How will new accounting standards for leases impact financial reporting?January 03, 2018
Michael Young, CPA, MBA
Last February, the Financial Accounting Standards Board (FASB) issued a set of new guidance for the accounting of leasing arrangements. In a previous article, we discussed the changing definition of lease agreements. In this article, we’ll outline various ways these new standards will impact companies’ year-end balance sheets and financial reporting processes.
Impact on year-end balance sheets
Under the new guidance, companies will now have to recognize assets and related liabilities on their balance sheets on—barring rare exception—each and every one of their leasing arrangements. The right of use (ROU) asset and related lease liability will be at the present value of payments tied to the lease agreement. These changes primarily apply to lessees. For lessors, the balance sheet requirements are relatively unchanged. One change for lessors will be that, depending on the circumstances, the related asset being leased out may go from property, plant and equipment on the balance sheet to a new account titled “net investment in lease.”
While the new leasing standard will significantly impact most companies’ balance sheets, there are certain exceptions of which business leaders should be aware. A number of lease arrangements are exempt from the new guidance, including leases related to inventory; construction in progress (CIP); intangible assets; or use of natural resources or biological assets, and any lease arrangements lasting 12 months or less (short term leases).
Changes to lease classification
Under existing guidance (ASC 840), leases are reviewed on a lease-by-lease basis to determine whether the risk and rewards of the leasing arrangement and the use of the assets included in the lease changed hands as part of the agreement. Currently, the rules are: If the risk and rewards were transferred, the lease would be defined as capital lease (or finance lease), and assets and related liabilities would be reported on the balance sheet of the lessee. If the risk and rewards were not transferred, the lease is defined as an operating lease – and all expenses related to the lease appear only on the lessee’s income statement.
From an accounting standpoint, unless leases included certain items such as a bargain purchase option—in other words, an option to purchase the asset below existing market rates—or other factors, many leases are currently defined as operating leases. Many industries have used this practice to their advantage in the past. For example, several major airlines opted to lease aircrafts rather than owning them outright. Even though these airlines used their leased airplanes on a regular basis, they were defined as operating leases, meaning the use of the assets and related liabilities were not reflected on their balance sheet. As a result, the readers of the related financial statements were not getting a full picture of the costs incurred by these entities in running their businesses.
In an effort to “provide users with a comprehensive understanding of the costs of property essential to a reporting entity’s operations and how those costs were funded,” the new standards will change this common practice going forward.
Under ASC 842, companies will still be required to classify leasing arrangements as either a finance or operating lease – but both types of leases will be shown on the company’s year-end balance sheet. Under the new guidance, any of the following five criteria for leases would require the lease to be defined as a finance lease:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The agreement grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying assets
a. Note: If the commencement of the lease is near the end of the economic life of the asset, this criteria shall not be used for classification.
- Present value of the sum of the lease payments, and any residual value guaranteed by the lessee that is not already reflected in the lease payments, equals or exceeds substantially all of the fair value of the underlying asset.
- 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.
If none of these criteria are met, the lease arrangement—under the new guidance—will be defined as an operating lease.
Companies should start planning for these new standards now.
While this new guidance does not take effect until calendar year 2019 (for public entities) — and not until 2020 for non-public entities — companies would be wise to start thinking about these changes immediately.
Depending on the industry a company operates in, adapting to the new guidance could be a significant undertaking as certain industries have more lease agreements than others. Therefore, all companies should start to take inventory of any existing lease agreements in place as a starting point to address the new leasing standards.
If you have further questions regarding accounting for leases under Section 842 of U.S. Generally Accepted Accounting Principles, please contact Michael Young, Audit Director, BlumShapiro, at 401-330-2706 or email@example.com.
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