Insights: Article

ASU Update - Operating Leases!

By   Tim McCutcheon

July 02, 2018

Nearly ten years after the release of the initial exposure draft, FASB issued ASU 2016-02, Leases. The standard may have been issued, but the conversation about this re-write of legacy guidance has not slowed.

The purpose of this overhaul to existing standards was to increase comparability among organizations by recognizing an asset and a liability on the balance sheet for assets leased under operating lease arrangements. Previous standards have long been criticized for obstructing comparability by not requiring such recognition, thus allowing lessees to keep related assets and liabilities off their balance sheets.

The accounting for a finance lease will not represent a major change compared to the current accounting requirements for a capital lease, with a lessee accounting for a right-of-use asset and a lease obligation at the commencement of the lease. The most significant changes resulting from the new standard affect the accounting for operating leases, and the remainder of this discussion will be limited to that lease class.

Let’s dive into some terminology and required analysis:

Do you have a lease? The contract must specify the use of an identifiable asset, and the lessee must control the use of the asset for the specified period.

What happens with non-lease components? The value attributed to goods and services that are separate from the right to use asset should not be included in the analysis (e.g. paper and toner related to copies leases). Lessees have an option to bundle non-lease components with the related lease component to avoid the bifurcation exercise.

What is the lease term? In determining the lease term, an entity is required to consider all relevant factors that create an economic incentive to exercise an option to extend, or not to terminate, a lease. Consideration of optional renewal periods and purchase options included in lease arrangements will be evaluated based upon a “reasonably certain” threshold, considering such “economic incentives”. For example, if the exercise of a renewal period or purchase option is considered to be reasonably certain, the renewal period(s) or purchase options would be included in the determination of the classification and initial measurement of the lease. Lease terms will only be reassessed if a significant event or change in circumstances occurs that is within the control of the lessee. If a lessee subsequently changes its assessment of lease term they are required to re-measure the lease payments and lease liability.

How do you calculate the lease payments? The fixed payments stated in the contract should be increased by any variable payments that depend on an index or a rate. Other increases might include the exercise price to purchase the asset, penalties for terminating the lease or amounts under a residual value guarantee, depending on specifics. The value of any lease incentives paid to the lessee are to be subtracted from the lease payments.

What is your discount rate? Lessees that are not public business entities should use the rate implicit in the lease. If that cannot be readily determined, use your incremental borrowing rate, which is equal to what a lessee would have to pay for a collateralized borrowing over similar terms as the lease

Do you have an operating lease? A lease that meets none of these criteria is an operating lease:

  • Ownership transfers to lessee by end of lease
  • Lessee is reasonably certain to exercise option to purchase the asset
  • Lease term is for major part of asset’s remaining economic life
  • Present value of lease payments is more than substantially all of the asset’s fair value
  • Asset will have no alternative use to lessor at end of lease

To apply the new guidance at initial measurement, lessees will first calculate the lease liability as the present value of lease payments not yet made, discounted using the rate described above. The right of use asset is the calculated lease liability, plus initial direct costs incurred by the lessee and any prepaid lease payments, less any receipt of lease incentives. An example journal entry is as follows:

Dr. Right of Use Asset $280,000

Cr. Lease Liability $280,000

In subsequent periods, the lessee will reduce the lease liability as lease payments are made, recording the interest portion of payments (resulting from discounting) as rent expense. The right of use asset is amortized over the lease term by the difference between the straight-line lease expense and the lease liability accretion. Example journal entries are as follows:

Dr. Rent Expense $19,088

Dr. Lease Liability 80,912

Cr. Cash $100,000

(Interest expense = $280,000 opening lease liability x 6.8172% discount rate)

Dr. Rent Expense $92,579

Cr. Right of Use Asset $92,579

(Amortization = $111,667 straight-line lease expense - $19,088 interest expense)

As you can see above, a lessee reports all activity related to an operating lease in a single expense account on its Statement of Activities. This approach results in all activity related to the operating lease being reported within the operating section of the Statement of Cash Flows. The lessee’s Statement of Financial Position would report both the Right of Use Asset and the Lease Liability.

Note that, for operating leases with a term of 12 months or less that do not contain one or more renewal options of which exercise is reasonably certain, a lessee is permitted to make an election by class of underlying asset to not recognize lease assets or liabilities. Under such election, the lessee continues to recognize lease expense on a straight-line basis over the lease term.

In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. These practical expedients relate to the identification and classification of leases that commenced before the effective date, initial direct costs for leases that commenced before the effective date, and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.

The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, for nonprofits that have issued or are conduit bond obligors for securities that are traded, listed, or quoted on an exchange or an over-the-counter market. For all other nonprofits, the new 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.

Application of the new standard to each operating lease may be complicated, depending on the complexity of the lease terms. Please contact any member of your Eide Bailly service team to discuss your specific circumstances and how this new standard will apply to your nonprofit organization.

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