The long-awaited update revising the proper treatment of leases under U.S. Generally Accepted Accounting Principles (GAAP) has recently been issued by the Financial Accounting Standards Board (FASB). Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), will affect companies that have leases including leases for office space, vehicles, construction and manufacturing equipment, as well as other assets. The standard requires these businesses to recognize most leases on their balance sheets, potentially inflating their reported assets and liabilities.
A Short History of Lease Reporting
According to the FASB, most lease obligations today aren’t recognized on the balance sheet, and transactions are often structured to achieve off-balance-sheet treatment. A 2005 U.S. Securities and Exchange Commission (SEC) report estimated that SEC registrant companies held approximately $1.25 trillion in off-balance-sheet lease obligations. As a result of these obligations being left off balance sheets, users of financial statements are unable to easily compare companies that own their productive assets to those which lease their productive assets.
To address this issue, the FASB launched a joint lease accounting project with the International Accounting Standards Board (IASB) back in 2006. However, because the boards couldn’t agree on how to report leases on the income statement, they ultimately decided to abandon the project in favor of issuing separate standards. The IASB issued its standard (International Financial Reporting Standards 16) in January, and the FASB followed suit, releasing its own standard at the end of February.
Impacts on Lessees
Currently, companies that lease assets (lessees) account for a lease based on its classification as either a capital (also known as a “finance”) lease or an operating lease. Lessees recognize capital leases (for example, a lease of equipment for nearly all of its useful life) as assets and liabilities on their balance sheets. But they don’t recognize operating leases (for example, a lease of office or retail space for 10 years) on the balance sheet. Such leases appear in financial statements only as a rent expense and disclosure item.
The new standard will require lessees to recognize on their balance sheets assets and liabilities for all leases with terms of more than 12 months, regardless of their classification. For example, lessees will report a right-of-use asset and a corresponding liability for the obligation to pay rent, discounted to its present value. The discount rate is the rate implicit in the lease or the lessee’s incremental borrowing rate.
For those leases that have a term of 12 months or less, a lessee is allowed to make an election not to recognize those lease assets and lease liabilities. If this election is made, the lessee should recognize lease expense for these leases on a straight-line basis over the lease term.
ASU 2016-02 also requires a lessee (and a lessor) to include payments to be made in optional periods only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. Similarly, optional payments to purchase the underlying asset should be included in the measurement of lease assets and lease liabilities only if the lessee is reasonably certain to exercise that purchase option.
The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee will continue to depend primarily on its classification as a capital or operating lease, as follows:
- For capital leases, lessees will recognize interest on the lease liability separately from amortization of the right-of-use assets in the statement of comprehensive income. In the statement of cash flows, they will 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.
- For operating leases, lessees will recognize a single total lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis. In the statement of cash flows, they’ll classify all cash payments within operating activities.
The standard requires additional disclosures to help users of financial statements better understand the amount, timing, and uncertainty of cash flows related to leases. Lessees will disclose qualitative and quantitative information about their leases, including information about variable lease payments and options to renew and terminate leases, significant judgments made with respect to their leases and amounts recognized in the financial statements related to their leases.
These changes may have additional repercussions for lessees. Companies may incur costs to educate their employees on the proper application of the new requirements and financial statement users on the impact of the requirements. They’ll need to develop supplemental processes and controls to collect the necessary lease information.
Additionally, the reporting changes could affect financial ratios, which may have implications for debt covenants. They might also lead to higher borrowing costs for lessees whose balance sheets look weaker with their operating leases included. As an alternative, businesses could consider buying instead of leasing, because they’ll end up with similar leverage on their balance sheets from either transaction.
Impacts on Lessors
Companies that own leased assets (lessors) will see little change to their accounting from current GAAP. As an example, most operating leases should remain classified as operating leases according to FASB, and lessors should continue to recognize income from those leases on a straight-line basis over the lease term. The new standard does, however, include some “targeted improvements” intended to align lessor accounting with both the lessee accounting model and the updated revenue recognition guidance issued in 2014 (ASU No. 2014-09, Revenue from Contracts with Customers).
Lessors could see the changes to lease accounting play out in lease negotiations. Existing lessees may seek to modify their leases to reduce the impact of the new standard on their balance sheets by, for example, securing lease terms of one year or less.
Contracts sometimes include both lease and service contract components (for example, maintenance services). ASU 2016-02 continues the requirement that companies separate the lease components from the non-lease components; and it provides additional guidance on how to do so.
The consideration in the contract is allocated to the lease and non-lease components on a relative standalone basis for lessees. For lessors, it’s done according to the allocation guidance in the updated revenue recognition standard. Consideration attributed to non-lease components isn’t a lease payment and, therefore, is excluded from the measurement of lease assets or liabilities.
Public companies are required to adopt the new standard for interim and annual periods beginning after December 15, 2018, as are employee benefit plans that file financial statements with the SEC and not-for-profit entities 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. All other companies (including nonpublic companies) following GAAP will need to comply for annual periods beginning after December 15, 2019, and for interim periods beginning a year later. Early adoption is permitted for all entities.
The standard requires companies to take a “modified retrospective transition approach,” which includes several optional practical expedients companies can apply. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that begin 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.
Because of this standard’s long gestation period, many companies have taken a wait-and-see approach to tackling the lease accounting changes. But now that the new standard has been released, businesses would be wise to begin their preparations immediately – particularly if they have extensive lease portfolios.
The accumulation of the necessary data, as well as development and implementation of new processes and controls, will likely require significant time and resources.
Because of the many nuances involved in this important change, we recommend that you contact your Untracht Early advisor for guidance on the implementation of the latest lease requirements created by the FASB’s new standard.