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On February 25, 2016, the FASB issued ASU 2016-02, Leases, (the new lease standard) culminating a decade long project. The new standard creates ASC 842, Leases, in the FASB Accounting Standards Codification and will supersede ASC 840, Leases.The new lease accounting guidance was effective for public entities for fiscal years beginning after December 15, 2018. For nonpublic entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
The major difference between the existing guidance on accounting for leases and the new standard is that operating leases will now be recorded in the statement of financial position as assets and liabilities. Current U.S. GAAP requires only capital (to be known now as finance) leases to be recognized in the statement of financial position and amounts related to operating leases largely are reflected in the financial statements as rent expense on the income statement and in disclosures to the financial statements.
The new guidance permits a lessee to not recognize a lease that, at the commencement date has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. The lease term would include renewals that the lessee is reasonably certain to exercise.
The new guidance indicates that variable lease payments that depend on an index or a rate (such as the Consumer Price Index (CPI) or a market interest rate), be initially measured using the index or rate at the commencement date.
When measuring assets and liabilities arising from a lease, the new guidance requires a lessee (and a lessor) to include payments to be made in optional periods only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. Similarly, optional payments to purchase the underlying asset should be included in the measurement of lease assets and lease liabilities only if the lessee is reasonably certain to exercise that purchase option.
Many contracts contain both lease and non-lease (e.g., service) components. Some examples of potential non-lease service components include maintenance, cleaning, and repair services. Existing U.S. GAAP requires an entity to separate those components but provides limited guidance on how to make those separations and the distinction is typically of limited financial reporting consequence for current operating leases. The new lease standard also requires an entity to separate the lease components from the non-lease components. The lessee should determine the relative standalone price of the separate lease components and the non-lease components on the basis of their observable standalone prices. If observable standalone prices are not readily available, the lessee should estimate the standalone prices, maximizing the use of observable information. A residual estimation approach may be appropriate if the standalone price for a component is highly variable or uncertain.The new guidance allows a lessee to make an accounting policy election by class of underlying asset, to not separate non-lease components from lease components and, instead, to account for each separate lease component and the non-lease components associated with that lease component as a single lease component. In other words, keep the non-lease and lease components together. The result of electing this practical expedient will be to record additional lease liabilities.
Under current U.S. GAAP, if costs related to the lessor’s ownership of an asset are included in the lease payments, they are excluded from the definition of minimum lease payments and capitalized lease payments. Under the new guidance, payments that are reimbursements or payment of lessor’s costs (such as property taxes and insurance payments) do not represent a separate good or service. Therefore, they are not considered a non-lease component for which consideration is allocated in an arrangement that includes a lease. If a lease includes amounts in fixed payments that represent reimbursement of lesser cost for property taxes and insurance, these payments will now be considered as part of the lease liability. Entities may wish to design leases such that reimbursements for property taxes and insurance are considered variable lease payments and not initially recognized as part of the lease liability.
Costs that meet the new definition of initial direct costs can be included in the capitalized right-of-use asset. The new lease standard defines initial direct costs as the incremental costs of a lease that would not have been incurred if the lease had not been obtained and indicates that commissions may be an example. However, the new lease standard also explicitly notes that costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as fixed employee salaries, are not direct costs. Some lessees may currently include these costs as assets in current capital lease arrangements.
The new lease standard retains a distinction between finance leases (previously known as capital leases) and operating leases. According to the FASB, the classification criteria for distinguishing between finance leases and operating leases are substantially similar to the classification criteria for distinguishing between capital leases and operating leases in existing U.S. GAAP. However, the lease classification criteria in the new guidance does not depend on bright-line thresholds as they do in existing U.S. GAAP, although the guidance indicates that the current bright-line thresholds are “one reasonable approach” to determine lease classification. Also, according to the FASB, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from existing U.S. GAAP.For finance (capital) leases, a lessee is required to:
For operating leases, a lessee is required to:
Under current U.S. GAAP, entities are required to account for leases with related parties on the basis of the economic substance of the arrangement. In a potentially significant change under the new lease standard, the recognition and measurement requirements for all leases should be applied by lessees and lessors that are related parties on the basis of legally enforceable terms and conditions of the arrangement. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties. That is, account for leases between related parties based on the legally enforceable terms just like leases between unrelated parties. In the Basis for Conclusions, the FASB noted that lessees and lessors are required to apply the disclosure requirements for related party transactions in ASC 850, Related Party Disclosures. The FASB also noted that the existing U.S. GAAP requirement to account for leases with related parties on the basis of the economic substance of the arrangement can be difficult when there are no legally enforceable terms and conditions of the arrangement.
The new lease standard places all leases on the balance sheet while largely retaining current income statement treatments and lease classification. New processes, procedures, and controls will be necessary including segregating lease and non-lease components and new accounting for related party leases. Entities can prepare for the impact of the new lease standard by starting to identify their arrangements that meet the new definition of a lease and beginning to quantify the impact to the balance sheet as well as other key financial statement metrics. Further entities can then ensure proper ASC 842 adoption disclosures and estimated balance sheet impact is in this year-end’s disclosure notes to the financial statement. This may minimize the potential that users are surprised when all lease arrangements show up on the 2020 balance sheet.
The above article is a part of a report we provide each quarter with up-to-date information for consideration in your financial reporting and disclosures. Our goal is for you to have current, relevant information available. See the full report here:Click here for PDF
If you have questions or need more information related to the new lease accounting standard, please contact your Elliott Davis advisor.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.
