Summary of ASC 842 & IFRS 16

A nearly 10-year process is complete, with the release in January/February 2016 of ASC 842 for U.S. reporting entities (published in Accounting Standards Update or ASU 2016-02) and IFRS 16 for entities covered by IFRS (International Financial Reporting Standards). The biggest change to lease accounting in 40 years, the joint project of the FASB (Financial Accounting Standards Board) and IASB (International Accounting Standards Board), which together cover the vast majority of exchange-listed companies in the world, accomplished its primary purpose of putting lessee operating leases on the balance sheet, and partially accomplished a secondary purpose of converging the standards for US GAAP and IFRS. However, certain significant areas are treated differently, most notably ASC 842's provision of a straight-line expense recognition profile for operating leases, which IFRS 16 eliminates except for short-term and low-value asset leases.

The following is a summary of the most significant parts of ASC 842/IFRS 16. At the bottom are links to more detailed resources published by the boards and by the Big Four accounting firms.

Lessee operating leases on the balance sheet (ASC 842)

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.

Lessee operating leases on the balance sheet (IFRS 16)

IFRS 16 eliminates operating leases. All leases with a non-cancelable term, including available options even if not considered reasonably certain of exercise, of more than 12 months must be treated as finance leases. Existing operating leases are capitalized according to the present value of the remaining rent (with deferred rent liability from rent leveling subtracted from the asset at transition), unless full retrospective implementation is chosen, in which case the lease is treated as finance from inception.

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 (in FAS 13).

Classification (ASC 842)

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.” This is virtually identical to IAS 17, the old IFRS standard for leases. (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.

Classification (IFRS 16)

The category of "operating lease" has been removed from IFRS 16. Existing operating leases will be converted to finance leases. Preparers can choose to either restate all leases from inception, or to capitalize just the remaining rent. However, IFRS 16, like ASC 842, permits excluding short-term leases from capitalization. The definition is slightly different: 12 months or less, including all available options (not just those deemed reasonably certain of being exercised). IFRS 16 also permits excluding leases of low-value assets from capitalization; IFRS 16, BC 100, indicates that the Board had in mind assets "with a value, when new, in the order of magnitude of US$5,000 or less." Short term and low value asset leases are treated like IAS 17 operating leases, with the rent recognized on a straight-line basis over its life.

Classification (lessor)

The distinction between finance and operating leases is maintained virtually unchanged. ASC 842 eliminates leveraged leases (though existing leveraged leases are grandfathered). In ASC 842, 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 a third-party guarantee of residual value exists that is large enough (when combined with the rent due, on an otherwise operating lease) to cause the lease to meet the present value test. 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. IFRS 16 doesn't distinguish between sales-type leases and direct financing leases; however, only a manufacturer or dealer should recognize a profit or loss at the inception of a finance lease.

Lessee reporting requirements

Finance leases create an asset and liability. 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.

ASC 842: 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).

Transition (ASC 842)

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.

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.

Transition (IFRS 16)

Implementation is required for fiscal years starting on or after Jan. 1, 2019, including that year’s interim periods. Earlier implementation is permitted as long as it is no earlier than implementation of IFRS 15, Revenue from Contracts with Customers. Preparers may choose either of two transition methods: 1) Full retrospective, restating all leases as if IFRS 16 had been in effect from inception, or 2) Cumulative catch-up, leaving finance leases unchanged while converting just the remaining portion of operating leases to finance leases. Preparers have similar "practical expedients" to those described above for ASC 842.

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.

Examples

See our examples of finance and operating leases under ASC 842 and IFRS 16.

For more information

The original texts of the new standards are available from the Boards. The IASB also has implementation information.

Each of the Big Four accounting firms has extensive documentation, typically with examples of different types of transactions.

Deloitte:
Ernst & Young:
KPMG:
PWC:

 

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