Enter to open, tab to navigate, enter to select
Lease Accounting: New FASB Guidance
Practical Law Legal Update w-001-4734 (Approx. 5 pages)
Lease Accounting: New FASB Guidance
by Practical Law Finance
| Published on 25 Feb 2016 • USA (National/Federal) |
The Financial Accounting Standards Board (FASB) has issued a new Accounting Standards Update (ASU), Leases (Topic 842), which makes significant changes to the FASB's standards for lease accounting.
On February 25, 2016, the Financial Accounting Standards Board (FASB) announced that it has issued a new Accounting Standards Update (ASU), Leases (Topic 842), which makes significant changes to the FASB's standards for lease accounting. The changes will become effective for public companies for fiscal years (and the interim periods within the fiscal years) beginning on or after December 15, 2018. For all other entities, the changes will become effective for annual reporting for fiscal years beginning on or after December 15, 2019, and interim periods within the fiscal years beginning after December 15, 2020.
Under the ASU, lessees must recognize the assets and liabilities created by their leases on their balance sheets. Lessees must:
- recognize a right-of-use for the leased asset and the lease liability, initially measured at the present value of the lease payments, on the balance sheet;
- recognize interest on the lease liability separately from amortization of the leased asset in the income statement;
- classify repayments of the principal portion of the lease liability as financing activities in the statement of cash flows; and
- classify payments of interest on the lease liability and variable lease payments as operating activities in the statement of cash flows.
- For operating leases:
- recognize a right-of-use for the leased asset and a lease liability, initially measured at the present value of the lease payments, on the balance sheet;
- recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term, generally on a straight-line basis; and
- classify all cash payments as operating activities in the statement of cash flows.
The ASU ends what investors, the SEC, and other financial statement users have long regarded as one of the largest forms of off-balance sheet accounting. Previous lease accounting was criticized because it did not always provide an accurate reflection of an entity’s leasing transactions.
Much of the criticism of lease accounting centered on the treatment of operating leases by lessees. With this in mind, FASB did not see a need to make fundamental changes to the lease accounting standards for lessors, which are largely limited to conforming changes that align lessor treatment with the new lessee treatment. Under the ASU, lessors must, among other things:
- Continue to classify the vast majority of operating leases as operating leases, and continue to recognize lease income for those leases on a generally straight-line basis over the lease term.
- Adhere to changes that align:
- lessor accounting provisions with those for lessees, such as changes to glossary terms and sublease provisions; and
- the lessor accounting model with the revenue recognition guidance in Topic 606 (for more information on Topic 606, see Practice Note, Financial Reporting in the US: Key Topics for Corporate Counsel: Revenue Recognition: New Standard for Revenue Recognition (ASC 606)). Previous lessor accounting guidance was derived from revenue recognition guidance that preceded Topic 606. The current ASU reflects changes made in Topic 606, and requires, among other things, that the determination of whether a lease is similar to a sale of the underlying asset depends on whether the lease gives the lessee control of the asset. It also precludes a lessor from recognizing selling profit or sales revenue at the commencement of a lease if the lease does not transfer control of the asset to the lessee.
The ASU follows lengthy discussions on the treatment of leases between a diverse group of stakeholders, and introduces some simplifications from the prior proposal (see Legal Update, FASB and IASB Propose New Lease Accounting Rules).
In addition to the specific treatment listed above, the current ASU provides changes to the following areas, among others:
- Finance and Operating Leases. Since functional distinctions still exist between finance and operating leases, the distinction between them is retained. The classification criteria for distinguishing between finance and operating leases remains substantially similar to previous criteria used for differentiating between capital and operating leases. This distinction, among other things, allows accounting for operating leases to remain largely unchanged in the income statement and statement of cash flows, because, under the ASU, lessees must recognize lease assets and lease liabilities for all leases (finance and operating) in the same way.
- Short Term Leases. Leases with a term of 12 months or less may be omitted from the balance sheet in certain circumstances. Lessees may make an accounting policy election by class of leased asset and may choose not to recognize lease assets and lease liabilities. When making this election, lessees should recognize lease expense for these leases on a straight line basis over the lease term.
- Purchase Options. Optional payments to purchase the leased asset should only be included in the determination of lease assets and lease liabilities if the lessee is reasonably certain to exercise the purchase option.
- Variable Lease Payments. Variable lease payments should be excluded when measuring lease assets and liabilities, unless they are dependent on an index or are in substance fixed payments.
- Leveraged Leases. The previous accounting model continues to apply for leveraged leases that commenced before the effective date of the ASU, which is, at the earliest, in 2018. After that date, the previous guidance on leveraged leases becomes obsolete.
- Lease Versus Non-Lease. Whether a contract constitutes a lease should be determined at the outset of the contract. A lease is a contract that give the lessee control of the asset. Control requires that the lessee has the right to obtain substantially all of the economic benefit from the use of the asset, and the right to direct the use of the asset. This departs from previous guidance, which concentrated on whether the lease was a capital lease or an operating lease, because now, lessees must recognize lease assets and lease liabilities for all leases, other than short term leases.
- Components of Contracts. Lease components of a contract must continue to be separated from non-lease components for accounting purposes, and the ASU provides additional guidance on this requirement. Only lease components, such as the consideration for the leased asset (allocated on a standalone price basis for lessees and in accordance with Topic 606 for lessors), must adhere to this guidance. Alternatively, lessees may make an accounting policy election by class of leased asset not to separate lease components from non-lease components.
- Sale and Leasebacks. Sale-leaseback transactions must adhere to Topic 606, and seller-lessee and buyer-lessor accounting must align with each other. Generally, sale-leaseback transaction treatment for real estate will be easier to achieve and sale-leaseback transaction treatment for other assets will be more difficult under this ASU and Topic 606.
- Transitional Period. The ASU adopts a transitional approach, which will have the practical effect of allowing entities to account for leases that commenced before the effective date of the ASU in accordance with previous GAAP, unless the lease is later modified. However, lessees will be required to recognize a leased asset and the associated liability for all operating leases at each reporting date that reflects the present value of the remaining minimum rental payments disclosed under previous GAAP.
For more information on lease accounting, see Practice Note, Financial Reporting in the US: Key Topics for Corporate Counsel: Lease Accounting.