After several years of work, including collaboration with the International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB) has issued Accounting Standards Update (ASU) No. 2016-02, Leases. The issuance and resulting application of this guidance will result in major changes in the financial reporting for leasing arrangements, particularly for lessees, as significantly more leasing arrangements will be reported on the balances sheets of lessees.
For (1) public business entities; (2) a not-for-profit entity that has issued, or is a conduit debt obligor for, securities that are traded, listed, or quoted on an exchange or over-the-counter market; and (3) an employee benefit plan that files or furnishes statements with or to the SEC, the new standard will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019 for a calendar year entity.) The standard will be effective for nonpublic business entities for fiscal years beginning after December 15, 2019 (i.e., January 1, 2020 for a calendar year entity), and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted for all entities.
Definition of a Lease – A lease has been defined as “a contract, or part of a contract, that conveys the right to control the use of an identified asset (the underlying asset) for a period of time in exchange for consideration.” The following two criteria are required to be met to conclude that a contract contains a lease –
Dual Approach Accounting Model - The new standard provides for a dual approach for lessee accounting, with leases that transfer substantially all the risks and rewards incidental to ownership as finance leases, with remaining leases accounted for as operating leases. While the accounting for a finance lease will be very similar to that of a capital lease under current standards, accounting for the newly classified operating leases will undergo a major change, as those leases will also result in the recognition of a right-of-use asset and a lease liability on the entity’s balance sheet.
As noted above, the accounting for a finance lease will not represent a major change compared to the current accounting for a capital lease, with a lessee accounting for a right-of-use asset and a lease obligation at the commencement of a lease. The right-of use asset and related lease liability will generally be recognized at the present value of the future lease payments, with the asset being amortized over the term of the lease, while the lease obligation will be accounted for similar to debt, with lease payments being recognized as a reduction of the lease obligation, along with an interest component determined using an effective interest method.
The initial measurement of an operating lease will also result in the recognition of a right-to-use asset and a lease obligation. Similar to a finance lease, the right-to-use asset will be recognized at the present value of the lease payments; however, in subsequent periods the asset will be effectively “remeasured” using the original lease assumptions. The lease liability will be charged to operations as rent expense in a manner that should approximate straight-line lease expense in the absence of other events, such as an impairment loss related to the right-of-use asset.
Lease Classification – the classification of leases between finance and operating leases is somewhat similar to, but not as explicit, as current guidance used to classify leases between capital and operating leases. The primary lease classification criteria are –
Lease Term, Optional Renewal Periods and Purchase Options – 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.
Short-Term Leases – Leases with terms of 12 months or less will not be required to be recognized on the balance sheet, unless the lease contains one or more renewal options and the exercise of the renewal option(s) is reasonably certain.
Impairment Considerations – As leasing arrangements will now result in the recognition of an asset, entities will be required to evaluate the new right-to-use assets in accordance with existing GAAP, by considering whether the undiscounted future cash flows associated with the asset are sufficient to recover the carrying amount of the asset. If not, an impairment charge will be recognized, consistent with current GAAP for long-lived assets.
Transition – The new standard requires 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. This approach does not require any transition accounting for leases that expired before the date of initial application of the standard. In plain English … existing leases included in financial statements presented for periods prior to the effective date will be required to be accounted for as right-of-use assets and corresponding liabilities, in accordance with the transition provisions of the standard unless the lease expired prior to the initial effective date.
Nonpublic Entity Alternatives – Other than allowing nonpublic business entities to use the risk free rate as a discount rate in the determination of the present value of future lease payments, and an effective date one year later than that required for public business entities, FASB is not providing any specific relief or accounting alternatives for nonpublic entities.
The information presented here only represents a summary of the provisions of the new standard. In addition to the topics addressed here, the standard includes changes in lessor accounting; however those changes are less substantial than those for lessees. Also included in the new standard are requirements related to consideration of variable lease payments, accounting for sale-leaseback transactions and sublease arrangements, as well as very specific requirements for financial statement presentation and disclosure and transition accounting. Depending upon the number and nature of leasing arrangements an entity has, implementation may be fairly straight forward or very complex.
In addition to beginning to plan for the implementation of the new standard, entities should review their existing loan agreements to determine whether or not the resulting changes to their financial statements, primarily the addition of additional liabilities to the balance sheet, may also impact loan covenant requirements, such as debt-to-equity and debt service ratio calculations and limitations on new indebtedness.
For more information on these changes, please contact your Eide Bailly representative.