in a 50 minute discussion.
One quick note is that throughout this presentation, we will refer to “existing GAAP” or “prior GAAP”, and that is intended to refer to the guidance under ASC Topic 840.

4. Background and Scope

5. Background Project added to agenda - July 2006
Discussion Paper - March 19, 2009
Exposure Draft – August 17, 2010
Comment period ended December 15, 2010
Outreach / Fieldwork / Re-deliberations
Revised Expose Proposal – May 16, 2013
Comment period ends Sept. 13, 2013
Issue final ASU – Feb. 25, 2016
The issuance of the new lease accounting standard is the culmination of a lengthy project aimed at improving the transparency of lease accounting. The evolution of the new lease standard began about 10 years ago as a joint project by the FASB and the International Accounting Standards Board. The project ultimately resulted in two rounds of exposure drafts, numerous comment letters, and outreach feedback before arriving at a final standard in February 2016.
The current lease accounting guidance in ASC 840 has been criticized for failing to meet the needs of users of the financial statements, particularly because it doesn’t require lessees to recognize assets and liabilities arising from operating leases. The new guidance addresses those criticisms by requiring lessees to recognize most leases on their balance sheets and providing enhanced disclosures. The FASB believes this will result in a more faithful representation of lessees’ assets and liabilities and greater transparency about the lessees’ obligations and leasing activities.
© 2012 Crowe Horwath LLP

6. Scope Identified Asset Right to Control Use During Term
Identifying a lease includes determining that the following are present:
Identified Asset
Explicitly or implicitly specified
No ability to substitute (or no benefit from substituting)
Right to Control Use During Term
Ability to obtain substantially all of the economic benefits from the use
Right to direct the use of the identified asset
The scope of the new lease accounting standard relates to contracts that are leases, or contain leases.
A lease is a contract, or part of a contract, that conveys the right to control THE USE OF an identified asset for a period of time in exchange for consideration.
Now, the requirement that there be an “identified asset” is fundamental to the definition of a lease. To break this down… in order to have a lease, there must be an identified asset that is:
Either explicitly or implicitly specified in a contract.
And
2) There is no ability to substitute that asset….or at least there is no benefit from substituting the asset.
Its important to note that an identified asset can also be a physically distinct portion of a larger asset. This can be something as simple a single “floor” of an office building.
A lease must also convey the right to control the use of the identified asset, which involves:
Having the right to obtain substantially all of the economic benefits from THE USE OF the asset throughout the term
2) Having the right to DIRECT THE USE OF the identified asset
The new lease standard introduces the concept of having control over the “right to use”. This interacts with the notion of control in the new revenue recognition standard. If you are party to a lease, you must ask…. Do you have control over the asset, or “control over the use” of the asset?
Most leases today will be leases under the new standard!

7. Effective dates and transition requirements
Public business entities (PBEs) and certain not-for-profit entities and employee benefit plans - fiscal years (including interims within) beginning after Dec. 15, 2018, including interim periods within those fiscal years
All other entities - fiscal years beginning after Dec. 15, 2019, interim periods beginning after Dec. 15, 2020.
Early application permitted for all entities.
Transition
Lessee – require modified retrospective for capital and operating leases existing at or entered into after the beginning of the earliest comparative period presented (no required transition for leases that expired before application).
Lessor – require modified retrospective transition approach for sales-type, direct financing, and operating leases existing at, or entered into after, the date of initial application (no required transition for leases that expired before application).
The effective dates are shown on this page. For public business entities with calendar year ends, the standard becomes effective starting for the March 31, 2019 interim financial statements. What this means is that public business entities that present 3 years of comparative income statements will need to gather information about leases beginning with calendar year 2017.
For all other entities with calendar year ends, the standard becomes effective for the December 31, 2020 annual financial statements. Similarly, all other entities will need to consider comparative reporting periods as they plan their implementation of the new lease standard.
Other than the effective dates, there is very little relief given to organizations that are not public business entities.
TRANSITION:
The good news at transition is that there is a package of practical expedients which we expect most entities to take advantage of. Most importantly, these practical expedients allow entities to NOT REASSESS the classification of existing or expired leases.
At a high level, from a transition perspective, in general, for lessees – Existing capital leases are grandfathered. Existing operating leases are capitalized by recognizing the present value of remaining lease payments as if they were newly started leases.
For lessors electing the practical expedients, Sales-type leases, direct financing leases, and operating leases will generally remain the same classification.

8. Lessee Accounting Model – How to determine classification
Criteria
Five classification criteria (ASC ) similar to existing GAAP
No bright line thresholds
Largely based on whether lessee obtains control of the underlying asset rather than control over merely the use of the underlying lease asset
“Reasonably certain to exercise”
Lease term includes periods subject to extension options if the lessee is Reasonably Certain to exercise that option
Application of reasonably certain in the lease term assessment and consideration of options to purchase is intended to be applied similar to the existing “reasonably assured” threshold
Related party leases
Accounted for on the basis of legally enforceable terms and conditions stated in the lease, rather than on the basis of the lease’s economic substance.
The new lease standard establishes five criteria for lessee’s to follow in classifying their leases.
These criteria are similar to prior GAAP, but most noticeably, the new standard eliminates the bright line thresholds and instead requires entities to apply more judgment as it relates to evaluating the lease term and options to purchase the underlying asset.
Also, the most critical underlying theme as it relates to lessee classification is the element of control.
A couple other differences between the new standard and prior GAAP are:
The lease classification test needs to be performed at the lease commencement date instead of the lease inception date.
There is a 5th classification criteria that requires lessees and lessors to evaluate whether the underlying asset is of such a specialized nature that it won’t have any alternative use to the lessor at the end of the lease term. This was not present in prior GAAP.
Also, the new lease standard eliminates real-estate specific classification criteria. As a result of this, some land lease arrangements could change under ASC 842.
Under the new standard, it is also important to note that related party leases will be accounted for on the basis of legally enforceable terms rather than the economic substance of the lease. This could lead to changes in the way entities classify related party leases.

9. Lessee Accounting Model – Five classification criteria
At lease commencement, a lessee classifies a lease as a finance lease if the lease meets any one of the following 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 a major part of the remaining economic life of the underlying asset.
The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already included in the lease payments equals or exceeds substantially all of the fair value.
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.

10. Lessee Accounting Model – Measurement and presentation
Finance Lease
Operating Lease
Has control of the lease asset passed to the lessee?
Yes No
Balance sheet
Right-of-use asset
Lease liability
Income statement (characterization)
Interest expense
Amortization expense
Lease expense (including initial direct costs)
Pattern of expense
Front-loaded
Straight-line
Cash flow statement
Operating - cash paid for interest
Financing - cash paid for principal
Operating - cash paid for lease payments
As discussed a minute ago, the most critical element of lessee classification relates to control.
The lessee accounting model lays out two types of leases – finance and operating
Under finance leases, the lessee has control of the lease asset. Under operating leases, the lessee does not….rather they only control the use of the asset during the lease term.
As we see it, the most important change in the new lease accounting standard is the fact that operating leases will now be recorded on the balance sheet. This will happen by present valuing the lease payments to establish a lease liability, and a RIGHT OF USE asset will be recorded initially as the lease liability amount, adjusted for lease incentives received, initial direct costs incurred, and any lease payments made before or at commencement.
Two other key takeaways – 1) lease expense under operating leases will still be recognized on a straight-line basis. And 2) The lease liability is considered an operating liability – NOT debt.
Finance leases, on the other hand, will be largely similar to capital leases under prior GAAP.

11. Lessee Accounting Model – Measurement and presentation (cont.)
Other considerations related to measurement and presentation
Most short term leases will not require recognition on balance sheet
Discount rate
Practical expedient – non-PBEs may use a risk free rate in measuring the lease liability
Portfolio approach – entities with large number of similar leases
Implementation planning is critical in selecting a discount rate
Variable lease payments
Only included in lease liability if they depend on an index or rate
Use the applicable index or rate at the commencement date; no need to adjust the rate at each period unless another event causes the lease to be adjusted
Recognize variable lease payments that were not included in the lease liability when the amounts become probable
Variable payments could be considered fixed if the variable payments are virtually assured of being incurred (eg. below-market rent).
As we look at the measurement and financial statement presentation for lessees, there are a few other highlights to discuss in the new lease standard.
First - Short term leases --- A lessee can make an accounting policy election, by class of underlying asset, not to recognize right of use assets and lease liabilities for these short term leases. A short term lease has a term of 12 months or less, AND does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
Second, the Discount rate – non-public entities can elect an accounting policy to use the risk free rate in measuring the lease liability. The risk free rate would generally be the T-bill yield for a comparable timeframe as the lease in question. This practical expedient is viewed as a way to simplify the accounting analysis for companies that are not PBE’s.
However, organizations should be aware that the use of a lower discount rate will generally result in a higher lease liability and ROU asset. Before selecting a discount rate, an organization’s implementation team should really consider the balance between understanding the impacts on key financial performance indicators, such as return on assets, versus practical expedients meant to simplify the accounting.
The third area we want to highlight is variable lease payments – Under the new lease standard – you would only include variable payments in the lease liability if they depend on an index or rate. Otherwise, they will be recognized when the amounts become probable. Also, entities should be careful to identify variable payments that are essentially hidden fixed payments if they are virtually assured of being incurred.

12. Let’s walk through a hypothetical lease…
Entity ABC, a lessee, entered into a four year lease of a commercial office building. At lease commencement, management of Entity ABC determined that the lease should be classified as an operating lease because the lease did not meet any of the five criteria to be classified as a finance lease.
The lease includes the following annual escalating lease payments due at the end of each year:
Year 1 - $12,000
Year 2 - $14,000
Year 3 - $16,000
Year 4 - $18,000
The lessor agreed to provide Entity ABC with six months of free rent in the first year of the lease. There are no extension periods, no options to purchase, and no other lease incentives from the lessor. Additionally, there were no initial direct costs.
As the rate implicit in the lease could not be determined, Entity ABC used a discount rate of 6.682% which is its incremental borrowing rate.

13. Let’s walk through a hypothetical lease…
At the commencement of the lease, Entity ABC would initially measure and record the right-of-use asset, lease liability, and the free-rent incentive as follows:
Payments
Year 1 $ 6,000
Year ,000
Year ,000
Year ,000
Total $ 54,000
PV of lease payments at the discount rate of 6.682% = $45,000
The initial measurement of the lease liability and right-of-use asset was determined based on the present value of the lease payments using the 6.682% discount rate. Note that the free-rent incentive is factored into the Year 1 cash flows.
Note that the discount rate used in this scenario is Entity ABC’s incremental borrowing rate. If entity is not a PBE, management could have used the risk free rate as the discount rate, which in many cases, will be a lower discount rate. For example, if this lease commenced in 2016, the discount rate could range between 1% and 2%. Had the risk free rate been used, the resulting lease liability and right-of-use asset would have been higher. As such, non PBEs with significant leasing activity should be aware of the potential impact when selecting the discount rate to use.

14. Let’s walk through hypothetical lease…
Entity ABC would then record the following entries in Year 1 of the lease:
To record lease expense and adjust the right-of-use asset for the difference between cash paid of $6,000 and the straight-line lease expense of $13,500 (i.e., accrued rent).
Payments
Year ,000
Year ,000
Year ,000
Total $ 48,000
To adjust the lease liability to the present value of the remaining lease payments at the end of Year 1, with an offset to the right-of-use asset. The adjustment of $2,993 is calculated as the initially recognized lease liability ($45,000) less the present value of remaining lease payments ($42,007) at the end of Year 1.
In year 1, the entity would record the following entries to reflect the straight-line lease expense and the effect of the lease payments made during the year.

15. Let’s walk through a hypothetical lease…
A summary of the lease contract’s accounting (assuming no changes due to reassessment, lease modification, or impairment) is as follows:
Here is an overview of Entity ABC’s financial statement effects over the term of the lease. As you can see, since this is an operating lease, the lease expense is recognized on a straight-line basis. The lease liability is considered an operating liability --- not debt.

16. Implementation Framework
Understand the New Standard
Develop Cross Functional Team
Evaluate Existing Leases and Impact
Determine When to Transition
Implement and Monitor
Organizations that engage in leasing activities should begin planning for implementation of the new leasing standard now. Because of the modified retrospective transition requirements, organizations with significant leasing activity may need to have dual reporting capabilities in place prior to the required implementation date so that comparative information is readily available at implementation.
Understand the new standard
Form an implementation task force – The impact of the new leasing guidance and the related information that must be collected for recognition and disclosure may require a cross-functional team effort. Various departments – including accounting, finance, operations, logistics, legal, tax, and IT – should be represented on the task force.
Evaluate existing leases – The implementation task force should understand how the structure of the organization’s current leases fits into the new lease model. Lease terms should be assessed and segregated into short term (less than 12 months) and long term (greater than 12 months) leases. After that, the team should identify the type of leases under the lessee and lessor models.
Assess the impact – The team should perform an assessment of the financial impact of accounting for its current leases under the new model. The team should compare this against the impacts under the organization’s current recognition and disclosure policies. Performing this exercise may be particularly helpful in understanding other ramifications of applying the new lease standard beyond the organization’s financial statements.
Begin documenting significant judgments – The team should analyze and document significant judgments and estimates such as:
Lease term
Discount rates
Determining whether the risks and rewards incidental to ownership of the underlying asset have transferred
Variable lease payments
Consider possible changes to systems, process, and controls – The new leasing guidance may require an organization to gather more or different information than in the past about its lease agreements and activity. Information systems and databases may require revision to incorporate additional fields or different information. Sources of information may involve additional personnel or procedures into the Company’s internal control procedures. As a result, an organization may need to adopt new internal controls or modify existing controls to help ensure the completeness and accuracy of the information used in applying the new leasing guidance.
Consider the impact on financial and business practices – The task force may identify significant changes in the timing of expense recognition for lessee activity. In addition, the new lease standard could have dramatic effects on the organization’s balance sheet and other key performance indicators, such as financial ratios. The task force should identify financial statement users and aspects of the business that may be affected by the application of the new lease standard. The task force should explore the potential impact on areas such as debt covenants, access to additional financing, capital spending, internal and external financial analyses, bonus and incentive plans, cash flow strategies, and contracting and pricing practices.
Consider the tax implications – Changes in the timing and amount of expense recognition could affect the organization’s income tax reporting. The new leasing standard could result in larger or smaller book versus tax timing differences. This may result in changes in the timing of tax payments and changes in the organization’s deferred tax assets and liabilities. The organization’s tax preparers will need to understand the impact of the new rules on current tax accounting methods and changes in the lease information accumulated by the organization.

17. Other Topics – Implementation considerations (continued)
Other practical considerations
Non-PBEs – Consider whether it makes sense to elect a policy to use the risk-free rate. Ease of application versus smaller lease liability and lease asset.
Establish a methodology to determine the organization’s incremental borrowing rate
Separating lease and non-lease components – Ease of application versus smaller lease liability and lease asset.
Consider the availability and practicality of other practical expedients offered as a package at transition. An entity may elect, as a package, to not reassess
Whether any expired or existing contracts are, or contain, leases (as defined in Topic 842)
The lease classification for any expired or existing leases
Previous capitalization of initial direct costs for any existing leases
Entities can also make an election to use hindsight in determining the lease term (generally regarding options to extend or terminate the lease, or purchase the leased asset) and in assessing impairment of ROU assets. This may be elected separately or in conjunction with the above practical expedients, and must be applied consistently to all leases.
In general, the practical expedients offered at transition, as well as in the initial measurement of lease assets and liabilities, are designed to lighten the transition burden and complexity. However, entities should consider resources and financial objectives before making a policy election to simplify the accounting analysis. For instance, the effect of applying a lower risk-free rate as the discount rate will generally result in a higher lease liability and ROU asset. On the flip-side, organizations that use an incremental borrowing rate will need to document their methodology and key judgments.
There is a package of practical expedients offered at transition. An entity that elects to apply these practical expedients at transition will, in effect, continue to account for leases that commenced before the effective date in accordance with previous GAAP unless the lease is modified. EXCEPT that lessees are still required to recognize an Right of Use asset and lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP. The other key takeaway from the practical expedients offered at transition is that the effect of electing these practical expedients could have a significant outcome for entities that incur significant initial direct costs, because fewer costs qualify as initial direct costs under the new standard.

18. Resources

19. Resources
Crowe Newsletter, “Something Borrowed, Something New: Get Ready for the New Lease Accounting Standard”
Issued April 8, 2016
16 pages
Background
Who Will Be Effected
Sale and Leaseback Transactions
Effective Dates
Transition
Disclosures
For some additional resources – please locate and download our article on the Crowe Horwath page.

20. Questions ?

21. Thank you
Jim Hannan Phone Scott Sachs Phone