Lease Accounting Changes: The Impact to the Hospitality Industry

7/28/2019 Lease Accounting Changes: The Impact to the Hospitality Industry

1/13iLease Management LLC

Lease Accounting Changes:

Impact to the HospitalityIndustry



Lease accounting, particularly as it relates to lessee accounting,has been a controversial topic for a number of years. The fact thata lessee under current generally accepted accounting principles(GAAP) can execute a contract to make legally binding payments

over a period of time, structure the contract so that it is classifiedas an operating lease and the not be required to reflect thatobligation as a liability on the balance sheet has been a major

concern for both financial regulators and analysts. In a jointproject, both the Financial Accounting Standards Board (FASB)

and the International Accounting Standards Board (IASB) began

to tackle this issue in 2009 by issuing a Preliminary Views topicpaper which was followed by Exposure Draft in August 2010 (the

2010 ED) which proposed major changes to manner in which

leases are accounted for. The 2010 ED sparked numerouscomments and a lively debate among financial statement

preparers because of the perceived additional complexity that theproposed changes would entail. The FASB and the IASB (the

Boards) undertook significant outreach to the financial statement

preparer and user communities and in May 2013 issued a revisionto the Exposure Draft (the Revised ED) which eliminates some of

the more complex provisions but retained most of the basicelements of the 2010 ED. This whitepaper presents the mostimportant elements and implications of the Revised ED at a high

level to provide the reader with a basic understanding of theproposed lease accounting changes, as those changes apply tolessees.

Background



A lease is defined as a contract that conveys the right to use an asset (the

underlying asset) for a period of time in exchange for consideration. Therefore,

the lessee must be able to identify an asset or assets that can be used and alsodemonstrate that the contract allows the lessee to control the use of theidentified asset for some period of time in exchange for consideration. In mostcases, this will be a rather straightforward evaluation but there are situationsinvolving, for example, where the lessee or the lessor have the right ofsubstitution of an asset or where it is not clear which party has control of theasset that will require judgment to determine whether the definition of a lease ismet.

The proposed guidance would require that the lessee evaluate whether anynon-lease components are contained in the contract and whether such non-lease components should be accounted for separately. An example of thissituation as provided in the Revised ED is where a manufacturer lessor ofequipment requires that the contract with the lessee include maintenanceservices of the equipment that are provided by the lessor.

Basic

Provisions of

the Revised EDThe provisions of the Revised ED require the financial statementpreparer to determine these most important elements associated with alease (not meant to be all inclusive):

Does the contract in question meet the definition of a lease foraccounting purposes?

Does the contract contain any non-lease components? What is the lease term? What are the lease payments? How should a lease be classified?



Determining the lease term and the lease payments associated with thelease term are significant because the Boards have retained therequirement that most lease contracts be recorded on the balance sheet ofthe lessee using a right-of-use model for recording the right-of-use asset(the ROU asset) and the liability to make lease payments. The calculation

of the lease liability would be derived from the present value of the fixedlease payments beginning with at the lease commencement date (the dateat which the lessor makes the underlying asset available to the lessee) withthe possible inclusion of certain lease incentives, certain variable leasepayments, residual value guarantees expected to be paid and certainpurchase and lease termination options. The initial carrying value of theROU asset would be equal to the initial value of the lease liability plus anyinitial direct costs associated with negotiating and arranging the particular

lease, any payments made to the lessor at or before the commencementdate of the lease less any lease incentives received from the lessor. Thediscount rate to be utilized in the present value calculation would bedetermined on a lease by lease basis and would be the rate used by thelessor for the particular transaction. Alternatively, since the lessee may wellnot know the rate used by the lessor, the lessee should use its ownincremental borrowing rate at the lease commencement date.

The Boards proposed a number of changes to the 2010 ED that aredesigned to reduce complexity including:

The lessee can make an accounting policy election to apply the currentGAAP operating lease accounting model for those short-term leases thathave a maximum possible lease term of 12 months or less, includingoption periods.

The previous requirement to include variable lease payments has beenrevised to apply only to those payments that are based on an index or arate or that are in-substance fixed payments.

The requirement to include payments during an option period has beenredefined to include only those payments where the lessee has asignificant economic incentive to exercise the option.

Lease and non-lease components (predominantly services provided bythe lessor) would generally be accounted for separately.



A major change from the 2010 ED would involve lease classification based uponthe nature of the asset being leased and how lease related expenses arerecognized. Leases of assets that are not property (mainly equipment) would beclassified as Type A leases unless either the lease term is for an insignificantportion of the leased assets economic life or the present value of the lease

payments is insignificant versus the assets fair value. Leases of property would

be classified as Type B leases unless either the lease term is for the majorportion of the leased assets remaining life or the present value of the lease

payments accounts for substantially all of the assets fair value.

Recognition of lease related expensewould differ significantly dependingupon how the lease was classified.For a Type A lease, the lease liabilitywould be accreted using the interestmethod with lease payments beingused to reduce the liability. The ROUasset would be amortized on astraight-line basis. This interestmethod pattern results in overall

accelerated expense pattern inearlier periods and lower expense inthe later periods of the lease term.

Additionally, interest and amortizationexpense is presented separately inthe financial statements for a Type Alease.

For a Type B lease, the lease liabilityis accreted in the same manner as aType A lease but the amortization ofthe ROU asset is adjusted so that theoverall lease expense is recognizedessentially on a straight- line basis.For Type B leases, a single leaseexpense line item is presented in thefinancial statements, comprising boththe interest and amortizationcomponents.



Reassessment

After the date of commencement, the lessee may have toreassess the initial accounting for the lease transaction if eitherthe lease term or the lease payment stream changes.

Circumstances that could trigger reassessment include:

The index or rate utilized to measure the variable leasepayments changes, for example, where CPI increases areincluded in the lease terms and the CPI index initially utilizedchanges or

The lease contains option periods and the lessee originalconclusion as the whether there is a significant economicincentive to exercise the option changes.

The reassessment may be required at each reporting period andresult in the adjustment of the carrying amounts of the leaseliability and the ROU asset. Additionally, if the reassessment doesresult in a change in the lease payment stream, the rate utilizedto discount the payments may also have to be reassessed.



Disclosures

The Revised ED proposes a series of both qualitative and quantitativedisclosures in order for the financial statement reader to understandmore completely the nature of the lessees lease portfolio. Unless

separately disclosed in the financial statements, the lessee would berequired to disclose all financial statement amounts relating to the leaseportfolio in the footnotes. Qualitative disclosures would include, amongother matters, significant judgments made in applying the accountingguidance, information about the nature of the lease portfolio, including adescription of the types of leases and certain information regardingoptions and variable lease payments. Quantitative disclosures wouldinclude a reconciliation of opening and closing balances of the

aggregate lease liability separately for Type A and Type B leases (thisdisclosure would be optional for nonpublic companies) and a maturityanalysis of the lease liability reflecting the undiscounted cash flowswhich would include a reconciliation to the ending carrying value of thelease liability.

Transition and

Effective DateThere are two transition approaches being proposed in the RevisedED (full retrospective and modified retrospective) but neither of theseapproaches would provide for grandfathering of existing leases. Underboth transition approaches, the lessee would be required to recognize

the ROU asset and the lease liability at the beginning of the earliestyear presented with some minor computational relief provided to thosethat choose the modified retrospective approach. The Boards have notyet proposed an effective date for the new standard but mostobservers have suggested that there would be an extendedimplementation period because of the significance of the changes ascompared to the current GAAP accounting requirements. It does notappear that the effective date would be earlier than January 1, 2017

with the possibility of a later date for nonpublic companies.



Example and Financial

Statement Analysis

An example of what one might consider a typical situation may the best wayto demonstrate the effect on the financial statements of the provisions in theRevised ED versus current GAAP accounting requirements. The lessee inour example is the operator of a 100 room hotel and leases the land and anewly constructed building on which the hotel is situated from one lessorand also leases various pieces of equipment from another lessor.

The land and building lease is triple net and there arent any non lease

components (such as real estate related executor costs) which have to beconsidered separately. In addition, although the lease contains twounderlying assets (land and building), we do not believe that they wouldhave to be accounted for separately within the lease because they aredependent upon one another and highly interrelated. The lease term is 10years and calls for monthly payments of $20,000 per month over the term of

the lease. There are no options to extend, variable lease payments,purchase options or residual value guarantees contained in the leaseagreement and no initial direct costs that have been incurred in executingthe lease.

As indicated, the lessee also leases equipment from another lessor. Theseare separate leases and as such would have to be evaluated separately,however, for purposes of our example; we will aggregate the leases into one

payment stream. The aggregated lease term is 60 months and the paymentis $10,000 per month over the term of the lease. The lessee is responsibleseparately for all costs of the equipment and, therefore, there arent any non

lease components that have to be accounted for separately. As with thelease of the land and building, there are no other payments, other than thefixed payments noted previously, that must be considered.



The lessee has determined that the real estate lease is a Type B lease sinceit is a property lease, the lease term is not for a major part of the remainingeconomic life of the real estate and the present value of the lease paymentsare insignificant when compared to the fair value of the underlying assets.

The equipment leases are determined to be Type A leases since theunderlying assets are not property and the lease term is for a significant partof the total economic life of the underlying assets.The present value of both payment streams must be calculated and, sincethe lessee is not privy to the interest rate that was utilized by the lessor instructuring the leases, the lessee will use its incremental borrowing rate forthe present value calculation assumed to be 5%.

Proposed GAAP Current GAAP

Year LeaseLiability

ROU Asset LeaseLiability

ROU Asset

Year 0 $2,415,534 $2,415,534 - -

Year 1 2,160,448 2,170,752 - -

Year 2 1,897,733 1,913,446 - -

Year 3 1,627,000 1,642,976 - -

Year 4 1,347,837 1,358,668 - -

Year 5 1,059,814 1,059,814 - -

Year 6 868,459 868,459 - -

Year 7 667,314 667,314 - -

Year 8 455,878 455,878 - -

Year 9 233,624 233,624 - -

Year 10 - - - -



The income statement impact of the proposed changes versus currentrequirements is presented in the following table:

Proposed GAAP Current

GAAP

Year LeaseExpense

InterestExpense

AmortizationExpense

Total LeaseExpense

Year 0 $240,000 $105,981 24,322 370,303 360,000

Year 1 240,000 $105,981 19,427 365,408 360,000

Year 2 240,000 $105,981 14,282 360,263 360,000

Year 3 240,000 $105,981 8,873 354,854 360,000

Year 4 240,000 $105,981 3,188 349,169 360,000

Year 5 240,000 $105,981 - 240,000 360,000

Year 6 240,000 - 240,000 240,000

Year 7 240,000 - 240,000 240,000

Year 8 240,000 - 240,000 240,000

Year 9 240,000 - 240,000 240,000

Year 10 240,000 - - 240,000 240,000

Note that under the Proposed GAAP as it relates to the balance sheet, thelessee would have both a significant liability and asset that must berecognized on its balance sheet as compared to Current GAAP. Both theliability and the asset balances decline as payments are made andamortizations is charged to income and are equal to zero at the end of theten year term of the property lease. The ROU asset that must be recognizedis not a tangible asset and will not enhance financial viability while the leaseliability will clearly be included in the overall indebtedness of the entity.Since the entitys equity would not change, the asset to equity and the debt

to equity ratios would change significantly and the impact is particularly

negative as to the debt to equity ratio.



With respect to the lessees income statement, what under Current GAAP is

relatively straight-forward accounting becomes considerably morecomplicated. The expense recognition for the Type A equipment leases isaccelerated into the early years of the lease term and the Type A leaseexpense is now presented in two separate categories of interest andamortization expense. The expense presentation for the Type B propertylease remains consistent with Current GAAP, namely, straight-linerecognition. The total column is presented here for illustrative purposes onlyto show how total expense will be impacted under Proposed GAAP but thatamount will not be presented separately in the financial statements.

It is interesting to note that, for those entities that have significant Type Aleases, although total expense recognition may be accelerated in the earlyyears of the lease term, Earnings Before Interest, Taxes, Depreciation and

Amortization (EBITDA) will be more favorable since interest and

amortization are added back to derive the EBITDA calculation.



Next Steps

Preparation is key for effective implementation. Summarized below is just a partial list ofnext steps that lessees should be considering in preparation for the lease accountingchanges.

The issues that must be considered are more numerous and complex than under thecurrent accounting standards and require a complete understanding of all of the terms ofthe lease. In addition, the reassessment requirements are much more are rigorous. It iscritical that the terms of each lease be documented clearly and consistently in a mannerthat allows for ready review. Lessees should strongly consider the need for a technologysolution that captures all of the key provisions of the lease and stores them in an easilyaccessible format.

How will your leasing strategy change as a result of the new accounting standards? Noone wants accounting to drive the economics of the organization but they willundoubtedly be a consideration. Will lease versus buy decisions change? Will leaseterms change? Longer lease terms will result in larger liability balances. The morecomplex the lease terms, the more time that is necessary to consider all of theaccounting implications.

Financial statement analytics will change dramatically, particularly debt to equity anddebt service coverage ratios. Lessees should consider the implications on among other

things, debt covenant compliance, employee compensation plans, contractualagreements and other key legal documents. And remember that although overallearnings may be lower, EBITDA may actually increase. How will this anomaly impact thekey financial ratios?

Income tax policy is unlikely to change as aresult of the proposed accounting changes,therefore, book-tax differences will likelyincrease and result in a more complex taxcomputation.

Start preparation early. Consult your technicaland financial advisers well in advance. Aneffective date of 2017 may seem far away but itis easy to underestimate the amount of workthat is necessary in order to prepare to adoptthe new standards.


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Lease Accounting Changes: The Impact to the Hospitality Industry

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