June 13, 2016

The New Lease Accounting Standard

On February 25, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases. The new standard creates Topic 842, Leases, in the FASB Accounting Standards Codification (FASB ASC) and supersedes FASB ASC 840, Leases. Entities that hold equipment and real estate leases, in particular those with operating leases, will be most affected by the new guidance. The amendments in ASU 2016-02 are expected to impact balance sheets at many entities by adding lease-related assets and liabilities. This may affect compliance with contractual agreements and loan covenants.

The new standard is effective for fiscal years, and interim periods within such fiscal years, beginning after December 15, 2018 for public companies, and December 15, 2019 for all other entities. Entities will be required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. Early application of the amendments is permitted for all entities.

The main 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. generally accepted accounting principles (U.S. GAAP) requires only capital (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 in the statement of activities and in disclosures to the financial statements. ASU 2016-02 retains a distinction between finance 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. 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.

ASU 2016-02 requires a lessee to recognize the assets and liabilities that arise from leases (operating and finance). However, for leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election not to recognize lease assets and lease liabilities. If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.

Lessee Accounting

For operating leases, a lessee is required to do the following:

Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position.
Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis.
Classify all cash payments within operating activities in the statement of cash flows.

For finance leases, a lessee is required to do the following:

Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position.
Recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income.
Classify repayments of the principal portion of the lease liability within financing activities, and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows.

Lessor Accounting

The FASB decided to keep lessor accounting essentially unchanged from existing U.S. GAAP. For example, according to the FASB, the vast majority of operating leases should remain classified as operating leases, and lessors should continue to recognize lease income for those leases on a generally straight-line basis over the lease term.

Some Key Aspects of the New Lease Standard (ASU 2016-02)

Definition of a Lease. Under ASU 2016-02, understanding the definition of a lease and determining whether a contract is or contains a lease will be crucial. Management will need to conduct a thorough inventory of their leasing arrangements. ASU 2016-02 provides detailed guidance and several examples to illustrate the application of the definition of a lease to assist entities in making these determinations. The new guidance on the definition of a lease is much more extensive than current U.S. GAAP.

Renewal Options. When measuring assets and liabilities arising from a lease, ASU 2016-02 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.

Segregating Lease Components. Many contracts contain both lease and non-lease (e.g., service) components. Existing U.S. GAAP requires an entity to separate those components but provides limited guidance on how to make those separations. ASU 2016-02 also requires an entity to separate the lease components from the non-lease components but it provides expanded guidance on how entities should account for such contracts. Under existing U.S. GAAP segregating lease components and non-lease components (services) under an operating lease had little financial reporting consequence since operating leases are not capitalized. However, under ASU 2016-02, with operating leases capitalized and services not capitalized, segregated lease and service components will have a significant financial reporting consequence. ASU 2016-02 provides a practical expedient that allows lessees to account for the non-lease components together with the related lease components as a single lease component.

Sale and Leaseback Transactions. ASU 2016-02 represents a substantial change from previous U.S. GAAP related to sale and leaseback transactions. For a sale to occur in the context of a sale and leaseback transaction, the transfer of the asset must meet the requirements for a sale in FASB ASC 606. There could be circumstances in which a transaction would have qualified for a sale under the existing lease guidance but will not qualify for a sale under FASB ASC 606, or vice versa. In ASU 2016-02 the FASB notes that many sale and leaseback transactions involving real estate will qualify for sale and leaseback accounting that would not have qualified for sale and leaseback accounting under current U.S. GAAP. However, the FASB also notes that the opposite may be the case for sale and leaseback transactions involving other than real estate.

Related Party Leases. In accordance with ASU 2016-02, 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. In addition, lessees and lessors are required to apply the disclosure requirements for related party transactions in FASB ASC 850, Related Party Disclosures. In existing U.S. GAAP, entities are required to account for leases with related parties on the basis of the economic substance of the arrangement, which can be difficult when there are no legally enforceable terms and conditions of the arrangement.

What Should Entitles Do Now? Be prepared – entities should start tracking leases that are currently off-balance sheet and identify the impact to operations and financial results. Entities should begin to renegotiate covenants with their lenders and revise long-term incentive programs for key employees. In addition, entities should also consider the impact of the new standard prior to entering into new lease arrangements.