THE WHAT, WHY & HOW OF IMPLEMENTING THE NEW LEASE ACCOUNTING - PowerPoint PPT Presentation

THE WHAT, WHY & HOW OF IMPLEMENTING THE NEW LEASE ACCOUNTING STANDARDS SEPTEMBER 18, 2018 PREPARED BY: MEDI ABBIS MARC MAIONA JEFF MANLEY TAYLOR WOOD 1

WHAT IS IT?  Core Principle – An entity should recognize ROU assets and Lease liabilities arising from lease transactions, using a discount rate.  Specific Definition of Lease  Embedded leases with other Service and Supply arrangements NEW LEASE ACCOUNTING STANDARD ASC 842 2

DEFINITION OF A LEASE  A Lease:  Conveys the right to use  An identified asset  For a period of time  In exchange for consideration  The supplier has no practical ability to substitute or would not economically benefit from substituting the asset. NEW LEASE ACCOUNTING STANDARD ASC 842 3

WHAT’S SCOPED IN?  Applicable for ALL industries, ALL entities  All arrangements that meet the “new” definition of a Lease  Embedded Leases with other Service/Supply arrangements  Service Contracts  Supply Agreements  Logistics Agreements  Data Center arrangements  Example: Embedded Lease of a manufacturing facility or generating asset. NEW LEASE ACCOUNTING STANDARD ASC 842 4

ACCOUNTING STEPS 1. Identify the Lease 2. Classify the Lease (Finance vs. Operating Lease) 3. Recognize and Measure the Lease NEW LEASE ACCOUNTING STANDARD ASC 842 5

IDENTIFYING THE LEASE - LESSEE  After determining a lease exists, an entity shall identify the separate Lease components within the contract.  The Lessee should: Separate Lease components from non-lease components (a component is an item or activity - that transfers a good or a service to the customer) - Example – supplier provided maintenance on an asset is not a Lease component - Allocate the consideration to each component, on a relative standalone selling/leasing price - Can elect practical expedient and account for Lease and Non-Lease components together for each class of underlying assets NEW LEASE ACCOUNTING STANDARD ASC 842 6

CLASSIFYING THE LEASE  Lease will be classified as Finance , if meets any of the following, otherwise it will be Operating : Lease transfers ownership of the asset to the Lessee by the end of the term 1. Lease grants a purchase option reasonably certain of being exercised 2. Lease term is for the major part of the remaining economical life* 3. Present value of Lease payments is substantially all of the assets fair value ** 4. Asset so specialized it is not expected to have alternative use to the lessor 5. NEW LEASE ACCOUNTING STANDARD ASC 842 7

BUSINESS IMPLICATIONS  Between now and adoption in 2019 (or earlier) Where are all my leases and where is the documentation? - What data do I need to start collecting? - Beyond financial reporting impact, what’s the impact on my lease systems and related internal controls? - What software can I use? - Do I need additional resources? - I should to talk to my bank, as this could have an effect on my debt covenants - Current historical financial performance ratios may no longer be useful and new operating metrics by - lessees may be used by analysts Reassess Lease vs. Buy - NEW LEASE ACCOUNTING STANDARD ASC 842 8

LEASE ACCOUNTING: NEGOTIATING STRATEGIES LEASE CALCS 9

WHAT’S IMPORTANT  THAT VOICE IN YOUR HEAD… WHAT DO YOU CARE ABOUT?...WHAT IS IMPORTANT?  “What part of your firm’s financial statement results do you care most about --- what drives financial decision making for your firm?”  “Are you balance sheet or P&L driven?”  “If it’s the P&L, is it the entire P&L or really just EBITDA that drives decisions?” LEASE ACCOUNTING: NEGOTIATING STRATEGIES 10

WHY IT MATTERS  WHY IT MATTERS…  When I know what part of your financial results are most important to your firm, I can design and negotiate your leases to improve the results you care most about.  Your existing leases can often be restructured to improve that portion of your financial results you care most about.  If you ― or your consultants or auditors ― are approaching Lease Accounting without focusing on these questions you are seeing the mortician! LEASE ACCOUNTING: NEGOTIATING STRATEGIES 11

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING LEASE ACCOUNTING: NEGOTIATING STRATEGIES 12

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1  But, but, but… they promised!!! Two Main Goals Consistency Transparency LEASE ACCOUNTING: NEGOTIATING STRATEGIES 13

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1 T oday’s Lease Accounting CAPITAL LEASES OPERATING LEASES On Balance Sheet Off Balance Sheet Interest & Amortization Straight Line Rent Expense Expense LEASE ACCOUNTING: NEGOTIATING STRATEGIES 14

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1 New Lease Accounting: No Off Balance Sheet Leases “Finance Lease” “Finance Lease” Same as today’s capital lease No other option / type of lease. “Operating Lease” A capitalized operating lease. Straight line rent: an optical illusion. LEASE ACCOUNTING: NEGOTIATING STRATEGIES 15

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1 Different standards create disparity in accounting results for the same lease under GAAP vs. IFRS. Finance Leases = Debt on Balance Sheet Net Income Early in Lease Shareholder Equity Differences Net Income Later in Lease Debt-to-Equity Difference Net Income at Adoption Date EBITDA Performance LEASE ACCOUNTING: NEGOTIATING STRATEGIES 16

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? WILL YOU HIT THE GREAT WALL? LEASE ACCOUNTING: NEGOTIATING STRATEGIES 17

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #2 LEASE ACCOUNTING: NEGOTIATING STRATEGIES 18

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #2 4 Big Subjective Issues: Each firm determines its own answers. What is “major portion” of asset’s “remaining economic life?” 1. What is “substantially all” of asset’s fair market value? 2. “Disguised minimum rent” – Think of percentage rent for retailers 3. Where to draw the line between “icing” and the “cake”? When are you “reasonably certain” to exercise options? 4. Renewal Options – Economic Incentives Termination Options – Theory vs. Reality LEASE ACCOUNTING: NEGOTIATING STRATEGIES 19

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #2 Renewal Options and “Reasonably Certain” What constitutes a “significant economic incentive”? 1.  Discounts  Penalties  Tenant improvement values / remaining useful life  Strategic value 2. Does tenant classify 90% FMV renewal option as “significant” incentive? 3. 10 year lease treated as 20 year deal for accounting 4. Look what happens to the financials … is it good or bad? LEASE ACCOUNTING: NEGOTIATING STRATEGIES 20

LEASE ACCOUNTING: SUBTLE CHANGES CAN IMPROVE PERFORMANCE LEASE ACCOUNTING: NEGOTIATING STRATEGIES 21

SUBTLE CHANGES CAN IMPROVE PERFORMANCE LEASE STRUCTURE MATTERS ― BALANCE SHEET IMPACTS  Need to understand whole financial statement impact, not just discounted cash flow.  Leases w/ identical cash flows can hit balance sheet differently  When they hit balance sheet differently, they hit P&L differently  260,000 RSF deal, 10 year term, 8% discount rate: - Building #1: Base Rent $27 w/ $13 of NNN - Building #2: Base Rent $40 w/ $10 of “base year” costs LEASE ACCOUNTING: NEGOTIATING STRATEGIES 22

SUBTLE CHANGES CAN IMPROVE PERFORMANCE LEASE STRUCTURE MATTERS ― NET INCOME IMPACTS  Why “free rent” isn’t free.  Understanding the difference between “rent” and “service components” or “executory costs”.  Companies focused on net income performance generally have a particular period they are focused on.  Free rent is diluted over the term – for both operating and finance leases.  Abatement of variable service charges can provide targeted P&L relief. LEASE ACCOUNTING: NEGOTIATING STRATEGIES 23

SUBTLE CHANGES CAN IMPROVE PERFORMANCE LEASE STRUCTURE MATTERS ― EBITDA IMPACTS  Structure of lease for tenant improvements matters greatly for EBITDA.  Key takeaway: “Turnkey” deals are very bad for EBITDA.  “Turnkey”? - Landlord does all of the work - Landlord pays for all of the work - Landlord has all risk of cost overruns.  To improve EBITDA, structure lease with allowance equal to what landlord would have spent on the “turnkey” improvements.  Reduces straight line rent, creates asset on books which is amortized. LEASE ACCOUNTING: NEGOTIATING STRATEGIES 24

LEASE ACCOUNTING: HOW LEASING STRATEGIES ARE CHANGING LEASE ACCOUNTING: NEGOTIATING STRATEGIES 25

HOW LEASING STRATEGIES ARE CHANGING IF BALANCE SHEET/SHAREHOLDER EQUITY IS FOCUS Using mechanics to your advantage  Who? Banks, Insurance Cos., Public Institutions (universities, hospitals)  Why? Regulatory capital impacts or general strength of balance sheet.  Effective Strategies - Renegotiating existing leases - Managing the nominal value impact - Managing the impact to shareholder equity LEASE ACCOUNTING: NEGOTIATING STRATEGIES 26