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Lease Accounting Changes Primer

Apr 09, 2018

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  • 8/7/2019 Lease Accounting Changes Primer

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    Primer: Proposed Lease Accounting Changes

    Background, Impact and Action

    Thomas Ball

    [email protected]

    http://www.dealerbahn.com

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    Proposed Lease Accounting Changes 2

    Disclaimer

    This presentation is 2010 DealerBahn LLC. All rights reserved. No part of this document maybe reproduced, transmitted or otherwise distributed in any form or by any means, electronic ormechanical, including by photocopying, facsimile transmission, recording, rekeying or using any

    information storage and retrieval system, without written permission from DealerBahn LLC.DealerBahn LLC expressly disclaims any liability in connection with use of this presentation or itscontents by any third party. This information is provided "as is", with no guarantees ofcompleteness, accuracy or timeliness, and without warranties of any kind, express or implied.

    This publication is general in nature and is not intended to answer specific questions or suggest

    suitability of action in a particular circumstance.

    Every effort has been made to offer current and accurate information. However, the informationherein should not be relied upon for your, or your companys, specific situation.

    The information presented in this publication should not be construed as legal, tax or accounting

    advice. You should consult with professional advisors familiar with your particular situation foradvice concerning specific matters before making any decisions.

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    Proposed Lease Accounting Changes 3

    Six Reasons Why Business Managers Should

    Care About Proposed Lease Accounting Rules

    1. Revised lease accounting islikely to have a drastic impacton your businesss financialstatements

    2. Existing and future leasecontracts for real estate, officeequipment and productionequipment will be effected

    3. Incentive compensation.Beware if your bonus plan(s)are based on financial metrics

    4. Sale treatment could be atrisk for companies who useleasing to fund sales

    5. Liquidity and fundingresources. Deteriorating debtcovenant ratios could restrictborrowing capacity

    6. It is going to cost time andmoney to assess andimplement new rules

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    Proposed Lease Accounting Changes 4

    Global Conversion to Common Accounting Rules

    Accounting standard setting organizations around the world have agoal to remove differences in accounting treatment betweencountries

    Objectives:

    Transparency

    Consistent application

    Comparable treatment and form

    Lease accounting is one of the first standards to be addressed as aglobal standard

    In2005, the SEC estimated the undiscounted amount of off-balance-sheetlease obligations at $1.25 trillion.

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    Proposed Lease Accounting Changes 5

    Scope of the Proposals

    Contracts that do NOT meetlease definition

    Contracts that meet lease definition

    Intangible Assets

    Natural Resource leases

    Biological assets

    Contracts that do not meetlease definition

    In-substance sales orpurchases

    Investment property leases

    Service / Maintenance

    Short-term leases (

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    Proposed Lease Accounting Changes 6

    Current Lease Accounting in the U.S.

    Rules based approach

    Two types of leases: Operating and Finance

    Problems with current approach All leases are not required to be shown on the lessees (users) balance

    sheet

    Rules based approach leaves too much room for accounting

    manipulation Does not fully consider impact of contingent payments or purchaseoptions on lessees financial position

    Credit analyst and investor concerns:

    Requires uniformed estimates and adjustments

    Limits comparability between periods and peers

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    Proposed Lease Accounting Changes 7

    IFRS* Proposed Lease Accounting Standards

    Principles based, Right of Use accounting

    All current andfuture leases must be capitalized and presented on thebalance sheet

    Capitalized amounts = Present value of most likely lease payments plus

    contingent and guaranteed items

    Short term leases (

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    Proposed Lease Accounting Changes 8

    IFRS Proposed Lease Accounting Standards

    Requires reassessment of lease value at every reporting period

    Considerations: Term, contingencies, guarantees, useful life

    Service contracts and executory expenses must be capitalized if they arenot separated from lease terms

    Excludes: Intangible assets, maintenance and security, taxes andinsurance, and mineral leases

    Final Rule expected in 2011; Implementation expected as early as 2013(?)

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    Proposed Lease Accounting Changes 9

    Accounting Treatment

    Lessee Accounting

    Classify cash repayments and interest payments related to leases asfinancing activities. (Interest expense from leases is NOT included inoperating expenses) Equipment acquisition must be classified ininvesting.

    Cash FlowStatement

    Depreciation expense for right to use asset. Straight line depreciation is

    default method.

    Interest expense to recognize money costs. (Interest method)

    Lessor will only be able apply sale treatment when applyingderecognition approach

    Income Statement

    Right of Use Asset (ROU) Equal to lease liability at inception.

    Presented as separate component of property, plant and equipment.Payment Liability Equal to present value (at incremental borrowingrate) of most likely lease payments including contingent rents, purchaseoptions, and residual guarantees. Amortized using interest method.

    Balance Sheet

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    Proposed Lease Accounting Changes 10

    Accounting Treatment

    Lessee Accounting: Front-end loaded expense pattern

    Interest Expense

    ROU Depreciation

    Current Expense Pattern

    Interest Expense

    + ROU Depreciation

    New Standard

    Total Expense

    $

    Time

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    Proposed Lease Accounting Changes 11

    Accounting Treatment

    Lessee Accounting: Balance Sheet Pattern

    Right to Use Asset

    Current Method:

    Deferred Tax Liability

    $

    Time

    Lease Liability

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    Proposed Lease Accounting Changes 12

    Lessee Example

    Differences in depreciation andinterest amortization createsequity shortfall

    Relative to current operating leaseaccounting, proposed accountingyields higher total expense in early

    portion of the lease that is offset inlater periods.

    Lease Term Assumptions

    Commercial Equipment X Operating Lease to LesseeMonthly Lease Payments 10,000$ No contingent rentsLessee's incremental borrowing rate 6.00% No purchase option

    Lease Term (Mos) 60 No residual value guarantees

    Lease Inception Y1 Y2 Y3 Y4 Y5

    Balance Sheet

    Current Accounting $0 $0 $0 $0 $0 $0

    Proposed Accounting

    Right to Use Asset $519,842 $415,874 $311,905 $207,937 $103,968 $0

    Lease Obligation $519,842 $425,803 $328,710 $225,629 $116,189 $0

    Net Equity $0 ($9,930) ($16,805) ($17,692) ($12,221) $0

    Income Statement

    Current AccountingRent Expense 120,000$ 120,000$ 120,000$ 120,000$ 120,000$

    Proposed Accounting

    Depreciation on Right

    to Use Asset$103,968 $103,968 $103,968 $103,968 $103,968

    Interest Exp on LeaseObligation

    25,961$ 22,907$ 16,918$ 10,561$ 3,811$

    Total Prop Accounting Expense $129,930 $126,875 $120,887 $114,529 $107,779

    Diff b/t Current and Proposed (9,930)$ (6,875)$ (887)$ 5,471$ 12,221$

    Cumulative Difference (9,930)$ (16,805)$ (17,692)$ (12,221)$ 0$

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    Proposed Lease Accounting Changes 13

    Accounting Treatment

    IncomeStatement

    Balance Sheet

    Lease Income

    Depreciation Expense

    Interest Income

    Sales Revenue

    Cost of Sales

    Interest Income

    + Asset: Equipment

    + Asset: Lease Receivable

    - Liability: Right of Use Liability

    = Net Asset or Liability

    Asset: Equipment Residual

    Asset: Lease Receivable

    Performance ApproachDerecognition Approach

    Lessor Accounting

    LessorAsset RiskTransfer

    Lessee

    NO sales treatment!

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    Proposed Lease Accounting Changes 14

    Potential Impact of Proposed Standards

    Changes to financial statements due to the proposed standards will alter keyfinancial ratios for many businesses. Businesses should consider the impacton common debt covenant ratios:

    Net worth

    Debt to EBITDA Interest coverage

    Leverage (debt / assets)

    Current fundingarrangements

    Lessee expenses would be front loaded due to interest method amortizationof lease liability. Lessor earnings would also be front loaded but withsignificant declines during interim periods before lease termination.

    Earnings Patterns

    Lessees will be required to capitalize all existing and future leases. Lesseedebt covenants could be triggered after implementation of the new leasestandards. Lease liability must be reassessed at each reporting period andvalues adjusted to reflect most likely scenario.

    All current andfuture leases mustbe capitalized

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    Proposed Lease Accounting Changes 15

    Potential Impact of Proposed Standards

    For lessees, rent expense (an operating expense) will be replaced with interestand depreciation expense. To the extent that value calculations are confined

    to EBITDA and constant multiples, then valuation metrics should rise. Theincrease is due to the removal of rent expense from the EBITDA equation.

    Business Valuation

    / EBITDA

    Current accounting rules classify expenses related to operating leases asrent. The proposed accounting will replace rent expense with the sum ofdepreciation of the right to use asset plus amortization of the lease paymentliability using the interest method.

    The net effects are:

    1. Higher EBITDA, as rent will be removed2. Lower interest coverage ratios

    3. Different characterization of expense between accounting and taxrecords

    Rent Expense vs.Depreciation andInterest Expense

    Sales / Leaseback transactions will continue to be used where the primarypurpose is cash generation. However, sale leaseback will no longer be aviable tool to reduce demands on capital.

    Sale / Leaseback

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    Proposed Lease Accounting Changes 16

    Potential Impact of Proposed Standards

    Businesses should plan for increased spending related to conversion to thenew accounting standards. IT systems will need to be designed, tested andimplemented to accommodate change in accounting treatment. Consulting

    and technical assistance is likely to be required to properly establish controland IT systems. (General ledgers, sub ledgers, inventory systems)

    Compliance / ITSystems

    Businesses who use leases as selling tool will only be able recognize grossprofit on sales if they use the derecognition approach. Further, even ifderecognition approach is used, the profit on sale using the derecognitionapproach excludes the portion of gain attributed to residual asset.Transactions that do not qualify as sales will be treated as a financing

    arrangements by both the lessor and the lessee.

    Sale Recognition

    Since cash rents will remain deductible by IRS, most lessees will book adeferred tax asset to recognize permanent timing difference.

    Book / Tax TimingDifferences

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    Proposed Lease Accounting Changes 17

    Business Impact

    New rules require a greater reliance on management judgment toproperly apply correct accounting treatment and revenuerecognition methods

    Changes limit the ability to financially engineer equipmentacquisitions

    Accounting period assessment and adjustments could be

    cumbersome and expensive to implement Performance metrics and management incentive programs

    Probable negative effects on credit / debt covenant ratios

    Leasing will remain a viable tool for acquiring new equipment forlessees desiring to limit cash outlays for capital expenditures

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    Proposed Lease Accounting Changes 18

    Business Impact

    Customers likely to ask for:

    Shorter lease terms

    Separate billing for lease payments, services, taxes

    Manufacturers likely to experience diminished accounting profitsfrom lease transactions

    Banks and other credit providers will be required to carry morecapital. Will this limit supply or increase price?

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    Proposed Lease Accounting Changes 19

    Recommended Actions

    1. Invest time required to learn fundamentals of proposed leaseaccounting changes

    2. Inventory all lease agreement

    Documenting contingencies, residual guarantees, andpurchase options

    3. Develop preliminary impact assessment:

    Transition costs

    Impact on financial statements and debt covenant ratios

    Systems support needs

    4. Develop a plan for addressing lease accounting changes

    Strategy for future capital expenditures

    Talking points for bankers and equity investors

    Renegotiation of existing lease and debt agreements

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    Contact:

    Thomas [email protected]

    http://www.dealerbahn.com

    DealerBahn provides high value on-demand services todistributors and users of commercial equipment

    Capital budgeting and business consulting

    Outsource finance and insurance sales

    Internet based tools that help distributors manage lenderrelationships and increase revenue on every sale