December 2010 Segment 3

Accounting for Leases: Are You Ready for a Major Change?

TRANSCRIPT

1. Upcoming Changes

QUINLAN: Operating leases may soon be a thing of the past. Earlier this year, the two
standard setters in accounting and financial reporting - the International Accounting
Standards Board, or IASB, and the Financial Accounting Standards Board, or FASB,
published a joint exposure draft on lease accounting. If finalized, the proposal would
represent a fundamental change in how leasing transactions are accounted for - by both
lessees and by lessors.

The purpose of the proposed changes to lease accounting, as we've reported to you in the
past, stems from the longstanding goal of the two standard setters to increase transparency
by bringing consistency to lease accounting.

In other words, the exposure draft would also eliminate the differences in treatment of lease
contracts between International Financial Reporting Standards, or IFRS, and U.S. generally
accepted accounting principles, or GAAP.

QUINLAN: As anticipated, the proposal requires both lessors and lessees to provide
extensive financial statement disclosures. In addition, lessors would be required to make
significant judgments around developing estimates of renewal periods and contingent
rentals.

The exposure draft requires lessees to book assets and liabilities for all their leases. In other
words, so-called off-balance-sheet accounting would no longer be allowed.

The dates for the end of the comment period - December 15th - and for the publication of
the final standard - June 2011 - have been set. However, it should be pointed out that the
effective date of the new leasing standard is still uncertain. Because the proposed transition
requirements would not grandfather any existing leases, both lessors and lessees need to
consider the potential affect of the proposed rules on existing leases.

We asked Rebecca Surran to find out if the standard, if implemented as proposed, will really
significantly increase the liabilities on a typical balance sheet.

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2. Move to Capitalization

SURRAN: Needless to say, Mike, I’m very excited to introduce today’s expert commentator
for a number of reasons.

He’s Dr. Peter Chant, and he’s a partner in the national assurance and advisory group at
Deloitte & Touche LLP. Some viewers may recall that he’s a former member, and a former
chair, of the Canadian Accounting Standards Board.

Other viewers may recall his book - "IFRS for Canada" - drawing upon his ongoing
experience in helping companies make the transition to the international financial reporting
standards.

Before I even ask you a question, Peter, I want to remind our viewers: the opinions that
Peter expresses here today are his own, and not necessarily those of Deloitte Touche
Tohmatsu, or any of its member firms. As always, thanks for joining us again this month.

CHANT: Nice to be here, Becky.

SURRAN: Obviously, I've got a lot of questions about the exposure draft, Peter. But first,
let me ask you more of a baseline question. Why is the subject of leasing so difficult for
standard setters in accounting and financial reporting?

CHANT: We’ve got ingrained habits. For those of us who are steeped in North American
GAAP, and even IFRS GAAP, we’ve all become used to the notion that there are some
transactions that we don’t capitalize, and now we’ve come to a point in time where we say,
“OK, those transactions we will capitalize.” There have been major industries developed
around this, such as the leasing industry, on the supply side, and many of the user
industries.

Airlines are well known as being major uses of leases. In many cases those obligations don’t
show up on their financial statements. Perhaps the argument is this is news to nobody, and
maybe it’s not really a burning platform.

CHANT: From a practical point of view, we know the credit rating agencies get copies of the
leases and do their own math. So we don’t believe they’re out to lunch on this. So, the issue
may be, whose ox is being gored?

I think the issue is the general user, who is not a sophisticated accountant, would be
surprised that obligations that have a high degree of certainty, and assets which have a
high degree of productivity, are neither on the balance sheet as liabilities or as assets,
respectively. Users take things at a prima facie value. They expect the financial statements
to say what they mean. Here are the assets that we use and the obligations that we owe.
However, leasing is one of those cases where we don’t do that. While we all get used to it,

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being the source of the problem, conceptually and realistically it is the exception that is a
weakness from a fundamental point of view.

SURRAN: It's one thing to propose a new standard or a new set of rules for everyone to
begin following. But what about existing leases and current contracts? Is there some kind of
transition roadmap to get from where we are to where they want us to be?

CHANT: It’s interesting that you bring up the transition issue. That is another hot potato
that I think is being handled by both the FASB and the IASB.

The transition proposal for leases doesn't stipulate a date. Interestingly, the date is open, or
TBD. But what they do is not permit any grandfathering or exemption of existing leases. So
that means enterprises that have signed a lot of leases under one accounting regime will
now have to go book those, recognize the liabilities, and deal with the contractual
consequences of that. They’re saying, they get to recognize some assets too, but this will be
a significant adjustment.

When leases were first capitalized, even to the extent that they are today, they were
grandfathered, and that is the transition date was leases after a specific date. The problem
with that is you have such a long runoff on some leases, leases for property in Europe, for
example, might runoff 200 years. That’s not an unusual circumstance, which means the
transition effect would be so long that the comparability of financial statements would be
compromised for such an extended period of time that one almost has to go grandfathering
or go bust.

Perhaps the issue is that it’s a contest between doing it all correctly, and recalculating
everything, or doing nothing. The middle road just doesn’t seem to satisfy anybody.

3. Question of Ownership

SURRAN: According to the exposure draft, a lease exists whenever you've acquired an
asset that you've got a right to use, and whenever you've got an obligation to make lease
payments. Is that controversial, Peter? I mean, it sounds like common sense to me.

CHANT: In the good old days, when I first started teaching, we used to have some rules
that were not principles-based, but were, let’s say, pragmatically based. One is, we found it
difficult to put an S on your balance sheet for what you didn’t have title to. Leasing is
actually borrowing somebody’s asset. They usually keep the title. You get to use it for a
portion of the asset’s life, and then you give it back.

A borrowed asset that you don’t own, but you control a portion of - is that really your asset
or is that the leasing company’s asset? Perhaps it was a different world where they were
more like day-to-day car leases than life of the asset aircraft leases, but the original answer
was that title is a key determinant. Who’s got risk in ownership? They ought to drive the
truck.

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CHANT: Nowadays, the legal community has gotten clever and can allocate the risks and
rewards around title with ease. The title has become almost secondary if not tertiary in
importance. That’s why, we’re now looking at, OK substantively the risk and rewards belong
to the lessee. That person, even though they don’t own it, even though they don’t have a
legal title, they may not even have an insurable risk, although they probably do pay for the
insurance, really they’re using the asset and that should be how it’s measured.

I also think we’re far more comfortable with fair valuing intangible assets such as contracts
now, whereas 20 years ago, people were pretty nervous about that. But the technology of
derivatives and of valuation has moved so far past the basic cash flow models that I doubt if
there’s a complex contract that would challenge the more sophisticated valuation people.

SURRAN: That makes sense, Peter, in the context of the bartered purchase or the
chartered aircraft. But what about the DVD that I rented last night? Or the tuxedo that I'm
making my husband rent next weekend for a wedding that we're going to? Clearly, not
every rental transaction involves "holding" an asset, does it?

CHANT: Well, you are using the asset and if possession is 9/10th etc., then I’m not sure
why one would see an exception. I know from personal experience that when one leases a
car, even on a day-to-day basis, you’re pretty well responsible for that car. If I run over
somebody while driving that car, or damage it, it’s as if I owned it. It’s not clear why the
accounting would differ.

Now, give this to the board, say simplify the approach. The simplified approach basically
reflects the entries that would be automatically made for short-term transactions like that. I
would see the accounting systems and the accounting proposals for short-term leases being
quite aligned. I don’t think the short-term lease is a big challenge.

It is maybe a big challenge for lessees who have gotten used to just paying the bill once a
month and not accruing anything, but I think realistically that’s probably a tweak in a
sophisticated platform. OK, maybe that’s an understatement, but not a sophisticated
accounting adjustment to get there.

4. Derecognition and Lease Types

SURRAN: In this context I often hear the word, "derecognition." Why is it that lessors are
so concerned about derecognition?

CHANT: Derecognition is an accounting word. The idea is if you can recognize something
and put it on your balance sheet, you should be able to do the opposite, which means take
it off your balance sheet.

The issue for the lessors is that there are two competing models. This I think the boards
only straightened out near the end of the project. There’s one model where you have an
asset and you lease it out. As the lessor, you undertake the obligation to let somebody

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borrow the asset. That would show up as a liability. In exchange for that, you’re going to
get a receivable. In essence, for the same asset, there will be three entries: the asset, the
obligation to let somebody use it, and the receivable.

If you’re a big time lessor, you can see how that balance sheet’s going to kind of explode.
There will be three entries for every underlying asset. Sooner or later there is a model that
says, “We’ve probably substantively leased that asset out, so, when it comes back, there’s
not a whole lot of risk here.” For those types of lease transactions, the IASB board members
originally, and the FASB by the end, got around to the view that when you get to those
points, you have actually disposed of the underlying asset.

Instead of having an obligation to lease the asset out, you actually have transferred the
asset to a third party. It comes off your balance sheet, so you just have a receivable in
place of a long-term asset. You won’t have an exploded balance sheet that has all sorts of
what one might have called, “double counted assets” on it.

SURRAN: I know some people who are, what you and the standards call, "lessors."
Sometimes they enter into sub-leases. Other times, they do "sale and leaseback"
transactions. Is this another one of those situations, Peter, where the devil is in the details?

CHANT: This is an area where, again, principles count. If you’ve leased in an asset and then
you sub-lease it out, it’s generally recognized as a business practice that you’ve assumed
the obligation to pay. When you sub-lease it, you’ve assumed that it is somebody else’s
credit risk to let them use the asset. So you have two transactions. It is difficult to see why
you can offset the two, especially if the sub-lease goes sour, but the lease that you’ve got
back with your original lessor still has to be paid. It’s difficult to see how you could net all
those transactions into one tiny little sum. I don’t think it’s realistic.

CHANT: Tax leases, another big area. There has been, is a big industry in tax leasing. For a
while there was an accounting standard that actually facilitated the recognition of the lease
as a tax-motivated transaction. Unfortunately, that doesn’t conceptually jive too well with
the IASB, and the global point of view was primarily a U.S. driven phenomenon for a time.
We remember the notion of wash leases. So, with those types of structures, essentially,
there has been no forgiveness and it is what it is.

If you’ve done a tax deal, then account for it. If you’ve done a sub-lease, then account for
it. If you’ve got an asset leased, then that’s a separate transaction. I think that would be a
necessary condition to sell this project globally to make amendments for a purely U.S.
environment issue. It would probably not be a good way to go about drafting international
standards.

SURRAN: Thanks, Peter. We'll return to your commentary in a minute.

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5. Financial Statement Impact

QUINLAN: As Peter Chant indicated, under the new proposal, the requirement to classify
leases as either capital or operating is gone. As a result, lessees must capitalize all of their
leases. This one-size-fits-all model, which treats "dollar-outs" and "FMV leases" the same,
will account for very different transactions in the same way.

Under the new rules, all leases will be treated essentially the same as current capital leases.
In a significant departure from FAS 13, though, lessees must now assess the impact on the
lease term of options to return, renew, or purchase the leased asset.

For example, if the lessee expects to renew the lease, the base term plus the renewal
payments now must be capitalized. Furthermore, these assumptions are reassessed each
reporting period.

In addition, lessees would be required to estimate - and to capitalize - the amount of any
contingent rents and residual guarantees that are likely to be paid under the lease.

SURRAN: Let's turn to the consequences of the exposure draft for lessees, Peter. I suppose
this could have a major impact to their income statement as well as their cash flow
statement, couldn't it?

CHANT: Absolutely. It’s almost signaled in the exposure draft, I think the boards wanted to
make sure that lessees were aware of this. The way the standard essentially works is it
says, “You would have an asset for the thing you've leased that you’re going to have to
depreciate.” Straight-line depreciation, if it’s got an asset lifetime of “n” years, is going to
be 1/nth a year.

You’re also going to have a liability when you start the lease, which is the present value of
all future lease payments. As a good liability, you’re going to be accruing interest on it and
it’s going to be equal to the asset. Now what that means is before you start paying that
lease down, the interest on the lease liability is going to be bigger than the lease payment
you made coupled with depreciation on that asset. There are going to be fewer, larger
charges for that asset combo of amortization and financing. Net income is going to go down.

Flip side is, near the end of the lease, the asset may be depreciated, that’s fine, but there
will be very little interest charge for the remaining balance of the lease. It’s possible that,
for older assets that are coming to maturity, there will be less lease expense from the
combination of these factors than the cash payment, which is currently the basis for
expense these days.

SURRAN: That makes sense. But what about their balance sheet and their business
practices? Is it likely to have an impact there as well?

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CHANT: Well, the balance sheet, it’s pretty clear. Lots of new assets that have been around
for a while. Lots of new liabilities bearing interest that probably do factor into long-term
debt calculations. On the income statement, depending upon the vintage and the
distribution of the assets, for new leases, definitely expenses go up. An interesting outcome
is on the cash flow statement. It may be a little accounting dogma, but currently lease
payments, when a lease is off the balance sheet and classified as operating or considered
operating expenses. So they go through margins, they’re expensed, they’re cash so there’s
no cash income difference. It’s pretty straightforward.

Under the new model, where leases are capitalized and treated as financing obligations,
there’s no more operating expense except perhaps the interest on the debt to the extent
that that’s in the operating cash flows. The payment for the lease will primarily be viewed as
the repayment of the principal amount of a debt, and that’s a financing transaction.

So, significantly what’s going to happen for enterprises with operating leases, they’re going
to see their operating cash flows climb. And for those who compute, free cash flow or other
numbers, you will see that as the free cash flow goes up, the financing outflow goes down in
an equal and opposite amount. But, sometimes people don’t get that far down the cash flow
statement and sometimes management likes to tout the operating cash flow, and this will
significantly migrate an outflow from operations to financing. So, there may be some net
enhancement.

6. Commenting on the Exposure Draft

SURRAN: I'm no exception, Peter. Everybody likes to receive invitations. But what about in
this case? Our viewers received an invitation to comment from FASB and the IASB on the
exposure draft. To what extent would you encourage people to send their comments to the
standard setters? Or is this proposal a "done deal" and they're just satisfying due process by
asking for comments?

CHANT: I think it’s a serious comment period. In the case of leases, the FASB and the IASB
have commenced actually a questionnaire post publication of the exposure draft on the
extent to which enterprises use leases. I’m not exactly sure of the motive for the
questionnaire at this point in the process, but I think there may be some suggestion that
they may want to find out the scope of this and how significant it is. You may want to look
at the IASB web site. If you want to participate in that questionnaire, you can hit the URL
and probably get a copy of it.

If you are a user of the FASB standards or the IFRS standards, I would write a letter. In my
experience, when I was in active standard setting, we counted those cards and letters. If
there were points made, I assure you the staff did not just put them in File 13. They looked
at them. They brought them to the board. The board is not always in some religious fervor
where it’s just got to do the right thing. In some cases there is a question as to whether or
not it’s net improvement.

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CHANT: If you have a true practical issue, for example, the nature of your leasing
arrangements is so convoluted that determining a fair value may be difficult, then I think
that’s worthy of communicating to the boards. There is no discussion of lease incentive
payments, translation, or payments by the lessor to the lessee at the front end of the lease.
In my experience, many sales-type leases are negotiated with incentives upfront.
Frequently startup enterprises, they’re given the working capital by the lessor as a condition
of using the asset. They go hand in hand. That’s a very complicated area to try to get the
financial reporting right. If you are familiar with that and if that deficiency and the exposure
draft is a significant weakness, I think the boards would like to know.

At the same time, if your experience is, we’ve been using operating leases for years. Yes, I
know the financial statement consequences. But no, I have not met a person that didn’t
understand what was going on. Then we’d have bigger fish to fry. That may be a message
that the board may want to hear from you, is, where are we in the priorities of things? We
have so many things coming down the pipe that may be more important. Maybe that’s a
message that needs to be expressed.

7. Going Forward

SURRAN: In terms of the goal of a single set of high-quality global accounting standards,
the buzzword used to be "convergence." Now, I hear people talking about the
"harmonization" of accounting standards. Aren't those essentially the same thing, Peter?

CHANT: Well, I think the difference is the mechanics of execution. Convergence means you
both end up on the same road, same standards, virtually identical, probably without a
significant word, even without a significant word, maybe some basis of conclusion changes.

Harmonization, that’s a little more like voices on the same wavelength. Occasionally they
can get out of touch, or maybe they’ll have a slightly different pitch.

I think, functionally, harmonization is probably easier to get to. Probably from a users point
of view, it’s not that significant. You get the same melody effect, essentially, out of the
application of the principles, but it’s a little easier to execute harmonization than it is
convergence where you’re fighting over every comma. That’s a little more drawn out
process.

SURRAN: That makes sense. But what about lease accounting specifically? Is this one of
those accounting standards that's likely to be merely harmonized, rather than truly
converged? Where do you think they're going to go in terms of accounting for leases?

CHANT: I think this will be a converged standard. I don’t see any basis for having different
words. This is a global industry, global practices, trans-border, tax transfer leases,
international organizations, there’s no justification in this case for a unique national
practice.

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Where will this go? The intellectual, conceptual arguments I think are reasonably sound. I
can’t think of one other than inconvenience or "nobody cares" that makes good sense. The
real roadblock here is this will significantly change financial statements and cause for
significant recontracting in some circumstances. If this comes down the pike at the same
time as revenue recognition, financial statement presentation, fair valuation, or some other
issue, or simply the adoption of IFRS in the United States, which would be a fairly
cataclysmic event if it occurs, then this may be just a little too much to swallow. That I
would see is perhaps the practical argument.

Who’s going to make that judgment? I would say the FASB and the IASB putting all the
factors on the scale including their predisposition to capitalize. But timing and the ordering,
and maybe even some cutoff, that’s a totally arbitrary remark on my part, but who knows
what the outcome might be. I think those are the issues that might defer the
implementation. As it is, I think it’s conceptually and realistically a good standard. But,
there are many realistic things that will make it through the process, because bigger issues
control the day.

SURRAN: Deloitte's Dr. Peter Chant, thanks, once again, for bringing us up-to-date.

CHANT: You’re welcome, Becky. It’s been a pleasure to be here.

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