Plan ahead for changes to accounting for leases

August 15, 2017|Chris Roble

Updated guidance on lease standards will affect all companies issuing financial statements in accordance with U.S. GAAP, and you’ll need to begin planning for the implementation of these changes.

In Accounting Standards Update (ASU) No. 2016-02, Leases, the Financial Accounting Standards Board (FASB) issued its final guidance on the accounting for leasing activities under its new principles-based accounting model. The new lease guidance is developed to enhance the transparency in financial reporting of an entity’s leasing transactions and removes industry-specific lease guidance.

In its main provisions, the FASB eliminated the significantly different accounting treatments for lease recognition under current U.S. generally accepted accounting principles (GAAP) as either capital or operating leases. In some instances, leases have resulted in recognized assets and liabilities in financial statements under capital lease accounting. Alternatively, the favorable treatment of some leases as operating leases have resulted in an off-balance sheet financing transaction by lessees.

Based on this divergence in lease treatments and classifications, under the new lease standard, lessees will be required to recognize assets and liabilities in the lessee’s balance sheet for the majority of leases to improve the transparency of an entity’s financial leverage included in its financial statements.

Development of new lease accounting standard

The new lease accounting standard was issued in its final form on February 25, 2016, and was published after nearly a 10-year joint project between the FASB and the International Accounting Standards Board (IASB). Before finalizing the standard, the FASB conducted significant deliberations with interested parties, including the issuance of two exposure drafts and holding over 200 meetings with company preparers, 15 public roundtables, and 15 preparer workshops which were attended by 90 organizations. With its expansive reach in its development, this standard will affect all companies issuing financial statements in accordance with U.S. GAAP which lease assets such as buildings, machinery and equipment, vehicles and transportation equipment, and office equipment.

Right-of-use model

A foundation to the new lease standard is an entity recognizing right-of-use assets and lease liabilities in the entity’s balance sheet for identified assets where control is transferred between the lessor and lessee in a contract arrangement.

The definition of a lease is more broadly constructed under the new lease standard, as compared to the previous lease guidance. The revised definition of a lease, under the new guidance, is “a contract, or part of a contract, which conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time, in exchange for consideration.”

As the previous definition of a lease agreement conveyed the use of property and equipment over a period of time, the new definition may result in additional asset and liability recognition, as the definition is applied to each of an entity’s contracts. When this transfer of an identified asset has occurred under contract and at the commencement of a lease, lessees will be required to recognize the following for all leases (with the exception of short-term leases):

  • A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term
  • A lease liability, which is the lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis

As compared to existing U.S. GAAP, the new lease accounting standard requires a new classification system of leases as either a finance lease, operating lease or a short-term lease. The new lease standard eliminates the old, two-tiered GAAP classifications of capital leases, which were less commonly used in lease structures, and the more commonly used operating leases that are an off-balance sheet financing activity.

In the new lease standard, the FASB has retained many similar principles for lease classification in defining either finance or operating classification:

  • Transfer of ownership
  • Lease contains a purchase option
  • Lease term is for the majority of the estimated economic life of leased property, and
  • Present value of lease payments exceeds substantially the fair value of the asset, the asset is of a specialized nature that is expected to have no alternative use at the end of the lease term to the lessor

A key distinction in the new criteria is that the “bright line tests” have been removed (75% useful life, 90% minimum lease payment threshold), as used in the previous lease guidance.

When an identified asset transferred under a contract meets one of the criteria, the lease will be classified as a finance lease. As simply defined in the new guidance, operating leases are any leases other than a finance lease. An exception exists to recording right-of-use assets and lease liabilities under a short-term lease exception. A short-term lease is defined as one that is 12 months or less at inception, including all extension options, and that the lessee is not expected to exercise an option to purchase.

From a statement of financial position perspective, the key distinction in the new lease standard compared to the previous guidance is that lessees will recognize both a right-of-use asset and associated lease liabilities for generally all finance and operating leases.

In contrast, the statement of income reporting will diverge slightly for each type of lease. For finance leases, expense recognition will be reflected in the financial statements in two areas, amortization of the right-of-use asset and interest on the lease liability. For operating leases, expense recognition will be reflected in the financial statements in a single lease cost. Under the disclosure requirements of the financial statements, right-of-use assets for both finance and operating leases will require separate presentation, either in an entity’s financial statements or within the footnotes to the financial statements.

Effective dates and modified retrospective transition approach

Ultimately after deliberations of the transition methods available in adopting the new lease standard, the FASB determined that entities will implement the standard using a modified retrospective approach.

From a timing perspective, the new standard is effective for fiscal years beginning after December 15, 2019 (January 1, 2020 for a calendar-year entity) for nonpublic entities. For public companies, the standard is effective a year earlier, for fiscal years and interim periods in those fiscal years beginning after December 15, 2018. Early adoption of the new leasing standard is permitted.

Under this method and timeline, lessees will first recognize the right-of-use assets and lease liabilities as of the earliest period presented in the entity’s financial statements. Therefore, assuming a calendar-year entity adopts the new lease standard for its year ending December 31, 2020, right-of-use assets and lease liabilities will be recorded as of January 1, 2019, the earliest period presented in comparative financial statements.

Recommendation

In planning for the implementation of the new lease standard, entities should begin by preparing an inventory of all leases, then assess your asset capitalization threshold and continue to monitor implementation strategies for recording right-of-use assets and lease liabilities.

With the forthcoming and the extent of the changes in the new lease standard, it will be vital for you to plan for and then execute the implementation process. Contact your Schenck assurance advisor for assistance in planning for the implementation of this new standard and determining its impact on your business.


Chris Roble, CPA, is a shareholder who has nearly 15 years of audit and financial reporting experience. He specializes in the planning, supervision and review of external audit engagements primarily serving the trucking, logistics and manufacturing industries.