On February 25, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), which will significantly alter the manner in which both lessees and lessors account for leases. This ASU is an amendment of the Accounting Standards Codification (ASC) Topic 840, Leases, and supersedes ASC 840.
This ASU will require organizations to recognize lease assets and lease liabilities (whether financing or operating leases) on the balance sheet, and to disclose key information about leasing arrangements. The purpose and intent of this pronouncement is to increase transparency and comparability among organizations and improve financial reporting.
Background: Capital Leases vs. Operating Leases
Under previous standards in U.S. generally accepted accounting principles (GAAP), there were two types of leases: capital leases and operating leases. Capital leases were reflected on the balance sheet, with the underlying asset being capitalized and a corresponding lease liability. The theory behind this is that a capital lease is essentially a method of financing the acquisition of an asset. There are bright-line tests under the previous standards for determining whether a lease is a capital lease. Under the previous GAAP standard, if a lease is not classified as a capital lease, it is considered an operating lease. Unlike a capital lease, an operating lease is not accounted for on the balance sheet, but rather, on the income statement. While there were still requirements for organizations to disclose the terms of operating lease commitments, the FASB felt that this did not give a complete representation of an entity’s true obligation as it relates to the leases. Much of the language in this blog is taken directly from ASU 2016-02 / Topic 842.
The new standard maintains a similar bifurcation between finance leases (formerly capital leases) and operating leases. However, the obligation associated with operating leases is now required to be recorded as a liability, with a corresponding “right-of-use” asset. The logic and theory behind this change is that all leases create an asset and a liability for the lessee in accordance with FASB Concepts Statement No. 6, Elements of Financial Statements, and therefore, recognition of those lease assets and liabilities represents an improvement over previous GAAP.
Further, the liability should include payments to be made in optional periods (e.g., an option to extend the lease) only if the lessee is reasonably certain to exercise the option to extend the lease, or not to exercise an option to terminate the lease. The lessee should exclude most variable lease payments (e.g., utilities, maintenance, etc.) from the calculation of the lease liability.
A lessee is permitted to exclude leases that have a term of 12 months or less from the new standard by making an accounting policy election. In such cases, lease expense is recognized generally on a straight-line basis over the term of the lease.
Lessee Requirements for Finance Leases
- Record a right-of-use asset and a lease liability, measured at the present value of the lease payments
- Recognize interest expense associated with the lease liability separately from amortization of the right-of-use asset in the income statement
- Classify repayments of the principal portion of the lease liability in financing activities in the statement of cash flows, and payments of interest on the lease liability and any variable payments in the operating activities in the statement of cash flows
Lessee Requirements for Operating Leases
- Record a right-of-use asset and a lease liability, initially measured at the present value of the lease payments
- Record a single-lease cost, calculated so that the cost of the lease is allocated over the term of the lease, generally on a straight-line basis
- Classify all cash payments within operating activities in the statement of cash flows
The accounting for leases by lessors is generally the same as it has been under previous GAAP. For example, the vast majority of operating leases should remain as operating leases (i.e., lessors recognize income for operating leases on a generally straight-line basis over the term of the lease).
Topic 842 also requires entities to separate the lease components from the non-lease components (e.g., maintenance provisions of a lease contract). Although this was a requirement from previous GAAP, the new lease accounting standard details more guidance on identifying and separating such provisions. In essence, only the actual components of the lease (e.g., base rental payment, exclusive of things like common area maintenance charges) are subject to the lease accounting standard. Non-lease components are separately allocated on a stand-alone basis, and should be accounted for in accordance with other existing GAAP. For example, a reimbursement of costs of the lessor by the lessee is not a component of the lease, and thus, is not considered part of the lease commitment, subject to the lease accounting standard.
However, there is a practical expedient provided within the language of Topic 842 that allows lessees to make an accounting policy election to not separate lease components from non-lease components.
Lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a “modified retrospective approach.” This approach includes the option to elect to apply practical expedients, such as:
- Identification of leases that commenced before the effective date of this pronouncement
- Initial direct costs that commenced before the effective date
- Ability to use hindsight in evaluating lessee options to extend or terminate a lease, or to purchase the underlying asset
Should an entity elect to apply the practical expedients, it will essentially continue to leases that commence prior to the effective date of this pronouncement in accordance with previous GAAP, unless the lease is modified. However, lessees are still required to recognize a right-of-use asset and corresponding lease liability at each reporting date, based on the present value of the remaining minimum rental payments that were disclosed under previous GAAP.
The new standard is effective for periods beginning after Dec. 15, 2018 (including interim periods within those fiscal years) for public entities, and for periods beginning after Dec. 15, 2019, and interim periods within fiscal years beginning after Dec. 15, 2020, for all other entities. Early adoption is permitted for all entities.
Companies must understand the changes to current GAAP based on this ASU, understand the transition requirements and educate users and other stakeholders about the changes they can expect in companies’ financial statements. There are a number of steps companies can take to begin to prepare for this significant change in accounting for leases and ensure a seamless transition. These steps include:
- Assigning an individual or team within the organization to take the lead in understanding and implementing the new lease accounting standard
- Updating lease inventories
- Deciding on how they will transition
- Reviewing legal agreements and debt covenants
- Considering whether improvements to the IT system are necessary
- Discussing with stakeholders the potential impact on financial statements
As stated earlier, this is a significant change in the method of accounting for leases that will require preparation and planning to ensure this change is handled appropriately.