New Accounting for Leases Standard: Are You Ready to Implement?
On February 25, 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited lease accounting standard, ASC 842. ASC 842 supersedes ASC 840, Leases. This updated standard was a result of the major convergence project with the International Accounting Standards Board.
“The new guidance responds to requests from investors and other financial statement users for a more faithful representation of an organization’s leasing activities,” said FASB Chair Russell G. Golden in a statement. “It ends what the U.S. Securities and Exchange Commission (SEC) and other stakeholders have identified as one of the largest forms of off-balance sheet accounting, while requiring more disclosures related to leasing transactions.”
The new guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, for any of the following:
- A public entity, as defined by U.S. GAAP
- A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market
- All employee benefit plans that file financial statements with the SEC
For all other organizations, the guidance is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
Early application is permitted for all organizations.
Understanding ASC 842 for the Lessee
Determining Whether You Entered into a Lease
A lease, including subleases, is defined as a contract, or part of a contract, that conveys the right to “control” the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. However, ASC 842 does not apply to any of the following:
- Leases of intangible assets
- Leases to explore for or use minerals, oils, natural gas, and similar non-regenerative resources
- Leases of biological assets, including timber
- Lease of inventory
- Leases of assets under construction
Control over the identified asset means that the lessee has both (1) the right to obtain substantially all of the economic benefits from the use of the asset and (2) the right to direct the use of the asset.
Classifying Leases as Finance or Operating Leases
Once the lessee has determined that a lease contract exists, the lessee must determine if the lease is a finance (capital) or operating lease.
A lessee shall classify a lease as a finance lease when the lease meets any of the following criteria at the lease commencement:
- The lease transfers ownership of the asset to the lessee by the end of the lease term
- The lease grants the lessee an option to purchase the asset that the lessee is reasonably certain to exercise
- The lease term is for the major part of the remaining economic life of the asset
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the asset
- The underlying asset is of such a specialized nature that it is expected not to have any alternative use at the end of the lease term
An operating lease is any other lease that does not meet the criteria above for finance leases.
Recording the Lease: Statement of Financial Position
For all leases, whether finance or operating, the lessee at the commencement date shall measure and record on the statement of financial position (a) the lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease, and (b) the right-of-use (ROU) asset.
The cost of the ROU asset consists of the following:
- The amount of the initial measurement of the lease liability
- Any lease payment made to the lessor at or before the commencement date, minus any lease incentives received
- Any initial direct costs incurred by the lessee
For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election not to recognize lease liabilities and ROU assets. When a lessee makes this election, he or she should recognize lease expense for such leases on a straight-line basis over the lease term.
Recording the Lease: Statement of Income and Cash Flows
There are different treatments on the statement of income and cash flows for finance vs operating leases. The following chart highlights these differences.
|Finance||Recognize interest on the lease liability separately from amortization of the ROU asset.||Classify repayments of principal of the lease liability as financing activities and payment of interest on the lease liability as operating activities.|
|Operating||Recognize a single lease cost on a straight-line basis over the lease term.||Classify all cash payments as operating activities.|
The new lease accounting standard affects both lessees and lessors. The information presented above is from the lessee’s perspective; and, while the new standards are not yet in effect, it is prudent to start thinking ahead about implementation and compliance. For more information on lease accounting requirements or our services, please contact us at email@example.com or (212) 245-5900.
Marisa Pershad, CPA, CVA, is a Senior Audit Manager at Farkouh, Furman & Faccio with 35 years of experience with Investment Partnership, Broker Dealer, Real Estate, and Commercial clients. Marisa specializes in the audit of GAAP and OCBOA basis financial statements.