2017 Lessee Accounting
On February 25, 2016, the Financial Accounting Standards Board (FASB) released an Accounting Standards Updated (ASU) with the goal of improving financial reporting about leasing transactions. They did so in conjunction with the International Accounting Standards Board (IASB), with whom they have partnered in pursuit of enacting common standards for U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).
The new lease standards, which will impact nearly every company, goes into effect for public business entities beginning January 1, 2019 and for all other entities beginning January 1, 2020. Though that may sound far off now, the new standard requires a modified retrospective application, which means that companies will need to begin planning implementation sooner rather than later.
The updated standards for lease reporting include the following:
Greater disclosures related to leasing transactions—organizations that lease assets for more than 12 months are required to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases.
- Lease liability is recorded as the present value of the unpaid lease payments, discounted at a rate implicit in the leases (if known), or at the lessee’s incremental borrowing rate. Lease payments include:
- Fixed payments, and in-substance fixed payments (i.e., variable payment that includes a floor/minimum amount)
- Variable payments if based on an index or rate (variable payments excluded if based on usage or asset performance)
- Amount that is probable will be owed under residual value guarantee
- Payments related to renewal or termination options that the lessee is reasonably certain to exercise
- The Right of Use Asset is recorded as the lease liability, plus initial direct costs, plus prepaid lease payments, less lease incentives received.
- The handling of former Executory Costs is as follows:
- If they are added to the lease cost based on the lessor’s actual costs, they are variable costs and are expensed as incurred.
- If they are fixed and included in the least cost (even if stated separately), the total is considered to be part of the lease payment and is included in measurement of Right of Use Asset.
- Common Area Maintenance or other maintenance services transfer a service to the lessee other than the right to use the underlying asset are therefore a “non-lease” component of the contract. Therefore, consideration in the lease is allocated to such items and they are excluded from lease payments by lessees that elect to separately account for lease and non-lease components (i.e., these costs would be expenses as incurred). However, lessees can make an accounting election to include non-lease components as part of lease payments (i.e., costs considered to be part of the lease payment and are included in measurement of the Right of Use Asset).
Leases must be classified as finance or operating leases—this classification affects the recognition, measurement, and presentation of expenses and cash flows arising from a lease; the result is that it yields different Income Statement and Cash Flow Statement outcomes.
- With a lease classified as a finance lease, both interest and amortization expenses are to be charged to the income statement (the same as the former treatment of a Capital Lease); a lease is classified as a finance lease if it meets ANY of the following five criteria:
- Lease transfers ownership of the asset to the lessee by the end of the lease term.
- Lease grants the lessee an option to purchase the asset that the lessee is “reasonably certain” to exercise.
- Lease term is for the major part (e.g., 75%) of the remaining economic life of the asset.
- Present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all (e.g., 90%) of the fair value of the asset.
- The 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.
- With a lease classified as an operating lease, the lease expense is to be charged to the income statement (the same as the former treatment of an Operating Lease); a lease is classified as an operating lease if it meets NONE of the above listed criteria.
Fewer initial direct costs—a more narrow definition of initial direct costs results in lessees and lessors recognizing more lease origination costs as expenses when incurred. Only incremental costs (e.g., commissions) incurred as a result of the lease being executed can be capitalized in the lease cost. Costs such as legal fees, the internal cost of the leasing department, etc. are no longer considered initial direct costs.
Sale-leaseback accounting—the updated standards significantly reduce sale-leaseback accounting because seller-lessees will recognize a Right of Use Asset and Lease Obligation. The entire gain from the sale of an underlying asset will be recognized at the time of sale, rather than a deferral of the gain and amortization over the lease term, which was the treatment under old lease accounting.
Build-to suit lease guidance replaced—new guidance to determine when the lessee controls an underlying asset before lease commencement will result in fewer transactions where the lessee is considered the accounting owner, which means that fewer build-to-suit lease arrangements will become subject to sale-leaseback accounting.
The updated standards apply to leases of property, plant, & equipment—they do not apply to leases of intangible assets, biological assets, inventory, assets under construction, or leases to explore for or use nonregenerative resources.
Lessees and lessors are required to use a modified retrospective transition method for all existing leases—this would apply the new model for the earliest year presented in the financial statements. The application of approach is linked to both the current lease classification and the new lease classification; an entity may use hindsight when evaluating the lease term. Lessees and lessors are not required to reassess the following upon transition:
- Whether any expired or existing contracts are leases or contain leases
- The lease classification for any expired or existing leases
- Initial direct costs for any existing leases
Be sure to contact your Scott and Company advisor for more information on the updated standards for lease reporting.