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FASB Unveils New Leasing Standard

March 1, 2016

Lease accounting received an accounting overhaul with the recent release of the Financial Accounting Standards Board (FASB)'s Accounting Standards Update 2016-02 Leases (Topic 842). The new standard most significantly changes lessee accounting compared to existing US GAAP, but also has some targeted changes for lessor accounting. Overall, ASU 2016-02 seeks to improve transparency to the economics of lease transactions and bring lease accounting into line with other recently released accounting standards updates, such as the changes to Revenue from Contracts with Customers (Topic 606).

Lessee Accounting

Lessees will now be required to recognize lease assets and liabilities on the balance sheet for leases with a lease term for accounting purposes that is longer than 12 months. As in earlier guidance, a lessee evaluates a lease to classify it in one of two types that, under the new standard, are referred to as finance and operating leases.

In a concept similar to existing guidance, when the lessee is reasonably certain a renewal option or purchase option will be exercised, those payments should be included in the calculation. Assets and liabilities arising from finance leases and operating leases must be presented or disclosed separately from each other and other assets and obligations.

Consistent with previous guidance, an entity should exclude variable lease payments from the measurement of the asset and obligation recognized. Lease payments, including fixed payments, in-substance fixed payments and those payments based on an index or rate, are measured based on the index or rate that exists at lease commencement. In certain circumstances, the lease payment may also be adjusted for lease incentives, purchase options, penalties and residual value guarantees. Lessees that have leases with lease terms for accounting purposes of less than one year can elect to recognize lease expense on a straight line basis over the lease term without recognizing the liabilities and assets associated with their lease.

Measurement of the lease asset and liability will require determining an appropriate discount rate. Similar to existing guidance, a lessee will look to the rate implicit in the lease or, if that rate is not determinable, its incremental borrowing rate to discount the lease payments. A private company will have a practical expedient to utilize the risk-free rate instead of determining the rate implicit in the lease or its incremental borrowing rate. The election to use the practical expedient is expected to result in a larger lease asset and liability.

Some simplifications were made to prior proposals. The new standard eliminates the previously proposed distinction between leases of real estate and leases of equipment in favor of lease classification tests distinguishing finance and operating leases that are similar to existing guidance.

Processes may have to be implemented to identify all leases and address the various requirements and allocations within the new standard. This may necessitate revisiting accounting or enterprise resource planning software to account for the new changes.

Lessor Accounting

Lessor accounting remains fundamentally similar to previous guidance, however the concept of leveraged leases was eliminated prospectively. Changes were made to reflect new terminology; capital leases are called finance leases in the new standard. There is also additional guidance related to revenue recognition. The changes coming to revenue recognition will affect accounting for sale and leaseback and other arrangements and may require entities to separately account for nonlease components in contracts that include a lease.

Determining if a Contract Contains a Lease

Evaluating whether a contract contains a lease takes on a new significance for lessees under Topic 842 because a contract containing a lease will result in capitalization of an asset and a liability. In contrast, under existing lease guidance there was no balance sheet impact for an operating lease, therefore the distinction between whether a contract was an operating lease or service agreement was typically not significant.

Entities will evaluate whether a contract contains a lease based on a new definition, which states that a contractual element that gives an entity the right to control an asset for a period of time in exchange for consideration is a lease. The definition of control under Topic 842 is consistent with the guidance in the new revenue recognition standard. The lessee is said to have control over the asset when it has the right to obtain substantially all of the economic benefits of the asset during the term of the lease and the right to direct the use of the asset.

Evaluating Lease and Nonlease Components

Contracts that contain leases will be required to be separated into components; those that relate to the lease and those that are nonlease components. The most common example of a nonlease component is maintenance, such as maintaining equipment or common areas and similar services. In addition to identifying the lease and nonlease components, the payments under the contract must be allocated between the two types of components. Separating the components is critical because only the lease component will be accounted for under Topic 842. In general, a lessor will account for nonlease components under the new revenue recognition guidance, while a lessee will not capitalize onto the balance sheet the amount of payments related to nonlease components.

However, for lessees, ASU 2016-02 creates a practical expedient that permits an accounting policy election by asset class that would exempt them from separating the assets into lease and nonlease elements. Entities making that election would then account for the lease components and their related nonlease components as a single lease component, resulting in the capitalization of a larger right to use asset and lease liability.

Sale and Leaseback Transactions

For an exchange to qualify as a sale and leaseback transaction, the provisions must meet the requirements for a sale defined in Topic 606. If the sale does not meet the guidelines, then the seller/lessee and the buyer/lessor do not account for the transaction as a sale/purchase. In that situation, both parties must account for any amount paid for a sale and leaseback transaction as a financing transaction.

There may be scenarios where transactions that previously qualified as sale and leaseback no longer qualify or transactions. For example, sale and leaseback of equipment in which the seller/lessee has a purchase option typically meet the requirements today for sale and leaseback accounting, but will rarely meet the requirements for sale and lease back under the new standard. At the same time, transactions involving real estate and build-to-suit leasing, may now qualify for sale and leaseback accounting in situations in which those transactions would not have qualified for sale and leaseback accounting under today's guidance. Entities should carefully consider how the new rules will affect these types of sales. For existing sale and leaseback transactions, entities are not required to reassess whether the transaction meets the definition of a sale under Topic 842.

Disclosures

Both lessors and lessees will be required to provide qualitative and quantitative disclosures about the amount, timing and uncertainty of cash flows that relate to leases. The information must be robust enough to provide users of financial statement more context about the entity's leasing arrangements.

Effective Date

Public business entities, not-for-profits that have issued or are a conduit bond obligor for publicly traded or over-the-counter securities, and employee benefit plans required to file with the Securities and Exchange Commission (SEC) must adopt the new standard for fiscal years and interim periods beginning after December 15, 2018. All other entities must adopt for fiscal years beginning after December 15, 2019 (calendar year 2020) and interim periods beginning after December 15, 2020 (calendar year 2021). Early adoption is permitted.

Entities will adopt the changes using a modified retrospective approach for all leases presented within the financial statements. Leases will be recognized beginning in the earliest period presented within the financial statements. For example, if a non-public business entity adopts Topic 842 for its December 31, 2020 comparative financial statements, then the lease assets and liability would be recognized as of January 1, 2019, (the earliest date presented within those statements) using the modified retrospective approach. If a public business entity adopts Topic 842 for its December 31, 2019, comparative financial statements that present three years, then the leases would be recognized as of January 1, 2017.

For More Information

If you have specific comments, questions or concerns regarding the new leasing standard, please contact Hal Hunt of the MHM Professional Standards Group. Hal can be reached at hhunt@cbiz.com or 816.945.5610.

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