The FASB’s Accounting Standards Update (ASU) 2016-02 (“Topic 842” or “the new standard”) applies to both lessees and lessors, and it brings significant changes to balance sheets. The extra time granted by the FASB reflects the mammoth task ahead, which will require more work, more resources, and more time than most businesses realize. It becomes effective on January 1, 2021 for calendar year-end private companies.
Understanding the New Standard: Lease Accounting Frequently Asked Questions
What is Lease Accounting (ASC 842)?
ASC 842, Leases, provides the financial accounting and reporting requirements for lessees and lessors. This standard establishes the right-of-use asset model, which shifts from the risk-and-reward approach to a control-based approach. Under the new standard, lessees will recognize an asset on the balance sheet, representing their right to use the leased asset over the lease term and recognizing a corresponding lease liability to make the lease payments for any lease arrangements that are over one year in duration. The lease liability is based on the present value of future lease payments using a discount rate to determine the present value based on the rate implicit in the lease, if readily determinable, or the lessee’s incremental borrowing rate. As a result, a lessee’s operating lease accounting model will change significantly. Additional complexity of the new standard requires the lease arrangements to be classified as either finance leases or operating leases.
However, for leases with a term of 12 months or less, a lessee is permitted to make an accounting election to not recognize lease assets and lease liabilities on the balance sheet. Instead, the organization should recognize lease expenses for these arrangements on a straight-line basis over the lease term.
What changes can I expect?
Finance leases will separately recognize interest expense on the liability and amortization expense on the right-of-use asset. The periodic expense at the beginning of the lease term will generally be greater than the corresponding cash payments but will decline over the lease term as the liability is reduced. Operating leases will recognize lease expense on a straight-line basis over the lease term as a single line item in operating expenses in the income statement.
In addition, the new standard changes the approach to how lease costs are recorded. Previously, all incremental costs associated with negotiating and executing a lease agreement, such as those for property taxes or insurance, were excluded from lease payments. Under the new guidance these types of costs are included in the lease payments used to calculate the right-of-use asset and lease liability.
For lessor accounting under ASC 842, a sale and related profit are recognized upon the commencement of the lease only when the arrangement transfers control of the underlying asset to the lessee. The changes in the new guidance are aligned with the new revenue recognition standard, ASC 606, as leasing is fundamentally a revenue-generating activity for lessors. ASC 842 also requires additional disclosures related to the lessor’s exposure to asset risk and credit risk. Lessors will classify the lease as a sales-type lease, direct finance lease, or operating lease.
What challenges can I expect?
This standard represents a wholesale change to lease accounting; as a result, many entities will face significant implementation challenges such as:
- Not identifying embedded leases in arrangements
- The number of arrangements that were previously not identified as leases may now be identified as meeting the definition of a lease or embedded lease
- Existing systems and processes may need to be modified or enhanced in order to provide information necessary to address the new reporting and disclosure requirements
- Multiple departments across the organization will be affected by this standard, including information technology, tax, legal, treasury, and financial planning and analysis, among others
- Ongoing efforts might be more significant than the initial implementation effort
This standard includes extensive disclosures intended to enable users of financial statements to understand the amount, timing, and judgment related to a reporting entity’s accounting for leases and the related cash flows. This standard requires disclosure of both qualitative and quantitative information about leases.
Who does Lease Accounting affect?
Lease accounting affects all entities that lease assets, including real estate, airplanes, and equipment. The standard excludes leases of intangible assets; leases to explore for or use nonregenerative resources; and leases of biological assets, inventory, and assets under construction.