In February 2016 the FASB issued Accounting Standards Update (ASU) No. 2016-02, replacing longstanding guidance on lease accounting. The requirements must be adopted by most calendar-year private companies in 2020, with early adoption permitted.
Under current rules, as promulgated under FASB Statement 13 in 1976, a lease that transfers substantially all the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing by the lessor. Such a lease is viewed as similar to an installment purchase. But all other leases are accounted for as operating leases and not reported in the balance sheet.
When FASB 13 was issued, some FASB members believed that all leases give rise to an asset and an obligation which should be reflected in the lessee’s financial statements. But FASB 13 restricted such treatment to those leases meeting specified criteria.
This guidance has been continually criticized for failing to meet the needs of the users of financial statements. Because assets and liabilities for many long-term operating leases do not appear on the balance sheet, conclusions about the leverage and capital used in operations are potentially distorted, and comparability among companies is affected. Many users try to adjust the financial statements for the effects of these unrecognized lease obligations. In short, they want the leases to appear on the balance sheet.
Under the provisions of ASU 2016-02, for leases with a lease term greater than 12 months, the lessee will be required to recognize a Lease Payment (LP) Liability and a Right-of-Use (ROU) Asset in the balance sheet. As a practical expedient, there is an optional exemption for leases of 12 months or less, provided that the lease does not contain (a) a purchase option that the lessee is reasonably certain to exercise, or (b) renewal options that would extend the lease term beyond 12 months which are reasonably certain of being exercised at the beginning of the lease term.
If the practical expedient option is elected, payments on short-term leases will be recognized on a straight-line basis over the lease term, and the leases would not be reflected in the lessee’s balance sheet.
The LP liability is based on the present value of the future lease payments, excluding variable payments such as Consumer Price Index increases, and amounts allocable to non-lease components of the contract such as common-area maintenance. However, a practical expedient enables lease components and non-lease components to be accounted for together. This could increase the amounts recognized in the balance sheet.
To compute present value, the interest rate implicit in the lease should be used if available. Otherwise, the lessee may use its incremental borrowing rate – the rate it would pay to borrow on a collateralized basis – as the discount rate. Or, as a private company accounting policy election for all leases, the lessee may use a risk-free discount rate, based on a period comparable to the lease term. This lower rate will also result in recording a larger asset and liability.
The ROU asset is based on the LP liability, less any lease incentive payments, such as cash provided for leasehold improvements, plus any initial direct costs, such as commissions incurred by the lessee.
Subsequent Measurement – Lessees
ASU 2016-02 essentially maintains the expense recognition patterns existing under current guidance. Accordingly, leases must be further classified by the lessee to determine how to recognize lease-related expenses. Using criteria similar to those currently used to identify capital leases, leases effectively transferring control of the underlying asset to the lessee will be classified as financing leases. In these cases, the lessee will recognize interest on the LP liability separately from amortization of the ROU asset in the income statement. The LP liability is amortized on an effective interest basis, resulting in a front-loading of lease related expenses.
For operating leases, even though the LP liability is discounted to present value, interest expense is not recognized. Rent expense will generally be recognized as a constant amount on a straight-line basis over the lease term. But because it includes both an interest component and an amortization component, the annual expense will differ from the annual reduction of the ROU asset balance.
Lessor accounting is largely unchanged from current guidance. Leases will be classified as sales-type leases, direct financing leases, or operating leases. Operating lease revenue will continue to be recognized on a straight-line basis over the lease term, unless a different method better represents the pattern of benefit to the lessee. For operating leases, the underlying asset will also continue to be recognized.
For most sales-type leases and all direct financing leases, the underlying asset will be derecognized and the net investment in the lease (i.e., the lease receivable, the unguaranteed residual asset and any deferred selling profit for a direct finance lease) will be recognized in a manner similar to current guidance. Any selling profit or loss on sales-type leases will be recognized if collection of payments is probable. Selling profit on direct financing leases is deferred and recognized over the lease term, but any selling loss is recognized immediately.
Subsequent Measurement – Lessors
A lessor will recognize interest income on direct-financing leases and most sales-type leases using the interest method and reduce the net investment in the lease for the payments received. Lessors are also required to assess their entire net investment in the lease (both the lease receivable and any unguaranteed residual asset) for impairment in accordance with the guidance applicable to the impairment of receivables.
Effect on Loan Covenants
Many users expressed concern that the new guidance could cause debt covenants to be violated of affect their access to credit. The FASB claimed that the following factors mitigate those concerns:
- Many users presently adjust an entity’s financial statements for operating lease obligations and, in doing so, often estimate amounts significantly in excess of what will be recognized under the new guidance.
- Some loan agreements contain “frozen GAAP” clauses, such that a ratio failure resulting solely from a GAAP accounting change either will not constitute a default or will provide for renegotiation in good faith.
- Even absent a frozen GAAP clause, banks have advised that they are unlikely to dissolve a good customer relationship by “calling a loan” because of a technical default arising solely from a GAAP accounting change.
- The new guidance characterizes operating lease liabilities as operating liabilities rather than debt. Consequently, key financial ratios used in debt covenants may not be affected,
- The extended effective date of the new guidance provides significant time to modify those loan agreements which will not expire prior to that date.
Effective Date and Transition
For public entities, the new guidance is effective for fiscal years beginning after December 15, 2018. For all other entities, the guidance is effective for fiscal years beginning after December 15, 2019. Leases will be presented using a modified retrospective approach, whereby the new guidance will be applied to all periods presented in the financial statements; however, any leases that expire before the beginning of the earliest comparative period presented will not require any accounting adjustment.