Do you lease office space or equipment? If so, have you heard about the changes to lease accounting? In February of 2016, the Financial Accounting Standards Board (FASB) issued a new accounting standards update regarding accounting for leases, known as ASU 2016-02. Forget everything you used to know about capital and operating leases – well, maybe not quite everything – and prepare to learn about a new world of lease accounting.
Current FASB guidance categorizes leases as operating or capital leases from a Lessee’s perspective. The new standard now classifies them as operating or finance leases, with essentially all leases being reported on the balance sheet. (There is an exception for short-term leases, with terms less than one year, which are not required to be capitalized.) Prior to evaluating the accounting treatment, all leases must be analyzed to determine if the contract qualifies as a lease, and if so, what classification it falls in to. We have summarized the new guidance in the following four simple steps.
Step 1. Determine if contract meets the standard qualifications for a lease.
The contract must convey the right to control the use of a specifically identifiable asset for a stated period of time.
Step 2. Determine the type of lease (finance or operating).
A lease must meet one of the following five criteria to be considered a finance lease:
- Transfers ownership of the asset to the lessee
- Option to purchase exists, which the lessee is reasonably certain that they will exercise
- Term of the lease is a major part of the asset’s economic life
- Present value of lease payments is substantially all of the fair value of the asset
- If asset is of such a specialized nature that the lessor will not be able to use it as after the end of the lease, then the lease is considered a finance lease.
If the lease does not meet any of the above criteria, it is considered an operating lease.
Step 3. Recognize the asset.
At the commencement of the lease, the lessee will recognize a right-of-use asset on their balance sheet, which will include any initial direct costs such as legal fees, advanced payments, and lease incentives, and a lease liability, which is measured at the present value of future minimum lease payments.
Step 4. Treatment of the expense.
Operating leases will record straight-line lease expense. (Note: This will be reported in the operating section of the statement of cash flows.)
Finance leases will front-load the income statement with amortization and interest expense calculated using the effective interest-rate method, and portions of the payments will either be classified as operating or financing on the cash flow statement.
(Note: Lessor perspective is largely unchanged. Lessors will continue to recognize leases as operating, direct financing, or sales-type leases. However, leveraged lease accounting has been eliminated. For further guidance on lease accounting from the lessor standpoint, refer to ASC 842-30.)
Nonpublic companies are required to adopt these changes for years beginning after December 15, 2019; however, early adoption is permitted.
This is one year after the new revenue recognition standards as required by ASU 2014-09 are required to be implemented. Consider this as you prepare for the future of accounting as it may be most efficient to plan for both significant changes together.
So how can you prepare your company for these changes? You should begin assessing all leases your company is a party to by collecting information on the terms of the leases and planning for the treatment of each one. It may also be a good time to review your processes and control requirements as the new rules will result in much more detailed tracking of leases for accounting and financial statement disclosures.
Contact Kristi Yanover for more information.