ASU Update – Operating Leases and Dealerships

March 15, 2019 | Article

The effective date for this new accounting standard has been delayed by one year. This gives organizations an opportunity to better comply with the new accounting standards and improve their processes.

FASB issued ASU 2016-02, Leases, with the purpose of overhauling the existing standards to increase comparability among dealerships 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 the article 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-touse asset should not be included in the analysis (e.g. paper and toner related to copies leases). Lessees have an optional election based on class of underlying asset to bundle non-lease components with the related lease component to avoid determining how to separate these items.

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 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. If borrowing rates are unavailable, nonpublic business entities could use a risk-free rate.

Do you have an operating lease?
A lease must not have any of these criteria to be 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.

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.

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 (ASU 2018-11 does provide an option to apply the new standard as of the adoption date with comparative years under the prior guidance.). 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. A dealership 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 Dec. 15, 2018, including interim periods within those fiscal years, for public business entities. For non-public dealerships, the new standard is effective for fiscal years beginning after Dec. 15, 2019 and interim periods within fiscal years beginning after Dec. 15, 2020. Early application is permitted for all entities.

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