By John M. Fleming, CPA, MBA, executive vice president, SmartPros Ltd.
Leasing is an important activity for many entities. ASC 840, Leases, the existing lease accounting GAAP, requires lessees and lessors to classify their leases as either capital leases or operating leases and account for those leases differently. This existing guidance has been criticized for failing to meet financial statement users’ needs because it does not always provide a faithful representation of leasing transactions. In particular, it does not require lessees to recognize assets and liabilities arising from operating leases.
In July 2006, the FASB and IASB initiated a joint project to develop a new approach to lease accounting that would require assets and liabilities arising from long-term leases to be recognized in the statement of financial position.
The FASB developed a new lease accounting proposal after considering responses to a discussion paper issued in March 2009. The FASB issued its proposed lease Accounting Standards Update in August 2010. To meet their 2006 objective, the IASB and the FASB released a jointly developed revised exposure draft standard on leases on May 16, 2013.
Financial statement users’ criticism of existing lease requirements primarily relate to the accounting for operating leases in lessees’ financial statements. Operating leases have traditionally been accounted for as off balance sheet, disclosed in a lease footnote rather than presented as assets and liabilities in the statement of financial position. Lessor accounting had little criticism, and has been left virtually unchanged except for conforming changes based on ASC 606, Revenue from Contracts with Customers, and enhanced disclosure requirements.
The core principle of the new lease guidance is that an entity should recognize assets and liabilities arising from a lease. A lessee will recognize a liability to make lease payments and a right-of-use (RoU) asset representing its right to use the leased asset for the lease term.
ASC 842 is a new leasing standard, and is not considered to be an update. ASC 842 is more principles-based and eliminates traditional operating lease accounting for all but short-term leases. The new standard requires lessees and lessors to classify all long-term leases on the statement of financial position. Thus, the four bright lines to distinguish between a capital lease and an operating (off balance sheet) lease that existed under ASC 840 are no longer relevant.
ASC 842, defines a lease 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”
ASC 842 classifies lessee leases into two types: finance and operating. Each type determines how and when a lessee recognizes lease expense and a lessor recognizes lease revenue based on whether the lease is a sale-type lease, direct-financing lease, or an operating lease. The concept of control is critical in determining whether a leased asset has been transferred to the lessee.
According to ASU 2016-02, a lease conveys the right to control the use of an identified property, plant, and equipment (an identified asset) for a period of time in exchange for consideration. Therefore, ASC 2016-02 does not apply to the following:
In addition, short-term leases are outside the scope of ASU 2016-02. A short-term lease is a lease that, at the commencement date, has a term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
Note: Reasonably certain is defined as a high degree of confidence (for example, 90 percent to 95 percent) that an event will take place.
The lessee has an accounting policy option to recognize payments on a short-term lease on a straight line basis over the lease term. If the accounting policy option is elected, the short-term leases would not be reflected on the lessee’s statement of financial position.
With the exception of short-term leases, a lessee should recognize the “right-of-use” (RoU) assets and lease payment liabilities that arise from a lease contract. All leases create an asset and a liability for the lessee based on the definitions of assets and liabilities in FASB Concept Statement No. 6, Elements of Financial Statements:
On the lease commencement date, the lessee recognizes a liability for its lease obligation measured at the present value of the future lease payments. A “right-of-use” (RoU) asset is measured at an amount equal to the lease liability adjusted for:
The lessee’s RoU asset is related to, but distinct from, the lease’s underlying asset. The underlying asset is the specific item (identified asset) for which the lessee is making payments to the lessor to use. The underlying asset is owned by the lessor, not the lessee, and therefore the underlying asset is an asset of the other party, not of the lessee. In contrast, the lessee’s RoU asset is an intangible asset – a right – that the lessee has acquired and therefore owns.
The RoU asset is typically classified as a long-term (noncurrent) asset on the lessee’s balance sheet. It is subject to systematic amortization over time. As such, at any given point in time, its carrying amount reflects the unamortized portion of its cost (i.e., the portion of the asset’s cost that has been allocated to future accounting periods).
The amortization of the RoU asset is recognized as a noncash expense unless the underlying asset is used in the production of goods or services, in which case the amortization accrues to work-in-process inventory or a similar asset account.
Leases from the lessees viewpoint, can be classified as:
An entity is required to determine the classification of a lease on the lease commencement date. The lease commencement date is the date the lessor makes an underlying asset available for use by the lessee. The lease classification should not be reassessed unless the contract is modified and the modification is not accounted for as a separate contract or if the lease term changes or a purchase option becomes reasonably certain to be exercised.
A lease will be classified as a finance lease when the lease meets any of the following criteria at lease commencement:
If one of the criteria above is in the lease contract, the lessee recognizes a right-of-use (RoU) asset and a lease payment liability in the statement of financial position. The lessee recognizes interest on the lease payment liability over the lease term separately from the amortization of the RoU asset in the income statement. The RoU asset is generally amortized on a straight line basis. The lease payment liability is amortized on an effective interest basis, resulting in a front loading of lease-related expenses.
Variable lease payments, not paid to reduce the principal lease payment liability, are recognized in the period in which the obligation for those payments is incurred. Any subsequent impairment of the RoU asset is determined based on the guidance in ASC 360, Property, Plant, and Equipment.
Repayments of the principal portion of the lease payment liability are classified in the financing section of the statement of cash flows. Payments of interest on the lease liability and variable lease payments are classified with the operating section of the statement of cash flows.
The RoU asset and the lease payment liability may not be the same at commencement, nor throughout the lease term, because the RoU asset is calculated as the amount of the initial measurement of the lease payment liability plus payments made by a lessee to the lessor at or before the lease commencement date minus any lease incentives the lessee received from the lessor and any initial direct costs incurred by the lessee.
In subsequent periods, the lease payment liability is increased by recognizing periodic interest on the lease liability and decreased by payments made during the lease periods. The RoU asset is reduced by accumulated amortization and any impairment losses based on reassessment requirements. The RoU asset is amortized on a straight line basis from the commencement date to the earlier of the end of the lease term or the useful life of the RoU asset. If the RoU asset will be transferred to the lessee at the end of the lease term or it is reasonably certain that the lessee will exercise a purchase option for the RoU asset, then the RoU asset’s amortization period should be to the end of the useful life of the RoU asset.
When none of the criteria for a finance lease are met, the lease is classified as an operating lease. The lessee recognizes a “right-of-use” (RoU) asset and a lease payment liability in the statement of financial position in the same manner as a finance lease. The lessee though, in an operating lease, will recognize a single-lease cost, calculated so that the undiscounted cost of the lease is allocated over the lease term generally on a straight line basis. This is accomplished by amortizing the lease liability on an effective interest basis and then amortizing the RoU asset by adjusting (plugging) the lease asset’s amortization to arrive at a constant lease expense amount.
Stated differently, the lease payment liability is reduced over time by recognizing the present value of the remaining lease payments not yet paid. The initial RoU asset balance is reduced by periodically adjusting the amortization of the RoU asset by the effective interest on the lease payment liability to arrive at a constant straight line expense amount. The RoU asset may also be impacted by any prepaid or accrued expenses, the remaining balance of any lease incentives received, unamortized initial direct costs, or any impairments.
The lease term and a purchase option should be reassessed if:
The lessee should remeasure the lease payments if any of the following occur:
Variable lease payments, not paid to reduce the principal lease payment liability, are recognized in the period in which the obligation for those payments is incurred. Any subsequent impairment of the RoU asset is determined based on the guidance in ASC 360, Property, Plant, and Equipment. All cash payments made for operating leases are classified within the operating activities of the statement of cash flows.
It is anticipated that between $2 trillion and $3 trillion of RoU assets and lease payment liabilities will be placed on U.S. reporting entities’ statements of financial position based on ASU 2016-02. While certain industries such as retail businesses, airlines, telecommunications, and banks will be impacted to a larger degree than other industries, all reporting entities that participate in leasing transactions will be affected to some degree. It is expected that reporting entities will all have to manage the following issues:
–Debt to equity will increase
–Interest coverage will decrease
–EBITDA will increase
–Return on assets will decrease
–Current ratio will decrease
–Budgeting and planning processes
–Lease vs. buy decisions
–Internal controls over lease transactions
ASU 2016-02, Leases, is effective for fiscal years beginning after Dec. 15, 2018, including interim periods within those fiscal years, for the following entities:
The ASU is effective for all other entities for fiscal years beginning after Dec. 15, 2019, and interim periods within fiscal years after Dec.15, 2020.
Early application is permitted for all entities.
John M. Fleming, CPA, MBA, is an executive vice president at SmartPros Ltd. He is a member of the PICPA’s Accounting and Auditing Technical Committee as well as chair of its Greater Philadelphia Chapter Accounting and Auditing Technical Committee.
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