Leases (ASC 842) - cbinet.com - 440 - Gupta_MacKay... · Leases (ASC 842) Transitioning to the new...

Leases (ASC 842)

Transitioning to the new standard

Tuesday, March 21, 2017

► This material has been prepared for general informational purposes only and is not intended to berelied upon as accounting, tax or other professional advice. Please refer to your advisors for specificadvice.

► The views expressed by presenters are not necessarily those of Ernst & Young LLP.

Disclaimer

Introductions

Topics of discussion

State of the industry

Q&A

Appendix


Moderator Shanti GuptaSenior Manager, Financial Accounting Advisory ServicesErnst & Young LLP

Panelists Rob AuslanderVice President Technical Accounting and PoliciesValeant Pharmaceuticals International

Kevin MackayVice President, Accounting Advisory ServicesPfizer, Inc.

Joe FitzgeraldSenior Manager, Financial Accounting Advisory ServicesErnst & Young LLP

Introductions

Introductions



Q&A

Appendix


Policy elections

Future state

Process

Other operational considerations

Systems and technology

Embedded leases

Lease and non-lease components

Lease term

Discount rate

Transition considerations


Introductions



Q&A

Appendix


Survey profile

The industry

Pharmaceutical

44%

Biotech

25%

Medical device

28%

Health care

3%

Net annual revenues(in US dollars)

Less than $1billion35%

$10-$20billion19%

$1-$10billion44%

More than $20billion34%

Less than $1 billion3%

Management of common leased asset types

Real estate

Morecommon

Lesscommon

100%

75%

IT equipment

Fleet

Plant, machinery, andR&D equipment

63% 11% 26%

30% 33% 33% 4%

26% 30% 33% 11%

19%7% 56% 19%

Centralized Decentralized Hybrid N/A

Where is the industry on the journey?

75% of companies have started adopting the new standard. Here’s the stepsthey’ve started/completed.

Planning andinitial

education

Datacompilation

and gapassessment

Identificationof embedded

leases

Policyevaluation

Future statedetermination

Processevaluation

Technologyevaluation

Preliminaryquantification

95%

76%

48%

33% 33%24%

43%

29%

Not material financial impact ≠ No significant effort toimplement the standard

Expected financial impact Level of effort

Material 36%

Not material32%

Don’t know/too early

32%

Significant 75%

Not significant 14%

Don’t know / too early11%

While 75% of survey respondents said adoptingthe new standard would require significant effort,56% of those respondents indicated that the effortwould take a moderately to very significantamount of time (greater than 2,500 hours).

!

Top operational challenges (in decreasing order)

► Compiling relevant lease data for analysis andaccounting

► Designing, selecting and/or implementing a new leaseaccounting solution

► Identifying and tracking arrangements with potentialembedded leases

► Developing and implementing framework for evaluationof options and application of judgments

► Implementing new processes or significant changes tocurrent processes

Most survey respondents think implementation ofthe standard would primarily engage theirTechnical Accounting, Commercial Operations,and Information Technology departments.!

Embedded leases

Do companies have third party supply arrangements / toll manufacturing inwhich they control the production output via a variable supply contract?

Yes59%

No15%

Do notknow26%

Only 19% of “Yes” surveyrespondents classify thesemanufacturing assets asembedded leases today!

Do you expect to implement a new lease accountingsolution?

Yes – a single solution for both real estate and non-real estate (31%)

Yes – separate solutions for real estate and non-real estate (11%)

Yes – not yet sure whether single or separate solutions for real estateand non-real estate (27%)

No (4%)

Don’t know / too early (27%)

Introductions



Q&A

Appendix


Lessees - recognition of assets and liabilities on balance sheet for most leases

Lessors - modification of today’s classification criteria and accounting for sales-type anddirect financing leases

All entities - elimination of today’s real estate-specific provisions

Leases would be classified using criteria similar to current US GAAP without the bright lines

New presentation and disclosure requirements

OverviewWhat’s changing?

OverviewNew accounting model

► Right-of-use asset► Lease liability

Balance sheet

Income statement

Lessor: similar to current US GAAP with somechanges:► Certain concepts would be better aligned with the

revenue recognition standard, and the guidancewould modify the accounting for sales-type anddirect financing leases

► Leveraged lease accounting would be eliminatedfor new leases after the effective date

Leased asset

Lessee

Lease classification

Financelease

Operatinglease

Sales-typelease

Operatinglease

Directfinancing

lease

Lease classification

► Finance lease - generally “front-loaded”interest and amortization expense

► Operating lease - generally straight-line leaseexpense

Lease considerationLessor

OverviewScope and definition of a lease

► Both standards apply to leases of PPE► They do not apply to:

► Leases of inventory, assets under construction, intangible assets and biologicalassets, including timber

► Leases to explore for or use minerals, oil, natural gas and similar non-regenerativeresources

An agreement conveying the right to use property, plant, or equipment (PPE) usually fora stated period of time

A contract, or part of a contract, that conveys the right to control the use of identified PPE(an identified asset) for a period of time in exchange for consideration

ASC

840

ASC

842

OverviewDefinition of a lease - ASC 842

Yes

Customer

YesNo

Yes

Neither; how and what purpose is predetermined

Yes

Supplier

No

No

No

No

Is there an identified asset?

Does the customer / supplier have the right to direct how and for whatpurpose the identified asset is used throughout the period of use?

Does the customer have the right to obtain substantially all of theeconomic benefits from the use of the identified asset

throughout the period of use?

The contract is or contains a lease The contract is not or does notcontain a lease

Does the customer have the right to operate the asset throughout theperiod of use without the supplier having the right to change those

operating instructions?

Did the customer design the asset (or specific aspects of the asset)in a way that predetermines how and for what purpose

the asset will be used throughout the period of use?

► Model for identifying a lease has changed:► ASC 840 definition is more focused on quantitative considerations► ASC 842 definition is more focused on decision-making rights

► Shift in focus may change conclusions for arrangements that were leases under ASC840 due to customer taking substantially all of output

► Definition is the new on/off balance sheet trigger► Judgment will be required when applying the definition of a lease to certain

arrangements

OverviewDefinition of a lease - what’s changing?

Generally expect leases under ASC 840 to be leases under ASC 842

► Customer enters into a 3-year agreement for Supplier to provide products meeting theCustomer’s specifications

► Customer and Supplier agree that the Supplier’s facility located in Baltimore, Maryland,will be used to produce the specialized products

► Supplier designed and constructed the facility► Customer must take 100% of the facility’s production capacity and cannot determine or

change the output during the contract► Supplier will charge Customer a price determined by the Supplier’s operating costs plus

an agreed-upon margin► Supplier has the right to make all operating and management decisions involving the

use of the facility

OverviewDefinition of a lease - contract manufacturing arrangement example

ASC 840 analysis ASC 842 analysisPPE must be specifically identifiedü Facility is explicitly identified in the arrangement

Arrangement contains an identified assetü Facility is explicitly identified in the arrangement, andü Supplier does not have substantive substitution rights

Arrangement conveys to the customer the right tocontrol the use of the specified PPEü It is remote that another party (or parties) will take

more than a minor amount of the output of thePPE (customer takes 100% of the output), and

ü Pricing of the arrangement is not fixed per unit ofoutput or at market at delivery

û Customer has the ability or right to operate (ordirect others to operate) the PPE while takingmore than a minor amount of the output

û Customer has the ability or right to controlphysical access to the PPE while taking morethan a minor amount of the output

Customer has the right to obtain substantially all of theeconomic benefits from use of the identified assetü Customer will take 100% of the output of the asset

Customer has the right to direct the use of the identifiedassetû Customer has the right to change how the facility is

used or what and when it producesû Customer has the right to operate, or direct others to

operate, the facilityû Customer designed the facility

ü Lease under ASC 840 û Not a lease under ASC 842

OverviewDefinition of a lease - ASC 840 vs. ASC 842 analysis

► What if Customer had the right to change the products produced by the facility duringthe 3-year period of use?

► What if Customer had the right to determine when and how many products the facilitywill produce throughout the period of use?

► What if Customer designed the facility in a manner that predetermined how and forwhat purpose the facility would be used?

► What if the arrangement did not specify that Supplier must use the Baltimore facility?

OverviewDefinition of a lease - contract manufacturing arrangement: ASC 842

Some arrangements will require a significant level of judgment

► Four classification criteria with bright-lineindicators

► Applied at lease inception► Real estate-specific considerations► Lessees:

► Operating leases► Capital leases

► Lessors:► Operating leases► Sales-type leases► Direct financing leases► Leveraged leases

► Two additional lessor classification criteria

► Five classification criteria without bright-lineindicators

► Applied at lease commencement► Elimination of real estate-specific guidance► Lessees:

► Operating leases► Finance leases

► Lessors:► Operating leases► Sales-type leases► Direct financing leases

► One additional lessor classification criterion

ASC 840 ASC 842

OverviewLease classification

OverviewLease term and purchase options

► The FASB indicated that “reasonably certain” has the same meaning as “reasonablyassured” in ASC 840► Reasonably certain is generally interpreted as a high threshold

► Purchase options are assessed in the same way as options to extend the lease term orterminate the lease

Any noncancellable periods

Periods covered by an option to extend the lease if the lessee is reasonably certain toexercise that option

Leas

ete

rm

Periods covered by an option to terminate the lease if the lessee is reasonably certain notto exercise that option

Periods covered by an option to extend (or not terminate) the leasein which the exercise of the option is controlled by the lessor

OverviewLease payments

► Lease payments should be consistent with the lease term determination

Lease paymentsFixed payments,

including in-substance fixedpayments, less

any leaseincentives paid or

payable to thelessee

Exercise price of apurchase option*

Payments forpenalties for

terminating thelease**

Variable leasepayments thatdepend on anindex or rate

* Include only if reasonably certain of exercise** Include unless reasonably certain that the lessee will not exercise an option to terminate the lease

► Also include executory costs (insurance and taxes) and fees paid by the lessee to theowners of a special-purpose entity for structuring the transaction

► Variable lease payments that do not depend on an index or rate (e.g., performance- orusage-based payments) are excluded from lease payments► Recognize expense as incurred (lessees) or income as earned (lessors)

Amounts it isprobable that thelessee will oweunder residual

value guarantees(lessees only)

OverviewLease and non-lease components

► Contracts may contain a lease coupled with an agreement to purchase or sell othergoods or services (non-lease components)► Non-lease components are identified and accounted for separately from the lease

component in accordance with other US GAAP► As a practical expedient, lessees can make an accounting policy election (by class of

underlying asset) to account for each separate lease component of a contract and itsassociated non-lease component(s) as a single lease component

► Lessees generally allocate consideration in the contract to the lease and non-leasecomponents (unless the practical expedient is elected) on a relative stand-alone pricebasis

► Lessors generally apply ASC 606 to allocate consideration in the contract between thelease and non-lease component(s) of the contract on a relative stand-alone sellingprice basis

In a change to practice, payments for some lease-related executory costs(e.g., maintenance activities) would be non-lease components

OverviewDiscount rates► Lessors use the rate implicit in the lease that causes the following:

► Lessees use their incremental borrowing rate when the rate implicit in the lease cannotbe readily determined

► Lessees that are not public business entities (PBEs) are permitted to make anaccounting policy election (for all leases) to use a risk-free rate determined using aperiod comparable with the lease term

The present value(PV) of leasepayments made bythe lessee for theright to use theunderlying asset

The PV of theamount the lessorexpects to derivefrom the underlyingasset following theend of the leaseterm

Fair value of theunderlying assetminus any relatedinvestment taxcredit retained andexpected to berealized by thelessor

Any deferred initialdirect costs of thelessor

+ +=

► The new standard requires lessees to reassess items such as whether an arrangementcontains a lease, lease term, lease payments, discount rates, classification, etc., incertain circumstances

► Reassessment could result in a change to the right-of-use and lease liability on thebalance sheet

► Companies will need to develop processes and controls to ensure reassessments areperformed on a timely basis

OverviewLessee accounting - modifications and reassessments

Overview of ASC 840 and ASC 842Lessee disclosures - ASC 842

Dis

clos

ure

obje

ctiv

e

Qualitative disclosures

► Information about nature of leases, including how variable lease payments aredetermined, existence of options and restrictions/covenants

► Significant assumptions/judgments made in accounting► Information about leases that have not yet commenced but create significant rights and

obligations to lessee► Lease transactions between related parties

Quantitative disclosures

► Finance lease cost, operating lease cost, short-term lease cost, variable lease cost,sublease income, net gain/loss on sale-leaseback transactions, etc.

► Cash paid for amounts in lease liability, weighted average remaining lease term andweighted average discount rate - each separated by lease type

► Maturity analysis of lease liability separated by lease type and reconciled to thebalance sheet

Prior periods presented

SAB Topic 11.M

2021201920182016

Effective

Publicentities*

2017

Early adoptionpermitted

All other entities

2020

Prior periodspresented

* Public entities include public business entities and certain not-for-profit entities andemployee benefit plans.

► The transition provisions are applied using a modified retrospective approach► Full retrospective adoption is prohibited

ASC 842 effective date and transitionEffective date and transition

ASC 842 effective date and transitionTransition practical expedients as a package (all or nothing)

Practical expedients If elected If not elected

Do not reassessexistence of leases

► No requirement to reassess expired orexisting contracts except when contractswere not correctly assessed under ASC840

► Arrangements that are leases underASC 840 but not under ASC 842 willbe recorded on the balance sheet ontransition date

► All arrangements, includingarrangements that are not leasesunder ASC 840, will be required tobe reassessed under ASC 842

Do not reassess leaseclassification

► Lease classification under ASC 840 willcontinue under ASC 842

► Recognize lease liability at presentvalue of remaining lease paymentsdetermined under ASC 840

► Subsequent modifications will require areassessment of lease classification

► Reassess lease classificationunder ASC 842

► Recognize lease liability atpresent value of remaininglease payments under ASC 842

Do not reassessmeasurement of initialdirect costs

► No additional efforts to reassess initialdirect costs

► Additional efforts to reassessinitial direct costs

ASC 842 effective date and transitionPractical expedients that may be elected individually

Practical expedients If elected If not elected

Transition: Use ofhindsight► Determination of

lease term► Identification of

impairment

► Look to previous experience to assess ifrenewal, termination or purchase optionsare reasonably certain to be exercisedand whether assets are impaired

► Potentially reduces likelihood ofremeasurement after transition as leasesare capitalized based on assessment oflease terms and impairment on thetransition date

► Evaluation of options must bemade independent of previousexperiences

Not to separate lease andnon-lease components► Election by class of

underlying asset► For lessees only

► Likely higher amount of right-of-use(ROU) asset and lease liability

► Potential lack of comparability betweenleases on transition date and new leasesafter transition date

► Separate sets of accounting recordsmay need to be maintained for leasesexisting on transition date and newleases entered into after transition date

► ROU asset and lease liabilitybased on payments for leasecomponents only

► Allocation of contractconsideration between lease andnon-lease components will berequired

Short-term lease► Election by class of

underlying asset► For lessees only

► Do not recognize lease on the balancesheet

► Recognize lease on the balancesheet

► Leases accounted for pursuant to the transition provisions may be accounted for differently thannew leases commencing on or after the effective date until the old leases are modified orreassessed

► Effectively results in two separate processes and potentially separate systems being required:

► Leases that exist prior to the effective date that are accounted for under the transition guidanceof ASC 842

► Leases entered into on or after the effective date accounted for using all of ASC 842’sprovisions

ASC 842 effective date and transitionLeases commencing prior to effective date

Leases commencing prior to the effective date maynot be accounted for using all of ASC 842’s provisions

Futurestate

Currentstate

1. Understand current stateof leasing activities(e.g., lease procurement,administration andaccounting and reporting)

2. Identify changes resulting fromthe new leases standards (e.g.,data gaps, processes, controls,systems and tax)

5. Transition to the newleases standards

3. Design solution for accountingchange(e.g., new accounting policies,processes, controls and systems)to capture new lease datarequirements and understandfinancial statement impact

4. Implement new accountingpolicies, processes,controls and systems, aswell as changes to financialstatements and disclosures

Understand the new leases standards

Operational considerationsThe journey ahead - challenges and opportunities

► Completeness of lease portfolio► Data to support accounting and disclosures► Process► Systems

Operational considerationsFour primary areas

Operational considerationsCompleteness of lease portfolio

► Does entity have an inventory of all lease arrangements?► Does entity have a good understanding of the different terms and conditions in a lease

arrangement?► Are there any arrangements that could be affected by the revised definition

of a lease?► What are the types of service arrangements that may contain a potential embedded lease, how

many arrangements and where located?► Will management be required to make more or different judgments when evaluating contracts?

► Compiling and validating data to support accounting and disclosures under ASC 842 will likely bethe most important challenge for many organizations

► Efforts for data compilation and validation will be influenced by:

► Contract terms and complexity of the lease arrangement

► Data gap between what is required and what is maintained today

► Alignment with the lease administration process under future state

► Data transition strategy such as requesting lessor to provide relevant data elements

► Strategy for dual reporting (US GAAP and IFRS statutory reporting)

Operational considerationsData to support accounting and disclosures

Operational considerationsWhat data required for lease accounting can be found in a contract?

Non-leasecomponentelection?

Stand-aloneprice

Asset underconstruction?

Sale andleaseback?

Fair value Remainingeconomic life

Remaininguseful life

Paymentamount

Paymentfrequency

Residualvalue

guarantee

Discount rate

Optionpaymentamount

Optionpaymentfrequency

Optionpayment date

Optioncontrolled by

lessor?

Non-leasecomponent(s)

Leaseexpiration

date

Payment date

Right-of-useend date

Contractcurrency

(Lease) assettype category

Name ofcustomer(lessee)

Name ofsupplier(lessor)

Contractlanguage

Optionpaymentamount

Optionpayment date

Optioncontrolled by

lessor?

Optionreasonably

certain to beexercised?


Optionpaymentamount

Optionpayment date

Optionreasonably


Leaseincentives


Leasecomponent(s)

Leasecommence-ment date

Number ofpayments

Optionnotification

date

Assetidentifier

Leaseinception date

Type ofpayment

Renewaloption

Contractname

Contractreference ID

Optionnotification

date

Terminationoption

Optionnotification

date

Purchaseoption

Sublease?

Short-termelection?

Low-valueasset

election?

Is thearrangement

a lease?

Transitionelection –

reassessmentpackage?

Optionreasonably


Transitionelection -reassesslease?

Transitionelection -hindsight?

Initial directcosts

Transfer ofownership?

Estimatedcost to

dismantle/restore asset

Specializedasset?

Disclosureinformation

Current leaseaccounting

classification

Unamortizedinitial direct

costs

Unamortizedlease

incentives

Capital leaseobligationbalance

Transitionelection -hindsight?

Transitionelection -

ROU assetmeasurement

Capital leaseasset balance

Transitionmethod

Prepaid/accrued lease

payments

Abstracted fromcontract

Potentially abstractablefrom contract* IFRS additional data* Transition data*Management judgment

and estimate

23% 30% 47% (other data - not in a contract)Legend

* If applicable

Operational considerationsHow does abstractable data compare with data required for lease accounting?

23% 30% 47% (other data - not in a contract)

Abstracted fromcontract

Potentiallyabstractable from

contractTransition data

Managementjudgment and

estimate

IFRS additionaldata

These data fields arenot in a contract and

requiremanagement‘sjudgments and

estimates.

Process may berequired to develop

and document policydecisions and

judgment framework.

These are data fieldsthat are potentially

abstractable if itapplies to the contract.

Process may berequired to abstract

these data, ifapplicable.

These data fieldsare not in a

contract and arerequired if IFRS isapplicable (e.g., forstatutory reportingof subsidiaries).

Process may berequired to

evaluate anddocument the

elections specific toIFRS and maintaindual set of data for

US GAAP andIFRS.

These data fields arenot in a contract and

are required fortransition to the new

leases standard.

Process may berequired to enrich thedata fields based ontransition elections

and carrying balancesfrom accounting

records.

For mostcontracts,

these are datafields

representingstandard termsand conditions

that wouldlikely be

electronicallyabstracted.

► Broader impact beyond accounting:► Lease strategy► Lease administration► Disclosures, policies and procedures► Training► Internal controls► Systems, investor relations, tax etc.

► Likely change to current processes and/orimplementation of new processes

► Opportunity to enhance/refine currentbusiness processes for efficiency andpotential cost savings

Operational considerationsProcess

Controllers

IT

Procurement/Shared services

Local/businessfinance

LeaseAdministration

& Reporting

TaxLegal andTreasury

Operational considerationsInteraction between lease administration and accounting process

Significant impactSome impact New

Determinelease

classification

Determinewhether

arrangementis a lease

Calculate newlease

accountingrequirements

Real estate

Office furnitureand fixtures

IT

Machineryequipment

Fleet (auto/transportation)

Generalledger

Financialstatement

presentationand

disclosure

Manage leasepayables,

including CPIincreases and

variablepayments and

CAM adjustments

Exercise leaseterm options (i.e.,

renewals,termination and

purchase options)or lease

amendments

End of term:return

leased asset

Leaseprocurement,lease vs. buy,

leaseabstraction

Leas

ead

min

istra

tion

Leas

eac

coun

ting

New system for lease accounting? Newmodule?

Reassessment andre-measurementwhere necessary

► Key challenges for many organizations will include:► Implementing a single solution that will meet requirements for both real estate and non-real

estate leases► Implementation of an interim solution to facilitate data compilation and preliminary analysis

before transitioning to a long-term solution► Implementing a solution that will meet accounting and reporting requirements under both US

GAAP and IFRS (statutory reporting where applicable)► Balancing needs of administration/operations and accounting

► System selection is a critical step in the journey and must be evaluated after organizations haveobtained a good understanding of the:► Lease portfolio, including embedded leases► Data requirements► Accounting and reporting requirements► Desired future state► Needs of relevant stakeholders

Operational considerationsSystems

SummaryWhat makes it complex?

1 Modified retrospective transition: There are many specifictransition requirements and practical expedients to consider.

2 IT systems, processes and controls: Implementation will likelyrequire new IT applications, process and controls.

3 Resource allocation: Management will want to make sure it hassufficient resources for implementation.

4 Judgments and estimates: The new standard will likely require morejudgments and estimates.

Interaction with other guidance: Understanding the interaction ofthe new leases standard with the new revenue recognition standardwill be key to successful implementation for lessors.

5

EY | Assurance | Tax | Transactions | Advisory

About EYEY is a global leader in assurance, tax, transaction andadvisory services. The insights and quality services we deliverhelp build trust and confidence in the capital markets and ineconomies the world over. We develop outstanding leaderswho team to deliver on our promises to all of our stakeholders.In so doing, we play a critical role in building a better workingworld for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one ormore, of the member firms of Ernst & Young Global Limited,each of which is a separate legal entity. Ernst & Young GlobalLimited, a UK company limited by guarantee, does not provideservices to clients. For more information about ourorganization, please visit ey.com.

Ernst & Young LLP is a client-serving member firm ofErnst & Young Global Limited operating in the US.

© 2017 Ernst & Young LLP.All Rights Reserved.

ED None

This material has been prepared for general informational purposesonly and is not intended to be relied upon as accounting, tax, or otherprofessional advice. Please refer to your advisors for specific advice.

ey.com

Leases (ASC 842) - cbinet.com - 440 - Gupta_MacKay... · Leases (ASC 842) Transitioning to the new...

Documents

Transcript of Leases (ASC 842) - cbinet.com - 440 - Gupta_MacKay... · Leases (ASC 842) Transitioning to the new...