Spring Cleaning

…from the Business Perspective

May 18, 2011

Why this topic and Why now?

 Leading economists indicate we are out of the “great recession”.

 There were a lot of lessons learned or to be learned from the “great recession”.

 Opportunities exist for well positioned companies to prosper and expand their business presence.

Who are We?

  Nichols Cauley & Associates, LLC – Certified Public Accountants and Advisors William Sammons, CPA, PFS, CIA, CFP ™, Managing Partner – Atlanta Office  William (Bill) McDevitt, CPA, Manager - Tax

A discussion of hot topics:

o o o o o o

Balancing risks and opportunities Utilizing risk assessments as a tool in strategic planning Using performance reviews as an engine for meeting business goals Budgeting, the key to tracking success Designing internal controls to minimize risks A “new lease on life”…lease accounting changes which will impact all businesses

What is Risk?

o Risk, by definition, is the possibility of suffering harm or loss, which is why many see risk as an overall bad thing. However, it is not all bad because with risk comes opportunity.

o Conducting business in general can be seen as a risk, and like conducting business, taking on new risks can yield exponential returns for those who manage it effectively.

o The key to success is understanding the risk associated with

your

business.

o We can first look to history to see examples of what happens when businesses fail to identify, properly manage, and even take advantage of certain risks.

Business Risk Versus Finance Risk

 Business risk generally involves a Company’s strategic decisions other than finance.  Business risk measures the dangers of operational choices – introducing new product lines to the market, entering into merger or acquisitions, vertical or horizontal integration, etc.

Business Risk Versus Finance Risk

    Financial risk deals primarily with the structure of the company’s finances.

Accurate measurement of risk is needed to formulate strategies and gain a competitive advantage.

Business Risk and Financial Risk go hand-in-hand. It takes a growing economy and companies using leverage to finance its operations and increase its operating/manufacturing footprint to take advantage of growth. In periods of a decline as in the recent recession it is hard to maintain the leverage because of the timing needed (and costs) of downsizing to meet the current economic trends.

Real Examples – Construction Company-Good and Bad and Manufacturing

Risk Management Tools

    Transferring the risk to another party – i.e. insuring risk such as credit insurance or entering into a joint agreement to share the risk with another party.

Avoiding the Risk – In avoiding the risk you must understand and quantify the risk – this does not mean identifying the risk.

Reducing the negative effect of risk.

Accepting some or all of the negative risk.

Polaroid & IBM

o Polaroid was founded in 1937 as an international consumer electronics company o The company single-handedly revolutionized the instant camera industry o Experienced changes in photography technology throughout the years o Failed to position itself in digital imaging and lost its drive for instant photography o Filed Chapter 11 bankruptcy in October 2001

Polaroid & IBM

o IBM was founded in 1911 as a computer systems and hardware company o It came to revolutionize the computer technology industry o Effectively adapted to technological changes throughout the years o In 2010, was ranked the 20th largest firm in the U.S. by

Fortune

and the 33rd largest globally by

Forbes

What happened?

o Polaroid was a globally successful brand, but it failed as a corporate entity due to the inability to recognize the need to adapt to the changing market. The company did not anticipate the magnitude of risks associated with the digital revolution.

o On the other hand, IBM positioned itself to thrive off of the technological changes the future brought and was on the forefront of leading the world into the digital age.

Risky Business

Risky Business

o Because of the economic downturn, many businesses believe they cannot afford to take risks or even invest in risk management.

Won’t it just increase costs, bog me down, and make me less competitive?

o It should be understood that effectively managing risks will make your business

more

flexible and competitive. As noted before, this is one of the things Polaroid failed to do.

o With the worst of the recession over, economists are projecting a new economic season of growth and recovery.

o The recessionary business strategies of cutting costs, shrinking operations and inventory, and minimizing risk have served their purpose in allowing companies to survive through the recession. Now, it’s time to look forward.

How Full is your Glass?

Out with the old, in with the new

o With the future looking brighter, it is time for companies to throw out their old strategies (or relook and redefine) to make room for the development of new strategic visions.

o Executives need to capitalize on the opportunities presented in this new economic season and promote future growth and success.

o Risk represents opportunity, and avoiding risk means avoiding opportunities, which, by definition, is a risk itself. In other words, risk can be a good thing!

o Those who choose to take on new risks now present themselves the possibility of exponential returns.

Mapping your business risk

o Risk must be assessed in the overall context of business strategic planning.

o A strategic risk management approach will help identify the core processes that drive a company’s earnings.

o o This approach allows you to monitor both internal processes and external events to ensure risk and reward are continually rebalanced.

Risk can and should be quantified.

o From there, you can generate a strategic vision of where you want your company to be in the future and develop a detailed road map to guide your business toward making that vision a reality.

Strategic risk management

o To incorporate this strategy, businesses must take several steps: o Prioritize the earnings drivers most susceptible to changes in the risk environment o o Identify infrastructure (people, processes, practices) most essential to those earnings drivers Find the critical areas on which all of the others depend and identify the weak spots o o Develop adaptation/response strategies for decisions to accept or reject risks/opportunities Finally, monitor the risk environment on a continuous basis and make changes accordingly.

Balancing Risks and Opportunities

Balancing Risks and Opportunities

o Businesses must make informed and rational decisions about the risks and opportunities they want to undertake in pursuit of their strategic vision.

o Aligning strategic planning and risk management processes can allow organizations to achieve a competitive advantage.

o However, it is important to understand how much risk you are willing to take while understanding how you plan to balance risks and opportunities.

Balancing Risks and Opportunities

o An appropriate level of risk appetite and tolerance must be established and defined by management.

o From here, it should be communicated to the rest of the organization.

o Risk appetite and tolerance must be updated constantly to adapt to changes in the company’s external environment, strategy, and performance.

Balancing Risks and Opportunities

o Important risk targets can be monitored and managed by using indicators that are linked to key performance indicators.

o Integrating risk factors and risk management into the company’s performance management tool is an effective way to measure and monitor risk and performance at the same time.

o A healthy risk appetite used in conjunction with performance management tools can be a great basis for balancing opportunities and risks.

Considerations in the Strategic Planning/Initiative Execution Process

 Regardless of the Strategic Vision of Your Company proven tactics for achieving your goals include: – – Setting clear and concise targets Creating a clear structure – – Maintaining energy and involvement throughout the organization and Exercising strong leadership

Most Important in Strategic Initiative Accomplishments

 According to Forbes Article (McKinsey Quarterly),

What Successful Transformations Share

, April 18, 2010 the most successful transformations included: – – – Importance of engaging employees collaboratively throughout the Company and transformation journey.

Building capabilities – especially leaders.

Focusing on Strengths and Accomplishments, not just problems, through the entire process.

Performance Reviews

Performance Reviews

o Performance reviews are an opportunity to assess the strengths and weaknesses of your employees

Company.

–

This is what most people think in the employee performance review process. This is a short sided approach which will often yield few results to the overall performance of the

Alternatively consider each Performance review to be meaningful in helping the organization achieve its strategic initiatives though employee reviews.

o

This will help identify how each employee can best fill particular roles in the strategic vision you have developed for your business.

o

It can also be seen as an opportunity to communicate the strategic vision as well as the benefits of taking on particular risks to the organization.

Performance Reviews

o

This review process also serves to reiterate the importance of each employee’s role in the strategic vision you have set and the rewards that can be attained by helping achieve that vision.

o

From an employee’s stance, performance reviews serve to develop goals for that individual and tend to instill a sense of ownership in the company’s vision.

o

Most importantly, it aligns organizational activities and processes with the goals of the organization. This realignment is crucial for taking on the new risks/opportunities that will present themselves.

Performance Reviews

 Rules of Engagement – – – – – – – Be in writing Involve others in preparing (we have experienced better reviews, feedback, and results with more input from including others in the evaluation process) Be timely Ask for feedback Clearly articulate Company Goals and Vision and how their role plays into this success.

Set goals Establish opportunity for future feedback

…the key to tracking success

…the key to tracking success

o Budgeting is the key to tracking your progress and evaluating your success in achieving the company’s strategic vision.

o It provides important insight into areas where the strategic plan may need adjustments or tweaking.

o Identifying these strategic missteps can allow you to make strategic changes sooner rather than later.

o An effective tool for saving time and money or identifying areas in which more time and money may be needed to achieve top line results.

…the key to tracking success

o Budgeting can also prove to be an important tool for providing insight into areas where new opportunities exist for your organization.

o A carefully designed budget is an integral part of your strategic roadmap.

o It can align the broad ideas and concepts of your strategic vision with a set of quantifiable financial goals as well as a financial blueprint of how to achieve that vision.

…the key to tracking success

o Although significant time and effort are required to properly construct budgets, you will find the benefits outweigh the effort put into the process.

o As we know, budgets translate your strategic plan into actions, but a number of additional benefits exist as well.

o The most successful budgets we see are those that are a living document as opposed to a static one time a year budget.

Benefits of Budgeting

o Serve as your formal financial plan o Combined, your strategic plan and budget can project your goals for one year, five years, or even twenty years.

o Establish benchmarks o Budgets allow you to see what you must do to have the resources available to meet your financial goals and stay in line with your strategic vision.

o Help identify deviations from your vision o When these benchmarks are not met, your budget serves as the tool to determine why so you can make adjustments before it can negatively affects your entire business.

Benefits of Budgeting

o Reinforce accountability o Your budget can reinforce accountability by establishing a record for the goals you have set. The reasons for variances can then be used to resolve problems effectively.

o Help allocate resources o Use your budget to prioritize those projects that most fit your strategic plan based on the resources available.

Internal Controls

Internal Controls

o What should companies think about regarding internal controls?

o As you undertake new opportunities, you will always face a level of risk. As you know, without risk, there is no reward.

o Carefully designed internal controls can provide a means to minimize and mitigate the risks these new opportunities bring to your company.

Designing Internal Controls

o The process of identifying and implementing these controls should be incorporated in your risk assessment procedures.

o The process will also serve to further your knowledge and understanding of the business and its related risks.

o These internal controls should be carefully designed and communicated to all levels of the organization.

o They are only effective if everyone in the company follows them.

Designing Internal Controls

o To ensure everyone is on board, lead by example and set a tone at the top that highlights the importance of the controls.

o Tie in the big picture by aligning them with and relating them to the company’s strategic vision.

o Implementing, following, and reviewing an effective set of internal controls today will position your company to capitalize on the unique opportunities presented to you during this economic season of growth.

Final thoughts

o o o o o o o Risk is all around you and your business The best way to deal with it is to use risk and risk mitigation tools to your benefit Capitalize on the unique opportunities the current economic environment presents to your company These tools will allow you to understand the risk your company operates in and use it to prosper in the future Create a strategic plan – indentify goals which will make your Company more profitable Re-engineer your employee performance evaluations – Don’t fall back into the same old routine Budgeting – don’t just dust off last years model – align with your established strategic vision – use key performance indicators – make your budget a living document.

Tax Advantages – Credits for the Growing Business

May 18, 2011

Begin Positioning Your Business Now To Take Advantage of Tax Credits

 

WOTC

– – – – – – –

Congress has extended and enhanced a federal tax credit for private for-profit employers called the Work Opportunity Tax Credit (i.e.,WOTC).

During 2011 employers can hire from the following targeted groups to qualify: Qualified TANF (Temporary Assistance for Needy Families) Recipients Qualified Veterans Qualified Ex-Felons Qualified Vocational Rehabilitation Referrals Qualified Food Stamp Recipients Qualified Supplemental Security Income (SSI) Recipients Qualified Long-Term Family Assistance Recipients

Begin Positioning Your Business Now To Take Advantage of Tax Credits

WOTC (Continued)

   

For 2011 qualifying employees, WOTC can be $2,400 for each new hire up to as much as $9,000 for each long-term TANF recipient.

Before the employer/taxpayer can claim the federal Work Opportunity Tax Credit on its federal tax return, the employer must request and receive certification from its state workforce agency (which in Georgia is GA Department of Labor). The purpose of this request is to certify that the new hire is a member of one of the WOTC target groups. To request certification, the employer should have the job applicant complete page 1 of the IRS Form 8850 “Pre-Screening and Certification Request for the Work Opportunity Credit” by the date of the job offer, and then the employer themselves complete page 2 of the IRS Form 8850 once the person is hired.

The employer should also have the job applicant complete the US Department of Labor Form ETA 9061, “Individual Characteristics Form” by the date of the job offer.

Begin Positioning Your Business Now To Take Advantage of Tax Credits



Immediately upon hiring the individual, the employer should send via registered and return receipt mail both the original (no copies accepted) signed/dated IRS and ETA forms to the state workforce agency’s WOTC coordinator no later than 28 days after the date of hire.



The Mailing Address for the GA Dept of Labor WOTC Coordinator is: WOTC Unit 148 Andrew Young International Boulevard Atlanta GA 30303



For further questions, one can also call the Georgia Dept of Labor WOTC Coordinator at 404-656-3157. They are very helpful over the phone.

Begin Positioning Your Business Now To Take Advantage of Tax Credits

R&D Credit

   Another popular federal and state credit available for 2011 is the Credit for Increasing Research Activities (i.e., R&D Credit).

If your business is spending considerable time and money to develop new products and or processes, these activities may qualify as increasing research expenditures leading to significant tax credits.

Successful claim of the credit requires the company to identify and track qualified research activities and the expenses associated with these activities. Project based accounting (versus cost center accounting) should be set up now to provide a tracking mechanism to adequately document the nexus between qualified research activities and their related costs.

Begin Positioning You Business Now To Take Advantage of Tax Credits

• • • •

GA Retraining Credit

50% of direct investment in retraining full-time employees, up to $500 per employee per approved training program per year; with a cap of $1,250 per year per full-time employee who has completed more than one approved retraining program.

Credits claimed, but not used may be carried forward 10 years. Training programs must be approved by the Technical College System of Georgia and be for quality and productivity enhancements and certain software technologies.

The credit can be used to offset up to 50% of a company’s state corporate income tax liability.

Begin Positioning You Business Now To Take Advantage of Tax Credits



See GA Tax Credits handout for details of other available GA Tax Credits.

The New and Improved Lease Standards?

May 18, 2011

A new lease on life

A new lease on life

o o o The lease accounting models currently in place have come under much criticism for failing to meet the needs of users of financial statements.

Certain criticized aspects include: o o The distinction between operating (rental contracts) and capital leases Omission of relevant information regarding rights and obligations that meet the definitions of assets and liabilities o o Lack of comparability Undue complexity regarding accounting treatments Accordingly, the FASB and IASB initiated a joint project to develop a new approach to lease accounting to ensure assets and liabilities arising under leases are appropriately recognized.

A new lease on life

o o o It will apply to all companies that lease plant, property and equipment. Consider – airlines, transportation companies, multiple site retail companies, etc.

According to some estimates the new rules could bring $1.2 trillion of leased assets onto corporate balance sheets.

Prepare for impact

to 2015

Prepare for impact

o According to a recent Deloitte survey of company executives, only 7% claimed to be extremely or very prepared for the proposed lease accounting standard changes.

o The survey also indicates the proposed changes could have a major impact on the financial statements of lessees.

o Many respondents expected impacts including: o o o o o Impacting debt to equity ratios (68%) Affecting existing debt covenants (44%) Making it more difficult to obtain financing (40%) Leading towards shorter-term leases (40%) Encouraging lessees to purchase rather than lease their space (25%)

Lessee snapshot

o All leases would appear on the balance sheet and no distinction would be made between operating and finance leases.

o Assets and liabilities would be grossed up. Lease asset would represent the “right to use” the leased asset.

o Lease liabilities would be reevaluated at each reporting date when indications of significant changes exist.

o May require significant changes in internal controls and information systems.

o Leverage ratios and capital ratios would deteriorate.

Lessee snapshot

o Timing of expense recognition would accelerate and expenses would be recharacterized as interest and amortization expense.

o EBITDA would be more favorable.

o On the Cash Flow Statement, cash flows from operating activities would be more favorable.

o Significant tax issues may come about with the proposed changes.

Future of leases

Accounting Treatment Capital Lease ALL FUTURE LEASES  Capitalize an asset and obligation equal to the PV of the minimum lease payments over the lease term  Do not capitalize Lessor operating expenses under a net lease  May capitalize initial direct costs incurred by Lessee in lease formation  Assumes longest possible lease term likely to occur  Includes estimates of contingent rents, term option penalties and residual guarantees  Capitalization discount rate used is Lessee’s incremental borrowing cost  Calculations & disclosures of accounting treatment will be updated quarterly based on changes in assumptions, market conditions, capital access, etc Current SFAS 13 Operating Leases  Do not capitalize either the leased asset or obligation  Rent expense is recognized on a straight-line basis over the term of the lease.

Future of leases

Capital Lease ALL FUTURE LEASES Balance Sheet Presentation  Assets and liabilities recorded in capitalized leases must be separately identified in the balance sheet footnotes  Liabilities are subject to the same conditions as other liabilities and should be allocated between current and non-current elements Current SFAS 13 Operating Leases  Not recorded on the balance sheet

Future of leases

Disclosure Requirements Capital Lease ALL FUTURE LEASES  General description of the leasing arrangements. Include the existence and terms of renewal or purchase options, escalation clauses, and restrictions imposed by lease arrangements  Additional qualitative and quantitative financial information  Reconciliation of opening and closing balances for assets and liabilities  Gross assets presented in the aggregate and in major classes by nature or function  Aggregate future MLPs, interest, amortization, and profits for each of the five succeeding years  Minimum sublease rentals to be received in the future under non-cancelable subleases Current SFAS 13 Operating Leases  General description of the leasing arrangements. Include the existence and terms of renewal or purchase options, escalation clauses, and restrictions imposed by lease arrangements  Aggregate future minimum lease payments for each of the five succeeding fiscal years  Minimum sublease rentals to be received in the future under non cancelable subleases

The latest…4/15/2011

o As discussed in prior meetings, the Boards have defined a lease as “a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration.” From the comments the difficulty lies in the broad definition of a lease. The discussion or concerns was whether a service contract could be conveyed as a lease.

1. Any entity would determine whether a contract contains a lease based on the substance of the contract by assessing whether: o o The fulfillment of the contract depends on the use of the asset AND The contract conveys the right to control the use of the asset for a period of time 2. A contract would convey that right to control if the customer has the ability to direct the use and receive benefit from the use throughout the asset’s lease term.

The latest…4/15/2011

o o o o Original exposure draft only outlined one method of accounting for leases. An issue was made whether this proposed single model for all leases would be sufficient.

At the April 15, 2011 meeting, the Boards have identified two types of leases for lessees and lessors with different profit and loss effects: o o A finance lease with a profit and loss pattern consistent with the proposals in the exposure draft An other-than-financing lease with a profit and loss pattern consistent with current operating lease accounting under GAAP However, the Boards are in the process of determining what indicators would distinguish a finance lease from an other-than finance lease.

Note – the further review deals with the method to account for the cost of the leases and not whether they are reflected on the balance sheet.

The latest…4/15/2011

 As a result of the questioning of whether one set of rules is applicable for all leases the Board has directed the staff to review and discuss with the Board advisors: – – – Cost/Benefit of making this change to the lease exposure draft How to better articulate the principle that determines whether a lease is a finance or an other than finance lease and Whether a separate set of indicators to determine the type of lease is necessary for lessees and lessors.

The latest…4/15/2011 -Approaches to lease accounting

Lessee Accounting Approaches

o For lessee accounting approaches (think of it as the initial balance sheet approach), the lessee would: o o Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the PV of lease payments.

Subsequently measure the liability to make lease payments using the effective interest method o For Finance leases, the lessee would: o o Amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits.

Present amortization of the right-of-use asset and interest expense on the liability to make lease payments, either in profit or loss or in the notes.

The latest…4/15/2011 -Approaches to lease accounting

o For Other-Than-Finance leases, the lessee would: o Amortize the right-of-use asset in a manner that would result in total lease expense being recognized over the lease term on a SL basis.

o Present amortization of the right-of-use asset and interest expense on the liability to make lease payments together as a single item within operating expense.

The latest…4/15/2011 -Approaches to lease accounting

Lessor Accounting Approaches

o The Boards have not yet made decisions regarding the two accounting approaches that would be applied by lessors.

Scope of standards on Leases

o It has been determined that leases of intangible, right to explore for or use minerals, oil or natural gas, and biological assets (which includes timber for US GAAP only) are not to be accounted for in accordance with the lease standard. o However, the following are within the scope of the standard: o o o Right-of-use assets in a sublease Leases of non-core assets Long-term leases of land

The latest…4/15/2011

o Prior Board meetings have brought up discussion on Variable Lease Payments.

o However, at the most recent meeting, the Boards decided the measurement of the lessee’s liability and the lessor’s receivable should: o not include variable lease payments that meet a high threshold o o include lease payments that are in-substance fixed lease payments but are structured as variable lease payments in form Will need to evaluate each lease liability regularly

The latest…4/15/2011

Short-term Leases

o A short term lease will be defined as a lease that

months or less

.

has a maximum possible term, including options to renew, of 12

o Lessees and lessors

may elect on a lease-by-lease basis

to account for all short-term leases by not recognizing lease assets or lease liabilities and by recognizing profit or loss on a straight-line basis over the lease term.

The latest…4/15/2011

Separating Lease and Non-Lease Components

o The Boards have decided an entity should identify and separately account for lease and non-lease components of a contract.

o o The lessor should allocate payments in accordance with revenue recognition guidance The lessee should allocate payments as follows: o o o If the purchase price of each component is observable, allocate based on the relative price of individual components If the purchase price of one or more, but not all, of the components is observable, the lessee would allocate the payments based on a residual method If there are no observable purchase prices, the lessee would account for all payments required by the contract as a lease

The latest…4/15/2011

Sale and Leaseback Transactions

o The Boards have decided that when a sale occurred, the transaction would be accounted for as a sale and then a leaseback. If the sale had not occurred, the transaction would be accounted for as a financing lease.

o When consideration is at FV, the gains and losses arising from the transaction should be recognized when the sale occurs o When consideration is not established at FV, the assets, liabilities, gains, and losses should be adjusted to reflect current market rentals

The latest…4/15/2011

Conception vs. Commencement

o The Boards have discussed the accounting for lease contracts at the date of conception vs. the date of commencement for both lessee and lessor and have decided the following: o o o o o Require a lessee/lessor to recognize and initially measure lease assets and lease liabilities at the commencement of the lease Require a lessee/lessor to use a discount rate at date of commencement to measure lease assets and lease liabilities Include application guidance on the accounting for costs incurred by the lessee before the date of commencement Include application guidance on accounting for lease payments made before commencement Include application guidance on accounting for incentives provided by the lessor to the lessee

The latest…4/15/2011

Discount Rate

o The Boards have decided the following regarding the discount rate used to measure the asset or liability: o The lessee would use the rate the lessor charges the lessee when the rate is available, or it would use its incremental borrowing rate o The lessor would use the rate the lessor charges the lessee o The lessor rate could be the lessee’s incremental borrowing rate, implicit rate, or yield on property if a property lease

The latest…4/15/2011

Initial Direct Costs

o Lessees and lessors will be required to capitalize initial direct costs into the corresponding asset or liability

Residual Value Guarantees

o Lease payments should include amounts expected to be payable under residual value guarantees except when amounts are payable under guarantees by an unrelated party

Term Option Penalties

o Term option penalties should be consistent with the accounting for options to extend or terminate a lease

Key points

o

Existing

lease model: o Two types of leases o Operating o Capital / Finance o Operating Leases o o o Rent payments are expenses on a SL basis over the lease term, extension options not considered Lease transactions & commitments are disclosed in footnotes No Asset or Liability on Balance Sheet

Key points

o Capital Leases o o o Asset & corresponding Liability on Balance Sheet Asset is depreciated over estimated useful life Liability is reduced based on effective interest method

Key points

o Proposed changes will eliminate operating leases o Preliminary Measurement o o o Asset and Liability measured at PV of lease payments, plus direct costs (prepaid rent) Excludes executory costs Discount rate is lessee’s incremental borrowing rate or lessor’s implicit rate, if known

Key points

o Subsequent Measurement o Asset o o Amortized cost basis, typically SL Subject to impairment tests o Liability o Amortized cost using effective interest method o Cash payments are booked as interest and reduction of principal o Changes in renewal terms o o Reassess at each reporting date based on facts and circumstances Recognize change in asset and liability

Key points

o Changes in amount of lease liability o Adjust the right of use asset due to: o Changes in lease term o o Changed in contingent rentals and other cash flows Changes related to future periods o Recognize on the Income Statement o Changes related to current or prior periods

Key points

o Disclosures o o It is up to the entity to determine the level of detail necessary to satisfy the disclosure requirements It should disclose the nature of its lease arrangements, including: o The existence and terms of renewal or purchase options, escalation clauses, and restrictions imposed by lease arrangements o o o o o Additional qualitative and quantitative financial information Reconciliation of opening and closing balances for assets and liabilities Gross assets presented in the aggregate and in major classes by nature or function Aggregate future MLPs, interest, amortization, and profits for each of the five succeeding years Minimum sublease rentals to be received in the future under non-cancelable subleases

Lease Example

o Assumption: o o A four-year non-cancelable lease term: 48 months Minimum monthly lease payments: $1,000 o No defined lease options, contingent rental payments, or residual value guarantee o Incremental borrowing rate: 7% o Calculated amounts: o o PV of lease payments = $42,000 Total lease payments over the 48 month term = $48,000

Example…B/S Analysis

Under current GAAP Accounting for an operating lease where rent is accounted for in the current period

Existing US GAAP

At Inception No Asset $0 No Liability $0 End of Yr 1 0 0 End of Yr 2 0 0 End of Yr 3 0 0 End of Lease Term 0 0 Under proposed guidelines, there is an increase in assets and liabilities

Proposed Model

At Inception

Assets

Right to Use Asset

Liabilities

Rent Payable $42,000 $42,000 End of Yr 1 31,500 32,600 End of Yr 2 21,000 22,450 End of Yr 3 10,500 11,600 End of Lease Term 0 0

Example…P&L Analysis

Under the proposed model, the right to use asset is amortized to expense over the term of the lease and the rent payable liability decreases as rental payments are made.

Year 1 Year 2 Year 3 Year 4

Existing US GAAP

Rental Expense 12,000 12,000 12,000 12,000

Proposed Model

Amortization of Right to Use Asset Interest Expense Proposed Expense 10,500 2,600 13,100 10,500 1,850 12,350 10,500 1,150 11,650 10,500 400 10,900

Example…Accounting Entries

Accounting entries under the proposed model would be as follows: Debit Credit

Accounting by lessee - at inception

Right to Use Asset Rent Payable

Accounting by lessee - year 1

Amortization Expense Right to Use Asset Interest Expense Rent Payable Rent Payable Cash $ 42,000 $ 42,000 $ 10,500 $ 10,500 $ 2,600 $ 2,600 $ 12,000 $ 12,000

Example

o On the P&L Statement, rental expense under existing US GAAP becomes a combination of amortization and interest expense under the proposed model.

o Expense under the proposed model is higher in the earlier years of the term of the lease due to interest expense calculated using the effective interest method applied to a declining outstanding balance of rent payable.

What to look for

What’s Changing?

The distinction between operating leases and capital leases will be eliminated What’s the Impact?

Balance sheets will swell and selected companies will see their debt loads increase by 7-10 times All leases, including existing arrangements, will go on the B/S and rent will no longer be an operating exp.

Capitalization of leases will be based on the PV of estimated net lease payments over the

expected lease term

, discounted at the lessee’s incremental borrowing rate Total occupancy exp will be higher and front-loaded over the first half of the lease, often 15 20% higher than today’s SL rent Re-amortization of asset and finance expenses from re-measurement will potentially result in a continuously front loaded expense profile

What to look for

What’s Changing?

Continuous reconsideration of estimates used in capitalizing lease liabilities will be made What’s the Impact?

Financial reporting will become more complex with the added burden of continuous re-evaluation of assumptions All existing leases will be capitalized based on the remaining lease payments Occupancy expense allocations to business units could change

What do we do now?

Loan covenants

o Lenders often set financial loan covenants based upon a company’s financial position, which has an effect on overall terms of the loan, including pricing.

o Companies with stronger financial ratios do not necessarily have more flexibility with their loan covenants.

o Upon adoption of the lease accounting changes, many will find they are no longer in compliance with their loan covenants, although there has been no economic change in the company’s financial position.

What do we do now?

Loan covenants

o To get a picture of how this will affect you, estimate the effect of capitalizing existing operating leases.

o o o o If there is significant potential of covenant violations, there are several approaches you can take: Amend existing loan agreements so loan covenants specifically exclude the effects from lease accounting changes Modify existing amounts used in setting financial loan covenants Modify definitions of loan covenants to specifically exclude capital leases from covenant calculations

What do we do now?

Tax implications

o There are also tax implications to consider, as most leases will now have a deferred tax component.

o The changes will front-end lease expense and cause book to tax differences that do not reflect the economic impact of leases.

o For state income tax reporting, this may also impact business income apportionment and sales/property tax considerations.

o It would be wise to evaluate lease vs. buy considerations.

What do we do now?

o Companies involved in lease arrangements should begin to look at the implications of these new standards now.

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Take inventory on existing leases For significant lease arrangements, review the contracts and agreements to summarize the key provisions (lease payments, renewal options, purchase options, residual value guarantees) Estimate the impact for significant leases Prepare a pro-forma balance sheet and income statement assuming the proposed guidance was effective o Consider changes in lease vs. buy evaluations

Questions & Comments?

o o o Contact William Sammons, CPA, PFS, CIA, CFP ™ o [email protected]

o 404-214-1301 o o Bill McDevitt, CPA [email protected]

404-214-1301 We appreciate your time and patience!