A nearly 10-year process is complete. The FASB and IASB announced in July 2006 that they would undertake a comprehensive review of lease accounting. the primary purpose was to end the off-balance-sheet status of lessee operating lease accounting, but the boards also wanted to converge their standards, and review other aspects of lease accounting. The original target date for completion was 2009, but it took a Discussion Paper, two Exposure Drafts, over 1700 comment letters, and hundreds of meetings with users and preparers of financial statements, associations of lessees and lessors, accountants, and various other interested parties to finally reach the final document, published by the IASB as IFRS 16 and the FASB as ASC 842. The final result is not converged in some important aspects; most significantly, the IASB has chosen to require all leases to be treated as finance leases, while the FASB is keeping a finance vs. operating distinction for purposes of calculating the expenses (usually recognized straight-line) and asset (equal to the liability for simple leases).
The following is a summary of the most important points, with a particular emphasis on what’s changed from FAS 13. (I will make a later post discussing the significant differences of IFRS 16.)
Lessee operating leases on the balance sheet
All leases with a non-cancelable term of more than 12 months must be capitalized and recognized on the balance sheet (or Statement of Financial Position, to use FASB’s preferred terminology). The liability is calculated as the present value of the remaining rents; the interest rate used is the lease’s implicit rate, if known, otherwise the lessee’s incremental borrowing rate. The asset is calculated starting from the liability, then adjusted by adding any initial direct costs, subtracting lease incentives and impairments, and adding any difference between cash and leveled rent; all these items are amortized straight-line.
What rent is capitalized
The old concept of “executory costs,” which are not capitalized because they don’t reflect recovery of the cost of the asset itself, has been replaced with “nonlease components.” Nonlease components represent payments made which transfer a good or service to the lessee. So charges for a service contract or common area maintenance (CAM) are both executory costs and nonlease components. Charges for taxes and insurance (such as in a gross property lease) are executory costs currently, but do not qualify as nonlease components, and therefore must be included in the capitalized rent.
Land and building leases still qualify for separated treatment, with the land usually not a finance lease. However, the assignment of rent is now proportional to the fair values of the land and building assets, rather than the land rent being calculated based on the incremental borrowing rate.
While the terminology has changed slightly—FAS 13 capital leases are now called “finance leases,” because all leases are capitalized—the tests to distinguish finance from operating leases are essentially unchanged. While ASC 842-10-25-2 uses “principles” language for the tests (“the lease term is for the major part of the remaining economic life”; “the present value of the … lease payments … equals or exceeds substantially all of the fair value”), 842-10-55-2 says that “one reasonable approach” is to use the 75% and 90% thresholds. We can expect virtually all U.S. preparers to stick with those tried-and-true methods. There is one additional test: “The underlying 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.” (In such situations, one would expect the lessor to fully recover his investment during the lease, so one of the previous tests would almost certainly be met as well, making the additional test probably insignificant.)
Leases with a non-cancelable term of 12 months or less (including renewal options that are considered reasonably certain of being exercised) may be excluded from capitalization, but their costs (excluding leases with a term of a month or less) must be separately disclosed.
Lessors: Leveraged leases have been eliminated (though existing leveraged leases are grandfathered). The distinction between sales-type and direct financing is no longer whether the fair value and carrying amount of the asset are equal, but whether the present value test is met via the rent & residual due from the lessee vs. a third-party guarantee of residual value. A sales-type lease permits immediate recognition of profit; a direct financing lease recognizes the profit from the difference between the fair value and carrying amount though interest income over the life of the lease.
Lessee reporting requirements
Finance leases create an asset and liability, as with current capital leases. The “right of use” asset is depreciated like other PP&E, usually straight line. The liability is amortized using the interest method. Depreciation and interest expense are recognized as currently with capital leases. Accrued interest is immediately booked to the liability account, rather than a separate accrued interest account.
Operating leases also create a right-of-use asset and liability, but the liability is called an “operating obligation,” not debt, meaning that it should not be counted as debt for loan covenants and financial ratios. Expenses are recognized in a single lease cost, which is normally straight-line over the lease’s life. For a simple operating lease with the same rent paid for its whole life and no asset adjustments, the net asset and liability are the same at all times. If there are scheduled rent increases, the leveling of rent is recognized as an adjustment to the asset, as are initial direct costs and lease incentives, all of which are amortized straight-line over the lease life.
Finance and operating lease assets and liabilities are reported separately (reflecting their different character; finance lease liabilities typically survive bankruptcy, for instance).
Two new disclosures are required: For finance and operating leases separately, the weighted-average remaining lease term (weighted by remaining liability), and the weighted-average discount rate (weighted by remaining lease payments, undiscounted).
Sale-leaseback accounting is permitted only if the “sale” qualifies as a sale under the new Revenue Recognition standard (ASC 606/IFRS 15). This requirement precludes continuing lessee control of the leased asset other than the lease itself; most significantly, if the lessee has a purchase option at a fixed price (rather than fair value at time of exercise), sale-leaseback accounting is not permitted, and the transaction is treated as a financing.
Implementation is required for fiscal years starting after Dec. 15, 2018, including that year’s interim periods. Private companies may delay until fiscal years starting after Dec. 15, 2019, and need not implement for interim periods until the following year. When implemented, the prior two years must be restated using the new standard, to provide comparable information. Earlier implementation is permitted, but still requires the two-year restatement. (This does not mean refiling prior financial statements, but reporting the prior comparable periods as if the new standard had been in place as of the first comparable period.)
Several “practical expedients” are offered which most lessees are expected to use in transition. On that basis, lease classification is not reassessed; unamortized initial direct costs are carried forward and added to the lease asset without determining whether they qualify as IDC under the new rules. Balances on capital leases are converted to finance lease balances without adjustment (aside from combining accrued interest with liability, and IDC with the asset). Operating leases are set up with the liability equal to the present value of the remaining rents (using the incremental borrowing rate as of the transition date); the asset is the same, adjusted for any unamortized IDC, lease incentives, and deferred rent from leveling scheduled rent increases.
Note that for the two-year lookback period, you will need to retain the data to report leases both ways. In particular, it will be important to record both executory costs and non-lease components of the rent, so that each can be used for the appropriate reporting.
Proposed changes that were eliminated
The 2010 Exposure Draft called for including all renewal options that were “more likely than not” to be exercised, and for projecting variable lease payments (such as those based on inflation or usage). Vehement disagreement on these proposals led the Boards to remove those proposals.
The 2013 Exposure Draft called for Type A and Type B lease classification based on characteristics of the lease (different rules for real property vs. equipment, in particular). The IASB decided to make all leases finance leases; the FASB decided to return to FAS 13’s classification system.
Lessors: The 2010 Exposure Draft called for creation of a Performance Obligation on leases previously considered operating, which would have affected lessor balance sheets. Lessor accounting for operating leases was reinstated virtually unchanged from FAS 13.
We will release later this year an update to our EZ13 lease accounting software which will fully comply with ASC 842. You can use EZ13 right now to forecast the impact of the new standard, because EZ13 includes the ability to treat operating leases as capital on a pro forma basis. For more information about how EZ13 can meet your lease accounting needs, whether you're a lessee or lessor, please check our web site or contact us.