The long-awaited accounting standards update (ASU) for leases is finally at our doorstep. ASU 2016-02, and its subsequently issued amendments, enacted some significant changes in accounting for leases, with the primary goal of increasing transparency and comparability among entities and disclosing key information about leasing arrangements.
The new lease standard is codified under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 842: Leases, and is effective for private companies with annual reporting periods beginning after December 15, 2021. Early implementation is permitted.
The new standard did not fundamentally change lease accounting for lessors. Because of that, we will focus the content of this article on changes specific to lessee accounting under the new standard.
The most significant difference between the previous lease accounting standards and the new one is the recognition of lease assets and lease liabilities on the balance sheet for leases that were classified as operating leases under the previous standards. As you probably recall, under previous standards, operating leases are “off balance sheet”. Under ASC 842, lessees are now required to record all leases with terms over 12 months on the balance sheet. These leases are now characterized as either “Finance” leases or “Operating” leases. Finance leases were referred to as Capital leases under previous GAAP, but the definition of this type of lease under the new standard is generally the same.
Lessees can make an accounting policy election not to recognize lease assets and liabilities on the balance sheet for leases with terms of 12 months or less and that do not include a purchase option that is “reasonably certain” to be exercised.
Finance vs. Operating Leases
You may be wondering, if all leases over 12 months have to be recorded on the balance sheet, why the separation between Finance and Operating leases? Well, the reason for that is that there are some differences in the accounting and reporting between Finance and Operating leases. The primary difference is related to the recognition of expense on the income statement. Expense recognized for Operating leases results in straight-line expense over the lease term, while expense recognized for finance leases is highest at the beginning of the lease and decreases over the lease term.
Lessees shall classify a lease as a Finance lease when the lease meets any of the following criteria at lease commencement:
- The lease transfers ownership of the underlying asset by the end of the lease term
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
- The lease term is for a major part of the remaining economic life of the underlying asset
- The present value of lease payments, plus any guaranteed residual value, equals or exceeds substantially all of the fair value of the underlying asset
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term
While the new standard does not include a bright-line threshold for determining what constitutes a “major part of the remaining economic life” (under #3 above) and “substantially all of the fair value” (under #4 above) like prior lease accounting guidance, ASC 842 implementation guidance suggests 75% or more to be a reasonable basis for determining what constitutes a “major part of the remaining economic life” and 90% or more to be a reasonable basis for determining “substantially all of the fair value”.
If none of the five criteria listed above hold true, then the lease should be classified as an Operating lease.
For Finance leases, a lessee will:
- Recognize a right-of-use (ROU) asset and a lease liability, initially measured at the present value of the lease payments, in the balance sheet
- Recognize interest on the lease liability separately from amortization of the ROU asset in the income statement
- Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows.
For Operating leases, a lessee will:
- Recognize a ROU asset and a lease liability, initially measured at the present value of the lease payments, in the balance sheet
- Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis
- Classify all cash payments within operating activities in the statement of cash flows.
Disclosure and Implementation Approach
The new standard requires a significant number of additional qualitative and quantitative lease disclosures. The intent of the disclosures is to enable financial statement users to assess the amount, timing and uncertainty of cash flows arising from leases. Companies should consider these additional disclosure requirements early in their implementation process to ensure they are prepared with all the required information.
A modified retrospective approach is required for transition to the new standard. Entities can elect to apply the transition approach to all leases in existence as of the date of the earliest period presented (and therefore, restate any comparative periods presented), or to apply it as of the beginning of the period of adoption with a cumulative-effect adjustment to the opening balance of retained earnings (and not restate comparative periods). The transition guidance also includes a variety of optional practical expedients that entities can elect into which are intended to reduce the burden of implementing the new standard.
It is expected that the new standard will likely have the greatest effect on businesses with large volumes of real estate, manufacturing equipment, and vehicles. However, most companies will be impacted in some way. Leases on buildings, as well as copier and phone system leases are common-place for most entities. Therefore, each company should review and update their system of internal controls to ensure that their processes effectively identify all leases and that their accounting policies and practices appropriately report these leases under the new reporting requirements of this standard.
Finally, given the balance sheet impact of the new standard, companies should closely review and be monitoring any financial covenants and proactively work with their lenders to consider whether amendments to the covenants are appropriate and called for given the change to the financial reporting requirements.
There are many complexities in the new lease standard. This article includes a summary of the high points of the new standard from a lessee approach; however, each company has a unique set of circumstances to be considered. Reach out to your CPA with any questions you have regarding how this standard may affect your company’s financial statements.
ASU 2016-02 in it’s entirety, and the subsequently issued amending ASUs, can be accessed on the FASB ASC website.