The Financial Accounting Standards Board (FASB) issued its long awaited Accounting Standard Update on accounting for Leases on February 25, 2016. The issuance of this standard marks the completion of one of the last convergence projects the FASB took up with the International Accounting Standards Board (IASB), although the final standard will not be completely converged with the IASB.
The main provisions call for all lease transactions (with terms in excess of 12 months) to be recorded on the balance sheet of the lessee. In general, this recognition will be measured by discounting to present value, using the interest rate implicit in the lease, the expected lease payments to be made over the life of the lease including lease escalators and options (if exercise is likely), as the lease liability. A right to use asset will then be recognized at the same amount as the lease liability. After initial measurement, the lease liability will be reduced based on the lease payments and the right to use asset will be amortized over the life of the lease, normally using the straight-line method.
While both the FASB and the IASB treat the measurement and recognition on the balance sheet in the same fashion, the FASB retains the current two-lease type model for income statement measurement. Leases meeting the definition of an “operating” lease will be recognized on a straight-line basis as the lease payments are made, with the expense recognized as a rent. Leases meeting the definition of a “capital” lease, alternatively will be recognized through interest expense and amortization expense, similar to the current recognition model.
The standard is quite comprehensive and consolidates all of the various lease guidance that exists currently in ASC 840, Leases, including accounting for sale-leaseback transactions and guidance on determining expected lease payments and lease terms. The ASU contains numerous examples to assist with adoption. The ASU also requires more extensive disclosures than those required by ASC 840.
Upon adoption, the lessee will apply the new standard retrospectively to all periods presented or retrospectively using a cumulative effect adjustment in the year of adoption. The initial measurement of the lease liability will be based on the remaining terms of operating leases in effect at the date of adoption and the remaining expected lease payments, discounted using the lessees incremental borrowing rate at the date of initial application; with a corresponding right to use asset. For capital leases, the existing balance will be carried over under the new standard.
The effective date for the new standard for public entities is for periods beginning after December 15, 2018, and for non-public entities for periods beginning after December 15, 2019, with earlier adoption permitted for all entities.
The new standard generally has no impact on lessors, who will continue to use the current guidance in ASC 840.
This standard will have significant impact on all entities that currently engage in leasing activities. The transition will require detailed analysis of each lease with attention paid to options and other features that may lead to variability in the expected term and lease payments. Once this analysis is performed, a detailed discount calculation must be made for each and then decisions on classification as operating or capital based on the terms of the leases. Thereafter, for each lease a schedule for expense recognition must be created in order to properly report expenses and reduce the carrying amounts on the balance sheet. Entities should consider this carefully when planning for transition, including the necessary adjustments to internal control over financial reporting and changes to information systems to accumulate the requisite data for financial reporting and new disclosure requirements.
For entities that rely heavily on leasing, the change to the balance sheet will be meaningful, with changes in traditional leverage ratios likely. These changes may necessitate discussions with lenders and investors to manage expectations and to anticipate potential adjustments to covenants and other loan terms. While cash flows will remain the same, it is possible that classifications in the statement of cash flows might differ.
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