Although issued in February 2016, the Financial Accounting Standards Board’s (FASB) new accounting rules for reporting leases finally goes into effect in 2019 for public companies and 2020 for nonpublic companies. While there is still ramp left on the implementation runway, we encourage businesses to take inventory of their existing leases now rather than wait until the last minute to begin implementation. Below provides a brief summary of what lessees can expect to change.
Where We Are
Currently, lessees classify a lease as an operating or capital lease based on terms of the lease agreement. Typically, only leases which qualify as capital leases are recorded as assets and obligations on the lessees’ balance sheet. As a result, lessees who have numerous or large operating leases may be significantly more leveraged than their balance sheet initially indicates. Additionally, the FASB noted there may be comparability issues between entities who enter into signification operating leases and those who finance asset purchases through other arrangements.
Where We Are Going
Under the FASB Accounting Standards Update 2016-02, “Leases (Topic 842)”, lessees will now be required to recognize on their balance sheet the rights and obligations resulting from virtually all leases as assets and liabilities. At the commencement of a lease agreement, the lessee will continue to make the determination of whether the terms of the lease qualify as an operating or finance (capital) lease. The factors used in this determination are similar to those provided under the previous lease guidance. Once made, this determination shall not be reassessed unless terms and conditions of the contract are deemed to have changed.
While the aforementioned determination will not result in differences during the initial measurement of the right-of-use asset and the lease liability, subsequent expense recognition and amortization of the right-of-use asset will differ based on the classification of the lease as an operating or finance lease. For operating leases, a single lease cost will be recognized on a straight-line basis over the life of the lease. All cash outflows associated with the lease expenditures will be classified as operating cash outflows. Alternatively, for finance leases, the lessee will recognize interest expense separately from amortization of the right-of-use asset. On the cash flow statement, repayments of the principal portion of the lease will be classified as financing cash outflows, and interest payments will be included in operating cash outflows in a similar fashion to interest payments on long-term debt.
The new guidance along with Accounting Standards Update 2018-11 “Leases (Topic 842) Targeted Improvements” allow for various approaches to implementation to assist an entity’s transition. However, all methods will require a historical review and cumulative catch-up as of the date of implementation. Disclosures required as part of implementation will vary based on the approach taken by the entity. As a result, the preferred method of implementation may vary based on each entity’s individual situation.
The new update provides for numerous exclusions of certain leasing arrangements. Additionally, the definition of a lease requires that the terms of other contracts be reviewed for potential lease arrangements. This magnifies the importance of strong internal controls to ensure contracts are reviewed to determine if they may contain an embedded lease agreement and, if so, are recorded appropriately. The impact of the new lease guidance for each individual business, including yours, may vary from your initial expectation.
Need help? Contact us to assist with your questions and help assess and evaluate the impact of FASB’s new lease guidance on your organization.