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Navigating the Revised Lease Accounting Standards

Navigating the Revised Lease Accounting Standards
Many companies choose to lease certain assets, rather than buy them outright. Leasing arrangements are especially common among construction contractors, manufacturers, retailers, health care providers, airlines and trucking companies that rely on expensive equipment or real estate in their day-to-day operations.

Roughly 85% of these leases aren’t reported on company balance sheets, according to estimates made by the Financial Accounting Standards Board (FASB). However, that is going to change under a new accounting standard – Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) – that was issued in 2016.

Financial Reporting Incentive to Lease
Management may decide to lease assets for a variety of reasons. For example, they may not have enough cash for down payments or access to financing – or they may not want to bear the risk that equipment will become technologically obsolete or property values will nose-dive. In essence, leasing can allow companies to be more flexible, lower risk and adapt to changing market conditions.

From a financial reporting perspective, leasing offers an added bonus: Under the existing rules, a lease obligation is reported on the balance sheet of the lessee as a capital lease only if the arrangement is similar to a financing arrangement by meeting one of four criteria:
  1. Transfer of ownership. The lease transfers ownership of the property to the lessee by the end of the lease term.
  2. Bargain purchase option. The lease contains a bargain purchase option.
  3. Lease term. The lease term is equal to 75% or more of the estimated economic life of the leased asset.
  4. Minimum lease payments. The present value, at the beginning of the lease term, of the minimum lease payments, equals or exceeds 90% of the fair value of the leased asset.
Absent one of the above provisions, the lease is currently classified as an operating lease, which is expensed as lease payment are incurred and the terms of the lease arrangement are disclosed in the footnotes to the financial statements. Globally, this treatment has allowed companies to hide trillions of dollars of operating leasing obligations in their footnote disclosures, rather than report them on their balance sheets.

The FASB Finalizes Long-Awaited Leasing Standard
The lease accounting project has been on the FASB’s agenda for more than a decade. In 2013, the FASB proposed another round of changes to lease accounting, which were largely aligned with an international accounting proposal on leasing. However, these proposals were met with significant opposition around the world. Therefore, the FASB and the international accounting standards board subsequently abandoned their effort to create a converged lease accounting standard and separately went back to their own drawing boards.

The finalized standard on lease accounting under U.S. Generally Accepted Accounting Principles is a watered down version of the FASB’s 2013 proposal. The big difference under the updated guidance when compared to existing guidance is that all leases (financing and operating) with terms of more than 12 months will be reported on the balance sheet. In other words, lessees will report a liability to make lease payments, initially based on the net present value of those payments, and a right-to-use asset for the term of the lease. When determining a discount rate for calculation of the net present value of the lease payments, the lessee should use its incremental borrowing rate at lease commencement if a rate implicit in the lease is not known.

Lessees may make an election to not recognize lease assets and lease liabilities for a short-term lease, which is defined as a lease term of 12 months or less.

The classification of financing leases still includes many of the same criteria utilized in prior guidance when identifying capital leases, although the terminology “capital lease” has been removed from the new standards. Definitive percentages used in the tests for lease term and minimum lease payment have also been eliminated, resulting in the lease classification becoming more subjective (although in practice it is assumed most entities will continue to utilize the percentages under prior guidance). In addition, new criteria regarding the nature of the leased asset has also been thrown in the mix. Essentially, a lessee will classify a lease as a financing lease when the lease meets any of the following criteria at the onset of the lease:
  • Transfer of ownership. The lease transfers ownership of the property to the lessee by the end of the lease term.
  • Purchase option. The lease contains a purchase option that the lessee is reasonably certain to exercise.
  • Lease term. The lease term is for the majority of the remaining economic life of the leased asset.
  • Minimum lease payments. The present value, at the beginning of the lease term, of the minimum lease payments, equals or exceeds substantially all of the fair value of the leased asset.
  • Nature of assets. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
If all leases must now be reported on the balance sheet, why does the classification criteria matter? Well, the new standard still allows for a distinction between how financing and operating leases are reported on the income statement and statement of cash flows. Financing leases will continue to report interest and amortization expense, in addition to rent expense. Because interest is calculated on a declining balance over time, the cost of financing leases will look more expensive at the beginning of a lease. Leases that qualify as operating leases will be treated as simple rentals on the income statement. Therefore, companies with rental-type contracts would report lease payments evenly over time.

Lessees will need to expand disclosures about the terms and assumptions used to estimate their lease obligations, including information about variable lease payments, options to renew and terminate leases, and options to purchase leased assets. As a practical expedient, the new standard allows private companies and not-for-profit organizations to use risk-free rates to measure lease liabilities.

The new standard also provides guidance on how to determine whether a contract includes a leasing arrangement and, therefore, must be reported on the face of the balance sheet. For example, some “combined” contracts include lease and service provisions. These components generally need to be valued separately, because ASU 2016-02 requires companies to report only lease provision on the balance sheet. For simplicity, however, the FASB allows companies with combined contracts to elect to also account for non-lease provisions under this guidance, if they prefer.

While the revised guidance provides a significant change to lessee accounting, the key concepts in the new lessor accounting are mostly consistent with current standards. However, initial direct costs of a lease were re-defined, which may result in more costs being expensed by the lessor rather than capitalized at the onset of a lease. In addition, lessors will see changes in the accounting guidance as it pertains to variable consideration and sale and leaseback transactions. The changes made to this guidance were to align with recent changes made to FASB’s new revenue recognition standard, ASU 2014-09.

Lease Accounting Example
For a simplified example comparing lease accounting under existing and future guidance from a lessee perspective, let’s assume the following facts:

All lease payments are made annually in arrears - $105,000 at the end of Year 1, $120,000 at the end of Year 2, and $135,000 at the end of Year 3. The assumed discount rate is 4.29%, resulting in a present value for lease payments of $330,000. An amortization table for the present value is presented below.
  Date Payment Interest Principal Balance
Loan 1/1/2019       330,000
1 12/31/2019 105,000 14,171 90,829 239,171
2 12/31/2020 120,000 10,271 109,729 129,442
3 12/31/2021 135,000 5,558 129,442 -
Grand Totals   360,000 30,000 330,000  

For applicable journal entries recorded under existing and future guidance, click here for continuation of the above example.

Effective Dates
Fortunately, you still have time to get your accounting systems and lease agreements in order. The new standard goes into effect for public companies with fiscal years beginning after December 15, 2018 (in other words, calendar-year 2019). Private companies have an additional year to implement the changes.
This doesn’t mean you should put this standard on the back burner for long. The lease standard requires a modified retrospective application, which requires measurement and recognition of leases at the beginning of the earliest period presented in comparative financial statements. The changes from the revised guidance could be significant from current accounting practices if you rely heavily on leased assets. Now is the time to begin reviewing all leases to accumulate the necessary information. In addition, it is recommended that companies engage in dialogue with the users of their financial statements to educate them on the expected changes to the financial statements. This is particularly the case with lenders, in order to identify the effect on any financial covenants included within debt agreements.