The Financial Accounting Standards Board’s (FASB) much anticipated standard on lease accounting (Leases – ASC 842) was finally issued on February 25, 2016. It’s now time to prepare to implement the new rules, which will take effect for public companies for fiscal years beginning after December 15, 2018. Although it seems like there is plenty of time, the rules are complex, so it’s essential to begin now.
To provide some background, the FASB issued ASU 2016-02 as part of its efforts to improve financial reporting related to leasing arrangements. Almost all entities will be affected by this standard, which is expected to increase the transparency and comparability financial reporting among entities. The overall purpose of this standard, which has been discussed among the accounting community for many years, is to bring substantially all leases on to the balance sheet, resulting in fewer opportunities for management to manipulate leasing agreements to accomplish favorable financial results. At the same time, the FASB has attempted to introduce a standard that is easy and inexpensive to implement.
Although most companies have been aware for a while that a new lease standard would eventually become a reality, not all have implemented controls and procedures to appropriately account for and track leases. One of the first steps is to make sure procedures are in place to inventory and track all leases. Leases may be embedded in other service type agreements or other arrangements, requiring additional analysis. It’s important to note that implementing this standard will likely affect more than just accounting entries and reporting. In addition to the disclosure requirements, items to consider include:
- The effect on debt covenants (have you begun discussions with your lenders
- State income tax considerations
- System requirements
- Buy vs. lease decisions
The standard is effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 (effective for private companies for fiscal years beginning after December 15, 2019), with early adoption permitted.
Below are key guidelines to keep in mind:
Lessee Accounting Model:
The Accounting Standards Codification (“ASC”) states, “The core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise from leases. 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 lease liabilities represents an improvement over previous GAAP, which did not require lease assets and lease liabilities to be recognized for most leases.” There continues to be a distinction between finance leases (akin to the old capital lease) and operating leases (akin to the old operating lease).
Under both an operating and finance type lease, the company will recognize a “right-of-use” asset and a liability to make lease payments based on present values. Leases under 12 months (short-term leases) are excluded from this guidance, when the appropriate accounting policy is present. There will be differences in the classification of lease expense and amortization expense on the income statement and cash flow statement, depending on the type of lease.
Lessor Accounting Model:
The lessor model is substantially the same as the previous GAAP model, with the most significant changes being terminology and alignment with the new revenue guidance of ASC 606.
Some additional observations from the guidance are as follows:
Lease options and variable payments:
When initially recording the asset and liability for a lease (or when determining if it’s a short-term or long-term lease), a company must take into consideration “options” when deemed to be “reasonably certain” to be exercised. Reasonably certain is a high threshold and is intended to be applied much like “reasonably assured” under the old guidance. The lessee should exclude variable or contingent lease payments, other than those that are indexed or a specific rate.
Topic 842 added guidance and clarification to the bifurcation of the components of a leasing arrangement. The guidance requires an entity to separate the lease and non-lease components (i.e., maintenance services and other activities that transfer a good or service to a customer) of a contract, as only the lease components are required to be accounted for under this Topic. It is generally practical for a company to treat these components as combined, but under the new lease standard, they must be separated.
This standard is required to be adopted under the modified retrospective transition method, with certain practical expedients, meaning the standard must be applied to all comparative periods presented and an adjustment made to opening equity.
One of the goals of this guidance is to provide the users of financial statements with more meaningful and transparent disclosures, including an assessment of future cash flow requirements under lease arrangements.
Under the guidance, there are certain lease arrangements that are exempt, including leases of intangible assets, leases of assets under construction, leases of biological assets, leases of inventory and leases for the use of minerals, oil, natural gas and similar non-regenerative resources.
There are many intriguing aspects to this new standard that can significantly affect how a company accounts for a lease arrangement, or if the arrangement is even required to be accounted for as a lease. As you prepare to implement this new standard, we at Friedman are available to help you navigate its nuances. The underlying reality is that the clock is ticking and now is the time to prepare.