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SPECIAL FEATURE! Is Growth an Opportunity or Risk?
October 2010
www.financialexecutivemag.com
October 2010
Financial Executive
Published by Financial Executives International
AreYou Optimistic?
n LEASE ACCOUNTING
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Proposed new rules
would require more
business knowledge and
professional judgment
n WORKING CAPITAL
Obtaining business
financing and customer
payments continue to
challenge SMEs
n TREASURY
New financial regulation
is sure to increase the
complexity of account
analysis statements
READ FOR CPE CREDIT
PREPARING FOR
THE NEW LEASE
ACCOUNTING
Is it a lease, or not a lease?
This is just one of the considerations in the new lease
accounting proposal, which could lead to major
changes in how leases are negotiated and administered. Though implementation is in the future, the
long-term nature of many leases means it’s not too early to start planning.
liabilities: Operating leases.
All leases will create a lease obligation liability and a corresponding
right-of-use asset on the balance
sheet, similar to the current accounting for capital leases. However, the
proposed changes go beyond the current rules for recording leases as capital leases.
The new rules would require con-
By John Hepp and Rahul Gupta
www.financialexecutives.org
october 2010 | financial executive
ACCOUNTING
While the recent financial crisis has
focused increased attention on offbalance sheet liabilities, proposed
changes to lease accounting are the
result of a project that dates back to
an earlier round of accounting scandals and the subsequent passage of
the Sarbanes-Oxley Act of 2002. The
current proposal would eliminate a
major category of off-balance sheet
49
sideration of additional items — such
as contingent rental payments and
optional renewal periods — that will
add complexity to the initial valuation of a lease obligation. Leases with
contingent rentals or option periods
may need to be re-evaluated every
reporting period.
The scope of the new standard
will also require evaluation of lease
contracts to determine whether any
of the payments are for distinct services. These services would not be
included with the lease obligation.
The additional complexity is likely to
change how lease terms are negotiated and structured.
The proposal will also affect how
rent expense is reported on the income
statement. Currently, rent expense is
recognized as part of operating
income and included in calculation of
earnings before interest, taxes, depreciation and amortization (EBITDA).
Under the new proposal, part of
rent payments will be recognized as
interest expense and the right-of-use
asset will be depreciated, moving the
expense out of the current definition
of EBITDA. In addition, more interest
expense will be attributed to the early years of a lease, accelerating the
recognition of overall expense.
The scope of the changes may
require redesign and reevaluation of
existing procedures for negotiating,
administering, recording and reporting leases in the financial statements.
Entities with significant leasing activities may also find it necessary to
redesign and test their internal controls over leasing to ensure
compliance with the proposed
accounting rules and expanded disclosure requirements.
Evaluating a New Lease
The proposed standard defines a
lease as “a contract in which the right
to use a specified asset is conveyed,
for a period of time, in exchange for
consideration.” Similar to the existing standards, any agreement that
transfers to the lessee more or less
exclusive rights to use property, plant
and equipment (or its output) would
be classified as a lease.
While it will no longer be necessary to evaluate a new lease to determine whether the lease is a capital
lease or an operating lease, it will still
be necessary to evaluate each new
lease for the proper accounting treatment. That evaluation will cover
eight distinct steps (and this list is
not exhaustive):
1. Determining whether an arrangement contains a lease.
2. Determining whether a lease is to
be accounted for as a sale or a lease.
3. Determining whether some elements of the lease should be account-
SUMMARY OF KEY CHANGES FOR OPERATING LEASES
Topic
50
Existing U.S. GAAP
Proposed Model
Expected Impact
OVERALL RECOGNITION
Operating leases are
“off balance sheet.”
Record an asset and
liability for all leases
based on the most likely
future rent payments
and lease term.
Increased assets and
liabilities on the
balance sheet.
PAYMENTS FOR SERVICES
Also off balance sheet.
Remains off balance
sheet.
Need to distinguish
payments for rent
from payments for
services.
LEASE TERM
Include option periods
with bargain renewals
or periods prior to a bargain purchase option.
Capitalize the most
likely lease term, including
option periods.
Need to reassess most
likely lease term each
reporting period and
adjust financial statements, if needed.
CONTINGENT RENTS
Generally recognize
when incurred.
Capitalize most likely
estimated future
payments and include
in recorded asset and
liability.
Need to estimate and
capitalize most likely
future payments each
reporting period and
adjust through income.
INCOME STATEMENT
PRESENTATION
Record rent expense on
a straight-line basis in
the income statement.
Recognize interest
expense on the obligation and depreciation
expense on the asset.
Increased EBITDA,
depreciation expense
and interest expense.
financial executive | october 2010
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ed for as distinct services.
4. Estimating the present value of
future rentals during option periods
that are more likely than not to be
exercised.
5. Estimating the present value of the
amount of any contingent lease payments.
6. Determining the amount of initial
direct costs to allocate to a right-ofuse asset.
7. Determining the proper discount
rate.
8. Determining the information to be
accumulated for disclosure in the
notes to the financial statements.
Step 1:
Is the Arrangement a Lease?
The first step in some evaluations
will be to determine whether an
arrangement contains a lease. In
addition to contracts that explicitly
identify equipment under a lease,
there may be other contracts that
contain implicit leases that will fall
within the scope of the standard.
Current generally accepted
accounting principles require similar
evaluations. However, their impact is
less significant because the accounting for an operating lease and the
accounting for a service contract is
essentially the same. This will change
dramatically under the proposed
revisions to lease accounting because
a service contract will not create a liability, but a lease contract will.
EXAMPLE: ABC Company contracts
with a truck owner-operator for a
three-year contract that includes exclusive rights to use the vehicle. The
arrangement may contain a lease, as it
conveys the right to use a specified asset for a period of time. As described
below, it would be necessary to separately account for the lease elements
and the non-lease elements of the
contract.
Step 2:
Is the Lease Accounted for as
a Sale or as a Lease?
Under the new standard, the second
step in accounting for a lease will be
to determine whether the lease is a
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lease at all. In some cases a lease will
be accounted for as a sale by the lessor and a purchase by the lessee. A
lease contract that transfers control at
the end of the contract — and all but
a trivial amount of the risks and benefits associated with the underlying
asset to the lessee — will be accounted for as a purchase.
Thus, a lease will usually be classified as a purchase in the following
situations:
• Title of the underlying asset automatically transfers to the lessee at the
end of the lease.
• The lease contains a bargain purchase option.
The determination of whether a
lease is to be accounted for as a lease
or a purchase will be made at the
inception of the lease and will not be
revisited. Regardless of whether the
lease is accounted for as a purchase,
it may still be necessary to determine
if there are distinct service elements
within the contract that will need to
be segregated and accounted for separately.
EXAMPLE: ABC Company leases production machinery from XYZ
Company for a five-year term. At the
end of the lease, ABC has the option
of purchasing the machinery for a
nominal amount. The lease would be
accounted for as a purchase.
Step 3:
What is a Lease and What is
A Service?
The third step in evaluating a lease
will be to look for distinct service elements in the lease contract. While
technically, current U.S. GAAP
requires separation of amounts for
lease elements and service elements,
it has been less of an issue because
most leases are at present classified
as operating leases. The accounting
for an operating lease and the
accounting for services are essentially the same.
The proposed changes would create a new and significant difference
between the accounting for a lease
and the accounting for a service. A
liability (and a corresponding asset)
The scope of the changes
may require redesign and
reevaluation of existing
procedures for negotiating,
administering, recording
and reporting leases in the
financial statements.
will be recognized for lease elements,
but not for service elements.
The Financial Accounting Standards Board has proposed that distinct service components should be
accounted for separately. The proposed rules for determining whether
a service is distinct come from the
FASB Revenue Recognition Project. A
service would be distinct if:
• The lessor or another entity sells
an identical or similar service separately; or
• The lessor could sell the service
separately, (i.e., the service has a distinct function and a distinct profit
margin).
The payments under the lease contract would be allocated between the
service and the lease components. If
the services are not distinct, or if it is
not possible to allocate the payments
between service and lease components, then all payments would be
considered to be lease payments.
The distinction between lease and
service elements is made at the inception of the lease. If total payments
change, the process is repeated, but
with one important difference: If the
amount attributable to the lease or
service elements cannot be determined, the change in payments would
be allocated to the previously identi-
october 2010 | financial executive
51
While it will no longer be
necessary to evaluate a new
lease to determine whether
it’s a capital lease or an
operating lease, it will still
be necessary to evaluate
each new lease for the
proper accounting treatment — which covers
eight distinct steps.
fied elements on a pro rata basis.
EXAMPLE: ABC Company rents
equipment from XYZ Company. The
contract includes service elements
for routine and emergency maintenance and repairs. XYZ provides similar services to customers who purchase equipment. The service element would be distinct, and the payments under the contract would be
allocated between payments for use
of the equipment and payments for
services. The present value of the
payments for use of the equipment
would be recognized as a lease obligation liability and a related right-ofuse asset (see chart on page 50).
Step 4:
What is the Lease Term?
Lease contracts that include optional
renewal periods will require a fourth
evaluation step to determine the
length of the lease term. Under current GAAP, the lease includes option
periods only when the rent is such a
bargain (or there are penalties for nonrenewal) that it is reasonably certain
that the lessee will extend the lease.
Under the proposal, it only needs
to be more likely than not that the
lessee will extend the lease by exercising an option, including options at
market value. The lease term would
be the longest possible period including all likely option periods (those
52
financial executive | october 2010
where exercise is more likely than
not). The present value of the rental
payments, including those potentially due during likely option periods,
would then be discounted to determine the lease obligation.
Because the likelihood of exercising
an option can change, the lease term
would be reassessed at each reporting
date, but a detailed examination of
every lease would not be required
unless there is a change in facts or circumstances. The effects of any change
in the lease term would be recorded as
an adjustment to the right-of-use asset
and lease obligation using the same
discount rate originally used at inception of the lease.
EXAMPLE: ABC Company enters into
a 10-year non-cancellable lease with
three renewal options of five years
each. The renewal options are at
market value. ABC will need to
determine whether any of the three
options are more likely than not to
be exercised based on all relevant
facts and circumstances. If it is likely
that one renewal option will be exercised, the present value of the estimated market rents during the
renewal period would be included in
the lease obligation and the right-ofuse asset. If in the fifth year of the
lease the customer company determines it is likely that all three option
periods would be exercised, the obligation and asset would be re-measured using the present value of estimated future market rentals measured at the same discount rate used
to measure the original obligation.
Step 5:
Are There Any Contingent
Rental Payments?
Contingent rental payments are payments whose timing or amount is not
determined at the beginning of the
lease. The amounts paid in future
periods may be contingent on future
changes in inflation, the amount of
use of the underlying asset (for
example, miles driven in a car lease)
or future sales.
Under the current standard, contingent rent payments are recognized
as rent expense when incurred. The
proposed accounting model would
change this by requiring the lessee to
estimate the most likely amount that
will be paid using an expected outcome technique.
The estimate would cover the
longest possible lease term that is
more likely than not to occur. Lessees
will measure contingent rentals
based on an index or rate, using
either forward rates, if readily available, or the rates current at the inception of the lease.
Estimated future contingent
rentals would be reevaluated each
reporting period if any new facts or
circumstances indicate that there is a
material change in the obligation.
Changes in estimated future contingent rentals would be discounted
using the same discount rate used to
measure the original obligation. On
re-measurement, changes in estimated contingent rentals incurred in the
current period or prior periods
would be recognized immediately in
earnings. Changes relating to future
periods would be recognized as
adjustments to the lease obligation
and the right-of-use asset.
EXAMPLE: ABC Company rents a
vehicle with a five-year lease term.
Rent payments include a fixed component plus a mileage charge for
miles in excess of an annual
allowance. At inception, ABC would
estimate the amount of miles that will
be driven each year using an expected
outcome technique. It would recognize the present value of total
estimated payments as a lease obligation and right-of-use asset.
Over the lease term, it would recognize differences attributable to the
current period in ear nings. Any
changes in the estimated amount to
be incurred in future years would be
recognized as an adjustment of the
lease obligation and right-of-use
asset.
Step 6:
Have Initial Direct Costs Been
Correctly Capitalized?
One feature carried over from current
GAAP is the ability of the lessee to
capitalize certain direct costs of
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obtaining a lease (e.g., commissions,
legal fees, negotiating costs, etc). General overhead costs and costs relating
to unsuccessful negotiations may not
be capitalized. These costs would be
combined with the right-of-use asset
and amortized over the lease term.
Step 7:
Have the Payments Been
Discounted Correctly?
The next step is to discount all of the
estimated future payments determined so far plus the residual value
guaranteed by the lessee and its related parties. All amounts (and any
future changes to those amounts)
will be discounted using the lessee’s
incremental borrowing rate at the
date of the lease or the rate the lessor
charges the lessee if reliably determinable. The result is then booked as
the initial lease obligation. The rightof-use asset is the amount of the obligation plus any initial direct costs.
EXAMPLE: ABC Company enters into
a lease contract to lease a property
for 10 years. The incremental borrowing rate for ABC (after considering its credit standing, term of the
lease and quality of underlying asset)
is 10 percent. The rate charged by
the lessor — which is determined
using the yield on the property — is
eight percent. ABC Company should
use the eight percent rate to discount
the estimated future payments. However, if the rate charged by the lessor
cannot be reliably determined then
incremental borrowing rate of 10
percent should be used.
Step 8:
Are Systems in Place to Provide Information for Required
Disclosures?
The final step required to record a
lease will be to ensure that the information needed for required disclosures is captured and made available
for audit and financial reporting purposes. The proposed standard
requires quantitative and qualitative
information that identifies and
explains the amounts recognized in
the financial statements and
describes how leases may affect the
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amount, timing and uncertainty of
the entity’s future cash flows.
The expanded disclosure requirements include a reconciliation of the
opening and closing balances of
right-of-use assets and lease liabilities separately by class of underlying
asset, including total cash paid during the period. The standard also
requires a maturity analysis of payments due, among other disclosures.
Needed: New Skills, Procedures
and Controls
As the above discussion indicates,
successful evaluation of leases under
the proposed standard may require a
very different set of skills than those
necessary for evaluating leases under
the present standard. The process will
require more business knowledge
and professional judgment because
each element of the lease contract
needs to be evaluated separately.
It also may be necessary to estimate future costs or prices, involving
consideration of future market conditions and the strategic direction of the
entity. It is not too soon to start considering changes in the procedures
and controls used to capture and
report information about leases in the
financial statements. The impact on
the balance sheet and income statement may require additional oversight from senior management and
reconsideration of the internal controls over the leasing process and
related financial reporting.
Interaction with provisions in other contracts and debt covenants will
also need to be monitored to ensure
compliance. The controls will need to
operate not only when a lease is initially signed or modified as is currently the case, but potentially every
reporting period if the lease contract
includes contingent rentals or optional renewal periods.
It is recommended that entities
review their existing leases (there are
no grandfathering provisions) to estimate the impact of the proposed
changes on the financial statements.
It would also be advisable to carefully consider the proposed changes
when negotiating new contracts of
Successful evaluation of
leases under the proposed
standard may require a very
different set of skills than
those necessary for evaluating leases under the present
standard. The process will
require more business
knowledge and
professional judgment.
more than a few years’ duration.
Overall, any entity that makes use
of lease accounting should be following events closely over the next several months. There is still time to submit comments to FASB and International Accounting Standards Board
so that your views can be considered
when preparing the final standard.
J OHN H EPP, CPA (John.Hepp@gt.com),
is a partner with the National Professional
Standards Group of Grant Thornton LLP
in Chicago. Rahul Gupta, CPA
(Rahul.Gupta@gt.com), is a manager with
the National Professional Standards Group
of Grant Thornton LLP in Houston.
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