FASB Issues New Standard for Lease Accounting

Expanding the Lessors Qualitative and Quantitative Disclosures

In February 2016, the FASB issued Accounting Standards Update (ASU) 2016 – 02, Leases (Topic 842). The existing standard has been criticized because its bright line classification criteria enabled entities to structure leases in such a way as to avoid putting them on the balance sheet. The standard aims to improve and simplify the financial reporting for leases and create a model that provides for faithful representation of leasing transactions for both lessees and lessors. This article summarizes the change.

Overview

In February 2016, the FASB issued Accounting Standards Update (ASU) 2016 – 02, Leases (Topic 842).  The existing standard has been criticized because its bright line classification criteria enabled entities to structure leases in such a way as to avoid putting them on the balance sheet.  The standard aims to improve and simplify the financial reporting for leases and create a model that provides for faithful representation of leasing transactions for both lessees and lessors.

The objective of the standard is to improve information for financial statement users by increasing transparency and comparability among organizations.  To accomplish this, the standard requires:

• Lessees to recognize lease assets and lease liabilities on the balance sheet; and
• Lessees and lessors to disclose significant information about lease transactions.

Lessors

The lessor accounting model is substantially unchanged.  However, lessors will have to review their systems and processes to ensure data will be available to management for the new required disclosures.  The main focus of the FASB was specifically to improve the guidance for operating leases in the financial statements of lessees.  Therefore, the Board decided to not make fundamental changes to lessor accounting.  However, some changes were made to lessor guidance in order to conform and align it to the new guidance for lessees and the new revenue recognition guidance, Topic 606, Revenue from Contracts with Customers.  The new lease standard is aligned with the revenue recognition standard, and those familiar with that standard will see some similarities in terminology and approach.

Lessor accounting remains substantially unchanged.  Lessors will retain the current classifications:

• Sales-type
• Direct financing
• Operating leases

However, leveraged lease classification is eliminated going forward.

Lessees

Lessees will recognize all leases, other than short-term leases, on the balance sheet.  Lessees will recognize a right-of-use (ROU) asset and a lease liability for those leases.  This may significantly increase reported assets and liabilities for some lessees for some leases.  For the first time, long-term operating leases will appear on the balance sheet as non-debt liabilities.  The new guidance offers some relief by exempting leases with terms of less than 12 months.  As a consequence, some lessees may request new or renewed leases with terms less than 12 months.

The critical determination is whether a contract contains a lease.  Lessees will classify leases as either operating or financing leases.  Under current GAAP, the classification of a lease determines whether or not it is on the balance sheet.  Under the new standard, because all leases will generally be on the balance sheet, the classification determines how entities measure and present lease income and expenses and cash flows.  A lease is present in the contract if the contract includes:

• An identified asset:
  The asset is explicitly or implicitly specified.
  The supplier has no practical ability to substitute or would not economically benefit from substituting.
• The right to control the use of the asset during the term of the lease:
  The lessee has decision-making authority over the use of the asset.
  The lessee has the ability to obtain substantially all economic benefit from the use of the asset.

Those familiar with the revenue recognition standard will recognize these “power and benefit” concepts.

Effective Date

The new standard is effective as follows:

	Public Business Entities	All Other Entities
Effective Date	Annual and interim periods in fiscal years beginning after December 15, 2018	Annual periods beginning after December 15, 2019 Interim periods in financial statements beginning after December 15, 2019
Early Adoption	Yes	Yes

 

Note that in order to capture comparative data, some companies will have to keep two sets of records beginning in 2017.  Some entities may want to take advantage of the synergies between the new revenue recognition standard and the lease standard by early adopting and aligning processes.

Key Terms in the Standard

A lease is a contract, or part of a contract, that 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.

Right-of-use asset is an asset that represents a lessee’s right to use an underlying asset for the least term. (ASC 842-10-20)

Transition

Like the revenue standard, the leases standard provides for transition using the modified retrospective transition approach.  The approach must be applied to all comparative periods presented.

Practical Expedients

Again, as with revenue recognition standard, the standard setters provide practical expedients to ease the transition.  The expedients must be applied consistently to all leases.  The expedients include:

• An entity may elect not to reassess:
  Whether expired or existing contracts contain leases under the new definition of a lease.
  Lease classification for expired or existing leases.
  Weather previously capitalized initial direct costs would qualify for capitalization under the new standard.
  (The above expedients must be elected as a package at the date of adoption.)

• Use of hindsight when determining the lease term and in assessing impairment of right-to-use assets.
• Making an accounting policy election by class of underlying asset not to separate lease components from non-lease components. Entities making this election account for the non-lease components and the lease components as a single lease component.

Significant Changes from Current U.S. GAAP

Collectibility Uncertainties

Under current GAAP, a lease with uncertainties related to collectibility cannot be classified as a sales-type lease.  This changes with the new standard.  Where collectibility of the lease payments plus any amount necessary to satisfy a lessee residual value guarantee is not probable for a sales-type, the entity accounts for the lease as follows:

• Lease payments received are recognized as a deposit liability rather than income.
• Generally, the underlying asset is not derecognized until collectibility of the remaining amounts becomes probable.

For a lease that otherwise would be a direct financing lease, collectible uncertainties require that the lease be classified as an operating lease.

Significant Variable Lease Payments

The new standard permits leases with predominantly variable payments to be classified as sale-type or direct financing leases.

Definition of Initial Direct Costs

The new standard’s definition is narrower than under current GAAP.  The new definition excludes:

• Legal fees
• Costs of evaluating the prospective lessees financial condition
• Costs of negotiating lease terms and conditions
• General overhead expenses

Those expenses must be expensed as incurred.  This change may have the effect of some lessors recognizing more expenses before the lease begins, and it may create higher margins on lease income earned over the lease term.

Allocation of Consideration to Lease and Non-Lease Components

The new standard only applies to accounting for leases.  So, if an entity has a lease that has a non-lease component, like a service component, that component is accounted for under the new revenue recognition standard.  (Also, see Practical Expedients above.)

The lessor may have executory costs to cover ownership of the underlying asset, like property taxes or insurance.  Those costs do not represent payment for a good or service and under current GAAP are excluded from lease accounting.  Under the new lease standard, such costs are allocated to the lease and non-lease components in the same manner as all other payments in the contract.

New Disclosures

The standard significantly expands qualitative and quantitative disclosures.  The lessor’s disclosures include:

• Qualitative information:
  Information about the nature of variable payment arrangements and termination, renewal, or purchase options.
  Information about how the lessor manages the residual asset, including a bad residual value guarantee and other means of limiting that risk.
  Significant accounting judgment and estimates.
• Quantitative information:
  Maturity analysis of lease receivables for sales-type and direct financing leases.
  Table of lease income, showing:
  Selling profit or loss recognized at lease commencement and interest income for sales-type and direct financing leases.
  Operating lease income.
  Variable lease income.

The lessee’s disclosures include:

• Qualitative:
  Nature of lease, such as terms and conditions of variable lease payments, extension and termination options, purchase options, and residual value guarantees.
• Quantitative:
  Operating lease cost.
• Amortization of finance lease ROU assets.
  Interest on finance lease liabilities.
  Variable lease cost new weighted-average discount rate.
  Maturity analysis of lease liabilities.
• Significant Judgments:
  Such as whether a contract contains a lease, stand-alone price for lease and non-lease components, and the discount rate for the entities leases.

Sale-Lease Back Accounting

Under current GAAP, a failed sale for the seller-lessee is not accounted for as a failed purchase by the buyer-lessor.  The new standard requires buyer-lessors to evaluate whether they have purchased the underlying asset based on the transfer of control guidance in the new revenue recognition standard.  The buyer-lessor must also account for failed purchase as a financing arrangement.

The new standard brings sale-leaseback transactions onto the balance sheet by requiring seller-lessees to recognize a ROU asset and a lease liability for the leaseback.

If the transaction does not meet the qualifications for sale under the revenue recognition guidance, the seller-lessee accounts for it as a financing transaction.  Purchase options preclude sale accounting unless:

• The strike price of the repurchase option is the fair value of the asset at the option exercise date; and
• There are assets that are substantially the same as the underlying asset and that are readily available in the marketplace.

If the sale-leaseback transaction qualifies as a sale of the underlying asset, the seller-lessee recognizes the entire gain from the sale at the time of sale as opposed to recognition over the leaseback terms.  The gain is the difference between the selling price and the carrying value of the amount of the underlying asset.  The sale-leaseback guidance is the same for all assets, including real estate.

Build-to-Suit Lease Guidance

Build-to-suit lease guidance is eliminated by the new standard.  The standard states that a lessee is the owner for accounting purposes of an asset under construction if it controls the asset before the lease commencement date.  The rules for determining control of an asset will likely result in fewer instances where the lessee is deemed the accounting owner of an asset during the construction period.  Under current GAAP, build-to-suit assets and liabilities may have remained in the balance sheet after the end of the construction period.  When those entities transition to the new guidance, many will be able to recognize those assets.

Implementation Considerations

As part of its change management approach to the new standard, management will want to have a robust implementation plan.  When implementing its project plan, management may want to:

• Review existing leases.
• Evaluate the ability of current systems to collect and maintain all the data necessary for compliance. IT systems must capture data for proper period or date related to disclosures.
• Identify where more judgment is required. Implement processes and controls to make sure adequate processes and controls are in place.  Also, make sure adequate documentation is in place to respond to auditors or regulators.
• Determine whether the standard affects other areas, such as:
  Taxation
  Debt covenant compliance. Debt covenants are often based on a measure of net income.  Entities must be careful not to unintentionally violate an agreement.  Debt covenants may have to be modified in preparation for change, while at the same time keeping their original intent.
• Review standard leases and determine if language should be changed. The standard introduces some new terms and those should be considered.
• Review lease terms. Entities want to make changes to better align with the standard.
• Analyze how implementation affects net income and communicate it internally, but also to stakeholders.
• Evaluate the need for training at all levels: audit committees, management, operational units.

Joanne Flood, MBA, CPA, (Rockville Centre, NY) has accounting experience within both a Big 4 international firm and a small firm. She has worked as a senior manager in the AICPA’s Professional Development group. Ms. Flood received her MBA in Accounting Summa Cum Laude from Adelphi University. She has written and produced training materials in a wide variety of media, including print, video, and audio, and pioneered the AICPA’s e-learning product line.
Ms. Flood can be reached at (516) 536-4374, or by e-mail to jflood3@optonline.net.