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

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PREPARED BY: MEDI ABBIS MARC MAIONA JEFF MANLEY TAYLOR WOOD

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

2 NEW LEASE ACCOUNTING STANDARD ASC 842

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.

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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.

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ACCOUNTING STEPS

• 1. Identify the Lease
• 2. Classify the Lease (Finance vs. Operating Lease)
• 3. Recognize and Measure the Lease

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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

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CLASSIFYING THE LEASE

• Lease will be classified as Finance, if meets any of the following, otherwise it will

be Operating:

1.

Lease transfers ownership of the asset to the Lessee by the end of the term

2.

Lease grants a purchase option reasonably certain of being exercised

3.

Lease term is for the major part of the remaining economical life*

4.

Present value of Lease payments is substantially all of the assets fair value **

5.

Asset so specialized it is not expected to have alternative use to the lessor

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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

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LEASE ACCOUNTING: NEGOTIATING STRATEGIES

LEASE CALCS

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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?”

10 LEASE ACCOUNTING: NEGOTIATING STRATEGIES

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!

11 LEASE ACCOUNTING: NEGOTIATING STRATEGIES

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING

12 LEASE ACCOUNTING: NEGOTIATING STRATEGIES

• But, but, but… they promised!!!

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 13

Two Main Goals Consistency Transparency

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1

T

• day’s Lease Accounting

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 14

CAPITAL LEASES On Balance Sheet Interest & Amortization Expense OPERATING LEASES Off Balance Sheet Straight Line Rent Expense

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1

New Lease Accounting: No Off Balance Sheet Leases

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 15

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1

“Finance Lease”

Same as today’s capital lease

“Operating Lease”

A capitalized operating lease. Straight line rent: an

• ptical illusion.

“Finance Lease”

No other option / type of lease.

Different standards create disparity in accounting results for the same lease under GAAP vs. IFRS.

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 16

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #1

Finance Leases = Debt on Balance Sheet Shareholder Equity Differences Debt-to-Equity Difference EBITDA Performance Net Income Early in Lease Net Income Later in Lease Net Income at Adoption Date

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 17

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? WILL YOU HIT THE GREAT WALL?

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 18

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #2

4 Big Subjective Issues: Each firm determines its own answers.

1.

What is “major portion” of asset’s “remaining economic life?”

2.

What is “substantially all” of asset’s fair market value?

3.

“Disguised minimum rent” – Think of percentage rent for retailers Where to draw the line between “icing” and the “cake”?

4.

When are you “reasonably certain” to exercise options? 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”

1.

What constitutes a “significant economic incentive”?

• 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

IDENTICAL LEASES HAVE TOTALLY DIFFERENT ACCOUNTING??? REASON #2

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 21

LEASE ACCOUNTING: SUBTLE CHANGES CAN IMPROVE PERFORMANCE

• 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―BALANCE SHEET 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―NET INCOME 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
• n the “turnkey” improvements.
• Reduces straight line rent, creates asset on books which is amortized.

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 24

SUBTLE CHANGES CAN IMPROVE PERFORMANCE LEASE STRUCTURE MATTERS―EBITDA IMPACTS

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 25

LEASE ACCOUNTING: HOW LEASING STRATEGIES ARE CHANGING

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

HOW LEASING STRATEGIES ARE CHANGING IF BALANCE SHEET/SHAREHOLDER EQUITY IS FOCUS

Using mechanics to your advantage – Net Income

• Who? Any tenant focused on net income in a particular time frame.
• Why? Normal profitability pressures.
• Shrinking the Great Wall
• Overlap with existing lease and new lease.
• When a longer term lease – or favorable renewal option – serves

to improve profitability.

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 27

HOW LEASING STRATEGIES ARE CHANGING IF NET INCOME IS FOCUS

Using mechanics to your advantage – EBITDA

• Who? PE backed firms, companies with high debt, heavy capex or

really any company that sees M&A activity on horizon.

• Why? Predominantly valuation multiples.
• Turnkey vs. Allowances
• Move vs. Renew in place
• Achieving “Finance” lease classification

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 28

HOW LEASING STRATEGIES ARE CHANGING IF EBITDA IS FOCUS

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 29

LEASE ACCOUNTING: HOW RULES MAY CHANGE TIMING OF TRANSACTIONS

Significant changes to SLB accounting rules

• Elimination of off-balance sheet deals means balance sheet “round trip”.
• But it’s not just about the “leaseback” …
• The treatment of the gain (or loss) on sale also changes.
• SLBs after transition: No deferral of gain.
• Existing SLBs: No continued deferral of if Operating lease under current rules. Any

unrecognized gains drop to retained earnings.

• BUT … existing SLBs where leaseback is capital lease have their deferrals “grandfathered”.

If deferral is important, complete Capital SLB now.

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 30

HOW NEW RULES MAY CHANGE TIMING OF TRANSACTIONS SALE/LEASEBACK – INCENTIVES TO ACCELERATE

Subleases –The “Math” changes How big of a difference can timing have on financial performance?

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 31

HOW NEW RULES MAY CHANGE TIMING OF TRANSACTIONS SUBLEASES – INCENTIVES TO ACCELERATE

Loss Calculation T

• day

PV of Head Lease Rents

• PV of Sublease Rent

+ Write off of LHI Asset

• Deferred Rent Credit Liability

= Loss on sublease Loss Calculation T

• morrow

PV of Head Lease Rents

• PV of Sublease Rent

+ Write off of LHI Asset

• Deferred Rent Credit Liability

= Loss on sublease There is no DRC to reduce loss

HOW NEW RULES MAY CHANGE TIMING OF TRANSACTIONS LEASE EXTENSIONS

• VS. RELOCATIONS

How Amendments May Change “Stay or Go” Decisions

• When do you have to book the impact?
• Amendments = Ink on paper
• New Leases = Possession

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 32

LEASE ACCOUNTING: NEGOTIATING STRATEGIES 33

LEASE ACCOUNTING: YOU’RE DOING IT WRONG IF JUST LOOK AT ACCOUNTING