New Guidance on Leases Finalized
On February 25, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02, “Leases (Topic 842).” The accounting guidance applied by a lessor (generally the owner) is largely unchanged from that applied under previous generally accepted accounting principles (GAAP). The following summary applies mainly to the lessee.
IT IS MATERIAL
The SEC has estimated that the amount of off-balance sheet operating lease commitments for SEC registrants is in the trillions. The key provision of this ASU will bring those commitments onto the balance sheet. The main difference between previous GAAP and ASU 2016-02 is the recognition of lease assets and liabilities by lessees for those leases classified as operating leases under previous GAAP; and a lessee will be required to recognize a right-of-use asset and a lease obligation for leases with lease terms of more than 12 months.
Under the ASU, from a lessee standpoint, a lease is treated as a financing transaction if the lease effectively transfers control of the leased asset; otherwise it is treated as an operating lease. Both require recognition of a right-of-use asset and a lease liability. For an operating lease, the lessee records lease expense on a straight-line basis. For a financing lease, the lessee presents separately on its income statement interest and amortization expense. As compared to an operating lease, overall expense will be higher in the earlier years of a financing lease and will decline over time.
Under ASC 842-10-25-2 a lessee shall classify a lease as a financing lease when the lease meets any of the following five criteria at the commencement of the lease; otherwise it is accounted for as an operating lease.
- The lease transfers ownership of the leased asset at the end of the lease term.
- The lease grants the lessee the option to purchase the leased asset that the lessee is reasonably certain to exercise.
- The lease term is for the remaining economic life of the leased asset. If commencement is at or near the end of the economic life of the leased asset, this criterion should not be used for purposes of lease classification.
- The present value of the lease payments and any residual value guarantee, not already reflected in the lease payments, equals or exceeds substantially all the fair value of the leased asset. The FASB did not include a bright line test to define “substantially all;” however it indicated that one approach is to consider payments equal to or greater than 90% of the leased asset’s fair value.
- The leased asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
A lessee should reassess the lease classification after the commencement date only if there is a change in the lease term, or in the assessment of whether the lessee is reasonably certain to exercise an option to purchase the leased asset.
ASU 2016-02 allows lessees the option to elect not to apply the balance sheet recognition for short term leases, which are defined as leases of 12 months or less which do not include a purchase option for the leased asset that is reasonably certain to be exercised. If a lessee so elects, lease payments should be recognized in net income on a straight-line basis over the term of the lease. A one year lease that contains an option to renew the lease which the lessee is reasonably certain to exercise is not considered a short term lease.
Under the ASU, a lease is defined as the right to use an asset legally owned by another party. The right to use an asset may not necessarily be conveyed in a typical lease arrangement. The right to use an asset may be conveyed in a service or supply contract; therefore it is important that entities carefully review their contractual agreements to determine if they provide the right to use an asset, for example a service contract that provides the entity with the use of computer equipment.
An entity shall determine the lease term as the non-cancellable period of the lease, plus, among other provisions, periods covered by an option to extend the lease if the lessee is “reasonably certain to exercise that option.” At the commencement date, a lessee assesses whether it is reasonably certain to exercise or not to exercise an option by considering all economic factors relevant to that assessment. The asset and liability are calculated using the present value of the minimum lease payments over the lease term, using the discount rate (defined as the rate implicit in the lease unless that rate cannot be readily determined; in that case, the lessee is required to use its incremental borrowing rate).
Lease modifications that are accounted for as a separate contract (that is, separate from the original contract) must contain both of these elements:
- the modification grants the lessee an additional right of use not included in the original lease, i.e. the right to use an additional asset, and
- the lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract.
Other modifications not accounted for as a separate contract require the lessee to reassess the classification of the lease as of the effective date of the modification based on its modified terms and conditions and the facts and circumstances as of that date. Modifications may require a reallocation of the remaining consideration in the contract and a re-measurement of the lease liability using the discount rate at the date of modification if the modification meets one of four criteria outlined in the guidance:
- Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8)
- Extends or reduces the term of an existing lease (for example, changes the lease term from five to eight years or vice versa), other than through the exercise of a contractual option to extend or terminate the lease (as described in paragraph 842-20-35-5)
- Fully or partially terminates an existing lease (for example, reduces the assets subject to the lease)
- Changes the consideration in the contract only.
In transition, lessees are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach which includes a number of optional “practical expedients” that entities may elect to apply. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees are required to recognize a right-of-use asset and a lease liability for all leases previously accounted for as an operating lease at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP. This practical expedient must be elected as a package and applied consistently to all leases. Lessees may also elect to use hindsight in determining the lease term when considering lessee options to extend.
If a lease was classified as a capital lease under previous guidance, and the lease will be classified as a financing lease under the new standard, the lessee should reclassify the existing capital lease asset as a right-of-use asset and the existing obligation as a lease liability for each period the lease was outstanding beginning with the earliest period presented.
Disclosures required by the guidance include qualitative and quantitative information about leases, significant judgements made and amounts recognized in the financial statements relating to those leases.
ASU No. 2016-02 is effective for most public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Thus, for a calendar-year public company, the effective date would be January 1, 2019; for other calendar-year companies the effective date is January 1, 2020. Early application is permitted for all entities.
ASU No. 2016-02 contains other provisions relating to sales-leaseback transactions and sub-leases. Most entities do not have such activity, but many entities, and maybe the majority of entities, have leases, and those leases tend to have options and modifications. Therefore, the above summary provides a starting point to help gain an understanding of all of the twists and turns of this comprehensive document.
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