In February 2016, the FASB issued Accounting Standard Update 2016-02, Leases (Topic 842), with the objective to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about lease arrangements.
What are some of the major changes as a result of this update? When is it effective? What do I need to do now in order to fully evaluate the impact of these changes?
New Lease Accounting Guidance
One of the most important provisions in the new guidance is evaluating whether or not a lease exists. The guidance defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. The leased asset must be specifically identifiable and the length of the contract must be more than 1 year. If the contract isn’t determined to be a lease, then the guidance in this update will not apply to the contract.
To help evaluate the existence of a lease, the FASB has provided a flowchart that depicts the decision process to follow in identifying whether a contract is or contains a lease. This chart is found in the Accounting Standards Codification 842 Leases, Implementation Guidance and Illustrations 842-10-55-1.
When a lease exists, it will now be classified as either a finance lease or an operating lease. The guidance for determining the classification of a lease is similar to prior guidance for a capital lease and an operating lease. The significant change is that both types of leases will be recorded as an asset and a liability on the balance sheet. Prior guidance did not require the recording of an asset and liability for operating leases.
So if both of these leases will be recorded on the balance sheet, what is the difference between an operating lease and a finance lease? The difference is in the subsequent measurement of the asset and the recording of expenses.
Finance leases will follow similar accounting for current capital leases in that the asset is amortized, usually straight-line, over the life of the lease. The company will record amortization expense and interest expense related to the lease.
An operating lease will also follow similar accounting on the expense side for current operating leases in that lease expense will be recorded based on the lease agreement. There will be no interest expense or amortization expense. The amortization of the asset will decrease the liability using the effective interest rate method.
Total expenses recorded over the life of the lease will be the same for both finance and capital leases. However, the expense by year will differ due to the amortization expense and interest expense amounts being recorded on the finance lease and the lease expense being straight-lined over the life of the operating lease.
For public entities, the guidance is effective for annual reporting periods beginning after December 15, 2018. For nonpublic entities, the guidance is effective for annual reporting periods beginning after December 15, 2019. Early application is permitted for all entities.
Considerations for Implementing the New Standard
Companies may apply some practical expedients to continue to account for leases that commenced before the effective date in accordance with previous GAAP rules, as long as the lease is not modified. However, 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. Thus, companies will need to evaluate any lease agreements that extend beyond the adoption of this guidance and determine the amount that will need to be recorded for the periods presented.
Companies will also need to effectively and timely communicate the adoption of this guidance to financial statement users. One example is with bank users. If a company has debt covenants with financial ratios, this standard may impact compliance with such covenants. Discussing with banks in advance can lead both parties to find a reasonable resolution for the non-compliance. If a bank is the only financial statement user, one solution may be that the bank allows the company to provide a qualified opinion with a departure from GAAP explaining that this standard was not adopted.
To see the entire FASB Lease Standard Update, click here.
For more information on how these lease accounting standards will affect your organization, contact Kyle Robbins today.