This document provides an overview and summary of key topics related to lessee and lessor accounting for leases. It discusses the classification of leases as capital or operating, accounting and reporting for both types of leases, and issues such as non-level rents, leasehold improvements, tenant incentives, and sale-leaseback transactions. It also provides an overview of the audit approach to leases and current developments regarding the FASB's proposed changes to the lease accounting standards that would eliminate off-balance sheet treatment of operating leases.

1. Lessee Accounting for LeasesJuly 29, 2010

2. 2AgendaTopics to be Covered:Lease Classification OperatingDirect FinancingAccounting and Reporting for LeasesOperatingDirect FinancingNonlevel RentsLeasehold Improvement AmortizationTenant IncentivesOur Audit ApproachOther Lease Issues and Current Developments

3. 3Capital Leases (ASC 840—30)A capital lease is defined as a lease that meets one or more of the following criteria (ASC 840-10-25-1):The lease transfers ownership of the property to the lessee by the end of the lease term.The lease contains a bargain purchase option.The lease term is equal to 75 percent or more of the remaining estimated economic life of the lease property.The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90 percent of the excess of the fair value of the leased property.If a lease does not meet one of the above criterion it is classified as an operating lease.

4. Bargain Purchase OptionA provision allowing the lessee, at his option, to purchase the leased property for a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable and exercise of the option appears, at the inception of the lease, to be reasonably assured.

5. SituationMoss Adams OC Construction and Real Estate group leases a Citation X twin engine jet for five years in order to better serve their clients in Baton Rouge, Louisiana. The original purchase price for this aircraft would be $19 million. The estimated fair price for this aircraft after five years is $11 million. The purchase option at the end of the lease is for $5.5 million.

6. POLLING QUESTION 1 Is the purchase option considered a bargain purchase?YesDefinitely notMaybe?What is a Po’ boy?

7. 75% TestIf the lease term is equal to 75 percent or more of the estimated economic life of the leased property then the lease should be classified as a Capital Lease. Exception: If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

8. 75% TestLease Term - The fixed noncancelable term of the lease plus any of the following:covered by bargain renewal optionsall periods, if any, for which failure to renew the lease imposes an economic penaltyall periods, if any, covered by ordinary renewal options during which there is a guarantee by the lessee of the lessor’s debtall periods, if any, covered by ordinary renewal options preceding the date as of which a bargain purchase option is exercisable.all periods, if any, representing renewals or extensions of the lease at the lessor’s optionEstimated economic life: The estimated remaining period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at the inception of the lease, without limitation by the lease term.

9. POLLING QUESTION 2Which of the following should be considered in determining the term of a lease?All periods during which the lessee reasonably expects to lease the propertyA renewal period where an economic penalty is imposed on the lessee if the lessee does not renew under the renewal optionAll renewal periods prior to the period a bargain purchase option is exercisableAll of the aboveItems 1 and 3Items 2 and 3

10. 1090 % TestIf the present value at the beginning of the lease term of the minimum lease payments to be paid by the lessor equals or exceeds 90 percent of the fair value of the leased property to the lessor at the inception of the lease the lease is a Capital Lease.Exception: If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

11. 90% Test – Minimum Lease Payment Calculation11Minimum rental payment include the following:The minimum rental payments called for by the lease over the lease term.Any guarantee by the lessee of the residual value at the expiration of the lease term.Any payment that the lessee must make or can be required to make upon failure to renew or extend the lease at the expiration of the lease term

12. 90% Test – Minimum Lease Payment Calculation12The Present Value of the Minimum Lease Payment is determined by using the lower of :The lessee’s incremental borrowing rate; orThe implicit rate in the lease, if it is practicable for the lessee to learn the implicit rate; plusthe guaranteed residual value(Hint: This is NOT always explicitly stated!)Contingent rentals

13. POLLING QUESTION 3QUESTION: What best describes a company’s incremental borrowing rate?The rate of interest charged on the Company’s only loanLIBOR plus a spread of 100 to 500 basis points The rate included in a loan for equipment the Company is considering buying

14. Capital vs. OperatingHANDOUT 1 – Key Equipment Finance dated11/20/2007 Additional Information: Asset Useful Life – 7 yearsDETERMINE IF THIS IS A CAPITAL OR OPERATING LEASE

15. POLLING QUESTION 4Is the lease a capital or operating lease?CapitalOperating

16. 16Accounting for Capital and Operating Leases by LesseeCapital LeasesAccountingRecord an asset (leased equipment) and a liability (lease obligation) equal to the present value of the rental paymentsRecord depreciation for the asset over the economic life of the assetDisclosuresInclude the gross amount of the asset, future minimum lease payments, total noncancelable minimum sublease rentals, total contingent rentals, and a general description of the lessee’s arrangementsOperating LeasesAccounting Do not record an asset or liabilityRecord rental expense as rental payments are made to lessorDisclosuresFor leases in excess of one year include future minimum lease payments and total minimum rentalsInclude rental expense and a general description of the lessee’s arrangements

17. 17Nonlevel RentsASC 840-20-25-2 (Nonlevel Rents)When is the inception of these lease?What qualifies as a scheduled rent increase?The period between the lease agreement and completion of construction may be a rent holidayStraight-line recognition of lease expenseExceptions to the straight-line method

18. 18Non-level (escalated) RentsCase StudySmith, a pharmaceutical company, leased office space from Jones. Smith took possession and began to use the building on July 1, 2009. Rent was due the first day of each month. Monthly lease payments escalated over the 5 year period of the lease as follows:PeriodLease Payment7/1/09-9/30/09 $0- rent abatement during move- in/construction10/1/09-6/30/10 $17,5007/1/10-6/30/11 $19,0007/1/11-6/30/12 $20,5007/1/12-6/30/13 $23,0007/1/13-6/30/14 $24,500What amount of deferred rent would Smith show in balance sheet at 12/31/12?

19. Leasehold Improvement Amortization/Lease Terms19ASC 840-10-35-6Leasehold improvements should be amortized over the shorter of the assets useful life or the lease termLease term is defined as:Fixed non cancelable term of the lease plus:Periods covered by bargain renewal optionsLease imposes an economic penalty such that renewal appears reasonably assuredRenewal periods under which there is a guarantee by the lessee of the lessors debt.Include reasonably assured renewal periods

20. 20Tenant IncentivesASC 840-20-25Payments made to or on behalf of the lessee represent incentives that should be considered reductions of rental expensesLeasehold improvements funded by the landlord under allowances should be recorded as leasehold improvements and amortized over the life of the leaseThe incentives should be recorded as deferred rent and amortized as reductions to the lease expense over the lease term

21. 21Sale-Leaseback TransactionsASC 840-20What is a sale leaseback?Sale of property by the owner and a lease of the property back to the sellerThe same criteria are applied to determining whether or not the lease should be classified as a capital or operating leaseThere is generally a gain or loss that should be recognized (deferred, with some exceptions for “excess” gain).Guaranteed residual value should be considered for deferring any gain on the sale-leaseback

22. 22Sale-Leaseback Transactions, (Continued)Recognition of Gain or LossDefer gain or loss and amortize over amortization period of leased asset if a capital lease, or in proportion to the gross rentals charged to expense over the lease term EXCEPT in the following situations:The seller-lessee retains the rights to only a minor portion of the remaining use of the property sold.The seller-lessee retains the rights to more than a minor portion but less than substantially all of the remaining use of the property sold. The fair value of the property at the time of the transaction is less than its undepreciated cost. In that event, a loss should be recognized equal to the difference between undepreciated cost and fair value.(FROM PPC GAAP GUIDE)

23. 23Polling Question 5Under which situation is a sale of property NOT recorded as stipulated by sale-leaseback accounting?The seller-lessee retains, through a leaseback, retains substantially all of the benefits and risks incident to the ownership of the property sold.The seller-lessee relinquishes the right to substantially all of the remaining use of the property sold retaining only a minor portion of such use.The seller-lessee retains more than a minor part but less than substantially all of the use of the property through the leaseback.Both b and cAll of the above

24. 24Sale-Leaseback Transactions, (Continued)On December 31, 2009, XYZ Corp sold ABC Corp two airplanes and simultaneously leased them back. Additional information pertaining to the sale-leasebacks follows: Plane 1 Plane 2Sales Price $600,000 $1,000,000Carrying Amt (12/31/09)$100,000 $550,000Remaining Useful Life 10 years 35 yearsLease Term 8 years 3 yearsAnnual lease pmts $100K $200KAt 12/31/09 what amount should XYZ record as deferred gain on the transaction?

25. 25Lease AmendmentsASC 840-10-35-4 – Any change to provisions of the lease other than renewing or extending its term, in a manner that would have changed the classification of the lease had the changed terms been in effect at inception of the lease, are to be treated as a new agreementEvaluate new agreement for classification of lease (Capital v. Operating)

26. 26Lease Amendments (Continued)Asset and obligation are adjusted by the difference between the PV of the new minimum lease payments and the present balance of the obligationThe PV of the minimum lease payments under the revised agreement is calculated using the interest rate used to record the lease initially.Change results in a new agreement and a change in classification from capital to operatingAsset and obligation are removed, gain or loss recognized, and new lease is accounted for as an operating leaseEarly lease termination Asset and obligation are removed and gain or loss is recognized

27. 27Sub-Lease Accounting If the nature of a sublease is such that the original lessee is not relieved of the primary obligation under the original operating lease, the original lessee(as sublessor) shall account for both the original lease and the new lease as operating leases.

28. If costs expected to be incurred under an operating sublease (that is, executory costs and either amortization of the leased asset or rental payments on an operating lease, whichever is applicable) exceed anticipated revenue on the operating sublease, a loss shall be recognized by the sublessor. 28Our Audit Approach – Operating LeasesPerform directed testing on selected leases utilizing section AS222 -224 to determine appropriate method for determining testing selections.Obtain and read copies of selected leases and any applicable amendments keeping in mind the issues, scan the leases, bookmark and highlight pertinent sections including lease terms, payments, etc. Include in the perm file with a summary of the lease and associated terms and determination of lease classification in the current year file or perm file.Obtain and test clients capital v. operating lease analysisPrepare (PFX template) or have client prepare the operating lease analysisReconcile amortization expense and deferred rent to the general ledgerInclude special reps in representation letter

29. 29Our Audit Approach – Capital LeasesObtain and read copies of selected leases and any applicable amendments keeping in mind the issuesIf new lease during the yearTest clients capital v. operating lease analysisConfirm lease terms (you will generally not be able to confirm the present valueFor leases selected for testing, obtain and test clients amortization scheduleDoes number of total payments and payments remaining agree to confirmationIs interest rate reasonable and consistent with other obligations of the CompanyIs term consistent with confirmationIs monthly payment consistent with confirmationObtain and test clients capital lease roll forwardFor lease selected for testing, agree balances, interest paid, principal payments, to the amortization scheduleReconcile total interest to the general ledgerObtain and test clients capital lease payoutFor leases selected for testing, agree future amounts to the amortization schedule

30. 30Polling Question 7Is using a detailed schedule of leases showing annual rent payments to agree lease expense per the schedule to the client’s trial balance a SAP or test of details?SAPTODOPEN FOR DISCUSSION?

31. 31Current DevelopmentsFASB released a discussion paper on March 19, 2009Summary version:Most of what we just covered will become irrelevant!

32. 32Current DevelopmentsThe Board has proposed an accounting model that will require the lessee to recognize an asset (the lessee’s right to use the leased item for the lease term) and liability (the obligation to pay the rental amount) in all lease contracts. The result will be a significant change: the elimination of off-balance sheet reporting of operating leases. The Boards believe this change will increase the transparency and comparability of lease accounting.

33. 33Current DevelopmentsWhat’s in scope? Deliberations are ongoing, but currently all leases will be in scope, except the following:Leases of intangible assets, Leases to explore or use natural resources, Leases of biological assets. Contracts that represent the sale or purchase of an asset. Tentative concession made for short-term leases (such as for copiers and laptops) defined as having a maximum possible lease term less than 12 months. The lessee would recognize the gross amounts payable and a corresponding right-of-use asset under a short-term lease in the statement of financial position. The concession for short-term leases would be optional for lessors.

34. 34Current DevelopmentsMeasurement: The lessee’s asset and the liability initially would be recorded “at cost”, Cost = present value of the lease payments, discounted at the lessee’s incremental borrowing rate or implicit rate if easily determinable. Subsequent measurement of the lessee’s asset would be at amortized cost Account description would be amortization rather than rental expense. Impairment consideration under existing guidance would also be applied.

35. 35Current DevelopmentsThe lessor, using a performance obligation approach, would recognize an asset representing its right to receive rental payments from the lessee( a lease receivable) and a liability representing its performance obligations under the lease (i.e., its obligation to permit the lessee to use the leased item). Revenue would be recognized over the lease term, as the performance obligation is met. Subsequent measurement of the performance obligation would be at amortized cost using the effective interest method.Complex leases can have multiple components, such as renewal options, early terminations, purchase options, contingent rentals, and residual value guarantees. All the components of a lease would be looked at as a whole and not valued as individual components.

36. 36Current DevelopmentsTiming and Transition: Assets and liabilities arise and would be recorded when a contract is signed. In addition, a company would provide disclosures about the assets and liabilities that arose upon contract signing. At the effective date of the new guidance, a lessee would apply the new lease standard by recognizing an obligation to pay rentals and an asset for the right of use for all outstanding leases at the transition date. No grandfathering of existing leases is expected to be allowed.

37. 37Current DevelopmentsPotential Impact: Changing the fundamental basis of lease accounting will impact certain of our clients’ core operating decisions, such as lease versus buy and how to structure transactions. The change in accounting may drive changes in their capital planning and budgeting processes. And, the financial statement effects will certainly create a need to reconsider performance measures, key ratios, and financial covenants.

38. 38Current DevelopmentsNext Steps: The proposal is under discussion with an Exposure Draft for public comment expected in Q3 2010, and a final standard expected in 2011.Many of our clients will be impacted by this proposed change, and would benefit from understanding it early. To facilitate an early discussion, get up to speed on this issue by visiting the lease project page on the FASB project pages, updated monthly.