CBIZ MHM Executive Education Series Oddities in Leasing

CBIZ & MHM Executive Education Series™ Oddities in Leasing: Don’t Let These Provisions Be the Odd Thing Out of Your Implementation Plan Heather Winiarski & Hal Hunt July 24, 2019 Questions? Email cbizmhmwebinars@cbiz. com 1

About Us • Together, CBIZ & MHM are a Top Ten accounting provider • Offices in most major markets • Tax, audit and attest and advisory services • Over 2, 900 professionals nationwide A member of Kreston International A global network of independent accounting firms MHM (Mayer Hoffman Mc. Cann P. C. ) is an independent CPA firm that provides audit, review and attest services, and works closely with CBIZ, a business consulting, tax and financial services provider. CBIZ and MHM are members of Kreston International Limited, a global network of independent accounting firms. Questions? Email cbizmhmwebinars@cbiz. com 2

Before We Get Started… • Use the control panel on the right side of your screen to: • Change your audio mode • Submit questions • Download handouts • If you need technical assistance: • Call support at 877 -582 -7011 • Email us at cbizmhmwebinars@cbiz. com Questions? Email cbizmhmwebinars@cbiz. com 3

CPE Credit This webinar is eligible for CPE credit. To receive credit, you will need to answer polling questions throughout the webinar. External participants will receive their CPE certificates via email within 15 business days of the webinar. Questions? Email cbizmhmwebinars@cbiz. com 4

Disclaimer The information in this Executive Education Series course is a brief summary and may not include all the details relevant to your situation. Please contact your service provider to further discuss the impact on your business. Questions? Email cbizmhmwebinars@cbiz. com 5

Presenters Heather is a shareholder in the Kansas City office. Her responsibilities include supervising medium to large audit engagements, and resolving critical audit and risk issues. Heather serves as a subject matter expert on lease accounting for MHM's Professional Standards Group. She specializes in the use of computer-assisted audit tools and techniques (CAATTs) to analyze large amounts of data and look for irregularities and leads MHM's IDEA Champions Group. HEATHER WINIARSKI, CPA 816. 945. 5168 • hwiniarski@cbiz. com • @Mc. Wini. CPA Shareholder Questions? Email cbizmhmwebinars@cbiz. com 6

Presenters Hal, is a Shareholder in the Kansas City office with more than 35 years of experience in public accounting working with manufacturing, distribution and other service-based companies. Hal is a member of the firm's Professional Standards Group as subject matter expert on Leasing, Business Combinations and Employee Benefit Plan Audit and Accounting Matters. Hal also leads MHM’s Employee Benefit Plan Audit Practice. 816. 945. 5610 • hhunt@cbiz. com HAL HUNT, CPA Shareholder Questions? Email cbizmhmwebinars@cbiz. com 7

Agenda 01 Sale and Leaseback Accounting 02 Build-to-Suit Leases 03 Transition and Effective Dates 04 Other Changes and Emerging Issues Questions? Email cbizmhmwebinars@cbiz. com 8

Polling Question Do you have of the following? § Sale and leaseback § Failed sale and leaseback § Both § Neither 9

SALE AND LEASEBACK ACCOUNTING Questions? Email cbizmhmwebinars@cbiz. com 10

Sale-and-Leaseback Accounting • The lease, in isolation, does not preclude the seller • • lessee from concluding a sale has occurred (842 -40 -25 -2) If the leaseback is determined to be a finance lease, then the transaction is treated as a financing rather than a sale (842 -40 -25 -2) If the leaseback is determined to be an operating lease, use the principles in the new revenue recognition standard to determine if a sale has occurred (even if not yet adopted) (842 -40 -25 -1) Questions? Email cbizmhmwebinars@cbiz. com 11

Sale-and-Leaseback Accounting (continued) • Real estate and equipment have the same rules • Consistent with the new revenue recognition standard, a repurchase option will preclude sale treatment unless: • The option is exercisable only at thenprevailing fair market value of the leased asset and • The leased asset is non-specialized and readily available in the marketplace (842 -40 -25 -3) Questions? Email cbizmhmwebinars@cbiz. com 12

Sale-and-Leaseback Accounting (continued) • Gains and losses on sale that meet the criteria for • • sale-and-leaseback accounting are recognized in income immediately (adjusted for off-market terms, if not with a related party) (842 -40 -30 -2) The leaseback will be accounted for in the same manner as any other lease (842 -40 -25 -4) A “failed” sale-and-leaseback transaction will be accounted for as a financing transaction (842 -40 -25 -5) Questions? Email cbizmhmwebinars@cbiz. com 13

BUILD-TO-SUIT LEASES Questions? Email cbizmhmwebinars@cbiz. com 14

Build-to-Suit Leases • Typically, a real property developer builds out space according to a tenant’s specifications. • These are sale-and-leaseback transactions, where a seller transfers the asset to and then leases it back from a buyer. • ASC 842 makes significant changes to current build-to -suit rules. Questions? Email cbizmhmwebinars@cbiz. com 15

Build-to-Suit Leases (continued) • A lessee will recognize the entire construction project on its balance sheet during construction only if the lessee “controls” the asset during construction (842 -40 -55 -5) • Considered a sale under ASC 606 and • Leaseback cannot be a sales-type of finance lease and contains a repurchase option at fair • value If the lessee does not “control” the project during construction, any amounts paid by the lessee during construction will be treated as prepaid lease payments (842 -40 -55 -4) Questions? Email cbizmhmwebinars@cbiz. com 16

Build-to-Suit Leases (continued) • Many build-to-suit arrangements are unlikely to be considered leases under ASC 842 and will be off balance sheets. Some public company examples are: • Tesla’s solar-energy leases will now be accounted for under ASC 606 because they will no longer meet the threshold for lease accounting under ASC 842. • Southwest Airlines has assets and liabilities for build-tosuit arrangements on its balance sheet that are expected to be derecognized, except for one project to be recognized as a lease liability due to the company’s guarantee of bond payments. Questions? Email cbizmhmwebinars@cbiz. com 17

TRANSITION AND EFFECTIVE DATE Questions? Email cbizmhmwebinars@cbiz. com 18

Transition • Two methods: “prospective” or a “modified retrospective” • The latter method requires the restatement of previously filed • financial statements. • PROs--It provides comparability between periods • CONs--It has high implementation costs FASB ASU 2018 -11, allows companies to not recast previously filed financial statements. • The impact is recorded as of adoption date, which is January 1, 2019 for calendar year-end companies. • More than half of the examined companies have already indicated that they plan to use the relief provided by FASB based on a recent study by Audit. Analytics Questions? Email cbizmhmwebinars@cbiz. com 19

Transition (continued) • Modified retrospective transition (842 -10 -65 -1) • Required for all leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements • Lessees may use hindsight in evaluating whether payments for lease renewals or purchase options should be included in lease payments for existing leases Questions? Email cbizmhmwebinars@cbiz. com 20

Transition (continued) • Lessees have the option to elect the following specified reliefs at transition, which must be elected as a package and must be applied to all leases: • Do not reassess whether any expired or existing contracts are or contain leases • Do not reassess lease classification for any expired or existing leases • Do not reassess capitalization of initial direct costs Questions? Email cbizmhmwebinars@cbiz. com 21

Transition (continued) • Failed build-to-suit arrangements that the lessee did not control during construction • Modified retrospective transition • Derecognize those assets and liabilities at the later of (a) the date of initial application and (b) the date that the lessee is determined to be the accounting owner of the asset under existing guidance with any difference recognized as an adjustment of equity • Follow the general lessee transition guidance for the lease as if the lease had not been accounted for as a failed build-to-suit arrangement Questions? Email cbizmhmwebinars@cbiz. com 22

Transition (continued) • Sale and leaseback transactions • Leases that qualified for sale-and-leaseback accounting under current guidance are not reassessed • Failed sale-and-leaseback transactions under current guidance that meet the new guidance for a sale-andleaseback • Same modified retrospective transition as failed build-tosuit transactions Questions? Email cbizmhmwebinars@cbiz. com 23

Transition Disclosures • A lessee should disclose: • The nature of and reason for the change in accounting • The method of applying the change in accounting, including: • A description of the prior-period information that has been retrospectively adjusted • The cumulative effect of the change on retained earnings • A lessee that issues interim period financial statements should provide the required disclosures in both the interim period of change and the annual period of change Questions? Email cbizmhmwebinars@cbiz. com 24

Effective Date • Public business entities (includes employee benefit plans that file financial statements with the SEC and not-for-profit entities that have issued securities that are traded, listed, or quoted on an exchange or an over-the-counter market) will be required to apply the new lease standard for interim and annual periods in fiscal years beginning after December 15, 2018 Questions? Email cbizmhmwebinars@cbiz. com 25

Effective Date (continued) • Other entities will be required to apply the new lease standard for annual periods in fiscal years beginning after December 15, 2019 and for interim periods in fiscal years beginning after December 15, 2020 • Early adoption is permitted Questions? Email cbizmhmwebinars@cbiz. com 26

Polling Question What is your level of readiness? § Not started § Just started § Halfway § Almost done or done 27

OTHER CHANGES AND EMERGING ISSUES Questions? Email cbizmhmwebinars@cbiz. com 28

Embedded Leases may be embedded within service, outsourcing, and maintenance contracts, such as: • Warehousing contracts – these are viewed as outsourcing contracts, but the agreement may contain language that meets the standards of a lease. • Security contracts – these are service contracts, but if they also contain access to scanners or equipment, those can be considered embedded leases. • Transportation contracts – these contracts may contain embedded leases for the trucks that are being used. • Data storage contracts – much like warehousing contracts, these agreements could include embedded leases for both the servers or the space the servers are stored. Questions? Email cbizmhmwebinars@cbiz. com 29

Unit of Account • Leases may include a number of different underlying assets. The right to use an underlying asset is a separate unit of account if both of the following criteria are met: • The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee • The right to use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract (842 -10 -15 -28) • If material, land is a separate unit of account Questions? Email cbizmhmwebinars@cbiz. com 30

Treatment of Options • Purchase options and renewal options • Include such options when determining the lease term, classifying the lease, and measuring the lease obligation if it is reasonably certain the lessee will exercise the option (842 -10 -30 -1 and 842 -10 -30 -5) • Reasonably certain is intended to equate to reasonably assured in today’s literature Questions? Email cbizmhmwebinars@cbiz. com 31

Residual Value Guarantees • Include the maximum amount of any residual value guarantee when determining lease classification (842 -10 -25 -2(d)) • Include the amount of residual value guarantee payment expected to be paid when measuring the lease obligation (842 -10 -30 -5(f)) Questions? Email cbizmhmwebinars@cbiz. com 32

Residual Value Guarantees (continued) Lessees are required to remeasure their lease liability if their estimate of the amount expected to be paid under a residual value guarantee changes (842 -10 -354) • Any change in the liability is recognized as an adjustment to the right-of-use asset (842 -20 -35 -4) • Reassessment of lease classification is not required Questions? Email cbizmhmwebinars@cbiz. com 33

Discount Rate • The discount rate is the rate implicit in the lease (842 -20 -30 -3) • If the rate implicit in the lease cannot be readily determined, the lessee should use its incremental borrowing rate • Nonpublic business entities can make an accounting policy election to use the risk-free rate Questions? Email cbizmhmwebinars@cbiz. com 34

Discount Rate (continued) The following items are included when computing the rate implicit in the lease (842 -10 -20): • Fair value of the underlying asset at lease commencement • Lease payments • Initial direct costs of the lessor (exclude for leases where fair value and carrying amount of the underlying asset are different) • Value the lessor expects to derive from the underlying asset following the end of the lease term Questions? Email cbizmhmwebinars@cbiz. com 35

Initial Direct Costs Only incremental costs qualify as initial direct costs (842 -10 -30 -9 and 842 -10 -30 -10) • That is, only costs that would not have been incurred if the lease had not been executed • This definition is consistent with the FASB’s definition of initial direct costs in its new revenue standard • Commission paid to a broker upon successful execution of the lease is an example of an initial direct cost • Legal fees paid related to reviewing the draft lease would not qualify as initial direct costs as those fees would be payable even if the lease is not executed Questions? Email cbizmhmwebinars@cbiz. com 36

Initial Direct Costs (continued) Under ASC 842, FASB changed how it defines indirect costs when it comes to lease origination costs. That could mean there will be fewer indirect capitalized costs. Executory costs, like property taxes or insurance, will be considered part of lease payments. Questions? Email cbizmhmwebinars@cbiz. com 37

Initial Direct Costs (continued) One public company example is Federal Realty Investment Trust, which notes that some indirect lease expenses that were previously capitalized will now be expensed: • “We will no longer be able to capitalize certain internal leasing and external legal leasing costs. For the nine months ended September 30, 2018, we have capitalized approximately $5. 3 million of internal leasing and external legal leasing costs, of which a portion will be expensed when we adopt ASU 201602. ” Questions? Email cbizmhmwebinars@cbiz. com 38

Impairment Right-of-use assets, for both types of leases, will be subject to the existing impairment guidance in ASC 360, Property, Plant, and Equipment (842 -20 -35 -9) • If an impairment is recognized related to an operating lease right-of-use asset, the right-of-use asset subsequently should be amortized on a straight-line basis (like a finance lease) (842 -20 -25 -7) Questions? Email cbizmhmwebinars@cbiz. com 39

Statement of Financial Position • Lessee should either present as separate line items on statement of financial position or disclose in the notes finance lease and operating lease right-of-use assets and the balance-sheet line items that include those assets (842 -20 -45 -1) • A lessee is prohibited from presenting finance lease and operating lease right-of-use assets within the same line item (842 -20 -45 -3) • The same requirements apply to presentation of the lease liabilities Questions? Email cbizmhmwebinars@cbiz. com 40

Statement of Income • Operating leases • • Rent expense in the statement of income is a single amount (do not separate amortization of the asset from interest expense on the liability) (842 -20 -25 -6) Finance leases • Interest cost on the lease liability is recognized as interest expense in the statement of income (842 -20 -45 -4) • The amortization of the right-of-use asset will be recognized separately in the statement of income (842 -20 -45 -4) • Absent unusual facts, the right-of-use asset will be amortized on a straight-line basis Questions? Email cbizmhmwebinars@cbiz. com 41

Statement of Cash Flows (842 -20 -45 -5) • Cash payments for the principal portion of a finance lease obligation are financing activities • Cash payments for the interest portion of a finance lease obligation are operating activities • Cash payments for operating leases are operating activities Questions? Email cbizmhmwebinars@cbiz. com 42

Polling Question How big of an impact do you expect? § No or a small impact § A moderate impact § A large impact 43

Reassessment Requirements Lessees will be required to continually reassess their lease liability. Events and circumstances that would result in remeasuring the lease liability include (842 -10 -35 -4): • A change in expectation about the exercise of purchase options and renewal options upon the occurrence of a significant event or a significant change in circumstances that is within the control of the lessee • A change in the amount expected to be paid under a residual value guarantee Questions? Email cbizmhmwebinars@cbiz. com 44

Reassessment Requirements (continued) q Variable payments based on an index or rate are reassessed any time the lease liability is remeasured q Lease classification (and discount rate) should be reassessed when there is a change in the lease term or the assessment of whether the lessee is (or is not) reasonably certain to exercise a purchase option Questions? Email cbizmhmwebinars@cbiz. com 45

Accounting for Reassessments • • Increases or decreases in the lease obligation will be offset by an increase or decrease in the right-of-use asset (842 -2035 -4), with the following exceptions: • Changes in variable lease payments based on an index or rate that relate to the current period are recognized immediately in the statement of income • If the carrying amount of the right-of-use asset is reduced to zero, any remaining amount of the remeasurement should be recognized in income Reallocate consideration (842 -10 -15 -36) Questions? Email cbizmhmwebinars@cbiz. com 46

Modifications • A lease modification is defined as any change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (842 -10 -20) • Treat as a new lease, separate from the original lease, when (1) the lease grants the lessee an additional rightof-use asset not included in the original lease and (2) the additional right-of-use asset is priced commensurate with its standalone price (842 -10 -25 -8) Questions? Email cbizmhmwebinars@cbiz. com 47

Modifications (continued) • A modification that only extends the term of a lease would not be accounted for as a separate lease (842 -10 -25 -8) • Modifications that are not treated as a new separate lease (842 -10 -25 -9) • Recognize immediately • A modification could result in a change in lease classification Questions? Email cbizmhmwebinars@cbiz. com 48

Modifications (continued) • If a modification fully or partially terminates a lease (for example, reduces the assets subject to the lease), the lessee should decrease the right-of-use asset on a basis proportionate to the full or partial termination of the lease and recognize a gain or loss (842 -10 -2513) • Otherwise, account for increases or decreases in the lease liability in the same manner as for reassessments (842 -10 -25 -12) Questions? Email cbizmhmwebinars@cbiz. com 49

Purchase of a Leased Asset • Any difference between the purchase price and the carrying amount of the lease liability should be recognized as an adjustment of the carrying amount of the purchased asset with no gain or loss recognized (842 -20 -40 -2) Questions? Email cbizmhmwebinars@cbiz. com 50

Variable Rent Payments • For all leases, recognize variable rent payments (other than the base amount included in the lease liability) in the period in which the variable rent payment is incurred (842 -20 -25 -5 and 25 -6) • Lessees will reassess variable lease payments based on an index or rate only when lease payments are remeasured due to a reassessment or a modification (842 -10 -35 -5) Questions? Email cbizmhmwebinars@cbiz. com 51

Related Party Lease Transactions • Lessees should account for related party leases on the basis of the legally enforceable terms and conditions of the lease (842 -10 -55 -12) • No adjustment is made for off-market terms in a sale and leaseback transaction (842 -40 -30 -4) Questions? Email cbizmhmwebinars@cbiz. com 52

Business Combinations • Classification of acquired leases • • Classify acquired leases using the contractual terms and conditions at the commencement date of the lease (842 -10 -55 -11) • If the lease is modified as part of the business combination, classify the lease using the modified contractual terms and conditions Measurement of a lease acquired in a business combination • Measure the lease liability as if the lease was a new lease at the acquisition date (805 -20 -30 -24) Questions? Email cbizmhmwebinars@cbiz. com 53

Business Combinations (continued) • The right-of-use asset is measured at an amount equal to the liability, adjusted for the following two items: • Off-market lease terms, favorable or unfavorable • Any other intangible assets associated with the lease (805 -20 -30 -24) • The net amount recognized for the lease should approximate the fair value of the lease Questions? Email cbizmhmwebinars@cbiz. com 54

Polling Question Have you talked to the users of your financial statements about these changes? § Yes § No 55

Disclosures (842 -20 -50) • Information about the nature of its leases • General description • Information about variable lease payments • Information about options to renew or purchase • Information about residual value guarantees • Restrictions or covenants imposed by the lease • Information about leases that have not yet commenced • Information about significant judgments and assumptions Questions? Email cbizmhmwebinars@cbiz. com 56

Disclosures (continued) • Quantitative disclosures: • Finance lease cost, separately disclosing amortization and interest expense • Operating lease cost • Short-term lease cost • Variable lease cost • Sublease income • Cash paid for amounts included in the measurement of the lease liabilities, segregated between operating and financing cash flows Questions? Email cbizmhmwebinars@cbiz. com 57

Disclosures (continued) • Supplemental noncash information on lease liabilities arising from obtaining right-of-use assets, segregated between finance and operating leases • Weighted-average remaining lease term, disclosed separately for finance and operating leases • Weighted-average discount rate, disclosed separately for finance and operating leases as of the reporting date • Gains and losses arising from sale-and-leaseback transactions • Maturity analysis of lease liabilities Questions? Email cbizmhmwebinars@cbiz. com 58

Corporate Debt Ratios • ASC 842 will require most companies to report operating leases as liabilities, which can affect debt-to-earnings ratios and loan covenants • Most loan covenants are written based on the GAAP rules in place when the loan is created. If a new GAAP accounting method is implemented, such as ASC 842, debt ratios need to be recalculated. • Companies may need to renegotiate loan terms or maintain another set of books. That means until the loans are due, they would need to run special reports for their creditors using the GAAP rules that were previously valid under the loan terms, but not under current GAAP rules that include the new ASC 842 rules. Questions? Email cbizmhmwebinars@cbiz. com 59

Bank Capital Requirements • The new standard will affect bank capital ratios, which establish to the amount of money regulators require banks to hold. Intangible assets are deducted from bank capital ratios, while tangible assets are not. • There is no specific guidance under ASC 842 on whether right-of-use assets are considered tangible or intangible assets. Deloitte suggests banks look to how the Basel Committee on Banking Supervision regards right-of-use assets. Basel considers right-of-use assets tangible because the underlying asset is tangible and should be risk-weighted at 100%. Questions? Email cbizmhmwebinars@cbiz. com 60

Bank Capital Requirements (continued) A public company example, Wells Fargo considers that its right-of-use assets will increase its risk-weighted assets and decrease its capital ratios (emphasis added): • “At adoption, we expect to have a cumulative effect adjustment of • approximately $140 million to increase retained earnings related to deferred gains on our prior sale-leaseback transactions. The calculation of our operating lease right-of-use assets and liabilities, for approximately 7, 000 leases, are expected to be $5 billion and $5. 6 billion, respectively, and will continue to be refined as we complete our implementation process. “We do not expect material changes to the timing of expense recognition on our operating leases or the recognition and measurement of our lessor accounting. While the increase to our consolidated total assets related to operating lease right-of-use assets will increase our risk-weighted assets and decrease our capital ratios, we do not expect these changes to be material. ” Questions? Email cbizmhmwebinars@cbiz. com 61

? QUESTIONS Questions? Email cbizmhmwebinars@cbiz. com 62

If You Enjoyed This Webinar… Upcoming Courses: • 8/7: Hidden Costs Not-for-Profits Need to Know About • 8/8: Eye on Washington Quarterly Update Q 2 2019 • 8/8: Leasing Considerations for the Construction Industry • 10/2: Third Quarter Accounting and Financial Reporting Issues Update Recent Publications: • The 2020 Campaign and Taxes Part 5: Your Taxes and the Federal Budget • New Lease Accounting to be Delayed • Opportunity to Lessen Tax Liability for Fulfillment By Amazon Sellers in California • Are Your Benefit Plan’s Alternative Investment Generating Taxes? Questions? Email cbizmhmwebinars@cbiz. com 63

Connect with Us MHM CBIZ linkedin. com/company/ mayer-hoffman-mccann-p. c. linkedin. com/company/ cbiz-mhm-llc @mhmcpa @cbizmhm youtube. com/ mayerhoffmanmccann youtube. com/ Biz. Tips. Videos slideshare. net/mhmpc slideshare. net/CBIZInc Questions? Email cbizmhmwebinars@cbiz. com 64

THANK YOU CBIZ & Mayer Hoffman Mc. Cann P. C. cbizmhmwebinars@cbiz. com Questions? Email cbizmhmwebinars@cbiz. com 65