The future of lease accounting

By Genevieve Hancock

Two exposure drafts, many meetings and 485 pages of an accounting standard update later, the Financial Accounting Standards Board (FASB) issued the long-awaited update to lease accounting guidance on Feb. 25, 2016. The guidance adds a new section to the codification, ASC 842 — Leases. The International Accounting Standards Board (IASB) also released IFRS 16 — Leases during January of 2016. The standards are different in many ways, yet both standards aim to increase the transparency of lease accounting and comparability of the lease commitments across companies’ financial statements.

The effective transition date of the new standard for public entities with a calendar year-end is fiscal year 2019, and allows an additional transition year for private entities. The transition will require a modified retrospective approach, with certain practical expedients as options to ease adoption. Adoption should accurately show all comparative periods presented within the financial statements with consistent application of the new guidance. Early adoption of the guidance is permitted.

By far, the change which will create the largest impact for companies’ financial statements is the new requirement of operating leases with terms over one year to be recorded on the Balance Sheet. Near the end of developing the new guidance, IASB and FASB estimated that this will effect final statements by $3.3 trillion. The new guidance will more accurately reflect the commitments of a company for a time period of over one year.

Classification of leases

The first step for classification within the updated guidance is to determine if the arrangement qualifies as a lease. The definition of a lease has been updated within the new accounting guidance as an arrangement in the form of a contract (or part of a contract) which, for a period of time, consideration is given in exchange for a customer having the right to control the use of a specific asset, and retain substantially all of the economic benefits from the asset during that period of time.

Similar to current lease accounting, classification of leases with periods of over one year will be split into two classification types: right-of-use leases and finance leases. While the wording of the bright-line tests have been removed concerning 90 percent of the fair market value and 75 percent of the useful life of the asset being triggering events, the essence is similar in nature under the new guidance. The new guidance indicates that instead of bright-line tests, any lease in which the majority of the use or substantially all of the fair value of the asset is consumed by the lessee should be treated as a financing lease. In essence, substantially all of the risks and rewards of ownership transfer to the lessee under the lease arrangement. Other items which require that the lease also be treated as a financing lease include leases where the asset is reasonably certain to be purchased by the lessee by the end of the lease, leases where the title transfers to the lessee by the end of the lease, or leases where an asset has a specialized nature and does not have an alternative use to the lessor.

With respect to the updated guidance on measurement of leases, operating leases will be similar in nature to current operating lease guidance. Operating leases should be recorded on the balance sheet at the present value of the lease as both an asset and a liability. The lease expense should be recognized on the income statement, generally through a straight-line allocation. This is different than financing leases in that there should be no interest component of the lease recorded. All cash outflows related to the operating lease should be shown as an operating activity on the statement of cash flows.

Finance leases are similar in nature to current capital leases. An asset and liability are recorded on the balance sheet at the present value of the right-of-use lease. The lease liability principal is amortized over the lease as an expense, and an interest component is also expensed. The principal portion of the lease payments should be classified as a financing activity on the statement of cash flows, while the interest portion should be included in operating activities.

Variable rent payments should generally be excluded from the present value calculation for liability and asset recordation for both lessee and lessor accounting models. The exception to this is a variable payment that is based on a specified rate increase (e.g., a 3 percent increase per year), or an indexation of the rent. Indexation should be calculated taking the rate as of the day of the commencement of each lease.

Lessee accounting model

Accounting for leases under the lessee accounting model changed in the new guidance, more so than the lessor accounting model. As described above, dependent on the classification of the lease type, lessees will need to recognize a right-of-use (ROU) asset and a liability. This will occur for all leases that are not “short-term,” generally implicated as less than one year. The liability should be recorded at an amount equal to the present value of the lease payments.

Right-of-use operating leases should be recorded in total as a lease expense when recognized as an expense on the income statement, whereas finance leases will result in a bifurcation of interest and lease expenses. The discount rate used is the rate charged by the lessor (if readily available) or their incremental borrowing rate if the lessor’s is not available. The new guidance allows for private companies to elect use of a risk-free rate, but this is not allowed for public companies. The asset should be recorded at the same value as the liability. Under the lessee accounting model, a finance lease will front-load the interest component of the expense, with a higher interest amount being recorded during the beginning of the lease, and a lower interest expense being recorded near the end of the lease.

Lessor accounting model

The lessor accounting model is similar to the current model in that lessors will classify leases as operating, direct financing or sales-type leases. There are specific items within the updated lease guidance, some of which include treatment of initial direct costs, and broad conceptual alignment with ASC 606 — Revenue from Contracts with Customers, the new revenue recognition standard. For direct financing or sales-type lease, the lessor will generally use the rate that they charge to the lessee.

It is also important to note that leveraged leases — a lease that has been partially financed by the lessor through a liability with a third-party company who holds the title to the leased asset — are no longer treated as a separate class of lease arrangement. Leases already in place as of the transition date can continue their treatment as leveraged leases under current lease accounting, but new leveraged leases will be assessed as if they are not leveraged, without any leveraged lease-specific accounting treatment.

Sale leasebacks

Sale leaseback arrangement guidance under ASC 842 — Leases has been amended for treatment of sale leasebacks and failed sale leasebacks. To receive sale leaseback treatment, the arrangement must qualify as a sale under the updated revenue recognition guidance, ASC 606 — Revenue from Contracts with Customers. Repurchase options are a triggering event for failing sale assessment under ASC 606 (revenue recognition), with the exception of the repurchase option being at fair value and the asset not being specialized. All leasebacks that are finance leases will not be considered as sales. Should the arrangement fail the sale treatment, the financial statements should reflect that the arrangement is, in essence, a financing.

The term “built-to-suit” has been removed from the guidance in relation to sale leasebacks and assessing continuing involvement in failed sale leasebacks; however, the assessment of continuing involvement remains similar to current lease guidance.

Additional updated guidance

Under the new guidance for leases, the definition of initial direct costs that may be capitalizable with respect to a lease has narrowed. The items that are capitalizable under ASC 842 are only incremental costs directly related to the execution of the lease. Generally, this should allow for commissions to be capitalized, and will likely result in more initial direct costs being expensed after the transition to the new lease standard.

The updated guidance within ASC 842 specifies many quantitative and qualitative disclosures within the financial statements, many of which require large amounts of judgment of the management of a company.

Lease modifications under the new guidance determine which modifications or changes to a lease contract should be treated as a separate contract or as the original contract. When an additional ROU asset is granted to the lessee and the lease payments are at an arms-length (fair value stand-alone) rate, the lease modification should be treated as a separate contract. All other modifications should likely be accounted by adjusting the discount rate for a change in payment terms as of the date of modification.

There are many other items under the new guidance for leases which have been amended or may need to be assessed for current and prospective lease implementation, and future clarifications and updates may be made by the FASB as we approach the effective date of transition. Overall, the new guidance will make financial statements increase transparency of lease arrangements. This will occur by increasing accuracy in the reflection the financial health of a company by including the lease arrangements a company has committed to within the financial statements. This will also create more comparable financials across companies in relation to liabilities and right-of-use assets. Most companies, especially companies that act as a lessor as well as a lessee or have complex lease transactions will need to gather and reassess most of their leases under the new guidance. Changes in lease accounting treatment that is determined through reassessment of leases will likely implicate that companies should implement new processes and controls for lease implementation and measurement.

Genevieve Hancock is a technical accountant specializing in complex modeling and changes in accounting guidance as a senior financial reporting analyst for Disney Parks & Resorts Controllership based in Lake Buena Vista, Fla.

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