Accountants have been taught since the mid-1970s to review executed lease contracts for any one of four criteria that would dictate whether a lease contract is to be categorized as a capital lease or as an operating lease. While those four criteria are specific, seemingly similar lease contracts are, in fact, being treated differently within financial statements. For example, debt covenants and/or calculations involving EBITDA show the impact of a capital lease is different from the impact of an operating lease.
Currently, capital leases require the lessee (the company leasing the asset) to recognize an asset and a liability on its balance sheet, and subsequently recognize both depreciation expense and interest expense within the income statement. Conversely, operating leases only require recognition of rent expense in the income statement. With no impact on the balance sheet, operating leases were a common form of off-balance-sheet financing.
After 10 years in the making, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2016-02: Leases in February 2016. The amendments included in this guidance are intended to address criticisms of existing accounting and reporting rules and increase overall transparency and comparability of financial statements.
What You Need To Know
1. Lease Classification Remains: The amendments maintain the dual model for lease classification by requiring leases to be classified as finance or operating leases in a manner similar to existing guidance. A lessee shall classify a lease as a finance lease when the lease meets any of the following criteria at lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option (that the lessee is reasonably certain to exercise) to purchase the underlying asset.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or substantially exceeds all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
If none of the five criteria above are met, a lessee shall classify a lease as an operating lease.
2. No Matter the Lease Classification, all Leases will be Recorded in the Balance Sheet: The most significant change from existing guidance is the requirement that operating leases be recorded on the lessee’s balance sheet. Because lease contracts convey a right to use an asset for the duration of the lease, the amendments indicated the lessee will recognize a right-of-use asset and a lease liability in the balance sheet as the present value of the lease payments. The lessee should use the rate implicit in the lease as the discount rate. If that rate is not readily determinable, the lessee should use its incremental borrowing rate. For non-public companies, the lessee is permitted to make an accounting policy election to use a risk-free discount rate using a period comparable to the lease term.
3. Operating Leases will be Reported as a Single Lease Cost in the Income Statement: Rather than separately recognizing amortization of the right-of-use asset and interest expense on the lease liability within the income statement as a lessee does with a finance lease, the cost of an operating lease is calculated and recognized as a single cost (e.g., rent expense).
4. All Cash Payments on Operating Leases will be Classified within the Operating Activities in the Statement of Cash Flows
5. Short-Term Lease Exceptions: For leases with a term of 12 months or less that do not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise, a lessee may be permitted to make an accounting policy election, by class of underlying asset, not to recognize lease assets and liabilities. If a lessee makes this election, the lessee should recognize lease expense for such leases generally on a straight-line basis over the lease term.
6. There is no Grandfathering: The FASB has called for a modified retrospective approach, so all executed leases in effect as of the effective date for these amendments will be impacted by the amendments.
7. When will the Amendments be Effective? For public companies (and certain non-profitentities and benefit plans), the amendments of ASU 2016-02 are effective for fiscal years beginning after December 15, 2018. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019. Early application of the amendments in this update is permitted for all entities.
It addition to the above, we also highlight the FASB transition guidance that requires the recognition and measurement of leases at the beginning of the earliest financial statement period presented using a modified retrospective approach. Said differently, while the amendments are first effective for a calendar year non-public company during the year ended December 31, 2020, presenting comparative financial statements would necessitate application of the amendments to the year ended December 31, 2019 using the modified retrospective approach.
8. Lessor Accounting has not been Fundamentally Changed.
While the effective date of these amendments may be several years away, we recommend companies begin to familiarize themselves with these new amendments and to think about the impacts the changes will have on their financial statements. What is the magnitude of the assets and liabilities that will need to be recorded? Do the changes impact debt covenants? We encourage companies to start collecting data now to help them ease the pressures of transition. Companies should begin to schedule how many leases they have, the renewal dates of those leases, any other significant terms.