Risk Insights - Lease Accounting Standards

Risk Insights Lease Accounting Standard — What You Need to Know

THE MOST RECENT STANDARD on lease accounting issued by the Financial Accounting Standards Board (FASB) has the potential to impact effectively all U.S. companies. Public companies must comply with the standard for periods beginning after December 15, 2018, while private companies have a one-year delay. Although this deadline may seem like a long time off, it will be here before you know it. Will the change impact your company? If so, how?

How did we get here?

WE CAN TRACE THE ORIGINS of this latest update back to 2005, when the U.S. Securities and Exchange Commission (SEC) recommended updates to the financial reporting requirements for leases in order to improve the transparency of a company’s financials.

At that time, much of the relevant information about operating lease transactions was buried in the financial statement footnotes, which led to extensive off-balance-sheet transactions, which users could not readily evaluate for an authentic depiction of an entity’s lease obligations.

The following year, FASB teamed up with the International Accounting Standards Board (IASB) to begin addressing the problems outlined by the SEC. Over the course of the next eight years, FASB and IASB jointly worked toward a solution. They reached out to the public for comments to help ensure changes would be both easy to implement and effective for improving transparency. In the end, each authoritative body released unique versions of the new accounting model. The IASB’s final version of the new accounting standards on lease accounting, International Financial Reporting Standards 16, was released in January of 2016; the FASB’s version, Accounting Standards Update (ASU) No. 2016-02, was released a month later.

Who does it impact?

AT A HIGH LEVEL, the new FASB standard affects any company that follows generally accepted accounting principles (GAAP). In practice, the required changes will ultimately impact lessees (those who lease property or equipment) more than lessors. (However, lessor accounting may be affected by the new revenue recognition standards under ASC-606.)

Any interim or annual reports released for periods beginning after December 15, 2018, by a public company must demonstrate the required changes. The original release of the standard mandated a modified retrospective transition that required application of the new

Lease Accounting Standard - What You Need to Know guidance to the current period and any prior periods presented in the report. ASU 2018-11, Leases (Topic 842): Targeted Improvements made transition requirements less burdensome by providing an option to apply the transition provisions of the new standard at the adoption date instead of the earliest comparative period presented in the financial statements.

What changed?

LEASES GIVE COMPANIES the flexibility to use property or equipment without purchasing it outright, and they are classified as either “capital” or “operating” leases under current guidance. Capital leases typically have longer lease terms, and the agreement between the lessor and the lessee indicates the lessee assumes ownership over the asset while they are using it. Often, the intent is that the lessee retain the asset at the end of the lease term, either by purchasing it outright or in a de-facto lease-to-own scenario. Operating leases, on the other hand, typically have shorter lease terms, and the ownership of the asset does not pass to the lessee. The lessee simply pays for the right to use that asset for a period of time.

Under current standards, only capital leases are recorded on the balance sheet. Operating leases are left off the balance sheet and, instead, appear only on the income statement as a monthly expense and in the footnotes to the financial statements. The new FASB guidelines require that both types of leases be recorded on the balance sheet.

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The new FASB guidelines require that both types of leases be recorded on the balance sheet.

The new guidelines also adjust some of the terminology historically used in lease accounting. For example, going forward, “capital leases” will be known as “finance leases,” but operating leases are still termed as such.

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Lease Accounting Standard - What You Need to Know Another key change is the expanded disclosure requirements. The old model required very little to be disclosed in the financial statement footnotes; the contractual details of any off-balance-sheet leases were listed alongside the future minimum rental payments for those agreements, but not much else. Under the new standard, lessees must disclose the nature of their leases, the assumptions used to account for the leases, the expense amounts for each type of lease and maturity tables of their arrangements.

What are some key components of the new standard?

Identifying a lease LESSEES MUST NOW TAKE CARE to identify every single lease in which they participate. To make this determination, the arrangement must pass a two-part test: 1. Can the lessee identify a specific asset? To be considered a lease, the agreement must identify (explicitly or implicitly) a specific asset. The asset must also be difficult for the lessor to substitute for an alternative asset. If, for example, the lessee is leasing a tractor to use on their tract of land, the lessor is not easily able to enter the lessee’s property to substitute that tractor for a different one. This portion of the test can also be satisfied if the asset is so customized that others would be unable to use it.

2. Does the lessee control the asset? Once the asset has been specifically identified, lessees must ask, “Do I control the asset?” If, during the lease term, they receive substantially all of the benefits from using the asset and have the right to direct how and for what purpose the asset is used, then they control the asset.

A leased asset cannot be a portion of another asset; it must be physically distinct. For example, a floor in a building would be physically distinct, but a portion of the use of an airplane would not.

Given the new guidance, some contracts previously identified as service contracts may have a component that is actually considered a lease. Some examples include: ⊲⊲ Oil and gas transportation and gathering contracts, when those assets are developed specifically for the collection and delivery of production from a field ⊲⊲ Leased space in a data center that is part of an information technology hosting service contract ⊲⊲ Contract manufacturing at a plant that consumes substantially all the capacity of the plant

Recognition and measurement of assets and liabilities CAPITAL LEASES WILL STILL BE RECORDED as they were under previous guidance, but operating leases must now be recorded on the balance sheet. An operating lease with a duration of more than 12 months will now be shown on the balance sheet as a “right-of-use asset” and as a “lease liability” equal to the present value of the lease payments.

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Lease Accounting Standard - What You Need to Know The discount rate for the present value of the lease liability is the rate implicit in the lease. A company may use its incremental borrowing rate when the implicit rate is not readily available.

Nonpublic companies may elect to use a risk-free rate. Companies may also choose to use a common discount rate for a portfolio of leases if that rate does not create a material difference compared to the implicit rate.

The right-of-use asset is initially measured and recorded as the present value of the total of the lease liability, plus lease commencement payments, minus lease incentives, plus direct costs incurred by the lessee.

For a simple lease contract, it will be relatively easy to calculate the present value in order to measure the initial liability; however, it may be challenging to separate the value of a lease that is embedded within a larger contract. Under the original release of the standard, such embedded leases had to be isolated and recorded separately on the balance sheet, which could prove to be more time-consuming, as there is no one-size-fits-all method to isolating a lease from a larger contract. For example, a contract may include both the lease of equipment and routine maintenance on that equipment; valuing the maintenance portion of the contract is necessary, but it may prove subjective. When separating the lease and non-lease components, lessees must disclose in the footnotes any assumptions they have made when determining the value of the asset in this instance.

The good news is that ASU 2018-11, Leases (Topic 842): Targeted Improvements provided a practical expedient permitting lessors to not separate non-lease components from the associated lease component if certain conditions are met.

Similar to their current treatment, operating leases will reflect lease expense on a straight-line basis.

Using the effective interest method, the straight-line expense will reflect the interest expense on the lease liability and amortization of the right-of-use asset. The amortization is calculated as the difference between the total straight-line expense and the interest expense on the lease liability for the period. Amortization expense associated with the right-of-use asset will grow as interest expense on the liability declines over the lease term. Lease expense will be presented as a single line item in the operating expense section of the income statement.

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Lease Accounting Standard - What You Need to Know Finance leases will reflect a front-loaded expense pattern (i.e., expense per period will decline throughout the lease term) similar to the pattern for current capital leases. The interest expense on the lease liability (effective interest method) and amortization of the rightof-use asset, generally straight line, will be reflected separately on the income statement.

Key considerations for the new standard THE NEW STANDARDS ENCOMPASS a wide array of considerations, many of which can be highly complex.

These include: ⊲⊲ The lease term. Renewal or termination options that are reasonably certain of exercise should be considered in determining the lease term. This prevents companies from establishing a series of leases less than 12 months to escape new lease accounting requirements. ⊲⊲ Variable lease payments. Payments dependent on an index or rate should be calculated at the commencement of the lease using the index or rate at commencement, assuming no change to the index or rate. However, variable payments not based on an index or rate should be excluded unless they are effectively unavoidable or there is an established minimum payment increase. Lessees should pay particular attention to treatment of variable lease payments. ⊲⊲ Lease incentives. Incentives provided by the lessor to encourage signing the lease, such as payment of lessee costs, up-front payments or the assumption of a preexisting lease, should be estimated to determine the loss incurred by the lessor. The lessee’s fixed lease payments should be reduced by the amount of the loss incurred by the lessor when classifying the lease and measuring the right-of-use asset and lease liability at the inception of the lease. ⊲⊲ Option payments. Purchase options provided for in a lease should be considered as part of the measurement of the right-of-use asset and lease liability at the inception of the lease. ⊲⊲ Lease modifications. A lessee’s accounting treatment for a modification to the lease depends on the type of modification made to the lease, either resulting in a separate new lease or a remeasurement of the existing lease.

Consideration is given to whether there is an additional right of use granted and whether the price for the new right of use is commensurate with the standalone price of the new asset.

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Lease Accounting Standard - What You Need to Know Disclosures required THE NEW ACCOUNTING METHOD requires expanded quantitative and qualitative disclosures about a company’s leases. The intent of these disclosures is to improve the transparency of the amount, timing and cash uncertainties of a lessee’s leasing transactions and to supplement the amounts investors see on the balance sheet in order to give context to the transactions.

Quantitative disclosures include: ⊲⊲ The cost of the lease, whether it is a short-term or long-term lease and whether or not the lease is variable ⊲⊲ Maturity tables for the next five years ⊲⊲ Income from any sublease transactions ⊲⊲ Gain or loss recognized in sale and leaseback scenarios Qualitative disclosures include: ⊲⊲ Assumptions and judgements when calculating the fair value of the lease, including discount rate, valuation method and the allocation of lease and non-lease components of a contract ⊲⊲ Related party information ⊲⊲ Details on future leases, if significant

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Lease Accounting Standard - What You Need to Know Where can you start?

IF YOU HAVE NOT ALREADY addressed how your company will implement these changes, you can start by understanding exactly what your leasing activities are: go through your files, look through your contracts and see what changes you need to make to account for these arrangements.

Remember that under the new guidance some contracts previously accounted for as a service could contain a lease. You may need to do additional digging or contact your vendors for information that will help you quantify certain leases. You may also need to update your systems to record these leases differently than you have in the past.

Changing how you think about leases With the new standard in mind as you sign or renew leases, you may start to choose certain lease terms over others. Over time you may determine that certain leases are ultimately not in your company’s best interests. For example, you may choose to sign only short-term contracts that will not need to be reported on the balance sheet, or even to purchase an asset instead of leasing it. Lessees should pay particular attention early in their impact analysis to how the new lease accounting rules will change their balance sheet and their effect on existing financial ratios within debt covenants.

In conclusion...

ALTHOUGH ACCOUNTING STANDARDS and reporting requirements regularly evolve, most experts agree the implementation of new lease accounting standards is more complex and nuanced than other updates in recent memory. Meeting the requirements of the new standard will require more than a simple accounting change. Instead, companies will likely have to change myriad related processes and, in the end, may even reevaluate which leases are worth the effort.

Given the nuance and complexities involved with the new standards, you may find that making the change is too daunting a task to take on yourself. In fact, many companies are opting to engage outside CPA firms to help them understand their current state and the scope of process changes that might be required to meet the new standard, as well as to develop a plan for how to get there.

In fact, approached correctly, this required change can serve as a prime opportunity for businesses to gain a better understanding of their finances and, ultimately, to improve their overall financial reporting processes over time.

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