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Background, Impact and Action
Thomas Ball email@example.com http://www.dealerbahn.com
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Proposed Lease Accounting Changes
Incentive compensation. Beware if your bonus plan(s) are based on financial metrics 4. Revised lease accounting is likely to have a drastic impact on your business’s financial statements 2. Deteriorating debt covenant ratios could restrict borrowing capacity 6. Existing and future lease contracts for real estate.Six Reasons Why Business Managers Should Care About Proposed Lease Accounting Rules 1. Liquidity and funding resources. It is going to cost time and money to assess and implement new rules Proposed Lease Accounting Changes 3 . office equipment and production equipment will be effected 3. Sale treatment could be at risk for companies who use leasing to fund sales 5.
Global Conversion to Common Accounting Rules • Accounting standard setting organizations around the world have a goal to remove differences in accounting treatment between countries • Objectives: – Transparency – Consistent application – Comparable treatment and form • Lease accounting is one of the first standards to be addressed as a global standard In 2005.25 trillion. Proposed Lease Accounting Changes 4 . the SEC estimated the undiscounted amount of off-balance-sheet lease obligations at $1.
Scope of the Proposals In Scope In Scope – With Exceptions Out of Scope Contracts that do NOT meet lease definition Contracts that meet lease definition •Lease of core assets •Leases of non-core assets •Real estate leases •Sale – Leasebacks •Subleases •Investment property leases • Intangible Assets •Service / Maintenance • Natural Resource leases •Short-term leases (<12 mo) • Biological assets • Contracts that do not meet lease definition • In-substance sales or purchases Proposed Lease Accounting Changes 5 .
Current Lease Accounting in the U. • Rules based approach • Two types of leases: Operating and Finance • Problems with current approach – All leases are not required to be shown on the lessee’s (users) balance sheet – Rules based approach leaves too much room for accounting manipulation – Does not fully consider impact of contingent payments or purchase options on lessee’s financial position – Credit analyst and investor concerns: • Requires uniformed estimates and adjustments • Limits comparability between periods and peers Proposed Lease Accounting Changes 6 .S.
IFRS* Proposed Lease Accounting Standards • Principles based. “Right of Use” accounting • All current and future leases must be capitalized and presented on the balance sheet • Capitalized amounts = Present value of “most likely” lease payments plus contingent and guaranteed items • Short term leases (<12mos.) are within scope but apply simplified (straightline) treatment *International Financial Reporting Standards Proposed Lease Accounting Changes 7 .
contingencies. Implementation expected as early as 2013(?) Proposed Lease Accounting Changes 8 . maintenance and security. guarantees. useful life… • Service contracts and executory expenses must be capitalized if they are not separated from lease terms • Excludes: Intangible assets. and mineral leases • Final Rule expected in 2011.IFRS Proposed Lease Accounting Standards • Requires reassessment of lease value at every reporting period – Considerations: Term. taxes and insurance.
Accounting Treatment Lessee Accounting Right of Use Asset (ROU) – Equal to lease liability at inception. and residual guarantees. Depreciation expense for right to use asset. Income Statement Interest expense to recognize money costs. Proposed Lease Accounting Changes 9 . Balance Sheet Payment Liability – Equal to present value (at incremental borrowing rate) of most likely lease payments including contingent rents. Presented as separate component of property. (Interest expense from leases is NOT included in operating expenses) Equipment acquisition must be classified in “investing”. Straight line depreciation is default method. plant and equipment. (Interest method) Lessor will only be able apply sale treatment when applying “derecognition” approach Cash Flow Statement Classify cash repayments and interest payments related to leases as “financing activities”. Amortized using interest method. purchase options.
Accounting Treatment Lessee Accounting: Front-end loaded expense pattern $ Interest Expense + ROU Depreciation New Standard Total Expense Interest Expense Current Expense Pattern ROU Depreciation Time Proposed Lease Accounting Changes 10 .
Accounting Treatment Lessee Accounting: Balance Sheet Pattern $ Right to Use Asset Lease Liability Current Method: Deferred Tax Liability Time Proposed Lease Accounting Changes 11 .
000 $ 120.000 $ 120.803 ($9. $103.189 ($12.968 $ 10.887 $103.875) $ (887) $ $ (9.968 $ 22.000 $ 120.874 $425.968 $116.842 $519.692) $ (12.811 $107.692) $103.905 $328.221 0 $ (9.Lessee Example Lease Term Assumptions Commercial Equipment X Monthly Lease Payments Lessee's incremental borrowing rate Lease Term (Mos) Lease Inception Balance Sheet Current Accounting $0 $0 $0 $0 $0 $0 $ 10.875 $103.221) $ Proposed Lease Accounting Changes 12 .00% 60 Y1 Y2 Operating Lease to Lessee No contingent rents No purchase option No residual value guarantees Y3 Y4 Y5 Differences in depreciation and interest amortization creates equity shortfall Proposed Accounting Right to Use Asset Lease Obligation Net Equity Income Statement Current Accounting Rent Expense Proposed Accounting Depreciation on Right to Use Asset Interest Exp on Lease Obligation Total Prop Accounting Expense Diff b/t Current and Proposed Cumulative Difference $519.529 5.930 $103.805) $ (17.961 $129.629 ($17.968 $ 16.937 $225.968 $ 3.000 6.000 Relative to current operating lease accounting.805) $207.471 $103.710 ($16. proposed accounting yields higher total expense in early portion of the lease that is offset in later periods.907 $126.930) $ (16.561 $114.842 $0 $415.000 $ 120.779 $ 12.918 $120.930) $ (6.221) $0 $0 $0 $ 120.930) $311.968 $ 25.
Liability: Right of Use Liability = Net Asset or Liability Lease Income Depreciation Expense Interest Income Balance Sheet Income Statement Sales Revenue Cost of Sales Interest Income Proposed Lease Accounting Changes 13 .Accounting Treatment Lessor Accounting Lessee Asset Risk Transfer Lessor NO sales treatment! Derecognition Approach Asset: Equipment Residual Asset: Lease Receivable Performance Approach + Asset: Equipment + Asset: Lease Receivable .
Potential Impact of Proposed Standards All current and future leases must be capitalized Lessees will be required to capitalize all existing and future leases. Lessor earnings would also be front loaded but with significant declines during interim periods before lease termination. Earnings Patterns Lessee expenses would be front loaded due to interest method amortization of lease liability. Lessee debt covenants could be triggered after implementation of the new lease standards. Businesses should consider the impact on common debt covenant ratios: • Net worth • Debt to EBITDA • Interest coverage • Leverage (debt / assets) Current funding arrangements Proposed Lease Accounting Changes 14 . Changes to financial statements due to the proposed standards will alter key financial ratios for many businesses. Lease liability must be reassessed at each reporting period and values adjusted to reflect “most likely” scenario.
Lower interest coverage ratios 3. Current accounting rules classify expenses related to operating leases as “rent”. rent expense (an operating expense) will be replaced with interest and depreciation expense. Depreciation and Interest Expense Business Valuation / EBITDA Proposed Lease Accounting Changes 15 . then valuation metrics should rise. The proposed accounting will replace rent expense with the sum of depreciation of the “right to use” asset plus amortization of the lease payment liability using the interest method. The net effects are: 1. as rent will be removed 2. Sale / Leaseback Rent Expense vs. Higher EBITDA. However. Different characterization of expense between accounting and tax records For lessees. To the extent that value calculations are confined to EBITDA and constant multiples.Potential Impact of Proposed Standards Sales / Leaseback transactions will continue to be used where the primary purpose is cash generation. sale leaseback will no longer be a viable tool to reduce demands on capital. The increase is due to the removal of rent expense from the EBITDA equation.
inventory systems) Proposed Lease Accounting Changes 16 . sub ledgers. (General ledgers.Potential Impact of Proposed Standards Book / Tax Timing Differences Since cash rents will remain deductible by IRS. Consulting and technical assistance is likely to be required to properly establish control and IT systems. Further. Transactions that do not qualify as sales will be treated as a financing arrangements by both the lessor and the lessee. tested and implemented to accommodate change in accounting treatment. IT systems will need to be designed. most lessees will book a deferred tax asset to recognize permanent timing difference. the profit on sale using the derecognition approach excludes the portion of gain attributed to residual asset. Sale Recognition Compliance / IT Systems Businesses should plan for increased spending related to conversion to the new accounting standards. even if derecognition approach is used. Businesses who use leases as selling tool will only be able recognize gross profit on sales if they use the derecognition approach.
Business Impact • New rules require a greater reliance on management judgment to properly apply correct accounting treatment and revenue recognition methods • Changes limit the ability to financially engineer equipment acquisitions • 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 for lessees desiring to limit cash outlays for capital expenditures Proposed Lease Accounting Changes 17 .
Business Impact • Customers likely to ask for: – Shorter lease terms – Separate billing for lease payments. taxes • Manufacturers likely to experience diminished accounting profits from lease transactions • Banks and other credit providers will be required to carry more capital. Will this limit supply or increase price? Proposed Lease Accounting Changes 18 . services.
residual guarantees. Invest time required to learn fundamentals of proposed lease accounting changes 2. 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 Proposed Lease Accounting Changes 19 . Develop preliminary impact assessment: • Transition costs • Impact on financial statements and debt covenant ratios • Systems support needs 4.Recommended Actions 1. and purchase options 3. Inventory all lease agreement • Documenting contingencies.
ball@dealerbahn.DealerBahn provides high value on-demand services to distributors and users of commercial equipment • Capital budgeting and business consulting • Outsource finance and insurance sales • Internet based tools that help distributors manage lender relationships and increase revenue on every sale Contact: Thomas Ball thomas.com http://www.com .dealerbahn.
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