By now, most accountants, and many other financial professionals, are aware that a significant change is coming in lease accounting. Considering that almost all entities, for-profit and nonprofit alike, lease vehicles or equipment or real estate, this update will have a far-reaching impact. The existing Financial Accounting Standards Board (FASB) lease guidance, dating back to 1976, will be replaced by FASB Accounting Standards Update (ASU) 2016-02. For nonpublic companies, this update is effective for the 2020 calendar year.
Why is a New Lease Accounting Standard Being Released?
In the current environment, operating leases are not recognized on the balance sheet. As such, most leases, especially real estate leases, are off-balance-sheet but disclosed as commitments in the notes to the financial statements. Financial statement users are continually seeking transparency and comparability, and in its efforts to obtain feedback from financial statement users, the FASB concluded that the existing lease guidance did not meet the needs of users because, despite disclosure in the notes to the financial statements, it did not a require lessees to present assets and liabilities arising from operating lease activities.
What Are the Lease Accounting Changes?
Right-of-Use Asset and Lease Liability Changes
Under FASB ASU 2016-02, lessees will be required to recognize right-of-use (ROU) assets and lease liabilities on the balance sheet for all leases with terms longer than 12 months. An entity may make an accounting policy election, for leases with terms of 12 months or less, not to recognize assets and liabilities but instead to recognize straight-line lease expense. Balance sheet leases will be classified as either finance or operating, with the difference affecting the pattern of expense recognition in the income statement.
Lease Type Determination Changes
One of the key differences between the existing and new standards is in the nature of determining the lease type. Under the existing standard, if any one of four conditions are met, the lease is considered a capital lease and placed on the balance sheet. The four conditions are treated as a “bright-line” test and if the thresholds are met, the lease is a capital lease. If one of the metrics is just short of the threshold, then the lease is an operating lease. This allows lessors and lessees to structure lease terms in a certain way to take advantage of desired financial statement treatment. From a consistency standpoint, U.S. generally accepted accounting principles (GAAP) can create two very different accounting outcomes for what can be two economically similar transactions.
Under the new standard, the determination of lease type is subjective. There are no “bright-line” test and thus, professional judgment will be required in evaluating lease types. This does not impact whether the lease becomes part of the balance sheet but does impact the treatment on the income statement.
Capital Leases and Operating Leases
Current capital leases will maintain the same accounting treatment, but are being renamed as finance leases. Current operating leases will maintain the same name, but will follow a much different accounting treatment, being reflected on the balance sheet as assets and liabilities under the new standard.
Finance leases will create a ROU asset that will be amortized, and the lease liability will result in interest expense; both of these treatments are consistent with today’s GAAP. Operating leases will create a ROU asset that will be amortized, on a straight-line basis, reflecting a single lease cost on the income statement, over the shorter of the asset’s useful life or the term of the lease. Because interest expense decreases over the period that a liability is decreased, finance leases will reflect greater expense than operating leases in the early years and less expense in the later years. This could potentially create a significant timing difference in expense recognition, depending on number and size of leases.
How Should I Prepare for FASB Lease Accounting Changes?
Though the new standard is not effective until 2020, it’s not too early to start preparing. With a large number of leases and significant dollar amounts, starting this analysis now will be a good idea. A starting point is a list of all the entity’s leases, including terms of the leases, enabling determination of lease type. The financial impact can be calculated based on asset value and useful life, payment schedule in the lease and an amortization schedule.
For operating leases, determine what the balance sheet impact will be, as these may not currently be on the balance sheet. And also important, talk to your banker, bonding agent or other financial statement user about the change that is coming. Being prepared will help to reduce the risk of an unpleasant surprise in a few years.
For questions on implementing the new lease accounting standards, contact BSSF today!
ABOUT THE AUTHOR
Brian is a Senior Manager with Brown Schultz Sheridan & Fritz and serves as Chair of the Firm’s Audit and Accounting Committee.