Finance and Operating Leases under ASC Topic 842

A new Financial Accounting Standards Board (FASB) leasing standard is finally available, and it likely will impact many companies in a wide array of industries. The major change in ASC Topic 842 is to put most leases, which reflect the right of the lessee to secure the asset in accordance with the underlying contract, on the lessee’s balance sheet instead of only in the footnote disclosures. This will affect corporate balance sheet and income statement ratios, the nature of corporate financing, and the leasing industry.

by Robert Bloom, PhD Dec 20, 2019, 13:18 PM

Short-term leases pertaining to no more than 12 months will be exempt, and will still be reflected off the balance sheet. For those leases on the balance sheet, there will be a dual approach to reporting:

Capital leases will now be called “finance” leases.

There will also be “operating” leases to be capitalized, which are expected to encompass most existing operating leases.

Finance leases are intended to be for control of the underlying asset. Essentially, the same criteria currently used for capital leases by the lessee will apply to finance leases, apart from bright lines: the 75 percent and 90 percent guidelines no longer exist.

At least one of the following criteria is needed to reflect a finance lease:

Transfer of ownership

A lessee option to purchase that is reasonably certain to be exercised

A lease term that covers a major part of the life of the asset

Lease payments and present-value-guaranteed residual value that cover a substantial part of the fair value of the asset at lease beginning

Specialized nature of the asset that makes alternative use for the lessor unlikely

If none of the above is met, the lease is an operating lease to be capitalized, assuming it is for more than 12 months.

Both types of leases will reflect the “right to use” an intangible asset subject to subsequent amortization and impairment losses. A “finance” lease will reflect an effective interest expense that is front-loaded along with the straight-line amortization expense of the right to use the asset. Thus, the total income statement expense will be higher early on in the life of the lease and will decline over time. There will be long-term debt to report on the balance sheet for finance leases. Furthermore, under a finance lease the income statement will show separate amortization and interest expenses, while under an operating lease only the total expense will be reflected.

For capitalized operating leases, the income statement expense will be constant in total from one period to the next. While the interest expense for the operating lease will be front-loaded as in the finance lease, the amortization of the right-to-use under the operating lease will be backed into to reach a constant total expense, as in the expense for operating leases under existing GAAP. The capitalized operating lease also produces on-the-balance-sheet debt, but the FASB refrains from explicitly designating it as such.

Should the lease begin in the final 25 percent of the asset’s economic life, it is deemed to be near the end of that life, and the lease term criterion for the major part of the asset’s life cannot be invoked. Options to extend the useful life or to not terminate a lease should be factored into the lease term if reasonably certain, which is a high threshold to attain. In the event of a change in the lease term or option to purchase the asset, the lessee must reassess the classification of the lease.

With respect to the lessor, the new standard does not call for significant changes.

All leases that do not transfer control of the asset to the lessee are operating leases. All leases that do transfer control to the lessee should be evaluated as to whether they meet the criteria for sales-type or direct-financing leases. Revenue recognition guidance under Topic 606 will have to be invoked to decide whether a sale/leaseback exists. Generally, transfer of control reflects a sales-type lease with sales revenue.

A lease receivable (or net investment) will continue to be reported by sales-type and direct-financing lessors. For an operating lease, the lessor will retain the asset on the balance sheet. The direct-financing and sales-type lessors will recognize interest revenue on the income statement.

IFRS Differences

International Financial Reporting Standards (IFRS) calls for capitalizing only finance leases to the lessee, in contrast to the new FASB standard. Accordingly, IFRS has a simpler standard, and its adherents will not have to distinguish between what is an installment purchase of property from a shorter-form capital lease. Under IFRS, as in the FASB standard, the income statement of the finance lessee will reflect both amortization of the right-to-use asset and interest expense, the latter front-loaded.

The balance sheet for the IFRS lessor will continue to show a net investment for finance leases. IFRS doesn’t use the terms for “sales-type” and “direct-financing” leases. On the income statement, IFRS will show interest revenue and profit on sales of leased assets for finance leases as the FASB does for sales-type and direct-financing leases.

Conclusion

The effective date of the new standards is 2019, but companies will need to prepare well in advance of that date for retrospective comparative analysis back to 2017, if not earlier.

For the FASB standard, there will likely be more short-term leases in an effort to avoid any capitalization on a long-term basis and the detrimental effects on debt ratios. There may well be more capitalized operating leases than finance leases to reflect a constant total lease expense on the income statement from year to year, as under existing operating leases.

Robert Bloom, PhD, is a professor of accountancy at John Carroll University in University Heights, Ohio. He can be reached at rbloom@jcu.edu.

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