Are You Ready for the Proposed Changes to Accounting for ... - PwC

Issue Alert November 16, 2010
Are You Ready for the Proposed
Changes to Accounting for Leases
By Jim Kaiser, Denise Cutrone and Lyn Fifer,
PricewaterhouseCoopers, LLP
On August 17, 2010, the Financial Accounting Standards Board
(FASB) and the International Accounting Standards Board (IASB)
proposed a new approach to lease accounting that would
significantly change the way entities account for leases. Their
exposure drafts, Leases, would result in a converged standard that
aims to address the perceived weaknesses of existing standards.
The key objective is to ensure assets and liabilities arising from lease
contracts are recognized in the balance sheet. The exposure draft
does not propose a specific effective date, but it is anticipated that
the final standard will not be effective before 2013 and would require
comparative periods.
Recently, Credit Suisse published an article in August 2010 entitled,
Leases Landing on Balance Sheet, where they estimated that $549
billion of off-balance sheet lease liabilities (i.e., operating leases) will
be recognized on the balance sheets of the S&P 500 companies
(Suisse, 2010, p. 1).
Given the potential impact of the proposed changes on accounting,
operations and IT systems, companies should begin assessing the
implications of the proposal on existing contracts, technology and
processes. This Issue Alert summarizes the key provisions of the
Leases exposure draft and includes a self-assessment questionnaire
developed by PricewaterhouseCoopers LLP to help companies
understand the potential impact of the Leases exposure draft.
What should companies be doing now
Inventory existing leases and perform an assessment to
determine the impacts of the proposed standard to your
company. (See attached questionnaire)
Evaluate existing IT systems and hold discussions with ERP
providers to assess the system’s current capabilities, and
whether upgrades are both necessary and available.
Consider the impacts of the new rules upon major company
initiatives, such as systems and compensation plans.
Begin to assess what data will need to be collected and
analyzed prior to adopting the standard, to allow for a
comparative presentation.
Consider the impacts on “lease versus buy” strategies.
Establish a training and communication plan with employees
and key stakeholders.
Consider sending a comment letter to the FASB and IASB to
express your views prior to the issuance of the standard.
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The Key Provisions
Lessee Accounting
The proposal effectively eliminates off-balance sheet or operating lease accounting for most
leases. All assets currently leased under operating leases would be brought onto the
balance sheet, removing the distinction between capital and operating leases. Lessees
would be required to discount the lease payments using its incremental borrowing rate at the
transition date (i.e., January 1, 2011). Other significant impacts include:
A right-of-use asset (representing the right to use the leased item for the lease term)
and an obligation (representing the obligation to pay rentals) would be recognized and
carried at amortized cost, based on the present value of payments over the term of the
lease.
The lease term would include optional renewal periods that are "more likely than not" to
be exercised.
Lease payments used to measure the initial value of the asset and liability would include:
contingent amounts, such as rents based on a percentage of sales or rent increases
linked to variables such as the Consumer Price Index (CPI).
Lease renewal and contingent rents would need to be continually reassessed, and the
related estimates adjusted as facts and circumstances change.
The income statement geography and the recognition pattern for lease expenses would
change. Straight-line rent expense would be replaced by amortization and interest
expense and would result in an acceleration of expense recognition, as interest on the
obligation would be greater in the earlier years.
Lessor Accounting
After much debate, the FASB and IASB are proposing a dual model for lessor accounting.
Depending on the economic characteristics of the lease, a lessor would apply either a
performance obligation approach or a de-recognition approach:
The performance obligation approach would be used for leases where the lessor
retains exposure to significant risks or benefits associated with the leased asset,
either during the term of the contract or subsequent to the term of the contract.
Under this approach, the lessor would recognize a lease receivable, representing the
right to receive rental payments from the lessee, with a corresponding performance
obligation, representing the obligation to permit the lessee to use the leased asset.
Lessors would measure the lease receivable and performance obligation using the
rate the lessor is charging to the lessee (from the lease inception date) as the
discount rate.
The de-recognition approach would be followed for all other leases. The lessor
would recognize a receivable representing the right to receive rental payments from
the lessee and record revenue. In addition, the carrying value of the leased asset
that is considered to have been transferred to the lessee would be derecognized and
recorded as cost of sales.
Under either approach, lessors would need to estimate the lease term and contingent
payments and adjust these estimates as facts and circumstances change. The lessor would
also measure the lease receivable using the rate the lessor is charging to the lessee (from
the lease inception date) as the discount rate.
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Presentation and Disclosures
Due to the significantly expanded use of estimates and judgments in the proposed lease
standard, disclosure requirements will go well beyond those required under current leasing
standards. Quantitative and qualitative financial information that identifies and explains the
amounts recognized in financial statements arising from lease contracts and a description of
how leases may affect the amount, timing, and uncertainty of the entity’s future cash flows
would be required.
Specific disclosures would also be required and include a description of the nature of an
entity's leasing arrangements, the existence and terms of optional renewal periods and
contingent rentals, and information about assumptions and judgments. In addition, any
restrictions imposed by lease arrangements, such as dividends, additional debt, and further
leasing should also be disclosed. The following disclosures would also be required:
Information about the principal terms of any lease that has not yet commenced if the
lease creates significant rights and obligations.
A reconciliation between the opening and closing balances of right-of-use assets and
obligations to pay rentals, disaggregated by class of underlying asset.
A narrative disclosure of significant assumptions and judgments relating to renewal
options, contingent cash flows, and the discount rate used.
A maturity analysis of the gross obligation to pay rentals showing (a) undiscounted cash
flows on an annual basis for the first five years and a total of the amounts for the
remaining years and (b) amounts attributable to the minimum amounts specified in the
lease and the amounts recognized in the balance sheet.
Additional disclosures would apply if (a) the simplified option for short-term leases is
elected, (b) significant subleases exist, or (c) there is a sale-leaseback transaction.
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Impacts to Existing IT Infrastructure
The system implications will affect lessees and lessors differently. As such, a separate
analysis of the system impacts for parties on both sides of the lease transaction is
necessary.
It is also worth recognizing that companies may have a variety of systems in place to
manage information. With so many systems, it is difficult to generalize the impacts.
Therefore the concepts discussed below are intended as thought provoking examples.
As a basic framework, there are five layers of systems that may be impacted, and will need
to carry different parts of the load. The five layers are:
1. Consolidations / Reporting
2. Data Warehouse
3. General Ledger
4. Subsystem / Subledger
5. Governance, Risk and Compliance
For lessee accounting, the following should be considered:
Consolidation / Reporting:
The immediate issue will be the need to support multiple reporting formats during the
adoption of the converged standard. Depending on how tax and other regulatory reporting
are supported, there may be a longer term need to support multiple reporting formats.
These systems will be the likely source for additional disclosures required by the new
standard. Additional disclosures will likely include:
• Rollforward information such as the opening and closing balance of the right-of use
asset and obligation, lease receipts and payments, lease income, interest income,
and depreciation expense, disaggregated by class of underlying asset.
• A narrative disclosure of significant assumptions and judgments relating to renewal
options, contingent cash flows, and the discount rate used.
• A maturity analysis of the gross obligation to pay rentals showing (a) undiscounted
cash flows on an annual basis for the first five years and a total of the amounts for
the remaining years and (b) amounts attributable to the minimum amounts specified
in the lease and the amounts recognized in the balance sheet.
These systems are also often used as a basis for budgeting and planning, and so the impact
to expense versus capital budgets should be considered.
Data Warehouse
The data warehouse will need to be evaluated to see how the change in transactional
treatment will impact the usability of the data. The data warehouse is often used as the
source for developing financial analysis and ratios. The underlying data may impact how
these are calculated and how comparative data is produced.
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General Ledger
For the majority of companies with an ERP solution in place, the general ledger (GL) is
currently being used to capture entries sourced in a subledger / subsystem. The impact to
the general ledger will depend on how much can be handled by the transaction system.
There will be different values posted into the GL, and depending on the approach taken, this
could require additional GL accounts or ledgers. The integration between the GL and the
data warehouse and consolidation / reporting systems will also need to be considered.
Subsystem / Subledger
The three subsystems / subledgers where impact might be felt include the asset system,
purchasing and the contract management system. The asset system will be brought into
play for many more assets than under existing US GAAP / IFRS, and those asset records
will need to contain amortization expenses of the asset and the accrued liability. The rightof-use
assets will also need to be distinguishable from other purchased assets for reporting
purposes, and the need to annually review and adjust the assets based on a change in
estimates also needs to be accommodated.
The purchasing application will also be impacted as the financial impact of what is being
acquired has changed. The purchasing process will need to be able to capture not just the
lease rental amounts, but also the full cost to the business, and any future renewal options.
The approval process against budgets will also need to be adjusted to fit the new accounting
treatment.
If contract details are maintained in a separate system, this system will need to capture
additional information regarding the lease obligations and right-of-use assets.
Governance Risk and Compliance
With additional and amended business processes around these assets, the process
documentation will need to be adapted and the appropriate controls will need to be
incorporated into the processes.
For lessor accounting, the following should be considered:
For the majority of areas, the items to be considered will be similar, although the source
transactions will be different. The area where there is an additional element to consider is in
the subledger / subsystem layer. Here the system used to manage assets and equipment
that is leased out will potentially need to handle the de-recognition approach as well as the
performance obligation approach, and will also need to adjust for contingent and other
estimates as circumstances change. Depending on the complexity of the lessor operations,
this may be managed through standard sales / revenue system or for more complex
situations where a lease administration/property management system is used. These
systems should also be evaluated and companies will need to assess whether the
necessary data is available in a usable format in their current lease administration systems.
Additional data will need to be captured under the new standard that may not have been
critical before. That data includes estimates of contingent rents, option renewal terms,
inputs to calculate lease terms in accordance with the new standard, and a review of
contracts to evaluate whether lease payments include service costs that should be
bifurcated from payments for the leased asset. Only the lease payment should be used in
calculating the lease receivable.
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Initial Lease Discussion Questionnaire
One way that companies can get started is to assess the potential impact of these
accounting changes on financial reporting systems and financial statements. A good first
step is to try to understand the scale of the potential effort at your organization, including
treasury, legal and real estate (if applicable). Below are a few questions that can help
companies perform a self assessment to try and understand the scale of the potential effort.
1. How many leases do you have (Include transactions that are not leases in legal
form, but are accounted for as such, such as embedded leases.)
2. What are the lease terms of your lease agreements
3. What types of "large ticket" assets do you lease (Include corporate real estate, real
estate used in operations/production, land leases, operating or manufacturing
equipment, etc.)
4. Do you have a large volume of "smaller dollar" leases that individually would not be
material, but that in aggregate could be significant, such as fleet vehicles, office or
inventory related equipment and software leases
5. "Complex" leases under the standard will involve more assumptions and require
significantly more on-going accounting than today's standards. Do your leases
commonly include any of the following:
Renewal options (market or fixed/ variable)
Contingent rent (market or fixed/ variable)
Purchase options (market or fixed/ variable)
Lessee participation in residual value, including Residual Value Guarantees,
remarketing rights/ obligations, TRAC leases.
6. Where does the information on your leases reside For example, are the lease
agreements located in a central or de-centralized location, regional headquarters, or
maintained on a country-by-country basis
7. What systems do you use to manage your leases How do you currently capture
lease specific information, such as executory costs, contingent rents, renewal terms,
tenant improvement allowance, options to expand or terminate early Some
common examples include an integrated workspace management system, Access
database, Excel worksheets, or SAP/Oracle.
8. Have you had discussions with your ERP/ Service provider about their ability to
make system changes to meet the new standard
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Conclusion
In summary, the proposed leasing model will have far reaching implications for companies.
It will not only affect IT systems and controls, but also the information needs, financial
metrics and lease-versus-buy decisions. As such, companies may want to begin thinking
about the potential business implications now, well before a final standard is issued.
If you would like further information on the proposed lease accounting model or assistance
in determining how it might affect your business, contact information for the PwC authors is
provided below.
For additional insight regarding the business impacts of convergence between U.S. GAAP
and IFRS, please visit PwC's dedicated convergence website at
www.pwc.com/usgaapconvergence.
About the Authors
Jim Kaiser is PwC's US GAAP convergence & IFRS leader. As such, he leads a
multidisciplinary team in developing the firm's strategy to help clients through the complex
business issues related to near-term convergence and ultimate conversion to IFRS in the
US. Jim has over 30 years experience serving major international clients in a wide range of
industries. He has worked extensively with his clients in mergers and acquisitions including
due diligence, merger integration and public offerings services, and has led his clients in reengineering
their audit and closing processes. Jim developed PwC's industry program for
the chemicals, forest products, metals, and diversified manufacturing industries. He serves
on a number of boards as well as the American and Pennsylvania Institutes of Certified
Public Accountants. James.kaiser@us.pwc.com
Denise Cutrone is a partner in PwC's Transaction Services Group in Atlanta servicing
financial services clients nationwide. Denise is fully dedicated to providing clients advisory
services in conjunction with complex or new accounting standards and conversions to
International Financial Reporting Standards ("IFRS") or U.S. GAAP. She is one of our
conversion and embedding experts, who has assisted Global companies with IFRS and U.S.
GAAP conversions for the past 13 years. Aside from providing technical and conversion
advice, some of her projects have included the redesign of financial reporting in order to
enhance standardization and processes. Denise has also supported clients with various
types of capital market transactions. Denise.cutrone@us.pwc.com
Lyn Fifer is a director is in PwC's Transaction Services Group in Atlanta and has nine years
of accounting experience advising clients in multiple industries, including financial services,
industrial products, and the automotive industry with respect to initial and ongoing U.S.
GAAP, IFRS, and SEC accounting and reporting matters. Lyn has served as an advisor to a
number of companies advising on emerging and complex accounting transactions,
specifically as it relates to leases, joint venture accounting, consolidation, and securitization
transactions under both U.S. GAAP and IFRS. Lyn has also advised various clients with
debt offerings and IFRS conversion projects. Lyn.fifer@us.pwc.com
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