After more than a decade of research and deliberation, the Financial Accounting Standards Board (FASB) issued its new lease accounting standard, Accounting Standards Codification® Topic 842, Leases, on February 25, 2016. It replaces ASC Topic 840, which had been around for almost 40 years. A major change in lease accounting, the new standard eliminates the previous requirement to use bright-line tests to determine whether a lease transfers substantially all of the risks and rewards of ownership. The new standard requires a determination of right-of-use. This move from risks and rewards to a right-of-use model is a considerable shift in thinking.
The objective of the new leasing standard is to eliminate the estimated $1.25 trillion in off-balance-sheet financing found in most operating leases, address concerns from the 2005 Securities & Exchange Commission (SEC) report on off-balance sheet activities, provide more robust information in the disclosure notes about operating leases, and increase transparency and comparability across organizations.
The new standard defines a lease as a contract to convey the right to use an asset (the underlying asset) for a period of time in exchange for consideration. The lessee will account for leases as either a finance or operating lease, which the exposure draft refers to as type A and B leases, respectively. A financing lease is treated as if the lessee had bought the equipment and simultaneously financed it with a loan. The lessee is required to consider all factors, such as the cost of terminating a lease, that create an economic incentive to renew a lease or exercise a purchase option and add it to the lease term. Prior to recording the lease as a right-of-use asset on the balance sheet and the corresponding liability to make payments, accountants will need to consider if the renewal or purchase option makes it reasonably possible that the lease term will extend beyond 12 months.
Most equipment leases (for items such as copiers, vehicles, lathes, etc.) should be accounted for as finance leases in which the asset is depreciated just like any other piece of equipment. The depreciation of the asset will be recorded separately from interest expense using the effective interest method on the lease liability. Most real estate leases will qualify as an operating lease.
The income statement will show a single lease expense line on a straight-line basis over the lease term. On the cash flow statement for finance leases, cash paid for the asset and payments of principal and interest on the lease are recorded as investing activities. For operating leases, cash paid for lease payments is an operating activity.
The FASB adopted a dual approach for financial statement presentation for lessees and lessors. For lessors, the accounting won’t change much from the current FASB standard. Leases are accounted for as either a sales-type, direct financing, or operating lease. A single lease expense gets recognized on a straight-line basis over the lease term. The balance sheet will reflect the net investment in the lease for direct financing and sales-type leases, while operating leases will continue to be recognized as an underlying asset.
For income statement recognition, interest income and any profit on the lease need to be recorded for direct financing and sales-type leases, while lease income needs to be recorded for operating leases. Cash received for lease payments is reflected as an operating activity on the cash flow statement.
For subsequent measurement, the lessee reassesses only upon the occurrence of a significant event or a significant change in circumstances that’s within the control of the lessee. The lessor isn’t required to reassess.
There are some leases that are outside the scope of the new leasing standard, such as leases of intangible assets, inventory, and assets under construction. Also outside the scope of the new leasing standard are transactions that are considered service contracts. These would fall under the new revenue recognition standard, ASC Topic 606, Revenue from Contracts with Customers.
Disclosures are required by lessees and lessors to allow financial statement users to assess the amount, timing, and uncertainty of cash flows arising from the leases. The FASB’s intention was to include both qualitative and quantitative disclosures in the new standard.
As for now, make sure the lease disclosures in the financial statements are accurate. Organizations should assess how the new standard will affect their financial statements as well as systems, controls, and processes of leases. Before adopting the new leasing standard, review existing leases that will extend beyond the effective date of the lease accounting standard and make sure they are in compliance with the new standard. If the new standard will impact key ratios, then you need to talk to lenders to modify any loan covenants. The new leasing standard will make changes to the financial statements. You’ll also need to consider the impact of significant performance measures to determine how they’ll be affected by the change. Companies may be incentivized to negotiate shorter-term leases under the new lease accounting standard.
The new leasing standard will be effective for public entities for annual periods beginning after December 15, 2018, and interim periods thereafter. For private entities, the effective date for annual periods begins after December 15, 2019, and interim periods thereafter. Early adoption is permitted. Although public and private organizations aren’t required to apply the new leasing standard until 2019 or 2020, respectively, many will want the effective date of the new leasing standard to be the same as the new revenue recognition standard.
IMA serves as a voice for our members and the profession on key issues. Its committees continue to advocate for and reach out to IMA members and the profession as a whole. Recent activities include:
- IMA’s Financial Reporting Committee (FRC) submitted a letter to provide feedback to the Public Company Accounting Oversight Board (PCAOB) about its proposed auditing standard for changes to an auditor’s report. A copy of the letter can be found at http://bit.ly/29TVCl9.
- Manny Sicre, a member of IMA’s Small Business Financial and Regulatory Affairs Committee (SBFRC), hosted a successful concurrent session at IMA’s 2016 Annual Conference & Expo in Las Vegas about the role of the CFO at a small organization.
- The “Tech Talk Mondays” webinar series endorsed by IMA’s Technology Solutions & Practices Committee began its second year on July 18 with a session titled, “Cybersecurity and the Future of Your Organization.” A copy of the presentation can be downloaded from webinar archives at LinkUp IMA. Look for notices about future sessions covering predictive analytics, technology trends, and data governance.