The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016—02 Leases (Topic 842) on February 25, 2016.
Under the FASB’s new standard, substantially all leases will be recognized by lessees on the balance sheet through a right-of-use (ROU) asset and corresponding lease liability, including today’s operating leases. Currently, entities that report under US generally accepted accounting principles (GAAP) are required to recognize capital leases with an asset and liability on the balance sheet, while only disclosing future obligations resulting from operating leases.
While lessees will face significant changes in their accounting for many leases, the new standard also will have some targeted changes to lessor accounting, which are intended to provide alignment with both lessee accounting and the new revenue recognition accounting in Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers.
For public business entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early application is permitted for all entities.
This marks the final chapter in the FASB’s long-standing objective of providing greater transparency and comparability to an entity’s leasing activities. It also brings GAAP into general alignment with the International Financial Reporting Standard No. 16, Leases, which was issued in January 2016. The Government Accounting Standards Board (GASB) has also issued an exposure draft with comments due May 31, 2016, that would bring changes to entities preparing financial statements in accordance with those standards.
The following are several of the key areas to be aware of when considering the impact of the new lease accounting standard.
Classification and Measurement
There are some terminology changes under the FASB’s new lease accounting model; however, all leases will still be classified by lessees as one of two types—either a finance or operating lease—using criteria substantially similar to what is used today to classify leases as either capital or operating.
Lessees will be required to record a ROU asset and lease liability for both finance and operating leases with the primary accounting difference being the timing, measurement, and classification of lease expense.
To qualify as a lease under the new standard, a contract must specify the use of an identified asset, either implicitly or explicitly, and the customer (lessee) must control the use of the identified asset for a period of time. For short-term leases (those with a term of 12 months or less without an option to purchase the underlying asset that’s reasonably expected to be exercised), lessees may make an accounting policy election not to recognize the ROU asset and lease liability. Lease expense for such short-term leases will generally be recognized on a straight-line basis over the lease term.
The lease liability for a finance lease will initially be measured using the present value of the lease payments over the lease term. The recognition and subsequent measurement of the lease liability will be similar to existing GAAP for capital leases. That is, the lease liability is increased for the accrual of interest at a constant periodic discount rate on the outstanding lease liability and reduced when lease payments are made.
The ROU asset will initially be measured at cost and consist of all of the following:
- The amount of the initial measurement of the lease liability
- Lease payments made to the lessor at or before the commencement date, less any lease incentives received from the lessor
- Initial direct costs incurred by the lessee
Lessees will record interest expense on the lease liability using the interest method and amortization of the ROU asset on a straight-line basis, unless another systematic basis better represents the pattern in which the lessee expects to consume the ROU asset’s future economic benefits. The amortization period will generally be the shorter of the lease term or the ROU asset’s estimated useful life. If the lessee is reasonably certain to exercise a purchase option or if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term, the amortization period will be the estimated useful life of the leased asset.
Finance leases will generally result in a front-loaded expense effect. This is due to the straight-line amortization of the ROU asset combined with interest charged on the outstanding lease liability, which decreases over the term of the lease and is similar to today’s capital lease income statement effect.
For operating leases, lessees will calculate the initial lease liability and ROU asset similarly to finance leases. However, the income statement presentation will differ from finance leases. Lessees with operating leases will recognize total lease expense as a single amount on a straight-line basis rather than separately recording amortization and interest expense, which is similar to today’s income statement presentation for operating leases. The subsequent measurement of the lease liability will be similar to a finance lease but the subsequent measurement of the ROU asset will differ because the total lease cost will be recognized as an expense on a straight-line basis.
Accordingly, the ROU asset of an operating lease will generally decrease at a slower rate in the early periods of the lease and at a faster pace in the later periods, as opposed to decreasing on a straight-line basis like the ROU asset of a finance lease.
Both lessees and lessors will need to consider any factors related to or associated with exercising lease renewals, termination, purchase options, or residual value guarantees when evaluating the lease terms and lease payments. Additionally, the occurrence of certain events during the lease term that are within the lessee’s control could trigger a reassessment of the lease term. These factors, which we explore below, will impact the resulting accounting treatment under the new standard.
Other Key Provisions
The rate the lessor charges the lessee will be defined as “the rate implicit in the lease.” When the lessee can’t determine that rate, the lessee will use its incremental borrowing rate. Nonpublic entities will be permitted to make an accounting policy election to use a risk-free rate. Lessees will only reassess the discount rate upon a lease modification, change in lease terms, or a change in determination as to whether the lessee is reasonably certain to exercise a purchase option. If there’s a change in the discount rate, the lessee will adjust the ROU asset and lease liability using the revised discount rate in the period of such change and use the new rate on a prospective basis.
The lease term will be determined at the lease commencement date (the date the underlying asset is made available for use to the lessee) based on the noncancelable term of the lease and both of the following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise the option
- Periods after the exercise date of an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which the lessor controls the exercise of the option.
A lessee should reassess the lease term only upon the occurrence of a significant event or a significant change in circumstances that are within the control of the lessee. If the lease term changes, a lessee will remeasure the lease liability using revised inputs (discount rate and allocation of contract consideration, for example) at the reassessment date and will adjust the ROU asset accordingly. However, if the ROU asset is reduced to zero, a lessee will recognize any remaining amount in earnings in the period in which the lease term is reassessed. A lessor isn’t required to reassess the lease term after lease commencement.
Purchase options will be assessed in the same way as options to extend the lease term or terminate the lease early. The lease will be classified as a finance lease when it contains a purchase option and the lessee is reasonably certain to exercise that option.
At the lease commencement date, the lease payments included in the lessee’s calculation of its lease liability should consist of the following payments. These are related to the use of the underlying asset during the lease term:
- Fixed payments, less any lease incentives paid or payable to the lessee
- Variable lease payments that depend on an index or rate
- Variable lease payments that are in-substance fixed payments
- Amounts likely to be owed by the lessee under a residual value guarantee
- Exercise price of purchase options if lessee is reasonably certain to exercise
- Payments or penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease
The lessee should reassess variable lease payments that depend on an index or a rate only when the lessee remeasures the lease liability for other reasons (because of a reassessment of the lease term, for example). Accordingly, reassessment isn’t required solely because of changes to the index or a rate.
Arrangements that include stepped or uneven lease payments will be accounted for using a straight-line basis or another systematic method if that basis better represents the income earned from the use of the underlying asset. Lease incentives made to or on behalf of the lessee to incentivize the lessee to enter into the lease will be accounted for on a straight-line basis as well.
Impairment Assessment of Lease Asset
The lessee’s ROU assets, for both finance and operating leases, will be subject to existing impairment guidance in Topic 360, Property, Plant and Equipment. The FASB decided to require a lessor to assess its entire net investment in the lease (that is, both its lease receivable and any unguaranteed residual asset) for impairment in accordance with Topic 310, Receivables.
Transition and Effective Date
Upon adoption of the new standard, lessees are required to apply a modified retrospective transition approach for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach won’t require any transition accounting for leases that expired before the date of initial application.
The FASB provided some specific relief to lessees upon transition. An accounting policy election can be made to not reassess any of the following:
- Whether any expired or existing contracts are or contain leases
- Lease classification for any expired or existing leases
- Initial direct costs for any expired or existing leases
If a lessee elects to apply this relief, it must be applied in its entirety to all leases and can’t be applied on a leases-by-lease or provision-by-provision basis. Additionally, lessees and lessors are permitted to make an accounting policy election to use hindsight with respect to lease renewals and purchase options on existing leases for purposes of evaluating the lease term and assessing impairment of the ROU asset of existing leases during transition.
Although companies have nearly three years (or more) before the effective date of the ASU, implementation efforts shouldn’t be delayed. Here are some steps to consider as you approach compliance with the new standard:
- Organize a team. Involving individuals from various departments within your company may be beneficial to help evaluate the effects of the coming changes. This evaluation should also be made when negotiating and entering into new lease arrangements from this point forward.
- Take inventory. Begin taking inventory of existing lease arrangements and other contractual agreements or performance metrics that will be impacted by this change—loan covenants, borrowing base calculations, and compensation arrangements, among others. Then consider whether they’ll need modification prior to implementation of the new lease standard.
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We will continue to follow this topic and provide more in-depth guidance that dissects the new rules and explains how they’ll affect a wide range of lease transactions. For any questions or to better understand how this new standard may affect your business, contact your Moss Adams professional.