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Implications of the Lease Accounting Changes to the Banking Industry
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Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Jun 29, 2015

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Banking Industry Whitepaper: This whitepaper presents the most important elements and implications of the Revised FASB and IASB Lease Accounting Change Exposure Draft at a high level to provide the reader with a basic understanding of the proposed lease accounting changes and the potential impact to banks as both a lender and a lessee. In the introductory pages we will review the background and details around the proposed changes to give the reader a historical recap over the past few years. We will then review how we see the proposed lease changes impacting the Banking industry.
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Page 1: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Implications of the Lease Accounting Changes to the Banking Industry

Page 2: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Contents

IntroductionBackground

Banking Industry ConsiderationsCurrent Status

Recommended Next StepsAbout the AuthorAbout iLeasePro

Page 3: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Introduction

Lease accounting, particularly as it relates to lessee accounting, will change significantly under current proposals put forth in a Joint Project between the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”).

The fact that a lessee under current generally accepted accounting principles (“GAAP”) can execute a contract to make legally binding payments over a period of time, structure the contract so that it is classified as an operating lease and not be required to reflect that obligation as a liability on the balance sheet has been a source of controversy for both financial regulators and analysts.

The FASB and the IASB began to tackle this issue in 2009 by issuing a Preliminary Views topic paper which was followed by Exposure Draft in August 2010 (‘the 2010 ED”) which proposed major changes to manner in which leases are accounted for. The 2010 ED sparked numerous comments and a lively debate among financial statement preparers because of the perceived additional complexity that the proposed changes would entail.

The FASB and the IASB (“the Boards”) undertook significant outreach to the financial statement preparer and user communities and in May 2013 issued a revision to the Exposure Draft (“the Revised ED”) which eliminates some of the more complex provisions but retained most of the basic elements of the 2010 ED.

This presentation will review how we see the proposed lease changes impacting the Banking industry.

Page 4: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Background

A lease is defined as a “contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”.

The lessee must be able to identify an asset or assets that can be used and also demonstrate that the contract allows the lessee to control the use of the identified asset for some period of time in exchange for consideration.

Page 5: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Basic Provisions of the Revised ED

The provisions of the Revised ED require that the financial statement preparer determine these most important elements associated with a lease (not meant to be all inclusive):

• Does the contract in question meet the definition of a lease for accounting purposes?

• Does the contract contain any non-lease components? • What is the lease term? • What are the lease payments? • How should a lease be classified?

…the boards have retained the requirement that most lease contracts be recorded on the balance sheet of the lessee…

Determining the lease term and the lease payments associated with the lease term are significant because the Boards have retained the requirement that most lease contracts be recorded on the balance sheet of the lessee using a right-of-use model for recording the right-of-use asset (“the ROU asset”) and the liability to make lease payments

Page 6: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

A major change from the 2010 ED involves lease classification based upon the nature of the asset being leased and how lease related expenses are recognized.

Page 7: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Basic Provisions of the Revised ED

The Boards proposed a number of changes to the 2010 ED that are designed to reduce complexity including: • The lessee can make an accounting policy election to apply the current GAAP operating lease

accounting model for those short-term leases that have a maximum possible lease term of 12 months or less, including option periods.

• The previous requirement to include variable lease payments has been revised to apply only to those payments that are based on an index or a rate or that are in-substance fixed payments.

• The requirement to include payments during an option period has been redefined to include only those payments where the lessee has a significant economic incentive to exercise the option.

• Lease and non-lease components (predominantly services provided by the lessor) would generally be accounted for separately.

Page 8: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Reassessment

After the date of commencement, the lessee may have to reassess the initial accounting for the lease transaction if either the lease term or the lease payment stream changes.

Circumstances that could trigger reassessment include: • The index or rate utilized to measure the variable lease payments changes, for

example, where CPI increases are included in the lease terms and the CPI index initially utilized changes or

• The lease contains option periods and the lessee original conclusion as the whether there is a significant economic incentive to exercise the option changes, like the option to renew.

The reassessment may be required at each reporting period and result in the adjustment of the carrying amounts of the lease liability and the ROU asset. Additionally, if the reassessment does result in a change in the lease payment stream, the rate utilized to discount the payments may also have to be reassessed.

Page 9: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Disclosures

The Revised ED proposes a series of both qualitative and quantitative disclosures in order for the financial statement reader to understand more completely the nature of the lessee’s lease portfolio.

Unless separately disclosed in the financial statements, the lessee would be required to disclose all financial statement amounts relating to the lease portfolio in the footnotes.

Qualitative disclosures would include, among other matters, significant judgments made in applying the accounting guidance, information about the nature of the lease portfolio, including a description of the types of leases and certain information regarding options and variable lease payments.

Quantitative disclosures would include a reconciliation of opening and closing balances of the aggregate lease liability separately for Type A and Type B leases (this disclosure would be optional for nonpublic companies) and a maturity analysis of the lease liability reflecting the undiscounted cash flows which would include a reconciliation to the ending carrying value of the lease liability.

Page 10: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Transition and Effective Date

There are two transition approaches being proposed in the Revised ED;

• Full Retrospective• Modified Retrospective

Neither of these approaches would provide for grandfathering of existing leases.

Under both transition approaches, the lessee would be required to recognize the ROU asset and the lease liability at the beginning of the earliest year presented with some minor computational relief provided to those that choose the modified retrospective approach.

The Boards have not yet proposed an effective date for the new standard but most observers have suggested that there would be an extended implementation period because of the significance of the changes as compared to the current GAAP accounting requirements.

Page 11: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Banking Industry Considerations

With respect to the proposed changes to lease accounting, the Banking Industry is somewhat unique in that these proposed changes will impact banks in customer relationships with the bank as a lender and will also impact the industry operationally with the bank as a lessee.

Page 12: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

The Bank as a Lender

Bank lending departments should consider the following action items: • Relationship managers should begin immediately to discuss with

borrowers the effect that the proposed changes will have on the borrowers’ financial statements.

• Financial covenants will likely be impacted by the changes to the borrowers’ financial statements. – Debt to equity, EBITDA and other ratios will change and may

cause non-compliance with financial covenants. Lending departments should anticipate these effects and have a plan in place to address these compliance issues.

• Changes to borrowers’ financial statements will affect how the risk of the loan relationship is rated in the bank credit assessment process. Risk managers should anticipate this issue and have a plan in place to address the implications

Liabilities will certainly increase, expense recognition will probably be accelerated, and expense classifications will probably change, along with cash flow classifications

Page 13: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

The Bank as a Lessee

Banks that have current lease arrangements at the implementation date will be required to recognize the liability for these leases on their balance sheet.

Due to this change banks may experience the following: • Need to increase regulatory capital amounts• Impact to capital and leverage ratios• Changes in leasing strategies• Future tax implications

Page 14: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Current Status

The Revised ED certainly eliminated some of the complexity but many in the user community continue to question the reasonableness of the proposals. In Roundtable meetings hosted by the Boards, there was very little support expressed for the proposed changes.

Many of those in attendance were very concerned about the 1. complexity of the proposals and 2. the amount of effort it would take to enact the changes, particularly as it relates to lessees.

Certain FASB/IASB Board members responded to that assertion indicating that the metrics currently being utilized to estimate the impact of operating leases was significantly faulty.

When it came to a question from a purely technical standpoint of whether a lease represented a legal obligation on the part of the lessee, it is interesting that most of the attendees were hard pressed to argue that the liability for lease obligations should not be recognized on the balance sheet.

So the issue may be one of how to apply this model in a less complex manner and how certain unique industry matters will be addressed. Most commentators following the project have indicated that the project will ultimately be finalized with lessee balance sheet recognition of most leases.

Page 15: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Recommended Next Steps

Given the delays in completion of the leasing project and an uncertain implementation date, it is easy to become complacent in preparing for the changes that are most likely to be finalized.

Timely preparation is the key to an effective implementation. Summarized below is just a partial list of next steps that banks should be considering in preparation for the lease accounting changes.

Page 16: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Recommended Next Steps

#1 Increase Internal Communication#2 Evaluate Current Procedures and Systems#3 Review Current Leasing Strategy#4 Understand Impact to Financial Reporting #5 Review Potential of Tax Implications

Page 17: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

Whitepaper

Download the full whitepaper on the Implications of the Lease Accounting Changes to the Banking Industry

Page 18: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

About the Author

Sean T. Egan is Co-Founder and Managing Partner of iLease Management LLC, the developer of iLeasePro. Mr. Egan retired from the accounting and advisory firm of KPMG LLP after having spent 35 years with the firm as a partner providing audit and advisory services to the financial services industry. In 2012, Mr. Egan founded iLease Management LLC along with Co-Founder and Managing Partner, John Meedzan.

iLease Management LLC14 Thatcher TerraceFarmington, CT 06032http://www.iLeasePro.com

Sean T Egan, Managing [email protected]

John J Meedzan, Managing [email protected]

Making It Easier To Manage the Entire Real Estate and Equipment Lease Lifecycle

Page 19: Banking Industry Whitepaper: Implications of the Lease Accounting Changes

About iLeasePro

The Management of iLeasePro is committed to keeping our constituents abreast of the status of the leasing project and operational issues that will result from these changes. Although significant changes to accounting such as these will undoubtedly be time consuming and disruptive, we believe that implementation of these changes should be viewed not just from an accounting perspective but as a way for the overall organization to become more efficient. That is why, in designing iLeasePro, we did not simply look at the project from an accounting perspective. In iLeasePro, we have a Lease Management technology solution that is able to capture all the key data related to the lease portfolio in one central location easily accessible to all those who have need of this information. Critical dates can be flagged so that there is never a reason to miss lease expirations or extensions or an insurance renewal. Lease related documents can be stored electronically for easy access and reference. Contact information regarding key personnel related to the lease can be readily accessed in our Contacts section. And these are only a few features of our Lease Management solution. Additionally, our Lease Analysis solution is fully integrated with Lease Management. We understand that a technology solution is a critical element of the entire lease cycle, not just after a lease is executed. Lease Analysis allows the user to perform a side by side comparison of various leasing options and provides the user with the critical analytics to make an informed decision about the best alternative for the organization. Once the proposed lease accounting standard has been finalized, we are ready to integrate our Lease Accounting technology solution into iLeasePro to complete a comprehensive and fully integrated Lease Analysis, Management and Accounting solution. For additional information about iLeasePro and for details as to how you can become a Beta tester of this exciting new product, please go to our website at http://ileasepro.com.