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156

I. Changes Coming To Lease Accounting The FASB's lease accounting project has nine lives and has survived two exposure drafts while headed toward final passage. As of early 2015, the FASB is putting the finishing touches on a new lease standard that, when passed, will make dramatic changes to the way companies account for lease transactions. In particular, most leases will be capitalized, resulting in billions of dollars of assets and liabilities being recorded on company balance sheets. Although the lease accounting project has gone through numerous changes, the fundamental concept that leases be capitalized is not going to change in the final document. In this section, the author discusses the general concepts that are included in the most recent lease exposure draft, with modifications that have been proposed by the FASB through their ongoing deliberations. Background Under current GAAP, ASC 840, Leases (formerly FASB No. 13), divides leases into two categories: operating and capital leases. Capital leases are capitalized while operating leases are not. In order for a lease to qualify as a capital lease, one of four criteria must be met:

1. The present value of the minimum lease payments must equal or exceed 90% or more of the fair value of the asset.

2. The lease term must be at least 75% of the remaining useful life of the leased asset. 3. There is a bargain purchase at the end of the lease. 4. There is a transfer of ownership.

In practice, it is common for lessees to structure leases to ensure they do not qualify as capital leases, thereby removing both the leased asset and obligation from the lessee’s balance sheet. This approach is typically used by restaurants, retailers, and other multiple-store facilities. Consider the following example: Facts: Lease 1: The present value of minimum lease payments is 89% and the lease term is 74% of the remaining useful life of the asset. Lease 2: The present value of minimum lease payments is 90% or the lease term is 75% of the remaining useful life of the asset.

Accounting and Financial Reporting – Current Developments

157 Conclusion: There is a one percent difference between Lease 1 and Lease 2. Lease 1 is an operating lease not capitalized, while Lease 2 is a capital lease under which both the asset and lease obligation are capitalized. SEC pushes toward changes in lease accounting In its report entitled Report and Recommendations Pursuant to Section 401(c.) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuer, the SEC targeted lease accounting as one of the areas that results in significant liabilities being off-balance sheet. According to the SEC Report that focused on U.S. public companies and a U.S. Chamber of Commerce report:

a. 63 percent of companies record operating leases while 22 percent record capital leases. b. U.S. companies have approximately $1.5 trillion in operating lease obligations that are

off-balance sheet.

c. European companies have a total of approximately $928 billion in off-balance sheet operating lease obligations.

d. 73 percent of all leases held by U.S. public companies ($1.1 trillion) involve the leasing of real estate. In its Report, the SEC noted that because of ASC 840’s (formerly FASB No. 13’s) bright-line tests (90%, 75%, etc.), small differences in economics can completely change the accounting (capital versus operating) for leases. Keeping leases off-balance sheet, while still retaining tax benefits, is an industry unto itself. So-called synthetic leases are commonly used to maximize the tax benefits of a lease while not capitalizing the lease for GAAP purposes. In addition, lease accounting abuses have been the focus of restatements with approximately 270 companies, mostly restaurants and retailers, restating or adjusting their lease accounting in the wake of Section 404 implementation under Sarbanes-Oxley. Retailers have the largest amount of operating lease obligations outstanding that are not recorded on their balance sheets. Consider the following table:

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Operating Leases Obligations Outstanding- Major Retailers Retailer

Lease Obligations

(in thousands) Office Depot Inc. $1,104 Walgreens Co. 27,434 CVS 38,917 Whole Foods 6,322 Sears 7,608

Source: Annual reports

The previous table shows the amount of off-balance sheet lease obligations for some of the largest U.S. retailers. These numbers are significant and bring to the forefront the pervasive impact the proposed lease standard would have on the larger retailers. For example, CVS has almost $39 billion of off-balance sheet lease obligations. FASB-IASB lease project Since the Sarbanes-Oxley Act became effective, the FASB has focused on standards that enhance transparency of transactions and that eliminate off-balance-sheet transactions, the most recent of which was the issuance of ASC 810, Consolidation of Variable Interest Entities (formerly FIN 46R). The FASB added to its agenda a joint project with the IASB that would replace existing lease accounting rules found in ASC 840 (formerly FASB No. 13) and its counterpart in Europe, IASB No. 17. The FASB and IASB started deliberations on the project in 2007, and issued a discussion memorandum in 2009, followed by the issuance of an exposure draft in 2010 entitled Leases (Topic 840). The 2010 exposure draft was met with numerous criticisms that compelled the FASB to issue a second, replacement exposure draft on May 16, 2013 entitled Leases (Topic 842), a revision of the 2010 proposed FASB Accounting Standards Update, Leases (Topic 840). Given the fact that the FASB has now issued two exposure drafts and received extensive public comments, the second exposure draft is likely to pass as a final statement, with minor further edits. Following are some of the changes that the FASB and IASB have included in their proposed new lease model as outlined in the May 2013 Exposure Draft. Basic concepts of the lease exposure draft The core principle of the proposed requirements found in the 2013 Exposure Draft is that an entity should use the right-of-use model to account for leases which would require the entity to

Accounting and Financial Reporting – Current Developments

159 recognize assets and liabilities arising from a lease. Thus, most existing operating leases would be brought onto the balance sheet. In accordance with the right-of-use model: 1. A lessee would recognize assets and liabilities for any leases that have a maximum possible

lease term of more than 12 months. a. Leases with terms of 12 months or less would have the option of remaining as operating leases. Following is a summary of the key elements of the proposed lease standard. Lessee: 1. At the commencement date, a lessee would measure both of the following:

• A lease liability (liability to make lease payments) • A right-of-use asset (right to use the leased asset for the lease term)

a. Lease liability: The lease liability would be recorded at the present value of the lease

payments over the lease term, discounted using the rate the lessor charges (the lessor’s imputed rate) the lessee based on information available at the commencement date.

1) If the lessor’s imputed rate cannot be readily determined, the lessee would use its

incremental borrowing rate. 2) Nonpublic entities would be permitted to use a risk-free discount rate, determined

using a period comparable to that of the lease term, as an accounting policy election for all leases. The risk-free discount rate would be a U.S. Treasury instrument rate for the same term as the lease.

b. Right-of-use asset: 1) At the commencement date, the cost of the right-of-use asset would consist of all of the following:

• The amount of the initial measurement of the lease liability • Any lease payments made to the lessor at or before the commencement date, less

any lease incentives received from the lessor, and • Any initial direct costs incurred by the lessee.

Accounting and Financial Reporting – Current Developments

160 2) At the commencement date, initial direct costs would be included as part of the cost

of the lease asset capitalized and may include:

• Commissions • Legal fees • Evaluating the prospective lessee’s financial condition • Evaluating and recording guarantees, collateral, and other security contracts • Negotiating lease terms and conditions • Preparing and processing lease documents • Payments made to existing tenants to obtain the lease

The following items are examples of costs that would not be initial direct costs:

- General overheads, including for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time, and

- Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities.

c. Lease payments: 1) At the commencement date, lease payments included in the lease liability would

consist of the following payments related to the use of the underlying asset during the lease term that are not yet paid:

• Fixed payments, less any lease incentives receivable from the lessor

• Variable lease payments that depend on an index or a rate (such as the Consumer

Price Index or a market interest rate), initially measured using the index or rate at the commencement date

• Variable lease payments that are in-substance fixed payments Note: The FASB has announced that it is considering changing the exposure draft so that variable lease payments would be included in the initial measurement of lease assets and liabilities only if such payments depend on an index or a rate.

• Amounts expected to be payable by the lessee under residual value guarantees

• The exercise price of a purchase option if the lessee has a significant economic incentive to exercise that option

Accounting and Financial Reporting – Current Developments

161 Note: The FASB has announced that it is considering replacing the "significant economic incentive" threshold with a higher threshold of being "reasonably assured" that the lessee will exercise the purchase option.

• Payments for penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease

2) Variable lease payments: Variable lease payments would be included in lease

payments used to calculate the lease liability if:

• The lease payments would depend on an index or rate, such as a CPI index. Each year, the lessee would adjust the lease obligation to reflect the present value of the remaining lease payments using latest index in effect at the end of that year.

• The lease payments would be in-substance, fixed payments, such as a minimum annual increase of 2 percent per year.

Lease payments based on performance (such as a percentage of sales, with no minimum) would not be reflected in the lease payments in computing the lease obligation. Instead, such payments would be recorded annually as actual sales are generated.

d. Lease term: An entity would determine the lease term as the noncancellable period of

the lease, together with both of the following:

1) Periods covered by an option to extend the lease if the lessee has a significant economic incentive to exercise that option, and

2) Periods covered by an option to terminate the lease if the lessee has a significant

economic incentive not to exercise that option.

a) Factors would be considered together, and the existence of any one factor would not necessarily signify that a lessee has a significant economic incentive to exercise, or not to exercise, the option. Examples of factors to consider would include, but would not be limited to, any of the following:

• Contractual terms and conditions for the optional periods compared with

current market rates

• Significant leasehold improvements that are expected to have significant economic value for the lessee when the option to extend or terminate the lease or to purchase the asset becomes exercisable.

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• Costs relating to the termination of the lease and the signing of a new lease, such as negotiation costs, relocation costs, costs of identifying another underlying asset suitable for the lessee‘s operations, or costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location.

• The importance of that underlying asset to the lessee‘s operations,

considering, for example, whether the underlying asset is a specialized asset and the location of the underlying asset.

Example: A retail lessee, a liquor store, has a 5-year lease with two, 5-year options. It would be very difficult for the lessee to move the liquor store due to neighborhood opposition. Thus, the store location is very important to the lessee.

Conclusion: The lessee most likely has a significant economic incentive to exercise the options so that the lease term is probably 15 years. Note: The FASB has announced that it is considering replacing the "significant economic incentive" threshold with a higher threshold of being "reasonably assured" that the lessee will exercise the option.

3) Reassessment of lease term: An entity would reassess the lease term only if either of the following occurs:

a) There is a change in relevant factors, that would result in the lessee having or no

longer having a significant economic incentive either to exercise an option to extend the lease or not to exercise an option to terminate the lease.

Note: A change in market-based factors (such as market rates to lease a

comparable asset) shall not, in isolation, trigger reassessment of the lease term.

b) The lessee does either of the following:

• Elects to exercise an option even though the entity had previously determined that the lessee did not have a significant economic incentive to do so, or

• Does not elect to exercise an option even though the entity had previously determined that the lessee had a significant economic incentive to do so.

e. Classification of leases: The Exposure Draft establishes two types of leases: Type A lease: Lease in which lessee expects to consume more than an insignificant portion of the economic benefits (life) of the asset:

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163

• Would apply to most leases of assets other than property (for example, equipment, aircraft, cars, trucks).

• Would recognize a right-of-use asset and a lease liability, initially measured at the

present value of lease payments.

• Would recognize the unwinding of the discount on the lease liability as interest separately from the amortization of the right-of-use asset.

• Total expense would be accelerated and shown in two expense components:

- Interest expense (accelerated), and - Amortization expense (straight-line).

Type B lease: Lease in which the lessee expects to consume only an insignificant portion of the economic benefits (life) of the asset: • Would apply to most leases of property (that is, land and/or a building or part of a

building).

• Would recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments (same as Type A lease).

• Would recognize a single lease expense, combining the unwinding of the discount on the lease liability (interest) with the amortization of the right-of-use asset, on a straight-line basis.

• Total expense would be recorded on a straight-line basis throughout the lease term. The following chart compares the proposed standard with existing GAAP for leases.

Comparison of Existing GAAP Versus Proposed GAAP for Leases

Lessee Side

Description Current GAAP for Operating Leases

Proposed GAAP

Lease type Leases are classified as operating or capital leases (financing arrangements) based on satisfying one of four criteria. • 75% rule • 90% rule • Bargain purchase • Transfer of ownership

All leases classified as financing arrangements (as if asset purchases) Right-of-use asset and lease liability recorded at present value of payments over the lease term

Accounting and Financial Reporting – Current Developments

164 Lease term Non-cancellable periods

Option periods generally not included in lease term

Non-cancellable period together with any options to extend or terminate the lease when there is a significant economic incentive for the lessee to exercise an option to extend the lease

Contingent/variable rents

Contingent rents excluded from lease payments. When paid, they are period costs

Variable rents included in lease payments in certain instances

Income statement Operating leases- lease expense straight-line basis Capital leases- depreciation and interest expense

Two approaches: TYPE A LEASE: Interest and amortization expense recorded as accelerated expense TYPE B LEASE: Lease expense recorded as combination of interest and amortization- straight- line expense

Assessment Terms are not re-assessed Leases reassessed in certain instances

TYPE A VERSUS B LEASES INCOME STATEMENT EFFECT

0

5

10

15

20

25

30

35

1 2 3 4 5

YEARS

E X

P E

N S

E /IN

C O

M E

TYPE A TYPE B

Lessor:

Accounting and Financial Reporting – Current Developments

165 1. A lessor would account for leases using the following rules: a. Type A lease: Lessee is expected to consume more than an insignificant portion of the economic benefits (life) of the asset:

• Most leases of assets other than property (for example, equipment, aircraft, cars, trucks)

• Lessor would:

1) Derecognize (remove) the underlying asset and recognize two new assets: a) Lease receivable: Reflecting the right to receive lease payments, and

b) Residual asset: Reflecting the right the lessor retains in the underlying asset at the end of the lease.

2) Recognize the unwinding of the discount on both the lease receivable and the residual asset as interest income over the lease term. Interest income is recorded on an accelerated basis. 3) Recognize any profit relating to the lease at the commencement date.

Note: The FASB has announced that it is considering changing some of the proposed elements in the May 2013 exposure draft as they relate to Lessors.

• A lessor would determine lease classification (Type A or B) on the basis of

whether the lease is effectively a financing or a sale. A lessor would make the determination by assessing whether the lease transfers substantially all of the risks and rewards incidental to ownership of the underlying asset.

• A lessor would be precluded from recognizing selling profit and revenue at lease commencement for any Type A lease that does not transfer control of the underlying asset to the lessee.

• For Type A leases from the lessor's perspective, the FASB would eliminate the receivable and residual approach.

b. Type B lease: Lessee is expected to consume only an insignificant portion of the

economic benefits (life) of the asset:

• Most leases of assets of property (that is, land and/or a building or part of a building).

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166

• Lessor would: 1) Apply an approach similar to existing operating lease accounting in which the lessor would do the following:

a) Retain the lease asset on the lessor’s balance sheet, and b) Recognize lease (rental) income over the lease term typically on a straight-

line basis. Short-term leases: 1. A lessee would not be required to recognize lease assets or lease liabilities for short-term leases. 2. A short-term lease is defined as follows:

"A lease that, at the date of commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less."

3. For short-term leases, the lessee would recognize lease payments as rent expense in the

income statement on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset.

Note: The proposal would treat short-term leases (12 months or less) as operating leases by not requiring the lessee to record the lease asset and liability. Instead, rent expense would be recorded on a straight-line basis as incurred, although the proposal would permit an entity to use another approach (other than a straight-line method) to record rent expense if that alternative is more representative of the time pattern in which the lessee uses the lease asset.

4. A lessee would be permitted (but is not required) to record a lease asset and liability for a short-term lease. 5. Lessors: Lessors would be permitted to elect to account for all short-term leases by not recognizing lease assets or lease liabilities and by recognizing lease payments received in rental income on a straight-line basis over the lease term, or another systematic and rational basis that is more representative of the time pattern in which use is derived from the underlying asset.

Accounting and Financial Reporting – Current Developments

167 Disclosures: 1. Both lessees and lessors would provide disclosures to meet the objective of enabling users

of financial statements to understand the amount, timing, and uncertainty of cash flows arising from leases.

Transition- existing leases: 1. Existing leases would not be grandfathered, thereby requiring existing operating leases to be brought onto the balance sheet.

a. All existing outstanding leases would be recognized and measured at the date of initial application using a simplified retrospective approach.

b. On transition, a lessee and a lessor would recognize and measure leases at the beginning

of the earliest period presented using either a modified retrospective approach or a full retrospective approach.

Effective date: The FASB will set the effective date for the proposed requirements when they consider interested parties' feedback on this revised Exposure Draft.

a. The effective date is likely to be no earlier than 2016, and possibly as late as 2017.

Impact of proposed changes to lease accounting The proposed lease accounting changes would be devastating to many companies and would result in many more leases being capitalized which would impact all financial statements. In particular, retailers would be affected the most. If leases of retailers, for example, are capitalized, the impact on financial statements would be significant, as noted below:

• Lessee’s balance sheets would be grossed up for the recognized lease assets and the lease obligations for all lease obligations. Note: Including contingent lease payments and renewal options may result in overstated liabilities given the fact that contingent payments must be included in the lease payments and renewal options must be considered in determining the lease term.

• For Type A leases, lessee’s income statements would be adversely affected with higher lease expense in the earlier years of new leases.

Accounting and Financial Reporting – Current Developments

168 Note: Even though total lease expense is the same over the life of a lease, lease expense (interest and amortization expense) under a capital lease is higher in the earlier years as compared with lease expense under an operating lease. On average, a 10-year lease would incur approximately 15-20% higher annual lease expense in the earlier years, if capitalized, as compared with an operating lease. That higher lease amount would reverse in the later years.

• For Type A leases, on the statement of cash flows, there would be a positive shift in cash flow to cash from operations from cash from financing activities. A portion of rent expense previously deducted in arriving at cash from operations would now be deducted as principal payments in cash from financing activities. Thus, companies would have higher cash from operating activities and lower cash from financing activities.

• In most cases, annual lease expense for GAAP (interest and amortization) would not

match lease expense for income tax purposes thereby resulting in deferred income taxes. Changes to both the balance sheets and income statements of companies would have rippling effects on other elements of the lessee companies. 1. On the positive side, a lessee’s earnings before interest, taxes, depreciation, and

amortization (EBITDA) may actually improve as there is a shift from rent expense under operating leases to interest and amortization expense under the proposed standard.

a. Both interest and amortization expense are not deducted in arriving at EBITDA while

rent expense is.

b. Changes in EBITDA may affect existing agreements related to compensation, earn outs, bonuses, and commissions.

2. On the negative side, for Type A and B leases, lessee debt-equity ratios would be affected with entities carrying significantly higher lease obligation debt than under existing GAAP. Higher debt-equity ratios could put certain loan agreements into default. Moreover, net income would be lower in the earlier years of the lease term due to higher interest and amortization expense replacing rental expense. How significant would the change to the proposed lease standard be for U.S. companies?

As previously noted, there are approximately $1.5 trillion of operating lease obligations that are not recorded on public company balance sheets. That $1.5 trillion is magnified by the many nonpublic companies that have unpublished operating lease obligations that are unrecorded.

Accounting and Financial Reporting – Current Developments

169 The author estimates that unrecorded lease obligations of nonpublic operating leases is at least another $1.3 trillion, bringing estimated total unrecorded lease obligations to approximately $2.8 billion. Consider the following estimated impacts of shifting those operating leases to capitalized right- of-use leases, based on a report issued by Change & Adams Consulting, commissioned by the U.S. Chamber of Commerce and others:

a. Earnings of retailers would decline significantly. One recent study suggested that there would be a median drop in EPS of 5.3 percent and a median decline in return on assets of 1.7 percent.

b. Public companies would face $10.2 billion of added annual interest costs. c. There would be a loss of U.S. jobs in the range of 190,000 to 3.3 million. d. Cost of compliance with the new standard would lower U.S. GDP by $27.5 billion a year.

e. Lessors would lose approximately $14.8 billion in the value in their commercial real estate.

f. Balance sheets would be loaded with significant lease obligations that would impact

debt-equity ratios.

• Aggregate debt of nonfinancial S&P 500 companies would increase by 17 percent if all leases were capitalized.

• Return on assets would decline as total assets (the denominator) would increase by approximately 10 percent.

• The S&P 500 would record an estimate of $549 billion of additional liabilities under the proposed lease standard on existing operating leases.31

• U.S. companies, as a whole (public and nonpublic), would record approximately $7.8 trillion of additional liabilities if operating leases are capitalized.32

According to a Credit Suisse study,33 there are 494 of the S&P 500 companies that are obligated to make $634 billion of total future minimum lease payments under operating leases. On a present value basis, including contingent rents, the $634 billion translates into an additional liability under the proposed standard of $549 billion. Of the $549 billion of additional liabilities, 15 percent of that total relates to retail companies on the S&P 500.

In some cases, the effect of capitalizing lease obligations under the proposed lease standard is that the additional liability exceeds stockholders’ equity.

31 Leases Landing on Balance Sheet (Credit Suisse) 32 Author’s estimate: $1.5 trillion for public companies and $6.3 trillion for nonpublic companies 33 Leases Landing on Balance Sheet (Credit Suisse)

Accounting and Financial Reporting – Current Developments

170 Consider the following table:

Impact of Capitalizing Leases – Selected Retailers Based on Annual Reports

Retailer

Operating lease obligations

PV converter 5 years

4% (a)

Additional liability

under new lease standard

Stockholders’ equity

% equity

Office Depot Inc. $ 2 B .822 $1.6 B $661 M 248% Walgreens Co. 35 B .822 28.8 B 18 B 160% CVS 28 B .822 23.0 B 38 B 61% Whole Foods 6.8 B .822 5.6 B 3.8 B 147% Sears 4.5 B .822 3.7 B 3.1 B 119%

Source:Annual Reports, as obtained by the author. (a) Assumes the weighted-average remaining lease term is 5 years, and the incremental borrowing rate is 4%.

The previous table identifies the sizeable problem that exists for many of the U.S. retailers which is that there are huge off-balance sheet operating lease liabilities as a percentage of company market capitalization. Under the proposed lease standard, these obligations would be recorded, thereby having a devastating impact on those retailers’ balance sheets. For example, look at Office Depot and its $1.6 billion lease liability that would represent 248% of its stockholders’ equity of $661 million. How would the proposed lease standard impact how leases are structured? Companies are going to consider the balance sheet impact when structuring leases and in deciding whether to lease or buy the underlying asset, in the first place. There are several likely actions that would come from the proposed standard:

1. Lease versus buy decision impacted: By implementing the proposed standard, the GAAP differences between leasing and owning an asset would be reduced. Having to capitalize all leases may have a significant effect on the lease versus purchase decision, particularly with respect to real estate. a. Tenants, in particular those in single-tenant buildings with long-term leases, may choose to purchase a building instead of leasing it.

• A similar amount of debt would be included on the tenant’s balance sheet under a long-term lease as compared with a purchase.

• GAAP depreciation under a purchase may actually be lower than amortization under a lease because the amortization life under the lease (generally the lease term) is likely to be shorter than the useful life under a purchase.

Accounting and Financial Reporting – Current Developments

171 Example: Assume there is a 10-year building lease with two, 5-year lease options, resulting in a maximum lease term of 20 years. Assume further that the useful life of the building is 30 years for depreciation purposes. If the entity leases the real estate, the right-of-use asset would be amortized over a maximum of 20 years. If, instead, the entity were to purchase the real estate, the building would be depreciated over the useful life of 30 years.

Note: In some instances, lessees may choose to purchase the leased asset rather than lease it, if the accounting is the same. In particular, the purchase scenario may be more appealing for longer-term leases that have significant debt obligations on the lessee balance sheets. Lessees with shorter-term leases will not be burdened with the extensive debt obligations and, therefore, may choose not to purchase the underlying lease asset.

b. Lease terms are likely to shorten: For many companies who do not wish to purchase the underlying leased asset, lease terms may shorten to reduce the amount of the lease obligation (and related asset) that is recorded at the lease inception.

• The proposed lease standard would affect not only the landlords and tenants, but

also brokers as there would be much greater emphasis placed on executing leases for shorter periods of times thereby increasing the paperwork over a period of time and the commissions earned.

c. Deferred tax assets would be created: Because many operating leases would now be

capitalized for GAAP but not for tax purposes, total GAAP expense (interest and amortization) would be greater than lease expense for tax purposes, resulting in deferred tax assets for the future tax benefits that would be realized when the temporary difference reverses in later years.

Under existing GAAP, most, but not all, operating leases are treated as operating leases (true leases) for tax purposes. Therefore, rarely are operating leases capitalized for tax purposes. Now, the game is about to change if operating leases are capitalized as right-of-use assets under GAAP, while they continue to be treated as operating leases (true leases) for tax purposes. As we have seen in the previous examples, most leases capitalized under the proposed standard would result in the creation of a deferred tax asset. Other Considerations – Dealing With Financial Covenants The proposed lease standard would cast a wide web across the accounting profession. By capitalizing leases that were previously off-balance sheet as operating leases, there may be consequences.

Accounting and Financial Reporting – Current Developments

172 Examples:

• Impact on state apportionment computations: Many states compute the apportionment of income assigned to that state using a property factor based on real and tangible personal property held in that particular state.

Note: When it comes to rent expense, most states capitalize the rents using a factor such as eight times rent expense. Although each state has its own set of rules, the implementation of the proposed standard may have a sizeable positive or negative impact on state tax apportionment based on shifting rent expense to capitalized assets.

• Impact on tax planning: Capitalizing leases might have a positive effect in tax planning.

Note: One example is where there is a C corporation with accumulated earnings and exposure to an accumulated earnings tax (AET). The additional lease obligation liability would certainly help justify that the accumulation of earnings is not subject to the AET.

• Impact on total asset and liability thresholds: Companies should also be aware that not

only would the proposed standard increase liabilities, but would also increase total assets.

Note: In some states, there are total asset thresholds that drive higher taxes and reporting requirements.

Dealing with financial covenants A critical impact of the proposed standard would be that certain loan covenants may be adversely impaired, thereby forcing companies into violations of their loans. Consider the following ratios:

Ratio Likely impact of proposed lease standard

EBITDA: [Earnings before interest, taxes, depreciation and amortization]

Type A Leases: Favorable impact due to shift from rental expense to interest and amortization expense, both of which are added back in computing EBITDA. Type B Leases: May be favorable impact depending on whether “lease expense” is added back to compute EBITDA.

Accounting and Financial Reporting – Current Developments

173 Interest coverage ratio:

Earnings before interest and taxes Interest expense

May be negatively impacted from lower ratio

Debt-equity ratio: Total liabilities Stockholders’ equity

Negative impact from higher ratio

There would be a favorable impact on EBITDA for Type A leases by implementing the proposed standard. Rent expense recorded for operating leases under existing GAAP would be reduced while interest expense and amortization expense would increase once the leases are capitalized. However, the issue is what happens to EBITDA for Type B leases. Under the proposal, interest and amortization are combined as one line item on the income statement entitled “lease expense.” The question is whether that line item is added back in arriving at EBITDA. The author believes it should be added back because it represents interest and amortization despite the lease expense label. As to the interest coverage ratio, the impact on the ratio depends on whether there is a Type A or B lease. For a Type A lease, earnings before interest and taxes would likely be higher as rent expense is removed and replaced with interest and amortization expense. For Type A leases, the denominator increases significantly due to the higher interest expense. On balance, the slightly higher earnings before interest and taxes divided by a higher interest expense in the denominator yields a lower interest coverage ratio. For a Type B lease, the impact on the ratio is unclear. Although interest expense, along with amortization expense, would be embedded in the caption line item “lease expense,” most analysts would likely carve out the interest and amortization components and adjust the interest coverage ratio by the interest portion. Perhaps the most significant impact of capitalizing leases under the proposed lease standard would be its effect on the debt-equity ratio. With sizeable liabilities being recorded, this ratio would likely turn quite negative and severely impact company balance sheets. In some cases, the debt-equity ratio would result in violation of existing loan covenants thereby requiring a company to renegotiate the covenants with its lenders or at least notify lenders in advance of the likely lack of compliance with loan covenants. What about the impact on smaller nonpublic entities? One leasing organization noted that more than 90 percent of all leases involve assets worth less than $5 million and have terms of two to five years.34 That means that smaller companies have a significant amount of leases most of which are currently being accounted for as operating 34 Equipment Leasing and Financing Association (ELFA) “Companies: New Lease Rule Means Labor Pains” (CFO. com).

Accounting and Financial Reporting – Current Developments

174 leases. Previously, the author estimated that the present value of unrecorded lease obligations under operating leases of nonpublic entities to be at least $6.3 trillion which is much higher than the estimated $1.5 trillion of unrecorded lease obligations of public companies. Unless these smaller, nonpublic entities choose to use the income tax basis for their financial statements, under GAAP, these companies would be required to capitalize their operating leases. What about related party leases? Some, but not all, related party leases result in the lessee (parent equivalent) consolidating the lessor (subsidiary equivalent) under the consolidation of variable interest entity rules (ASC 810) (formerly FIN 46R). The common example of a related-party lease is where an operating company lessee leases real estate from its related party lessor. In general, under FIN 46R, if there is a related party lessee and lessor, consolidation is required if:

1. The real estate lessor is a variable interest entity (VIE) (e.g., it is not self-sustaining), and 2. The lessee operating company and/or the common shareholder provide financial support to the real estate lessor in the form of loans, guarantees of bank loans, above-market lease payments, etc.

If these two conditions are met, it is likely that the real estate lessor must be consolidated in with the operating company lessee’s financial statements. If there is consolidation, capitalizing the lease under the proposed standard would be moot because the asset and liability, and lease payments would be eliminated in the consolidation. In 2014, the Private Company Council (PCC) issued ASU 2014-07, Consolidation (Topic 810) Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements (a consensus of the PCC), which provides private (nonpublic) entities an election not to apply the consolidation of VIE rules to a related-party lease arrangement. When implemented, the ASU should provide most private companies with relief from the VIE rules for related party leases. Thus, most private (nonpublic) entities involved in related-party leases will not be consolidating the lessor into the lessee. When it comes to a related-party lease in which there is no consolidation, the parties would have to account for that lease as a right-of-use lease asset and obligation, just like any other lease transaction. Consequently, under the proposed standard, the operating company lessee would be required to record a right-of-use asset and lease obligation based on the present value of the lease payments.

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175 Many related parties either do not have formal leases or the leases are short-term. If the operating company lessee is going to have to record a significant asset and liability, it may make sense to have a related-party lease that has a lease term of 12 months or less or is a tenant-at-will arrangement. With respect to a related party lease that is 12 months or less, the proposed standard would permit (but not require) use of the short-term lease rules as follows:

a. A lessee would treat the short-term lease as an operating lease with no recognition of

the lease asset or lease liability. The rental payments would be recognized as rent expense on a straight-line basis.

b. On the lessor side, the lessor would record rental income on a straight-line basis and not

record the lease asset and liability. c. Either the lessee or lessor could elect to record the lease asset and liability using the

proposed standard rules. With many related-party leases, the operating company lessee may issue financial statements while the real estate lessor does not. Therefore, how the lessee accounts for the transaction under GAAP may be more important than the lessor’s accounting for the transaction. Let’s look at a simple example: Example: Company X is a real estate lessor LLC that leases an office building to a related party operating Company Y. X and Y are related by a common owner. The companies sign an annual 12-month lease with no renewals, and no obligations that extend beyond the twelve months. Monthly rents are $10,000. Y issues financial statements to its bank while X does not issue financial statements. Y chooses ASU 2014-07’s election not to consolidate X into Y’s financial statements. Conclusion: Because the entities have a short-term lease of 12 months or less, Y, as lessee, would qualify for the short-term lease rules. Therefore, Y would not record a lease asset and liability and, instead, would record the monthly rent payments and rent expense on a straight-line basis over the short-term lease period.

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176 Alternatively, Y could elect to treat the short-term lease as a standard lease by recording both the lease asset and liability. As to the lessor, it would also not record the lease asset and liability and, instead, would record rental income on a straight-line basis over the 12-month period. Observation: If the proposed standard is issued in final form, many nonpublic entities would take steps to avoid its arduous rules. One approach will likely be to make sure the related-party leases have terms that are 12 months or less so that the lease can be treated as an operating lease and not capitalized. Another approach would be to issue income tax basis financial statements. Status of lease project: As of February 2015, the FASB and IASB continue redeliberating on the May 2013 exposure draft. The Boards are proposing the following changes to the May 2013 exposure draft: 1. A lease modification should be accounted for as a new lease, separate from the original

lease, when certain criteria are met. 2. Variable lease payments should be included in the initial measurement of lease assets and

liabilities only if such payments depend on an index or a rate, and that the entity should measure those payments using the index or rate at lease commencement.

3. Discount rate:

• Initial direct costs of the lessor should be included in determining the rate implicit in the lease.

• The lessee would be required to reassess the discount rate only when there is a change

to either the lease term or the assessment of whether the lessee is or is not reasonably certain to exercise an option to purchase the underlying asset.

• The lessor would not be required to reassess the discount rate.

4. Type A and B leases:

• The dual approach (Type A and B leases) would be retained except for the way in which leases are classified between Type A and B. A lease would be classified as Type A if it is essentially an installment purchase of the asset. Most existing capital leases would fall into the Type A category, while most existing operating leases would fall into the Type B lease category.

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177 Note: The IASB decided not to follow the FASB's dual approach and, instead, uses a single approach of accounting for all leases as Type A leases.

• For lessors, the determination of whether a lease is a Type A or Type B lease would change from the May 2013 exposure draft:

A lessor would determine lease classification (Type A or B) on the basis of whether the lease is effectively a financing or a sale. A lessor would make the determination by assessing whether the lease transfers substantially all of the risks and rewards incidental to ownership of the underlying asset.

• A lessor would be precluded from recognizing selling profit and revenue at lease commencement for any Type A lease that does not transfer control of the underlying asset to the lessee.

• For Type A leases from the lessor's perspective, the FASB would eliminate the

receivable and residual approach found in the May 2013 exposure draft. 5. The Boards have tentatively agreed to permit lease guidance to be applied at a portfolio level by lessees and lessors. 6. Lease term and options:

• The Boards decided that, when determining the lease term, an entity should consider all relevant factors that create an economic incentive to exercise an option to extend, or not to terminate, a lease.

• The concept of "significant economic incentive" to exercise a purchase option, would be

replaced with a higher threshold of "reasonably certain."

• An entity would include an option period in a lease term only if it is "reasonably certain" that the lessee will exercise the option having considered all relevant economic factors.

Note: "Reasonably certain" is a high threshold substantially same as "reasonably assured" that is in existing U.S. GAAP.

• A lessee would be required to reassess the lease term only upon the occurrence of a significant event or a significant change in circumstances that are within the control of the lessee.

• A lessor would not be permitted to reassess the lease term.

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178

• A purchase option would be included in the computation of the initial lease amounts using the same "reasonably assured" threshold that would apply to lease options.

Latest developments- lease accounting standard The FASB and IASB are moving forward toward the issuance of a final lease statement. In its January 2015 meeting, the FASB modified some of the disclosures that would be required under new lease accounting. In particular, the FASB decided not to provide any disclosure relief for nonpublic entities, so the disclosure package would equally apply to public and nonpublic entities alike. J. The GAAP Codification It is important for all accountants to fully understand the Accounting Standards Codification (ASC) that became effective in 2009. After years of a FASB codification based on FASB statement numbers, the FASB recodified all standards by topic, rather than statement number reference. Now, the FASB Accounting Standards Codification (ASC) consists of a single source of authoritative nongovernmental U.S. GAAP, that superseded all documents previously issued by the FASB, AICPA, EITF, and related literature. The FASB’s objective is to establish the FASB Accounting Standards Codification™ (Codification or ASC) as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of GAAP financial statements. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. The codification was established through the issuance of FASB No. 168: The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (currently ASC 105) which establishes a new Codification. FASB Accounting Standards Codification (FASB ASC) is the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Key elements of the codification follow: 1. FASB Statement No. 168 was the final standard issued by FASB in an individual statement format.