How the Lease Accounting Update Will Impact Your Company

By John Eaves, CPA

Companies will see a major impact from the new lease accounting standards update. In February 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) 2016-02 Leases (ASC 842). ASC 842 requires the recognition by leases of assets and liabilities that arise from all lease transactions, except for leases with a lease term of 12 months or less. For non-public entities, the new accounting standard goes into effect for years beginning after December 15, 2019, and would impact both capital and operating leases. Although these standards aren’t effective until 2020 (2019 for public business entities), companies face significant changes. Both lessees and lessors need to evaluate the effect of the new standard on their business processes, financial statements, and internal controls prior to implementation.

Below are five biggest changes companies face as a result of implementing the new leasing standard under U.S. GAAP.

Operating leases recognized on the balance sheet

Under current U.S. GAAP, operating leases are “off-balance sheet.” This treatment required management to estimate the effect of operating leases on financial leverage and earnings. However under ASC 842, lessees are required to recognize a liability for the required lease payments and a right-to-use (ROU) asset representing their right to use the underlying asset for the lease term.

The result? Companies are going to see huge impacts on their balance sheets, although the expense recognized in the income statement will most likely not be affected. Retailers, drug stores, restaurants, supermarkets, airlines, and telecommunications companies are examples of companies that will feel the biggest impact of the new leasing standard. There is an exception from balance sheet recognition for leases with a term of 12 months or less.

Determining whether the arrangement is a lease

Under current U.S. GAAP, meeting certain “bright line” tests means classification as an operating lease and off-balance sheet treatment. However, under ASC 842, all leases, except for short-term leases as previously discussed, are reported on the balance sheet. Therefore, the only way to get off-balance sheet treatment is if the arrangement does not meet the definition of a lease.

The criteria for determining whether an arrangement meets the definition of a lease under ASC 842 are similar to current U.S. GAAP. However, there are important differences, specifically whether or not a lessee has the right to control the identified asset. If the lessee does not have the right to control the use of an identified asset, then the arrangement may not qualify as a lease.

Lease payments: What is included?

Lease origination costs capitalized under ASC 842 will most likely differ from current U.S. GAAP. Specifically, there is a new definition of indirect costs, which will most likely result in fewer indirect costs that are capitalized under the new leasing standard. Additionally, under current U.S. GAAP, all executory costs, such as those for property taxes or insurance, are excluded from minimum lease payments. However, under ASC 842, these types of costs are part of lease payments used to calculate the lease liability and ROU asset.

Sale-leaseback transactions

Under ASC 842, sale-leaseback accounting is substantially different than current U.S. GAAP. Under the new standard, for a sale to occur, the transfer of the asset must meet the revenue recognition requirements in ASC Topic 606 Revenue from Contracts with Customers. If there is not a sale of the asset from the seller-lessee perspective, the buyer-lessor does not account for a purchase of the asset. As a result, both the seller-lessee and the buyer-lessor account for any consideration paid for the asset as a financing transaction. In addition, ASC 842 provides new guidance on determining when a lessee controls an underlying asset before lease commencement, resulting in fewer built-to-suit arrangements subject to sales-leaseback accounting requirements.

Increased financial statement disclosures

The new leasing standard will require a significant amount of new financial statement disclosures, both quantitative and qualitative, for both lessees and lessors. This includes information about significant judgments and assumptions. Before implementing ASC 842, companies need to ensure that they have the appropriate systems, procedures, and controls in place to provide this new information.

Contact one of our Certified Public Accountants to proactively identify and plan for the audit issues that may arise from the new implementation.