The effective date of the update to lease accounting is drawing closer. As a continuation of our Leasing Serial, we will discuss lease modification and the transition guidance. To prepare for the standard, entities should be evaluating their adoption process and how it will affect their operations.
How leases are transitioned to the guidance under FASB ASU 2016-02, Leases (Topic 842) will depend on the types of leases in place at the date of adoption and whether electing available practical expedients makes sense for the organization.
If the terms and conditions of a lease change, an entity should reassess whether the contract contains a lease. If the change to the terms and conditions results in a change in the scope or consideration for a lease, then there has been a lease modification. Entities should treat a lease modification as a new lease when it grants the lessee an additional right-of-use that is priced commensurate with its standalone price. For example, if a tenant modifies an existing lease to rent an additional floor of a building at market rates, then the entity would treat the lease modification as a new lease.
Other modifications are not considered to be new, separate leases. In those instances, entities should reassess the lease classification and discount rate as of the effective date of the modification. In addition, lessees should reassess the lease classification and discount rate if there is a change in the lease term or their assessment of whether they are reasonably certain to exercise an option to purchase the underlying leased assets. This reassessment should be done if any of the following occur:
- There is a significant event or change in circumstances that occurs within the control of the lessee;
- An event that is written into the contract occurs that obligates the lessee to exercise an option to extend or terminate the lease; or
- The lessee changes its election on whether to exercise an option.
An entity does not need to reassess lease classification after commencement unless there is a modification that is not accounted for as a separate contract or one of the items above is triggered. Any time the lease liability is remeasured, entities should reassess any variable lease payments based on an index or rate.
If a lease is partially or fully terminated, the right-of-use asset should be decreased proportionally to the decrease in the lease liability and the entity should recognize a gain or loss. Otherwise, if it is not a termination, increases and decreases in the lease liability are offset by changes in the right-of-use asset. If the right-of-use asset is reduced to zero, any remaining amount is recognized as a gain.
Entities will adopt the leasing standard for leases existing at or entered into after the beginning of the earliest comparative period presented in their financial statements using a modified retrospective approach. As a result, in the year of adoption, entities will recognize and measure leases presented in their financial statements and adjust beginning equity as if the new standard had always been applied.
There are some practical expedients available. If an entity elects not to record lease assets and liabilities for short-term leases (less than one year), then those leases should not be included in the transition.
Entities may also elect to use hindsight regarding lease term and impairment of right-of-use assets for all leases.
The remaining practical expedients must be elected as a package and applied to all expired and existing leases. An entity that elects this practical expedient package will not need to reassess whether the existing and expired contracts contain leases, the lease classifications, nor the initial direct costs. Under this practical expedient package, any ASC Topic 840 operating leases will be ASC Topic 842 operating leases and any ASC Topic 840 capital leases will be ASC Topic 842 finance leases. Furthermore, if the practical expedient is not elected, then any initial direct costs that not meet the definition under ASC Topic 842 will be written-off to equity.
To transition operating leases from ASC Topic 840 guidance to ASC Topic 842, lessees will recognize a lease liability based on the remaining rental payments and probable residual value guarantee using a discount rate for the lease established at the beginning of the earliest comparative period presented. Lessees will recognize a right-of-use asset based on the lease liability adjusted for prepaid or accrued rent, lease incentives, unamortized initial direct costs, any impairment and exit or disposal cost obligations.
To transition leases that are capital leases under ASC Topic 840 to ASC Topic 842 finance leases, lessees will recognize a lease liability and right-of-use asset at the carrying amount of the lease asset and capital lease obligation. Any unamortized initial direct costs meeting the ASC Topic 842 definition will be included in the right-of-use asset.
If a lessee has recognized assets and liabilities solely as a result of an arrangement's ASC Topic 840 build-to-suit designation, the lessee will derecognize those assets and liability and recognize any difference as an adjustment to equity. Lessees should follow the general lessee transition requirements for the lease if the arrangement qualified as a sale and leaseback transaction under ASC Subtopic 840-40 and the or construction period concluded before the beginning of the earliest comparative period presented in financial statements.
Lessors will transition operating leases under ASC Topic 840 to the guidance under ASC Topic 842 by continuing to recognize the carrying amount of the underlying asset and any lease assets or liabilities, accounting for previously recognized securitized receivables as secured borrowings.
Transitioning direct financing or sales-type leases under ASC Topic 840 to ASC Topic 842 will not require lessors to change their current practices; lessors will continue to recognize a net investment in the lease.
The concept of leveraged leases does not exist in the new leasing standard. As a result, entities will continue to account for existing leveraged leases under ASC Topic 840 unless the lease is modified, at which time the leveraged lease will be treated as a new lease under ASC Topic 842 guidance.
Transition for Sale and Leaseback Transactions
Leases that qualified as sale and leaseback transactions will not be reassessed. Entities will continue to recognize any deferred gains or losses for sale and capital leasebacks. For sale and operating leasebacks, an entity will recognize:
- Any deferred gain or loss not resulting from off-market terms to equity or to earnings;
- Any deferred loss resulting from off-market terms as an adjustment to the leaseback right-of-use asset; and
- Any deferred gain resulting from off-market terms as a financial liability.
Failed sale and leaseback transactions should be reassessed to see if the arrangement would have qualified as a sale under ASC Topic 842. If it meets the definition of a sale, the entity will follow the sale and leaseback transition guidance. If it does not meet the sale definition, the entity will account for the arrangement as a financing transaction.
Transition for Favorable and Unfavorable Leases
Entities with favorable or unfavorable leases from business combinations will also need to adjust their financial records. Any favorable or unfavorable leases will be derecognized, except for those related to operating leases for lessors. For operating leases, lessees will adjust the carrying amount of the right-of-use asset. For sales-type and direct financing leases, entities will adjust beginning equity.
Adopting the new standard will have an impact on disclosure requirements. Entities will be required to make disclosures under ASC Topic 250, Accounting Changes and Error Corrections. Disclosures will include:
- The nature of and reason for the change in accounting;
- The method of applying the change in accounting, including a description of the prior-period information that has been retrospectively adjusted and the cumulative effect of the change on retained earnings, and
- Whether practical expedients for transition the new standard are used.
Public business entities, which includes not-for-profits that have issued or are conduit bond obligors for securities that are traded, listed or quoted on an exchange or over-the-counter market, and employee benefit plans that furnish files or financial statements to the U.S. Securities and Exchange Commission, must adopt the new leasing standard for fiscal years beginning after Dec. 15, 2018 and interim periods within that year. All other entities must adopt the standard for fiscal years beginning after Dec. 15, 2019 and interim periods after that date. Early adoption is permitted.
What Can Be Done Now
Whether public or private, you can get a jump start on the transition to the new leasing standard in three ways:
- Take inventory. Gather information about existing leases and create processes and controls to ensure the information is complete. Then, review modifications that may be needed to comply with ASC Topic 842.
- Evaluate the expected impact. Design and implement controls to evaluate contracts, modifications and potential impairment. Determine which practical expedients may apply and educate users of your financial statements, including investors, bankers and other relevant contacts, about the financial statement impact of adopting the new standard.
- Prepare for implementation. All comparative periods must reflect the change to ASC Topic 842, so entities should get a jump start of gathering the necessary information for adoption.
For More Information
Adopting the new leasing standard may have a significant impact on your operations and your balance sheet. An accounting advisor with a deep understanding of the new standard may be able to assist with the transition. If you have specific comments, questions or concerns about the changes to lease accounting, please contact Heather Winiarski or Hal Hunt of MHM's Professional Standards Group. Hal can be reached at firstname.lastname@example.org or 816.945.5610. Heather can be reached at email@example.com or 816.945.5168.
MHM's Understanding the Leasing Standard Serial
Published on January 23, 2017