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.
Like most new standards, this one will require changes in company software to
ensure compliance and changes to leasing contracts.
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:
- A lessee option to purchase that is reasonably certain to
- A lease term that covers a major part of the life of the
- 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
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
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.
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.
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
Robert Bloom, PhD, is a professor of accountancy
at John Carroll University in University Heights, Ohio. He can be reached at