By Matt McWhirter
After many years of waiting, the FASB has finally released ASC 842, bringing major changes to the world of accounting for leases. One of the main goals of the new lease accounting standards is to bridge the gap between GAAP and IFRS accounting for leases. While the new standard does not completely align the two accounting methods, the gap between the two has become much smaller.
The first question asked by many is, “How much do these standards really change the way we account for leases?” This question has a surprisingly simple answer – the only place there is a dramatic change from the prior accounting standards is on the Balance Sheet for Operating Leases. Lease expenses and payments on the Income Statement and Statement of Cash Flows, Financing Lease Accounting and Lessor Accounting remain substantially unchanged under the new standards. Now before I dive into the accounting updates, I want to spend some time discussing how the new accounting standards affect the way we categorize leases.
Prior to ASC 842, leases were placed into one of two categories – Operating Leases or Capital Leases. With the implementation of ASC 842, Capital Leases no longer exist and are instead referred to as “Financing Leases.” However, Financing Leases under ASC 842 are substantially similar to what was known as “Capital Leases” under the previous lease accounting standards. As was the case before, any lease that does not meet the standards listed below is classified as an operating lease. The similarities and differences of the new standards are summarized in the table below:
|Pre-ASC 842 – Capital Leases
||Post-ASC 842 – Financing Leases
|Lease transfers ownership of the asset to the lessee at the end of the lease term
||Lease transfers ownership of the asset to the lessee at the end of the lease term
|Lessee has a bargain purchase option
||Lessee has a bargain purchase option
|Lease term is greater than 75% of the remaining economic life of the asset
||Lease term is for the major part of the remaining economic life of the asset
|Present value of future minimum lease payments amounts to greater than 90% of the fair market value of the leased asset
||Present value of future minimum lease payments amounts to substantially all of the fair market value of the leased asset
As mentioned above, the most substantial changes under the new accounting pronouncements are with regard to the balance sheet presentation of operating leases. Under the new standards, companies are required to recognize a “lease liability” and a “right of use asset” on the balance sheet for all leases other than short-term leases, which are defined as leases that are less than 12 months in length. Renewal or termination options that are reasonably certain of exercise by the lessee are required to be included in the lease term. Thus, a lease that is less than 12 months long but includes a renewal option that the lessee is reasonably certain to extend is not considered to be short term and must be included in the calculation of the lease liability and right of use asset.
Balance Sheet Measurement
The original lease liability is measured as the present value of future minimum lease payments, using the rate implicit in the lease (if known) or the company’s borrowing rate from the bank. The original right of use asset is recorded at an amount equal to the lease liability but is subject to adjustments such as initial direct costs, prepaid lease payments, or lease incentives received. The asset and liability are then reduced annually by using the effective interest method. The liability is reduced by the difference between the cash paid during the year and the interest expense, whereas the right of use asset is reduced by the difference between the straight-line lease expense and the interest expense. Alternatively, the right of use asset can be derived from the lease liability as of the end of the year.
Although companies are required to include this lease asset and liability in their financial statements for reporting purposes, whether at quarter-end or year-end, there is no requirement from the companies to include these assets and liabilities in their general ledger and reduce them throughout the year. Thus, at the end of each fiscal year (or quarter), the company is able to review their future lease commitments as of that date and compute the present value of the future minimum lease payments. This amount may be recorded at year-end for financial reporting purposes and subsequently reversed on the first day of the following fiscal year. This process will continue annually and is a much less complex way of obtaining the lease liability and right of use asset each year.
Either one of these methods is acceptable – it is up to the company to decide the best way for them to account for their future lease commitments.
ASC 842 is effective for all public companies for fiscal years beginning after December 15, 2018. For private companies, the standards are effective for fiscal years beginning after December 15, 2019 and for interim periods beginning after December 15, 2020. Early adoption of the standards is permitted. However, the standards must be adopted using a modified retrospective transition, requiring the new guidance to be applied to the earliest comparative period presented.
Enhanced Disclosure Requirements
With these changes, there are a number of additional items that are required to be disclosed in the notes to the financial statements. The disclosure on leases is now required to include the following:
- Information regarding the nature of the leases
- A maturity analysis of the lease liabilities
- Lease expense, separated between operating lease expense and financing lease expense
- Short-term lease expense, for which there is no asset or liability recorded
- Weighted average remaining lease term
- Weighted average discount rate used to calculate the present value of future lease payments
Relevance to Our Clients
With the new requirement to record a right of use asset and a lease liability, there are key balance sheet measures and ratios that will change, potentially affecting debt covenants. It is important for each company to be supported by a firm that understands their financial covenant calculations in order to assess the potential impacts of these new accounting standards. An additional goal of this new standard is to provide an increase in transparency and comparability for financial statement users by providing them with more information regarding the leasing activities of companies. This makes it more difficult for companies to “hide” their leasing activities off-balance sheet. The most important task for companies to complete is establishing a process to appropriately gather information and report on their leases to ensure that the inventory of leases is accurate and complete. This will be more challenging for larger companies with numerous leases, but these companies have time before these accounting standards take effect!