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Preparing for the New Lease Accounting Standard

January 15, 2018

In early 2016, the Financial Accounting Standards Board (FASB) issued a new lease accounting standard that will affect all companies that lease buildings, equipment and other assets. Codified in ASC 842, the new guidance is intended to increase transparency and streamline financial reporting across these organizations.

This new standard will become effective for public companies for fiscal years beginning after December 15, 2018. Private companies have until fiscal years ending after December 15, 2019 to comply. However, early application of the rues is permitted, and preparation for the changes is essential.

A New Way to Account for Leases

The majority of changes in the new standard were made to the way lessees account for lease-related assets and liabilities on their balance sheets. While the new standard does not change the basic accounting framework for lessors, guidance has been amended in certain areas that affect them as well.

Generally speaking, all leases with a term of more than 12 months will need to be recognized on a lessee’s balance sheet. This differs from current Generally Accepted Accounting Principles (GAAP) guidance that requires only capital leases to be reported.

When identifying which leases will be affected, keep in mind the following updated definitions, processes and guidance contained within the Accounting Standards Update (ASU) issued by the FASB:

Lease Term

The new standard defines the lease term as “the non-cancellable period of the lease adjusted for options to renew the lease, terminate the lease or purchase the leased asset.” The renewal period must be included in the term if the lease can be renewed at the option of the lessee and the lessee is reasonably certain to exercise that option. If the lease can be renewed at the option of the lessor, the renewal period is included in the term, regardless of lessee intent.

Lease Components

Once a lease is identified as subject to the new standard, an entity needs to consider whether the contract includes more than one lease component or non-lease components. When the lease includes non-lease components, such as cleaning services, gym access, concierge services or building security, the fixed payments to be paid during the lease term need to be allocated based on the relative standalone prices of those components.

A lessee is permitted, however, to elect to account for each lease component and its related non-lease components as a single lease asset.

Lease Classification

The new standard also changes the way lessees and lessors are required to classify leases. 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, on the other hand, 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.

Lease Recognition and Measurement

Some of the most significant updates to the standard affect the way lessees and lessors recognize and measure leases on their balance sheets.

Lessees must now record a lease liability and a related right-of-use (ROU) asset on their balance sheets on the commencement date of the lease. The lease liability figure is determined by the present value of future lease payments. A ROU asset is based on the cost of the asset, including the lease liability, pre-payments and initial direct costs (i.e. incremental costs that an entity would not have incurred had the lease not been obtained).

For lessors, the standard now requires that net investment in sales-type leases and direct financing leases appear on the balance sheet separate from the lessor’s other assets.

Short-term Leases

Under the new standard, a lessee can elect to exclude short-term leases from the ROU asset and lease liability. Short term leases have a term of 12 months or less and do not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

Sales and Leasebacks

The new standard simplifies the accounting model for sales and leaseback transactions. Under the new accounting model, the transfer of the asset is accounted for as a sale only if: (1) It meets the conditions in the new revenue recognition standard, and (2) the lease qualifies as an operating lease under the new lease standard. Otherwise, the transaction is accounted for by both the seller/lessee and the buyer/lessor as a financing arrangement.

Gains and Losses

Under the new standard, both gains and losses are immediately recognized as income.

Presentation

Updates have also been made to the presentation of interest expenses, cash flow, and variable lease payments, as well as the amortization of ROU assets and allocation of lease costs on a straight line basis.

Impairment of Lessor’s Net Investment in the Lease

Lessors are required to assess the net investment in the lease (i.e. combined lease receivable and any unguaranteed residual asset) for impairment.

Disclosures

Lessees and lessors will be required to provide additional disclosures to help balance sheet users assess the amount, timing and uncertainty of cash flows from leases. The disclosures include both qualitative and quantitative items.

Transition Approach

The new lease standard requires companies to transition to the new accounting requirements using the “modified retrospective approach” which requires companies to recognize and measure leases as of the beginning of the earliest year presented in their financial statements in the year the new lease standard is adopted.

Preparing for the New Lease Accounting Standard

While some leases are straightforward with relatively standard terms and conditions, many are complex agreements tailored to the specific needs of the lessee or requirements of the lessor. The more complex the transaction, the more complex the accounting.

Developing a transition plan should be an immediate priority for both public and private companies. Financial reporting personnel need to be educated regarding the application of the new standard, but individuals from departments other than accounting and reporting should also be involved in planning activities, such as:

  • Identifying all leases
  • Evaluating leases individually to determine applicable accounting model for each
  • Subsequently accounting for each lease, including disclosures
  • Assessing the impact on contractual agreements, such as bank loan covenants
  • Evaluating the efficiency and effectiveness of existing processes and controls over leasing activities
  • Ensuring that vendor products used to handle lease administration (i.e. classification, measurement and recognition) will be compliant under ASC 842

After initial implementation, the new standard will require ongoing evaluation of a company’s leases to ensure compliance when any changes are made to a lease’s terms, components, disclosures, etc. With the help of your CPA, early planning and action are critical to ensure timely preparation and continual compliance.