7 Things to Know About the New Lease Accounting Rules

More than ten years in the making, the FASB announced sweeping changes to the accounting for leases earlier this year that will affect nearly all financial statement issuers. Here’s a brief summary of what you need to know about Topic 842.

1.  The distinction between operating and financing leases remains. Those of us whose misspent adolescence included committing the attributes of a capital lease to memory while preparing for the CPA exam can take heart: the FASB has retained the distinction between operating and financing leases.

From the perspective of the lessee, there are five triggers that signal a financing lease (from paragraph 842-10-25-2).

1. Ownership of the underlying transfers to the lessee by the end of the lease term
2. The lease contains a bargain purchase option for the underlying asset
3. The lease term covers the major part of the remaining economic life of the underlying asset
4. The present value of the lease payments equals or exceeds substantially all of the underlying asset’s fair value
5. The underlying asset has no alternative future use to the lessor at the end of the lease term

If none of the five triggers are present, the lease will be classified as operating.

2. Operating leases will be recorded on balance sheet. The biggest change from existing practice is that operating leases will be recorded on the lessee’s balance sheet through recognition of a right-of-use asset and a corresponding lease liability (paragraph 842-20-35-3). The lease liability is the present value of the remaining lease payments, calculated using the discount rate for the lease. The discount rate for the lease is the rate implicit in the lease (if determinable) or the lessee’s incremental borrowing rate. As a result of this change, corporate balance sheets will expand; analysts will need to re-calibrate their analysis of lessee financial position accordingly.

3. Operating lease expense reported as a single amount on the income statement. Since both operating and finance leases will be recognized on the balance sheet, the principal remaining distinction is how the periodic lease expense is reported on the income statement. Whereas a finance lease gives rise to depreciation expense and interest expense, the cost of an operating lease will be recognized as a single amount. As described in paragraph 842-20-25-6, the periodic operating lease expense is calculated as the straight-line amortization of the remaining cost of the lease over the remaining lease term. For a simple lease, the lease cost will approximate the annual lease payment. For leases with initial indirect costs (commissions, etc.), those costs are capitalized as part of the right-of-use asset, with amortization through the life of the lease as a component of the operating lease expense.

4. Exception for short-term leases. The new standard provides an exception for short-term leases. Lessees may elect, as an accounting policy, to forego balance sheet recognition of leases having original terms at commencement of less than twelve months (paragraph 842-20-25-2). If this policy is adopted, such leases will continue to be accounted for off-balance sheet, with periodic expense equal to the lease payments (with adjustment for straight-line rent).

5. Private company expedient. Private companies are not exempt from the new lease accounting standards and will be required to recognize a right-of-use asset and corresponding lease liability for operating leases having original terms in excess of twelve months. However, private companies may, at their election, calculate the amount of the right-of-use asset using a risk-free discount rate for a corresponding term rather than the rate implicit in the lease (paragraph 842-20-30-3). This policy must be applied comprehensively, rather than only for select leases. This exception was presumably granted to allow private companies to bypass calculating the rate implicit in the lease. However, since present value is inversely related to the discount rate, use of this exception will result in higher asset and liability balances for private companies making this election. It remains to be seen how prevalent this election will be.

6. Implementation timetable. For public companies, adoption of the new standard is required for fiscal years beginning after December 15, 2018. For private companies, the implementation deadline is delayed for one year. Early application is permitted. With regard to transition, the modified retrospective method is to be followed.

7. Reconciliation to IFRS. Convergence remains an elusive goal. The corresponding international guidance (IFRS 16) does not distinguish between operating and finance leases from the perspective of lessors. So, under international standards, all leases are treated as finance leases in the lessee’s financial statements. The remaining discrepancies between ASC Topic 842 and IFRS 16 are generally minor, relating primarily to the availability of certain practical expedients. IFRS 16 includes an exemption for leases of underlying assets with values less than $5,000 and allows alternative measurement bases for the right-of-use asset. IFRS 16 does not provide any exceptions for private companies.

Related Links

• SEC Staff Report on Off-Balance Sheet Arrangements, SPEs, and Related Issues
• FASB Update 2016-02 – Leases (Topic 842)
• Premature Obituaries and Other Mixed Signals