New Rules for Lease Accounting

Background:

In February 2016, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) which is effective for public companies for annual periods beginning after December 15, 2018 and for annual periods beginning after December 15, 2019 for non-public companies. The update seeks to improve transparency and convey more useful information to a user of the financial statements.  One of the core principles behind the release of Topic 842 is that an asset represents future economic benefit to an entity and a liability represents a future obligation. The economics can vary from lease to lease, however all leases create both an asset and a liability and, as such, FASB decided that all leases should be reflected within the financial statements. Thus, a primary difference between Topic 842 and the previous guidance under Topic 840 is the requirement of the lessee to recognize an asset and corresponding liability for all leases.

Identification of a Lease:

Per the new guidance, a lease is now defined as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration.”  It’s worth noting that this standard is not applicable to leases of inventory, intangibles assets, or leases of an asset under construction.  The update maintains two classifications of leases: operating leases and finance leases (capital leases under previous guidance).

To determine whether a lease is present within a contract according to Topic 842,  entities need to assess whether they have both the “right to obtain substantially all the economic benefits from the use of the asset” and the “right to direct and control the use of the asset” throughout the specified period. If both are present, under the new guidance the contract contains a lease that needs to be recognized by the entity. It’s important to keep in mind that a contract may contain more than one lease. The right to use an underlying asset is considered a separate lease component if both of the following are applicable: (1) the lessee can benefit from the right to use the asset on its own or in conjunction with readily available resources, and (2) the right to use is neither highly dependent or interrelated to other assets within the contract. Another key provision of this standard is that when an agreement provides an entity the right of use of land, the land should be accounted for as a separate lease component.

Classification of Leases:

An entity should proceed to classify each individual lease component as either operating or financing. Additionally, an entity should identify their active leases and assess whether their classifications have changed. Aside from two main differences in the language of Topic 842, the criteria used by a lessee when determining between an operating vs. financing lease remains mostly unaltered from that of previous guidance in Topic 840.

Previously, a lessee would test the specific details of each individual lease against the following established criteria;

  • The lease transfers ownership of the leased property to the lessee by the end of the lease term.
  • Presence of a bargain purchase option in the lease.
  • Term of lease represents 75% or more of the leased property’s estimated economic life.
  • Present value of minimum lease payments equals 90% or more of the fair value of the lease property.

Assuming any one of the above criteria was met, the lessee would classify the lease as a capital (finance) lease. If, however, the lease did not meet any of the criteria above or the term of the lease was less than 12 months, the lessee would proceed to classify it as an operating lease. Topic 842 maintains the four criteria noted above with the exception being that the new language removes the following explicit thresholds of “lease term equal to 75% or more” and “minimum lease payments equals 90% or more,” from the third and fourth criteria above, respectively. In place of lease term equaling the “75% or more” threshold, the current language reads as “the lease term is for “a major part” of the underlying assets remaining economic life”. Similarly, rather than minimum lease payments “equaling 90% or more” of the leased property’s fair value, the new threshold to be met is that “the present value of lease payments and any residual value guaranteed by the lessee amounts to “substantially all” of the underlying assets fair value.” The removal of these explicit, line-in-the-sand thresholds in favor of more subjective language leaves it open to interpretation for an entity to determine whether their lease term represents a “major part” of the remaining economic life or what amount constitutes “substantially all” of an assets fair value.

The second of the two main differences set forth in the update regarding lease classifications is the addition of the following criterion; the leased asset is specialized such that it will have no expected or alternative use to the lessor at the end of the lease. Whereas Topic 840 had a set of four criteria against which a lessee would test the details of a lease, Topic 842 provides a set of five criteria for the lessee to test against, (the four previous criteria with updated language and the additional criterion noted above), and provided that the lease meets at least one of the five, the lessee will classify the lease as a financing lease.

Presentation and Disclosure Requirements:

To convey more relevant information regarding an entity’s leases to a user of the financial statements, the new standards require that a lessee recognize an amount for right-of-use assets and corresponding lease liabilities, either on the face of the balance sheet or disclosed in the footnotes, for all operating and financing leases. Another stipulation is the amounts of right-of-use assets and lease liabilities from an entity’s operating leases must be shown separately from those related to their financing leases.

Whether the lease is classified as operating or financing will affect how it is presented in the lessee’s income statement. For its operating leases, a lessee will recognize a lease expense, and with respect to its financing leases, a lessee’s income statement will show both amortization of the right-of-use asset in addition to interest expense on the lease liability.

In addition to the presentation of leases in the financial statements, Topic 842 stipulates that an entity must disclose information about its leases from a qualitative standpoint. The nature of a lease may include a general description of whether options to extend or terminate the lease exist, or any possible covenants restrictions within the lease. Significant judgements and estimates made by an entity relating to their lease transactions must also be disclosed. Such information would pertain to how contracts are evaluated for potential lease obligations or how the entity determined the discount rate to use.

Quantitative information relevant to an entity’s leases also require disclosure. With respect to its lease obligations, a lessee must provide a maturity analysis which contains un-discounted cash flows due for each of the next five years along with the total due for the remaining years. Amounts relating to a lessee’s total lease cost must be disclosed. When disclosing the cost of financing leases, a lessee must separate the amortization of the asset from the interest on the lease liability. Operating lease costs should be calculated such that any remaining cost is allocated over the remainder of the lease term on a straight-line basis.

Benefits:

A primary benefactor to the issuance of Topic 842 are the users of financial statements, as they are provided with enhanced information relating to various aspects of the entity’s lease transactions. Previous standards only required capital leases to be recognized, and as such, a common practice was to tailor the lease terms in such a way to ensure the lease either met an explicit threshold or fell just short, as in some circumstances entities would find one classification favorable to the other. By requiring recognition of all leases, the financial position of an entity is subject to less potential for misrepresentation. Combined with the new enhanced lease disclosure requirements, financial statement users are provided with more complete and relevant information by which to evaluate an entity’s exposure to both financial and non-financial risks posed by a lease.