Impact Of New Lease Accounting Standards

Presented By:

Aasma Nawab

1OutlineBackgroundObjective Existing lease accounting approach Proposed lease accounting approach Impact of new lease accounting standardsSummary

Impact Of New Lease Accounting Standards

Impact Of New Lease Accounting Standards

2A lease is a contractual agreement between a lessor and a lessee, that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time.Background

Impact Of New Lease Accounting Standards

Leasing is an important and widely used source of financing. It enables entities, from start-ups to multinationals, to acquire the right to use property, plant and equipment without making large initial cash outlays.

Three general categories: BanksCaptive leasing companiesIndependentsWho Are the Players?Largest group of leased equipment involves: Information technologyTransportation Construction AgricultureImpact Of New Lease Accounting Standards

Lessors who own the property:Banks: The largest lessors in the leasing industry. They provide general finance for companies. Examples: Wells Fargo, Chase, Citigroup.Captive leasing companies: subsidiaries whose primary business is to perform leasing operations for the parent company (i.e., structure lease contracts for the parent companies and their customers). Examples: Chrysler Financial (for Daimler-Chrysler), IBM Global Financing (for IBM), Boeing Capital. Independents: leasing companies whose primary business is to perform general finance for other companies. Their market share of leasing business has declined as the other two types of lessors market share has increased. Some independent lessors have become the captive finance companies for other companies without a leasing subsidiary.

Many organizations lease assets such as real estate, airplanes, trucks, ships, and construction and manufacturing equipment.

photocopies, computer, airplanes, and warehouses.(trucks, aircraft, rail)Lease classification is based on complex rules;

On 16 May 2013, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) (collectively, the Boards) issued exposure drafts proposing a new accounting model for leases, which would require lessees to record most leases on-balance sheet. The project objective is to :TransparencyStandardizationAccuracy

Objective Why the change?

Impact Of New Lease Accounting Standards

Impact Of New Lease Accounting Standards

Background Why the change?The major criticism of the existing lease standards is that they fail to meet the needs of investors, analysts and other users of financial statements because lessees do not record all lease obligations on their balance sheets.

Companies worldwide will be forced to list trillions of dollars of additional liabilities on their balance sheets, Companies currently report operating leases in the footnotes, while incorporating capital leases on the corporate balance sheet.

To create more transparency, the FASB wants all leases on the balance sheet.The original expectation was to implement the changes by late 2016 or early 2017. Without the final FASB exposure draft, however, the effective date likely will be no sooner than 2018.

The project objective is to provide greater transparency in financial assessment

harmonise accounting standards will Standardized reporting across national borders

The ED proposes to simplify lease accounting standards by establishing one method of accounting by lessees. All leases would require booking an asset and liability, thus bringing operating leases on comparable financial reporting.

Financial statements would provide users with more accurate information on company liabilities and cash flows. Financial metrics, such as profitability and leverage ratios, would be readily determinable.

Existing Lease Accounting Approach

Impact Of New Lease Accounting Standards

Existing lease accounting approach Under existing International Financial Reporting Standards (IFRS), businesses account for leases or rentals either as:

Finance leases (Capital lease)

Operating leasesImpact Of New Lease Accounting Standards

Finance and operating leases receive different accounting treatment both for the lessor and the lessee. We will focus on the lessee in this analysis. Under operating lease accounting, the lessee does not own the asset, which has the following implications:Lease payments are considered operational expenses for the business.The asset/lease liability is not reported on the balance sheet The firm cannot claim depreciation on the asset.In contrast, accounting for a finance lease treats the lessee as the owner of the asset, in which all the benefits and risks of ownership are transferred substantially to the lessee and the lease is considered as a loan. Interest payments are considered operational expenses.The asset is included in the balance sheet: the outstanding loan amount (net present value of all future lease payments) is included as a liability, and the present market value of the asset is included as an asset.The lessee can claim depreciation on the asset every year.

Finance Lease: Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is no cancelable. When a lease is reported as a finance lease, Lessee records an asset (i.e., leased equipment) and a liability (i.e., lease payable).In a finance lease, the lessee is usually responsible for the executory costs.

Existing lease accounting approach Impact Of New Lease Accounting Standards

Finance and operating leases receive different accounting treatment both for the lessor and the lessee. We will focus on the lessee in this analysis. Under operating lease accounting, the lessee does not own the asset, which has the following implications:Lease payments are considered operational expenses for the business.The asset/lease liability is not reported on the balance sheet The firm cannot claim depreciation on the asset.In contrast, accounting for a finance lease treats the lessee as the owner of the asset, in which all the benefits and risks of ownership are transferred substantially to the lessee and the lease is considered as a loan. Interest payments are considered operational expenses.The asset is included in the balance sheet: the outstanding loan amount (net present value of all future lease payments) is included as a liability, and the present market value of the asset is included as an asset.The lessee can claim depreciation on the asset every year.

9Operating Lease: (Lessor) Leases that do not transfer substantially all the benefits and risks of ownership are operating leases.The leased equipment is reported on the balance sheet in Property, Plant and Equipment subsection entitled Equipment Leased to Others" and record depreciation. The lessor usually pays the executory fees and records them as operating expenses.Existing lease accounting approach Impact Of New Lease Accounting Standards

Executory Costs:InsuranceMaintenanceTaxes

9TransferofOwnershipBargain PurchaseLease Term>= 75%PV of Payments>= 90%Operating LeaseNoNoNoNoYesFinance Lease

Lease AgreementYesYesYesLeases that DO NOT meet any of the four criteria are accounted for as Operating Leases.Existing lease accounting approach (Lessee)Impact Of New Lease Accounting Standards

Finance and operating leases receive different accounting treatment both for the lessor and the lessee. We will focus on the lessee in this analysis. Under operating lease accounting, the lessee does not own the asset, which has the following implications:Lease payments are considered operational expenses for the business.The asset/lease liability is not reported on the balance sheet The firm cannot claim depreciation on the asset.In contrast, accounting for a finance lease treats the lessee as the owner of the asset, in which all the benefits and risks of ownership are transferred substantially to the lessee and the lease is considered as a loan. Interest payments are considered operational expenses.The asset is included in the balance sheet: the outstanding loan amount (net present value of all future lease payments) is included as a liability, and the present market value of the asset is included as an asset.The lessee can claim depreciation on the asset every year.

To record a lease as a capital lease, the lease must be noncancelable.One or more of four criteria must be met:Transfers ownership to the lessee.Contains a bargain purchase option.Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property.

10The Proposed Leasing Standard

Impact Of New Lease Accounting Standards

The key elements of the proposed lease accounting model and its effect on financial statements are as follows:

The distinction between operating leases and finance leases will be eliminated.Risk and ownership transferred to lessee.Leasing payments will treated like a loan.Entities will recognize an asset and liability at the start of a leaseThe Proposed Standard-One Model for all Leases

Impact Of New Lease Accounting Standards

12Current standardsReportingUtilityCapital (Finance) Lease BS--- asset & liability recordedPL---depreciation & Interest ExpInvestors & creditors use FS info for decision making and analysis (ratios)Operating LeaseBS---no asset or liability recorded PL---rent expense

Investors & creditors must adjust FS info to reflect all assets, liabilities & finance costs arising from operating leasesProposed standardsReportingUtilityOne Model for all Leases(i.e. Finance Lease )

BS---Right-of-use asset & liability for future lease payments PL---Amortization expense interest expense Investors & creditors have more complete info in FS on all assets and liabilities resulting from Leasing as well as expected cash flows for all leasesA Comparison of Current & the Proposed Standard Impact Of New Lease Accounting Standards

New Lease Accounting Model Reflects all Lease Contract Assets & Liabilities * Greater Transparency * Consistent Lease Accounting13Impact of New Leasing Standard

Impact Of New Lease Accounting Standards

Impact of new leasing standardCompanys performance and growth projectionsFinancial ratiosAdditional Reporting Burden Threat to breach of financial loan covenantsRisk of default

Impact Of New Lease Accounting Standards

New lease standard has major affect on operating lease. The proposed new standard would eliminate the operating lease category and the liabilities have to be reported in the balance sheet.

Debt contracts rely on accounting standards at the time of initiation. Introducing new lease standard will put debt levels higher allowing some companies to breach debt covenants.

their current loan covenant ratios can find themselves in default after they add all lease assets and liabilities onto their balance sheetWhen minimum accounting based stipulations are unmet, companies are in technical default of debt contracts.

The proposed changes to accounting for leases require all leases to be recognized on balance sheet. Under current lease accounting rules, a lease may be categorized as either a capital lease or an operating lease. Assets and liabilities for a capital lease are recognized on a companys balance sheet. For an operating lease, however, assets and liabilities do not appear on the balance sheet: Payments are simply accounted for as expenses over the leases lifetime.The proposed new standard would eliminate the operating lease category. An asset would be recorded for right to use and would be amortized over the lifespan of the lease. A liability would be recorded for the present value of future lease payments.A change in the accounting standard for leasing will also affect existing loan covenants that organizations have with financial institutions. Many loan covenants include clauses related to balance sheet leverage and cash flow coverage such as debt-to-total assets and cash-coverage ratios. If an organizations financial performance fails to meet those measures, based on the new leasing rules, the loan will be regarded as being in technical default. The remaining loan balance will be considered a current liability. It will impact gearing levels, which may result in existing debt covenants being breached.

15Impact Of New Lease Accounting Standards

16Impact Of New Lease Accounting Standards

100% Financing at Fixed RatesFlexibilityTax AdvantagesProtection Against ObsolescenceOff-Balance-Sheet FinancingLess Costly FinancingWhy do companies favor operating leases?Impact Of New Lease Accounting Standards

Leasing is a significant source of financing for many sectors and entities in our economy.1. The lease provides 100% financing (no down payment is needed). For companies with cash shortage, lease is a good alternative to purchase;2. Operating leases require no down payment and give the flexibility to return the equipment at the end of the term. Companies can upgrade to state-of-the-art equipment without large down payments. The lease contract may contain fewer restrictive provisions than other debt agreement; and3. Tax deduction may be accelerated since it is often spread over the lease term (rather than the economic life of the property). The full cost of the leased asset can be written off including the part that relates to land. 5. For an operating lease, the lease does not add a liability or an asset to the balance sheet, and therefore does not affect financial ratios. By maintaining these ratios, the company's borrowing capacity can also be maintained. Off-balance-sheet financing: acquiring the right to use assets but not reporting the assets and liabilities on the balance sheet

Understatement of Assets & Liabilities For Operating Leases

6. An operating lease offers an extremely low cost of use for a company that is capital intensive. As an example, if a company has net operating losses, it cannot utilize depreciation. With a true lease structured as an operating lease, the lessor takes the depreciation and prices a residual into the deal, giving the lessee a lower rate. For many companies, the proposed lease accounting standard could have far-reaching impacts on their balance sheet and financial ratios, such as Debt to Equity and ROA. Both lessees and lessors are likely to face significant additional reporting burdens. Few companies currently appear to be prepared to comply with the proposed standard and little progress has been made at completing the required implementation tasks. Although the proposed standard could be approved in 2014 and to take effect no sooner than 2017, the new proposals aim to improve the quality and comparability of financial reporting by providing greater transparency about leverage, the assets an organization uses in its operations, and the risks to which it is exposed from entering into leasing transactions, according to the FASB.

SummaryImpact Of New Lease Accounting Standards

The new standard will generally make lessor accounting more complex. Both income statements and balance sheets will likely require numerous adjustments to analyze the true economics of the business.

the new lease accounting standards will make cross-border peer comparisons much more consistent. Thank YouImpact Of New Lease Accounting Standards

The new standard will generally make lessor accounting more complex. Both income statements and balance sheets will likely require numerous adjustments to analyze the true economics of the business.

the new lease accounting standards will make cross-border peer comparisons much more consistent.