Insights

Bigger Balance Sheets on the Horizon: FASB Issues New Leases Accounting Standard

Feb. 25, 2016


Today, the Financial Accounting Standards Board (FASB) issued its long-awaited standard on leases. Accounting Standards Update (ASU) No. 2016-02, “Leases (Topic 842),"1 is the culmination of a joint project of the FASB and the International Accounting Standards Board (IASB) that both boards added to their agendas in July 2006. Earlier this year, the IASB issued International Financial Reporting Standard (IFRS) 16, “Leases,” which is converged with the FASB standard with respect to recording all leases on the balance sheet.

The lease standard applies to all lease contracts. A lease contract is defined as a contract, or part of a contract, that conveys the right to control the use of an asset for a time period in exchange for consideration.

Consistent with current generally accepted accounting principles (GAAP), lessees will be permitted to make an accounting policy election to not recognize lease assets and liabilities for short-term leases (that is, lease terms that are 12 months or less, subject to certain conditions2) under the new standard. The “lease term” includes periods subject to an option to extend the lease if the lessee is reasonably certain to exercise that option. This means leases of 12 months or less with extension options that meet that criteria will come on balance sheet.

Lessees

Most leases today are considered operating leases, which are not accounted for on the lessees’ balance sheets. The significant change under the new standard is that those operating leases will be recorded on the balance sheet.  All leases, whether finance or operating, will be on balance sheet unless they are subject to the short-term lease accounting policy election. An asset will be recorded to represent the right to use the leased asset, and a liability will be recorded to represent the lease obligation.

Most capital leases under existing GAAP will be accounted for as finance leases under the new standard (that is, recognizing amortization expense on the asset separately from interest expense on the liability). Most operating leases under existing GAAP will remain operating (that is, recognizing lease expense that includes amortization expense on the asset and interest on the liability).

Under the new standard, after determining that a contract contains a lease, a lessee will need to evaluate whether the lease is finance or operating at the commencement of a new lease and upon change in the lease term or change in the lessee’s option to purchase the asset. Generally consistent with existing GAAP, a lessee will assess criteria in the new standard to determine whether it has the ability to direct the use of and obtain substantially all the remaining benefits from the leased asset (that is, determine whether a lease is effectively an asset purchase by the lessee and, therefore, a finance lease).

The differences in lease classification are outlined in the table below.

Lessee Lease Classification

  Finance Lease Operating Lease
Has control of the leased asset passed to the lessee?
  • Yes
 
  • No
 
Lease type
  • Financing approach
 
  • Operating approach
 
Balance sheet
  • Right-of-use asset
  • Lease liability
 
  • Right-of-use asset
  • Lease liability
 
Income statement (characterization)
  • Interest expense
  • Amortization expense
 
  • Lease expense
 
Pattern of expense
  • Front-loaded
 
  • Straight-line
 
Cash flow statement
  • Operating – cash paid for interest
  • Financing – cash paid for principal
 
  • Operating – cash paid for lease payments
 

Lessors

Lessor accounting for direct-finance, sales-type, and operating leases is similar under existing GAAP and the new standard.

  • A lessor will determine lease classification (direct-finance, sales-type, or operating) based on whether the lease is effectively a financing or a sale and, therefore, not an operating lease.
  • Similar to the lessee model, classification depends on whether the ability to direct the use of and obtain substantially all the remaining benefits from the leased asset is transferred.
  • If control of the asset is not effectively transferred to the lessee, or if collectibility of the lease payments is not probable, it is an operating lease.

Lessor Lease Classification


Direct-Finance or Sales-Type Lease Operating Lease
Lease type
  • Direct-finance or sales-type
 
  • Operating
 
Balance sheet
  • Net investment in the lease (unless for sales-type lease, collectibility is not probable, and the leased asset is not derecognized)
 
  • Continue to recognize underlying asset
 
Income statement
  • Direct-finance – interest and profit over lease term, loss at commencement
  • Sales-type – interest over lease term, profit/loss at commencement if collectibility is probable
 
  • Lease income, typically straight-line
 
Cash flow statement
  • Operating – cash received for lease payments
 
  • Operating – cash received for lease payments
 

Effective Dates

Public business entities (PBEs) and certain not-for-profit entities and employee benefit plans – Interim and annual periods beginning after Dec. 15, 2018, which applies to March 31, 2019, financial statements for calendar year-end entities.

All other entities – Fiscal years beginning after Dec. 15, 2019, and interim periods within the fiscal years beginning after Dec. 15, 2020, which applies to Dec. 31, 2020, financial statements for calendar year-end entities.

Early adoption is permitted upon issuance.

Transition

Lessee – Modified retrospective transition for finance and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented.

Lessor – Modified retrospective transition for sales-type, direct-finance, and operating leases existing at, or entered into after, the date of initial application.

Under the modified retrospective transition, the earliest historical periods presented will need to be revised, but leases that expire prior to the beginning of the earliest period presented need not be assessed under the new standard. Finally, practical expedients have been provided for transition, including the option to make an accounting policy election that provides relief from reassessing the existence and classification of certain leases in contracts that existed before the effective date.

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1 ASU No. 2016-02 is composed of three sections: Section A – Leases: Amendments to the FASB Accounting Standards Codification (ASC); Section B – Conforming Amendments Related to Leases: Amendments to the FASB ASC; and Section C – Background Information and Basis for Conclusions
2 Certain conditions for a “short-term lease” are included in the new standard’s definition of that term and definition of “lease term.”

  
Staci Shannon contributed to this article.   

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