Prepare Now for the New Lease Standards

January 18, 2017

Leasing is common practice for business owners.  From equipment to warehousing and manufacturing space, leases often present an economically viable opportunity to maintain or expand operations through the utilization of additional resources which may not otherwise be possible through direct financing or purchasing options.  Therefore, it is likely that your business is currently leasing or is considering entering in to a leasing arrangement and you may be surprised to learn of the future impact such arrangements will have on your financial statements and in particular, your balance sheet.  

For years, the Financial Accounting Standards Board (FASB or “the Board”) has been deliberating in an attempt to finalize the new lease related financial accounting standards.  Last year, the FASB issued its long-awaited standard requiring all lessees to recognize all leases with terms of greater than 12 months on their balance sheet as lease liabilities with a corresponding right-of-use (“ROU”) lease asset.  

The main difference between previous generally accepted accounting principles (“GAAP”) and Topic 842 is the recognition of right-of-use lease assets and lease liabilities by lessees, for those leases previously classified as operating leases under pre-existing GAAP.  During deliberations, the Board considered the feedback received throughout the project and in response to the different models proposed in the earlier FASB discussion papers.  The Board eventually decided that, consistent with earlier proposals, lessees should be required to recognize lease assets and liabilities arising from all leases on the balance sheet.  

The core principle of the new lease standards is that a lessee should almost always recognize the assets and liabilities that arise from leases. All leases create an asset and a liability for the lessee in accordance with FASB Concepts Statement No. 6, Elements of Financial Statements.  Therefore, recognition of those lease assets and lease liabilities represents a change over previous GAAP, which did not require lease assets and lease liabilities to be recognized on the balance sheet for most operating leases, as certain disclosures in the footnotes to the financial statements was generally deemed sufficient.

Under the new lease standards, today’s capital leases and new leases that are determined to be effectively installment purchases by the lessee will be classified as finance leases, while current operating and future operating leases will be classified as operating leases.  Regardless of classification, all leases for lessees will be reported on the balance sheet as a right-of use (“ROU”) asset and corresponding liability.  Such classification may include your current facilities lease and all equipment leases.  

The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from previous GAAP. There continues to be a differentiation between finance leases and operating leases. However, the principal difference from previous guidance is that the lease assets and lease liabilities arising from operating leases should be recognized in the statement of financial position (i.e. the balance sheet).  For a financing lease, the annual expense will be separated into the amortization of the right to use asset and interest on the right to use liability.  For an operating lease, a single lease cost will be recognized, calculated such that the cost of the lease is allocated over the lease term on generally a straight-line basis.  

The accounting applied by a lessor is largely unchanged from that applied under previous GAAP. For example, the vast majority of operating leases should remain classified as operating leases, and lessors should continue to recognize lease income for those leases on a generally straight-line basis over the lease term.

Disclosures are required by lessees and lessors to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. To meet that objective, the Board decided to require qualitative disclosures along with specific quantitative disclosures. The Board’s intention is to require enough information to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity’s leasing activities.

In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. These practical expedients relate to the identification and classification of leases that commenced before the effective date, initial direct costs for leases that commenced before the effective date, and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset.

An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the estimated present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.

The new lease standards are generally effective for public companies in calendar year 2019, and for others in calendar year 2020.

While companies have some time to get ready, we advise not to wait too long.  Companies should begin the evaluation process as soon as possible as balance sheets and income statements could be effected.  Start early and engage not only your accountant but other interested parties, like end users of your financial statements and, in particular, your banker, as these new standards could have a major impact on loan covenants and other issues of credit compliance.

If you have any questions about the new lease standards or would like to learn more about how these changes will impact your company, please contact John Oeltjen, CPA, CMP, CGMA.

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