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Understanding the Leasing Standard: Part 2 - Lessee Accounting

June 21, 2016

Early preparation is critical to adapting to the changes coming to lease accounting. Passed in February 2016, the new leasing standard brings terminology and treatment of leases into line with other recent accounting changes, such as the new revenue recognition standard.

In our leasing serial, Understanding the Leasing Standard, we evaluate the components of the standard and discuss the potential effect of the changes on your accounting. Part 2 takes a look into the changes to lessee accounting.

Impetus for Change

Currently, U.S. generally accepted principles (GAAP) requires capital leases to be recorded on the statement of financial position as assets and liabilities while operating leases are only shown as rent expense on the statement of comprehensive income with related disclosures in the footnotes for future minimum rent payments. This results in very different accounting treatments for leases of a similar nature. It also is conducive to the structuring of contracts so that leases are off-balance sheet operating leases.

Users of financial statements are interested in understanding the lease transactions in order to assess the entity's cash flows, returns and capital structures, as well as the entity's ability to pay future commitments. There is diversity in practice in evaluating an entity's leases. Some users of lessees' financial statements adjust operating leases by capitalizing leases' assets and liabilities while others estimate the present value of future minimum lease payments. The adjustments are made based on the disclosures within the financial statements, which often contain incomplete information.

To address these concerns, the FASB started looking into changes it could make to improve accounting for leases.

Determining the Right Model

The FASB released a discussion paper in March 2009 that laid out a right-of-use (ROU) accounting model, in which a lessee would recognize a ROU asset and a lease liability at the start date of the lease. Feedback on the discussion paper led to a 2010 exposure draft that retained the ROU and lease liability recognition model. It also proposed that an entity would estimate variable lease payments to be made during the cancellable periods of the lease and the optional extension periods. Respondents raised concerns about the cost and complexity of this provision for variable lease payments because it would require a significant amount of judgment.

Based on these and other responses, the FASB released a second exposure draft in 2013. The second exposure draft simplified proposed changes to variable lease payments, but stakeholders shared with the FASB that the lessee model changes would still be complex and costly to implement, recommending instead that the concerns be addressed through enhancing disclosure requirements.

After deliberations, the FASB issued its final accounting standards update, which requires entities to recognize lease assets and liabilities on the statement of financial position for leases with terms longer than 12 months. Consistent with previous guidance, entities will evaluate contracts to determine the lease type. Definitions, such as lease term, lease payments and initial direct costs, as well as lease classification was previously discussed in the Understanding the Leasing Standard: Part 1 - Overview of the Key Concepts publication. Each lease type has its own recognition model, as discussed below.

Allocating Consideration

As discussed in Part 1, consideration of a contract should be allocated between lease and nonlease components. Lessees may elect to make an accounting policy election by class of underlying asset to account for each lease component and its related nonlease components as a single lease component. Otherwise, lessees should allocate consideration for components of a contract based on the relative standalone prices. The new leasing standard presents the following example.

An entity enters into a contract to lease a bulldozer, crane and truck for three years in $200,000 annual installments (therefore, total contract consideration is $600,000). In addition, the lessor (supplier) will maintain each piece of equipment throughout the lease term. In this example, the three pieces of equipment are each determined to be separate lease components. Furthermore, the maintenance services for each piece of equipment are determined to be distinct and, therefore, separate nonlease components. The lessee ascertains the following standalone prices for each lease and nonlease component:

Equipment

Lease

Maintenance

Bulldozer

$200,000

$50,000

Crane

240,000

70,000

Truck

120,000

20,000

Total

$560,000

$140,000

The lessee does not elect the practical expedient discussed above so it allocates the total contract consideration of $600,000 to each of the lease and nonlease components on a relative basis using the standalone prices listed above. The lease components are treated as separate leases in accordance with the new leasing standard while the maintenance service components are accounted for in accordance with other applicable GAAP. The allocation of consideration is as follows:

Equipment

Lease

Maintenance

Bulldozer

$171,429

$42,857

Crane

205,714

60,000

Truck

102,857

17,143

Total

$480,000

$120,000

Accounting for Finance Leases

Finance leases are substantially the same as capital leases in current GAAP. Lease assets and liabilities are recorded on the statement of financial position. Interest expense and amortization expense are recorded on the statement of comprehensive income in a manner that causes greater expense recognition toward the commencement of the lease compared to the end of the lease.

The FASB provides the following example in its final accounting standards update to illustrate what the process would look like.

An entity signs a 10-year lease to use an asset. The lease contains an option to extend the lease for an additional five years. Lease payments are $50,000 payable at the beginning of year during the 10-year period, and $55,000 during the extension period. To enter the lease, the entity incurs direct costs of $15,000.

The lessee determines when it enters the lease that it is not reasonably certain to exercise the extension period, so the lease term is 10 years. The rate implicit in the lease is not readily determinable. The entity's incremental borrowing rate is 5.87 percent, which is the fixed rate the lessee would pay to borrow a similar amount for the same term with similar collateral as the lease.

The entity evaluates the lease and determines it qualifies as a finance lease.

Initial Measurement

The lease liability is initially measured at the present value of the lease payments not yet paid using the discount rate of the lease.

Initial Lease Liability = Present value of 9 remaining annual payments of $50,000 using a 5.87% discount rate = $342,017

The right-of-use asset equals the lease liability plus initial direct costs and prepayments to the lessor, less lease incentives received from the lessor.

Initial Right-of-Use Asset = $342,017 initial lease liability+ $15,000 initial direct costs + $50,000 initial lease payment (prepayment) - $0 lease incentives = $407,017

Subsequent Measurement

The lease liability is increased based on the effective interest rate method and reduced by any lease payments made, similar to an individual's mortgage on a house. So, at the end of the first year, the entity calculates the following:

Year 1 Interest Expense = $342,017 beginning of period lease liability x 5.87% discount rate = $20,076

End of Year 1 Lease Liability = $342,017 beginning of period lease liability +$20,076 interest expense - $0 lease payment made during the period = $362,093

The right-of-use asset is depreciated generally on a straight-line basis over the shorter of the lease term or useful life of the right-of-use asset, adjusted for any impairment loss recorded.

Year 1 Amortization Expense = $407,017 initial right-of-use asset / 10 years = $40,702

End of Year 1 Right-of-Use Asset = $407,017 initial right-of-use asset - $40,702 amortization expense = $366,315

The lessee recognizes a total expense of $60,778 (segregated between interest expense and amortization expense) for year one of the finance lease.

Accounting for Operating Leases

The expense recognition pattern for operating leases is substantially the same as operating leases in current GAAP, using a straight-line approach unless another systematic and rational method is more representative of the pattern of expected benefit. The difference for operating leases lies in the recording of lease assets and liabilities.

So, if the example above resulted in an operating lease, rather than a finance lease, the entity would record the following:

Initial Measurement

The initial lease liability and right-of-use asset are calculated and recorded in the same manner as the finance lease above.

Initial Lease Liability = Present value of 9 remaining annual payments of $50,000 using a 5.87% discount rate = $342,017

Initial Right-of-Use Asset = $342,017 initial lease liability+ $15,000 initial direct costs + $50,000 initial lease payment (prepayment) - $0 lease incentives = $407,017

Subsequent Measurement

In addition, the subsequent measurement for the operating lease liability is the same as the finance lease. It is measured at the present value of the lease payments not yet paid using the discount rate determined at lease commencement (unless a reassessment of the discount rate is needed), which is the same as using the effective interest rate method.

Year 1 "Interest" Expense = $342,017 beginning of period lease liability x 5.87% discount rate = $20,076

End of Year 1 Lease Liability = $342,017 beginning of period lease liability +$20,076 "interest" expense - $0 lease payment made during the period = $362,093

However, the next step creates the difference between the accounting for finance and operating leases. Rather than reducing the right-of-use asset on a generally straight-line basis, the entity calculates its total lease cost (which is equal to the total lease payments for the duration of the lease plus initial direct costs) and then determines a straight-line lease expense amount (total lease cost divided by the lease term). That straight-line lease expense is recorded on the statement of comprehensive income as a single line item. Part of the total straight-line lease expense is recorded as an increase of the lease liability (as calculated above). The remaining straight-line lease expense is recorded as a reduction of the right-of-use asset.

Total Lease Cost = $50,000 annual lease payments x 10 year lease term + $15,000 initial direct costs = $515,000

Annual Lease Expense = $515,000 total lease cost / 10 year lease term = $51,500

Year 1 "Amortization" of the Right-of-Use Asset = $51,500 annual lease expense - $20,076 year 1 "interest" expense = $31,424

End of Year 1 Right-of-Use Asset = $407,017 beginning of period right-of-use asset - $31,424 year 1 "amortization" expense = $375,593

By definition, and as an alternative way to perform the calculation, the right-of-use asset at the end of year one is the amount of the lease liability adjusted for the cumulative prepaid or accrued lease payments, the remaining balance of the lease incentives received, unamortized initial direct costs and any impairment loss recorded.

Year 1 Reduction of Initial Direct Costs = $15,000 initial direct costs/ 10 year lease term= $1,500

End of Year 1 Right-of-Use Asset = $362,093 end of period lease liability + $15,000 initial direct costs - $1,500 reduction of initial direct costs = $375,593

The lessee recognizes at total lease expense (as a single line item) of $51,500 for year one.

Presentation

Statement of Financial Position

The new leasing standard requires lessees to present the right-of-use assets in the statement of financial position as separate line items or to disclose in the footnotes which line items include those right-of-use assets. However, operating lease right-of-use assets are prohibited from being included in the same line items as finance lease right-of-use assets.

Lease liabilities are subject to the same presentation requirements as the right-of-use assets.

Statement of Comprehensive Income

The lessee must report finance lease-related interest expense and amortization in a manner consistent with how it presents the interest expense and amortization of similar assets in the statement of comprehensive income. Lease-related interest expense and amortization do not have to be presented separately from non-lease related interest expense and amortization.

For operating leases, the lessee should present lease expense as a single line item in the statement of comprehensive income.

Statement of Cash Flows

Finance leases should present the principal payments of the lease liability within financing activities. Lessee should present interest expense related to the lease liability consistent with the guidance in Topic 230, Statement of Cash Flows.

Operating leases should present all lease-related payments within operating activities, except to the extent that those payments represent costs to bring another asset to the condition and location necessary for its intended use. In that instance, those costs should be classified within investing activities.

Variable lease payments and short-term lease payments that are not included in the lease liability should be presented within operating activities. Supplemental cash flow disclosures, segregated by lease type, are also required. This includes cash paid for amounts included in the measurement of lease liabilities, as well as non-cash lease liabilities that arise from obtaining right-of-use assets.

Disclosures

To address concerns from the FASB's stakeholders, the new leasing standard also includes enhanced disclosure requirements for lessees. A lessee should disclose quantitative and qualitative information about its leases, significant judgments made related to those leases, and amount recognized in the financial statements. The lessee should disclose the information at a level of detail that provides useful information without giving users too much detail and without combining items that have different characteristics.

Qualitative disclosures should provide additional information about the nature of an entity's leases and subleases including:

  • General description
  • Existence and terms of conditions related to variable lease payments, residual value guarantees and options to extend or terminate the lease
  • Restrictions or covenants imposed by leases.

Additionally, lessees will have to disclose information about leases that have not commenced, as well as any information about significant assumptions and judgments made, including the determination about whether a contract contains a lease, the allocation of contract consideration and the determination of the discount rate for the lease.

Quantitative disclosures will also be required. Total lease cost should be presented, segregated between finance lease amortization, finance lease interest expense, operating lease expense, short-term lease cost, variable lease cost and sublease income separated from finance or operating lease expenses.

Lessees will disclose net gain or loss recognized from sale or leaseback transactions, which will be discussed in a future Understanding the Leasing Standard serial.

Furthermore, the disclosures should include the following, making a clear delineation between finance and operating leases:

  • Cash paid for amounts included in the measurement of lease liabilities, segregated between operating and financing cash flows
  • Noncash lease liabilities arise from obtaining right-of-use assets
  • Weighted-average remaining lease term
  • Weighted-average discount rate
  • Maturity analysis of undiscounted lease liabilities reconciled to the statement of financial position. The analysis should including a minimum of five years with a total for the remaining years.
  • Related-party transactions
  • Practical expedients that have been elected, including the classes of underlying assets to which they apply. The practical expedients can include the elections for short-term leases, not separating lease components from nonlease components, and using the risk-free discount rate.

Up Next

In our next edition of our Understanding the Leasing serial, we will discuss the changes coming to Lessor Accounting.

Previous Editions

Part 1 - Overview of the Key Concepts

For More Information

If you have specific comments, questions or concerns about the changes to lessee accounting, please contact Hal Hunt or Heather Winiarski of MHM's Professional Standards Group. Hal can be reached at hhunt@cbiz.com or 816.945.5610. Heather can be reached at hwiniarski@cbiz.com or 816.945.5168.

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