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A new era for lease accounting. Are you prepared?

June 2, 2016 Article 7 min read
David Grubb Greg VanKirk Plante Moran Cresa
FASB’s new lease accounting guidelines have a lot of companies unsure how to react. The rules affect everything from financial metrics to debt covenants — even the fundamental choice to lease or buy. Here’s what you need to know.

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On February 25, 2016, the Financial Accounting Standards Board (FASB)issued new guidance that will have far-reaching implications for how leasesare reflected in the financial statements of entities in nearly every sector of theeconomy. Leases are one of the most popular forms of asset financing, in nosmall part due to the ability in many situations to structure the arrangement tokeep lease obligations off the balance sheet.

The new standard was originally part of a joint effort between the FASBand the International Accounting Standards Board (IASB) to improvelease accounting, while also further converging U.S. generally acceptedaccounting principles (U.S. GAAP) with the International Financial ReportingStandards (IFRS). While the two boards successfully issued a joint standardon revenue recognition in 2014, they were unable to come to a similaragreement on lease accounting, and ultimately elected to issue separatelease standards (the international lease accounting standard was issued inJanuary 2016). The new U.S. standard, titled simply Leases, follows more thansix years of work and numerous outreach sessions to gather feedback fromkey stakeholders prior to finalizing the standard. The new guidance affects theaccounting for both lessees and lessors in a leasing transaction.

Lessee accounting

The most significant change in the new standard is the requirementfor lessees to report lease obligations on their balance sheet, with fewexceptions. Historically, leases have been classified as either capital leasesor operating leases, with only capital leases recorded on the lessee’s balancesheet. Under the new standard, there will continue to be two types of leases,finance leases and operating leases; however, both finance leases andoperating leases will be recorded on the lessee’s balance sheet. When anentity enters into a lease arrangement, it will record a liability for the futurelease payments, along with an asset representing its exclusive right to use theunderlying leased asset over the term of the agreement. The new guidancecontains an exception for short-term leases, which are those with a maximumlease term of 12 months or less (including any renewal periods). Short-termleases will not be recorded on the balance sheet, but rather will be accountedfor similarly to operating leases under current U.S. GAAP.

The most significant change in the new standard is the requirement for lessees to report lease obligations on their balance sheet, with few exceptions.

The criteria for differentiating between finance leases and operating leases issimilar to the current guidance used to classify leases as capital or operating.It is expected that most leases currently classified as capital leases will beconsidered finance leases under the new standard, and most leases currentlyclassified as operating leases will continue to be treated as such under thenew guidance. While both types of leases will be recorded on the balancesheet, there is a difference in the way lease expenses will be recognized in theincome statement.

Finance leases vs. operating leases

 Finance leases under thenew standard are similar to capital leases under current U.S.GAAP. They are viewed as a type of financing with expenserecognition similar to loans and other debt. Interest expensefor finance leases will be recognized over the lease term similarto a loan, with amortization of the asset based on the entity’spolicies for other long-lived assets. This method results inhigher amounts of lease expense recognized early in the lifeof the lease, and lower lease expense in later years due tothe declining balance of the liability over time. This expenserecognition pattern was one of the more controversial aspectsof the new lease standard, and ultimately resulted in thesplit between the U.S. and international versions of the leaseguidance. To alleviate concerns over expense recognition forleases that have historically been classified as operating leases,the FASB in the new guidance will continue to permit straight-linerecognition of expense over the term of the lease foroperating leases.

Lessor accounting

Under the new standard, there will be comparatively fewer changes for lessors, and leaseaccounting will continue to be largely consistent with existing U.S. GAAP. However, onechange that will be made is that lessors now will be required to assess the collectability oflease payments under the new standard.

Related party leases

 The new standard also changes the accountingfor related party leases. Under existing accounting standards, an entityis required to account for leases between related parties based on theeconomic substance of the transaction, even if it differs from the terms of theagreement. Under the new standard, leases between related parties will bebased on the legally-enforceable terms of the agreement. This may provideplanning opportunities for entities involved in leasing arrangements withrelated parties.

Sale and leaseback transactions

Sale and leaseback arrangements,whereby an entity sells an asset to another party and concurrently leases itback, are common in many industries. The new standard changes the rules forsale and leaseback transactions by tying determination of whether a sale hasoccurred to the new revenue recognition guidance. If the transaction qualifiesas a sale, then the leaseback should be evaluated the same way as any otherlease transaction by both the seller-lessee and buyer-lessor. If a transactionfails to qualify as a sale, the new guidance requires the arrangement to beaccounted for as a financing transaction.

Effective date and transition

The new lease guidance will be effective for public business entities for periodsbeginning after December 15, 2018 (2019 for calendar-year entities), with privatecompanies and other entities provided a one-year deferral until periods beginning afterDecember 15, 2019 (2020 for calendar-year entities).

The standard requires a modified retrospective application approach, which will shortenthe time frame for implementation. For example, for companies initially applying the newguidance in the first quarter of 2019, retrospective application would be required for thecomparative quarter in 2018.

The new standard requires existing leases to be transitioned to the new rules at implementation.

Planning for transition

With a three to four year implementation time frame, it may seem earlyto begin planning for the transition. However, many lease contracts coverperiods of three to five years or longer, and the new standard requiresexisting leases to be transitioned to the new rules at implementation. Inaddition, many lessees that have historically structured lease arrangements asoperating leases may begin to recognize significant lease obligations in theirfinancial statements. As a result, entities should begin to plan for the effectsof the new standard. Some actions that should be taken during 2016 include:

  • Understanding the new lease classification requirements
    Accounting and finance staff will need to develop a thoroughunderstanding of the key principles for determining how a leaseis classified. In addition, individuals responsible for negotiatinglease agreements will need to gain an understanding of thestandard so that new lease agreements and renewals of existinglease agreements take the new accounting standards intoconsideration.
  • Review existing lease contracts
    The new lease standardwill require nearly all leases to be recorded on the balancesheet based on the terms of the lease agreements. Reviewingexisting contracts will be necessary to quantify the effects ofimplementing the new standard.
  • Consider changes to systems and internal controls
    The newlease guidance will require more information to be gatheredto recognize and disclose lease arrangements in the financialstatements. Information systems will need to be evaluated todetermine whether they can provide the necessary data, and therelated internal controls may also require modification.
  • Consider other impacts on the business
    Given the significantimpact that is expected when the new standard is implementedand additional leases are required to be recorded on thebalance sheet, it’s likely that numerous other areas will beaffected. Some of the most common include:
    • Financial metrics: Key financial metrics communicatedto investors, lenders, and others will likely be affected as more leases will be recorded on the balance sheet.Communication of the changes in advance will berequired.
    • Debt covenants: Many debt covenants are affected byratios that are likely to be impacted by having additionalleases recorded on the balance sheet. Changes tocovenants may be required in advance of adopting thenew standard.
    • Lease vs. buy decisions: The new lease guidance mayinfluence how entities evaluate lease vs. buy decisions,taking into account the elimination of off-balance sheetfinancing available under current U.S. GAAP.
  • Communicate with key stakeholders
    As with all significantaccounting changes, communication of the expected effectson the financial statements to key stakeholders (management,investors, audit committee, lenders, and others) is critical.

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