For years, lease accounting has been criticized as a means of structuring off-balance sheet financing, particularly as it related to the airline industry. In response to this feedback, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) initiated a joint project to overhaul accounting for leases in 2008, which was one of the cornerstone projects of a path towards convergence.
The FASB issued an exposure draft in 2010, but it received such heavy criticism from multiple parties that it didn't issue the final standard until early 2016. Accounting Standards Update 2016-02, Leases (ASC Topic 842) may be cumbersome to implement as it affects all leases (i.e. property, equipment, copiers) with only a few, minor scope exceptions. It also removes any differences between leases of equipment and real estate that exist in today's U.S. generally accepted accounting principles (GAAP).
The new guidance is effective for public business entities for fiscal years beginning after December 15, 2018 (2019 calendar year). The effective date for most other entities is deferred one year (2020 calendar year). Early adoption is permitted for all entities.
Lessees in particular will need updating on several aspects of lease accounting. Implementing the standard may also affect debt covenant compliance, evaluation of leasing alternatives, accounting and finance departments and lease negotiations, which could have a significant impact on your future planning.
Summary of Major Changes
The leasing standard brings the definition of a lease in line with the recent changes to revenue recognition, clarifying that a lease exists as a contract or part of a contract when a party has a contractual right to control an identified property, plant and/or equipment for a period of time in exchange for consideration. In addition, if a party has the right to obtain substantially all of the economic benefits from using the asset and the right to direct the use of the asset, then a contract is or contains a lease.
Lessees will classify a lease as either operating or financing. Capital leases under current practice will be considered finance leases under the new leasing standard.
To determine whether you have an operating lease or a finance lease, the new leasing standard is similar to current practice. A new criterion has been added, however. Lessees will be required to consider whether the underlying asset in the lease is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Meeting this criterion would result in a conclusion that the lease is a finance lease.
Impact on Rental Leases
The type of lease will impact how you report rental expense in your income statement. By and large, you follow the same guidance as current GAAP to determine whether you have an operating lease or a finance lease. For most operating leases, a lessee will recognize rental expense on a straight-line basis over the lease term. For finance leases, a lessee will recognize rental expense in a similar manner to capital leases under current lease accounting. The new standard removes the bright lines that currently exist in the capital versus operating lease criteria. It's likely that companies will continue to use the traditional 75 percent and 90 percent thresholds as a starting point, which is referenced in the new leasing standard as a reasonable approach to assess certain of these criteria.
Factoring renewal options into the lease classification process is not expected to be difficult. Any renewal options that are reasonably certain to be exercised should be included in the lease term. This more or less gets us to the same place we are today. The conclusion requires reassessment upon triggering events.
Effect on Debt Covenants
Lessees will find that most leases will be recognized on their balance sheet when they enact the new leasing standard. Operating and finance leases are recognized on the balance sheet through right-of-use (ROU) assets and related lease obligations.
Debt covenants may also be affected. Banks are likely already using a factor to adjust operating lease payments in situations where these payments are a significant expense, such as with retailers. Nevertheless, classifying leases as liabilities may affect certain metrics for your debt covenant compliance, particularly if your debt covenants include balance sheet tests. You should account for these changes and determine their potential impact. If you find that the standard has a substantial effect on your debt covenants, you should discuss the lease liability classification with your bank.
Most credit arrangements include a provision stating that GAAP reporting should be used in order to comply with the debt covenants. Both borrowers and lenders will need to determine if definitions or amendments need to be made to debt agreements that will be in existence when the new leasing standard takes effect.
Impact on Types of Leases
Many in the industry wonder if the changes to lease accounting will trigger more synthetic lease structures, or structures where a special purpose entity is created and "owns" the leased asset and leases the assets to an operating entity. These lessor entities, as well as similar entities employed by a lessee, should be evaluated to determine whether they should be consolidated by the lessor or lessee. However, we expect that given their highly specialized nature, we will primarily see synthetic leases in sophisticated investment markets rather than used broadly.
A demand is also expected for other types of alternative lease structures because of the effect this will have on companies' financial statements. For example, short-term leases are defined as those that are 12 months or less and the lease does not contain a purchase option that the lessee is reasonably certain to exercise. A lessee is permitted to forgo recognizing a right-of-use asset and related lease liability on its balance sheet for short-term leases. Other companies may be deterred from leasing and consider buying assets instead, though the number of companies who forgo leasing all together is expected to be minimal.
Tenant improvements may also be affected because some companies may find that funding the improvements themselves is more economical than including them in the lease.
Additional Responsibilities for Accounting and Finance Departments
Accounting and finance departments should get familiar with the leasing standard because it requires consideration of certain leasing elements.
Embedded leases will be critical to identify. Previously, if leases embedded in contracts were missed, the only impact would be misclassification of operating expenses (i.e. cost of goods sold (COGS) vs. rent). However, because leases are now required to be presented on the balance sheet, there is a much greater risk to not properly identifying embedded leases, which can be challenging at a granular contract level.
Identifying the appropriate unit of account by which to measure the lease and distinguishing between lease and non-lease components will also require heightened involvement from the accounting and finance functions.
Finally, impairment models will need to change to address the new lease related assets and consideration must be given to how cash flows are calculated and compared to the asset base.
More Time Needed for Lease Negotiations
Particularly in the beginning of the roll-out, you will need to allow more time for lease negotiations. More individuals are going to be involved with the leasing decisions, and given the potential effect on your financial statements, alternatives to leasing may be explored in more detail than they were in the past.
It is also recommended that you engage your broker early in the leasing negotiations so you can understand how debt covenants may change after the leasing standard is implemented. For upcoming renewals or new deals, be sure your projections and those of your bank include the accounting standard's effect on debt covenant compliance and that you understand if there any policies or procedures the bank has adopted because of the new leasing standard.
In the interim, you can get prepared for the leasing standard by learning about its provisions through live training, webinars or leasing standard publications. Consider whether you need to modify your internal controls to help ensure compliance with the new requirements and have the appropriate, audit-ready documentation to comply with the new standard. You should also evaluate whether the relevant system solutions you are using are capable for accounting for your leases with the new guidance.
Leasing is not the only major accounting change that will be going into effect in the next few years. Major updates are coming to revenue recognition and accounting for financial instruments, and you should factor this into your new accounting standards implementation planning.
For more information about the new leasing standard, please contact Brad Hale of MHM's Professional Standards Group. Brad can be reached at 727.572.1400 or firstname.lastname@example.org.
Published on August 08, 2016