Understanding the Updated Lease Accounting Rules

By Alan Becker  |  May 29, 2018

Updated lease accounting rules have been the subject of numerous exposure drafts, comment periods and rounds of debate by the Financial Accounting Standards Board (FASB) and the accounting industry over the past decade. Finally, on February 25, 2016, FASB issued Accounting Standards Update (ASU) 2016-02, intended to improve financial reporting regarding lease transactions. The standard is applicable for public entities for years beginning after December 15, 2018 and for non-public entities for years beginning after December 15, 2019. In the nonprofit industry, nonprofit organizations that issue publicly traded debt will be treated as public entities, required to comply with the earlier effective date. All others have less than two years to prepare for these major changes to their lease reporting. Now is the time to understand the steps involved.

IDENTIFYING A LEASE

The first step in transitioning to the new lease accounting standard is to identify all of an organization’s leases that are subject to the new rules. A lease is defined as a contract conveying the rights to control use of an identified asset such as a building, vehicle or some other equipment with a term of more than 12 months, in exchange for some consideration by the lessee. Usually this consideration is in the form of periodic payments to the lessor. In a contract agreement such as this, the standard concludes that the rights being conveyed to the lessee constitute a right of use from the lessor to the lessee.

RECORDING A LEASE

The resulting accounting treatment under this standard will now require that the lessee record the entirety of future payments under the terms of the lease, discounted back to present value. The lessee must also record an offsetting adjustment to a right-to-use asset on the organization’s statement of financial position. The calculation should not include any non-lease components such as cleaning or janitorial service, security, etc. A lessee will need to follow the new guidance closely to determine if their leases should be classified as operating leases or finance leases. Lessors will use the new guidance to determine how to classify their leases into one of three types: sales-type leases, direct financing leases or operating leases.

MEASURING LEASE VALUE

The initial measurement being the commencement date of the lease, the lessee will measure both the present value of the lease payment not yet paid, discounted using the discount rate for the lease and the right-to-use asset. The lessee should use the rate implicit within the lease document if that rate is determinable. If the rate is not determinable, the lessee would use its incremental borrowing rate. If the lessee is not a public business entity, they would be permitted to use a risk-free discount rate for the lease based on a period comparable with that of the lease term.

The FASB concluded this process would result in a better representation of the actual rights and obligations of an organization that arise from leasing obligations, more so than the previous method of footnoting the future commitment obligation at the end of an entity’s financial statement.

PREPARING FOR THE CHANGES

Organizations should find time right away to conduct an inventory of all the lease agreements they currently have and will be entering into. They should then calculate how recording the right-to-use asset and lease obligations on their statements of financial position will impact the presentation of those statements.

For organizations that have numerous equipment, vehicle and rental lease agreements, this can be a painstaking process and could require a significant amount of time to gather, assess and calculate all the necessary information to ensure that the correct right-to-use assets, liabilities, and proper discount calculations are being applied in time for implementation.

Additionally, for organizations that have debt that includes financial covenants (e.g. debt to equity ratios), the new lease standards could have a negative impact on these ratios and may throw an organization out of compliance. By performing these calculations well in advance of the standard’s effective date, the organization will be able to project whether any covenants could be impacted and require an immediate conversation with their financial institutions.

OTHER NEW STANDARDS

The new lease accounting standard is one of several updates that were released from FASB and are approaching their effective dates. ASU 2016-14 (Nonprofit Financial Reporting Model) and ASU 2014-09 (Revenue from Contracts with Customers),

were also released as part of an overall effort to create a single principles-based revenue recognition standard and eliminate inconsistencies in Generally Accepted Accounting Principles (i.e. disparate industry-specific revenue recognition guidance).

ASU 2016-14 includes major changes in the way nonprofit organizations’ financial reporting will look going forward and is designed to paint a better picture of the nonprofit’s overall financial situation. Public organizations already had to comply with the new standard in 2017, while it will affect private nonprofits for years beginning after December 15, 2018.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which focuses on contracts with customers but does not include lease contracts (covered in ASU 2016-02), insurance contracts, financial instruments, guarantees, certain nonmonetary exchanges, and contributions and collaborative arrangements (i.e. the parties to the contract share costs, risks and benefit).

While these two standards take effect sooner than the new lease accounting rules, don’t lose sight of the significant amount of data gathering, analysis and calculations that need to be done to get your organization’s leases ready for the change. Early preparation is key to a smooth and successful transition.

 

 

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