The FASB Lease Accounting Project Overview Issues and

The FASB Lease Accounting Project Overview, Issues and Status May 30, 2013

Agenda • Timing • What is the Project? • Issues and Impacts – Lessees – Lessors • Summary impacts and action plans • Q&A

Project Timeline ED Issued August 2010 Comment Letters Dec 2011 Outreach Redeliberations Jan 2011 – September 2012 Comment Draft New ED To Letters Issued Now Due 5/16/2013 9/13/13 Re-deliberate Final 4 QTR 2013 Standard & into 2014 Timeline is not fixed • Dependent upon number of comment letters and extent of redeliberations • We expect a high volume of negative comment letters • Effective date uncertain – likely to be 2017

Questions addressed by the Boards What is a lease? What is the lease term? What are the lease payments ? How does a lessee allocate cost? How does a lessor recognize income? How to account for short term leases? 4

Definition of a lease • A contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration – Specified asset (PP&E plus certain types of inventory like spare parts) – Right to control the use of a specified asset (different from current GAAP) – No guidance on purchase vs. lease 5

Lease term • Recognized lease term would include non-cancellable period, plus any optional periods where there is a significant economic incentive to extend (or not terminate) the lease (virtually same as current GAAP) • Purchase options – include on a basis consistent with renewal options – Assume exercise if significant economic incentive to exercise exists • Consider all factors (contract, asset, market and entity based) 6

Lease payments • Lease payments include: – – Fixed payments (bundled services must be bifurcated) Variable payments based on index or rate (e. g. , CPI or LIBOR) Termination penalties (if term is assumed not to be renewed) Residual value guarantees, at the amount expected to be paid, if any (lessee only); lessor does NOT include all types of them – Exercise price of purchase option included in lease term • Contingent rents based on performance or usage would be excluded: – Recognized as incurred/accrued – Contingent rents must be truly variable to be excluded (aka not “disguised min lease pmts”) 7

Lease Models “Right to use” leased property Lessor Models Lessee Models Lease payments Short term leases - use op lease method Operating Lease Recognize receivables and residuals Receivable & Residual approach Derecognize leased property Short term leases - use op lease method Right of use model* Recognize liability to make lease payments *2 lease types: SLE (Type B) vs. I&A (Type A) leases with different P&L cost patterns Recognize “right of use” asset Most TRALA leases will be classified Type A for lessees & R&R for lessors

Lease Classification – ROU Model Lessees: • • 2 new lessee types and approaches (except for short term leases) Interest & Amortization (I&A) (Type A) – The lease is capitalized and the asset is amortized straight line and interest is imputed on the liability. – The result is a front ended expense pattern. • Single Lease Expense (SLE) (Type B) – The lease asset and liability are capitalized, then adjusted each month With inoerest imputed on the liability and plugged amortization on the asset to create a single (straight line) lease expense Lessors: • Receivable & Residual (R&R) (Type A) – Record a PV receivable & residual asset, recognize finance income • Operating Lease (OL) (Type B) – Same as FAS 13 method

Lease Classification – ROU Model Lessees: • • Real estate and equipment leases are treated drastically differently. For equipment leases – including most vehicle leases – It is presumed that the lease is an I&A lease for lessees (bad news!) and an R&R lease for lessors (good news!) – Unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the lease payments is insignificant relative to the fair value of the asset – These criteria are radically different for lessees than under existing FAS 13 GAAP so that most equipment leases will have front ended lease costs • For real estate leases – It is presumed the lease is a SLE lease for lessees and operating leases for lessors – Unless the lease term is for the major part of the economic life of the underlying asset; or the present value of fixed lease payments accounts for substantially all of the fair value of the asset. – These criteria are virtually the same as the line under existing FAS 13 GAAP so that most real estate leases will have straight line rent expense • Net result: balance sheet amounts for equipment capital & operating leases are jumbled & analysts won’t be able to adjust to get what they need!!!

Determining lease type So, the million $$$ question – What is insignificant? ? ? • FASB/IASB – no bright lines; joint webinar examples (lease term versus life) Property Commercial real estate (10 yr/40 Yr) I&A SLE Commercial real estate (30 yr/40 Yr) Other Than Property Truck (4 Yr/10 Yr) SLE Vessel (5 Yr/40 Yr) Vessel (20 Yr/40 Yr) I&A Airplane (8 Yr/25 Yr) Car Fleet (3 Yr/6 Yr) Re the PV test 10% has traditionally been the “insignificant” bright line 1111

Lessee Project Summary Lessees: • Capitalizes lease assets & liabilities via complex calculations & adjustments ignoring lease economics • Short term leases can use existing operating lease accounting (off balance sheet) • Estimate lease term & payments (include only bargain/compelling renewals, bargain POs, “rate & index based” contingent rents & value of residual guarantees) and capitalize at incremental borrowing rate with continual adjustments to estimates • Unbundle full service lease payment or else capitalize the whole payment – lease portion should be capitalized, service portion should be expensed as paid • New classification tests – different for real estate and equipment • Real estate lease get straight line rent expense (SLE or single lease expense method) • Equipment lease costs front ended – amortization & imputed interest (I&A or interest and amortization method) • Deferred tax accounting needed for all equipment leases

Front Ending of Lessee Lease Cost Book Expense Imputed Interest Expense + Depreciation Str Line Rent Exp Imputed Int Exp Depreciation of ROU Asset Mid Point Lease Term Expiry

What is the Project?

What is SLE accounting? Example A company enters into a three-year lease for new office space and agrees to pay the following: $10, 000 in year 1, $12, 000 in year 2 and $14, 000 in year 3. The present value of lease payments is $32, 500 (using a discount rate of 5%). Initial Year 1 Year 2 Year 3 Income statement*: $12, 000 Lease expense $12, 000 $11, 333 $ – Balance sheet Right-of-use asset $32, 500 $22, 125 Liability to make lease payments $(32, 500) $(24, 125) $(13, 333) $ – * Consists of Initial Year 1 Year 2 Year 3 Interest expense $ 1, 625 $ 1, 208 $ 667 Amortization expense $10, 375 $10, 792 $11, 333 Total $12, 000 15

What is I&A accounting? Example A company enters into a three-year lease for new $1, 000 (list price) PC and agrees to pay the following: $339 per year in arrears. The present value of lease payments is $890 (using a discount rate of 7%). Initial Year 1 Year 2 Year 3 Interest expense $ 62 $ 43 $ 22 Amortization expense $297 $296 $ 297 Lease expense $359 $339 $319 $890 $593 $297 $ 0 $(890) $(613) $(317) $ 0 Average rent paid $339 % Lease exp B/(W) average rent (6%) 0 6% Total Income statement: $1, 017 Balance sheet Right-of-use asset Liability to make lease pmts $1, 017 16

What is the Project? TRALA Lessee Issues & Impact Issue Impact New ROU asset & lease liability capitalized – but not broken out Same as calculation S&P and Fitch, less than Moody’s capitalizes Lease costs front ended for equipment leases Up to 16% higher than today in year of transition, 3 to 8 years to turn around Cash rent paid still the IRS tax deduction New deferred tax assets on B/S Bundled payment Must break out service to avoid capitalization Lease cost more evident Capitalize interim rents, CFO involved Lease treated as capital item No longer in operating budget, tougher internal approval process Simple short-term lease method Good news for terms of 12 mos or less with no option to renew Compliance costs Transition, ongoing process, complex

Lessee Analysis TRALA Product Offerings Product Impact Short Term Rental (1 yr or less with no option to renew) Exempt from new rules – election to continue to use operating lease method (off balance sheet) Full Service Lease “Lease” portion of pmt capitalized - lessee must break out the “service” portion or else the whole payment amount is capitalized Operating (Tax) Lease Capitalized, but PV lower than equipment cost Synthetic Lease/TRAC Capitalize only contractual rents, compelling renewal rents & estimated residual guarantee payments – capitalizes far less than expected Capital lease Capitalized as under current rules

Impact by Lessee Type Lessee type Potential impact Investment grade/large companies Some negative impact as leases often accounting focused, have more sources of capital, more analytical staff, loss of leveraged lease product increases lease costs Non-investment grade/small & medium sized Less impact as source of capital is prime reason for leasing, fewer sources of capital, level payments & 100% financing conserves cash, less concerned about balance sheet optics, less staff to analyze lease and less analytical Municipal/tax exempt No change in municipal market as GASB, not FASB, issues rules and operating leasing appears to be retained by GASB, tax exempt leasing offers lowest cost, leasing avoids issuing debt with all its constraints

What might the numbers look like? Truck lease example: Vehicle cost Lease term Basic rent payment Lessee incremental borrowing rate PV of basic rent Percent capitalized vs. truck cost $89, 000. 00 84 months $1, 101. 51 7. 00% $72, 983 82% Capitalization Journal Entry: Right to Use Leased Asset $72, 983 Capitalized Lease Obligation $72, 983 To record lease at inception (PV of lease rents) Issues with bundled billed full service leases: -Lessee must bifurcate service portion or capitalize whole payment (results in well over 100% of vehicle cost capitalized!) -Lessee will ask for break out of lease and service portions of payment

Implications for Lessees • The PV of the lease rents will be recorded by the lessee as an asset and liability. As an example, assume a 5 year $100, 000 truck, where the PV rents are capitalized at $89, 517 or 89% of cost assuming a 8% discount rate (incremental borrowing rate). • The P&L pattern will not represent the economic nature of a rental agreement as it will be front-ended as level rent expense is replaced by imputed interest on the liability at 8% and straight line depreciation of the capitalized asset. For a 5 yr lease with monthly rents of $1, 815 the increase in first year expense is $2, 333 or 11% higher than straight line. • P&L Pattern Current GAAP Proposed GAAP Difference YR 1 21, 781 24, 114 (2, 333) -11% YR 2 21, 781 23, 026 (1, 245) -6% YR 3 21, 781 21, 863 (82) - YR 4 21, 781 20, 618 1, 163 6% YR 5 21, 781 19, 286 2, 495 11% TOTAL 108, 905 108. 905 0 0. 0% • The lessee will have to include contractual rents, bargain POs, bargain/compelling renewals & estimated payments under residual guarantees. Non bargain renewals and POs ignored in TRACs. Estimates to be reviewed & adjusted at each reporting date with complex calculations & catch-up adjustments to be made. • The P&L pattern will not match the IRS tax treatment triggering deferred tax accounting.

Lessee TRAC Lease Example

Customer Talking Points • New rules will capitalize lease payments on balance sheet • Amount capitalized will be less than if you borrow to buy • P&L cost will be front loaded for most vehicle leases • Not logical - rent should be the expense • The leasing industry & lessees will fight through comment letters • % of front loading may not be material • The front ending “turns around” so the reported cost is the same as total rents • Reasons for leasing remain • Service/outsourcing/convenient • Capitalized payments less than cost to buy • Additional source of financing • 100% financing/level payments • Low financing costs/tax benefits/residual • Right to return equipment/transfer residual risk

Business Reasons for Leasing Reason for Leasing Details Status After Proposed New Rules Raise Capital Additional capital source, 100% financing, fixed rate, level payments, longer terms Low payments/rate due to tax benefits, residual & lessor low cost of funds Lessee can’t use tax benefits & lease vs. buy shows lease option has lowest after tax PV cost Lessee has flexibility to return asset Still a major benefit versus a bank loan especially for SME & non-investment grade lessees with limited sources of capital Still a benefit versus a bank loan Still a benefit Regulatory Outsource servicing of the leased assets. Quick & easy financing process often available at point-of-sale Capital issues Accounting Off balance sheet Low cost capital Tax benefits Manage assets/residual risk transfer Service Convenience Still a benefit Partial benefit if the PV < cost of the asset, S/B true for hi residual assets w tax benefits

What is the Project? - Lessor Details • Lessor classification same as for lessees • There are 2 methods as proposed – The Receivable & Residual (R&R) method for most vehicle leases (Type A leases) – The Operating Lease method (for lease terms of one year or less – without renewal options & most RE leases(Type B leases)) • Lessors rebook virtually all leases except short term leases on transition

Lessor accounting - receivable and residual (most equipment leases) • • Right-ofuse “sold” • Underlying asset • • Residual asset Record a lease receivable Allocate a portion of the carrying value of the underlying asset to the right-of-use asset “sold” Recognize “sales type” profit (or loss) for the difference between the PV of lease payments and the carrying value allocated to right-of-use asset “sold” Record a residual asset as an allocation of the carrying amount of the underlying asset “Sales type” profit associated with the residual asset would be deferred until the asset is subsequently sold or re-leased 26

Illustrative example – Receivable & Residual Lessor Assumptions: • A lessor manufactures a machine for $7, 500 with a fair value of $10, 000 = $2, 500 gross profit • Enters into a three-year lease with annual lease payments of $2, 400 paid at end of each year • Expected fair value of the residual asset at the end of the lease term is $4, 770 • Interest rate implicit in the lease is approximately 7. 87% Commencement Subsequent (year 1) Lease receivable $6, 200 Gross residual $3, 800* Cost of sales $4, 650 Deferred profit $950* Asset $7, 500 Revenue $6, 200 *Presented as net residual: $2, 850 Cash $2, 400 Interest income – receivable Lease receivable Gross residual Interest income – residual $ 488 $1, 912 $ 299 Lease receivable (PV of annual lease payments of $2, 400 at 7. 87%) = $6, 200 (rounded) Carrying value of asset allocated to right-of-use asset “sold”: $7, 500 x $6, 200/$10, 000 = $4, 650 Profit recognized at lease commencement: $6, 200 – $4, 650 = $1, 550 (or 62% of $2, 500 gross profit) Gross residual (PV of the estimated FV of residual asset of $4, 770 at 7. 87%) = $3, 800 (rounded) Carrying value of asset allocated to residual asset (net residual): $7, 500 x $3, 800/$10, 000 = $2, 850 Deferred profit: $3, 800 – $2, 850 = $950 Interest income on gross residual: $3, 800 x 7. 87% = $299 (rounded) 27

Illustrative example – Receivable & Residual Proposed standard vs. current standard Proposed standard Deferred profit Net residual Profit (sales-type lease) $3, 800 $ (950) $2, 850 $1, 550 $2, 500 $4, 288 $4, 099 $ (950) $3, 149 $ 787 Year 2 $2, 225 $4, 422 $ (950) $3, 472 $ 660 Year 3 $ $4, 770 $ (950) $3, 820 $ 523 $3, 520 $4, 470 Period Receivable Initial $6, 200 Year 1 Gross residual Current standard Total prior to sale of residual 28

Lessor presentation – Receivable & Residual Balance sheet • • Lease receivable and residual asset presented separately (summing to a total “lease assets”) or shown as one “lease assets” with two amounts disclosed in notes Present gross residual and deferred profit together as a net residual asset Income statement • • Lease income and expense (e. g. , revenue and cost of sales) in separate line items or net in a single line item (lease income), depending upon lessor’s business model Income and expense from lease transactions presented separately in income statement or disclosed in the notes Accretion of residual asset in interest income Amortization of initial direct costs as an offset to interest income 29

Lessor Issues & Impact Issue Impact Short term leases exempt Elect to keep using operating lease method New Receivable & Residual (R&R) method Almost identical to current direct finance method – earnings @ implicit rate Sales-type gross profits Recognized on all R&R leases but residual portion deferred until residual resolved Residual value insurance Need for RVI? ? No operating lease accounting, may change residual to a financial asset? FAS 166 receivable sales Receivables under former operating may be financed as asset sales – works best for synthetic leases (non-tax leases) Transition Virtually all leases rebooked, huge project, revise systems

Lease Accounting Project Possible Strategies/Tactics • • • Monitor the project – TRALA website, Leasing-101 website, IASB/FASB/ELFA websites, articles Comment to the FASB Sales training • Understand proposed rules • Talking points • Dealing with objections Review products – Accounting driven products will change – no longer 100% off balance sheet – Customer will know PV of rents – Focus on FMV tax leases, TRACs and synthetics with low PVs – Interim rents & certain contingent rents will be capitalized New products/offerings – Use more TRAC-type structures – Develop a “residual guarantee” product – Provide accounting info to customers as a service

What is the Industry Doing? • TRALA issued a comment letter to the FASB/IASB citing major issues re the first ED: – Estimating payments and adjusting continuously makes compliance costly and burdensome – Immaterial leases (cost =/< $250, 000) and short term leases should be exempt from capitalization – Lease cost should be straight line – Different leases should be accounted for differently – Contingent rent and non-bargain renewals are not liabilities to be capitalized – Full service leases should not be unbundled – should be service contracts • Results: They changed positions on renewals, mileage based contingent rents, short term leases & revised lessor methods

What is the Industry Doing? • TRALA & the NPTC issued an unsolicited comment letter to the FASB/IASB citing major issues re their final decisions: – Classification tests S/B the same for equipment and real estate leases & S/B based on FAS 13 & same as tax & legal view – Lease cost former operating leases S/B straight line to preserve capital – Capitalized op lease liability should not be called “debt” to avoid covenant breaches/preserve borrowing capacity – Rules are too complex – most lease customers are small companies

What is the Industry Doing? • • TRALA, ELFA & worldwide leasing trade organizations jointly interacting with the FASB & IASB providing industry input & expertise Influencing the process to: – Lessee accounting should reflect lease economics – SL recognition of lease expense – Operating lease liability not “debt” – Avoid burdensome compliance for our lessee customers – Save DFL, leveraged & sales-type lease accounting and get tax effected DFL-like income recognition for true leases PR campaign – Engage lessees & manufacturers/lessors encouraging comment letters – Meetings, articles & webcasts Results: – Got them to change position on renewals, mileage contingent rents and short term leases – Got them to reconsider lessor accounting model

WE NEED COMMENT LETTERS!!! • • • Read the Exposure Draft dated May 16, 2013 Comment on the Exposure Draft Deadline for comments will be September 13, 2013 Get your customers and their parents to comment There is an unofficial hierarchy of comment letters: • User/lender comment letters carry the most weight • Preparers are next in importance • Lessor trade associations letters are viewed as self serving – so trade associations alone cannot change their views

Remaining Advocacy Issues – Lessee Issue Desired outcome Basis for request Lessee cost pattern for equipment leases • Maintain current straight line average rent expense for all operating leases as they are executory contracts • Reflects economics of an executory contract • Asset = liability reflects value of the contract • Matches revenue with costs in rent reimbursement scenarios • Matches tax and legal view Lessee balance sheet presentation Lease liability re capitalized operating leases should be separately reported and not labeled as debt • Legally not the same as debt in bankruptcy • Intent of debt limits is to limit more debt having same legal claims on assets • Avoids debt covenant limits Sale leasebacks with any A non bargain purchase PO not considered sales per option should not negate Rev Rec sale treatment All the risks and most of the rewards in the asset’s residual value have transferred to the buyer indicating that a sale has taken place Renewals that rise to a significant economic incentive are booked at inception & costs are front ended Renewals should be booked at commencement & the cost pattern should be straight line • New leases are booked at commencement • Front ending costs creates a saw toothed pattern • Costs of the renewal are accelerated into the remaining term of the base lease Ease requirements for bundled lease payments Estimates s/b allowed if no rates available to lessee • Elements of pricing proprietary • Full capitalization onerous/incorrect

Remaining Lease Project Advocacy Issues - Lessor Issue Desired outcome Basis for request Gross profits deferred in proportion to residual risk RVI & RVGs to be considered in the profit calculation A guarantee/insurance changes the residual’s nature to a financial asset Required symmetry in lease • Lessor business model classification with the lessee should be the basis for lease tests classification • Lessors in the “operating lease” business should get operating lease treatment as real estate lessors do • For financial lessors, the R&R method best reflects the economics for their business • For operating lessors, operating lease accounting best reflects the economics of their business Tax benefits should be factored into the revenue recognition of leases • The after tax yield on the net cash invested should be the pattern of revenue recognized in R&R leases • ITC should be a revenue item • Tax benefits are as much a part of revenue as rents and residual sales • Some transactions have significant tax benefits & ignoring them distorts revenue recognition Leveraged leases • Grandfather existing deals • Retain some form of leveraged lease accounting • Reflects economics of the transaction • Avoids capital adequacy issues • Reduces lease rates

Questions ?