Lease Accounting Standard Issued
December 27, 2018
This piece is an update of one written when the FASB issued ASU 2016-02-Leases (Topic 842) in February, 2016—which previously appeared on this website.
Hopefully the substance of this piece does not come as complete news to you, dear reader, as these new rules will be effective for public companies in calendar 2019 and for non-public companies in calendar 2020. Public companies have presumably been combing through their leases and other service arrangements which may in substance contain lease elements because there are disclosures required in this year’s 10Ks which require registrants to quantify the impact upon standard adoption and going forward. Private companies have a little longer but need to be doing their reviews NOW.
IN (VERY) BRIEF:
Lessees will recognize a right-of-use asset and corresponding liability on the balance sheet for ALL leases (as defined), which in general require that the minimum non-cancellable lease payments be for use of a SPECIFIC IDENTIFIED asset or group of assets and not for a general capacity arrangement—i.e., leasing an undifferentiated portion of a warehouse or a pipeline capacity arrangement) with the only significant exception being for bona fide leases covering a period of fewer than 12 months.
The right-of-use asset is to be measured as the present value of the future minimum lease payments (taking into account renewal options only if there is either an incentive to renew or disincentive to not renew which is obvious at the inception of the lease) PLUS initial direct costs – which (in a narrowing of practice) will only include incrementally incurred costs such as commissions but will no longer include items such as legal fees and negotiation costs. ONLY lease payments which are fixed will be subject to this initial measurement. Other amounts of rent which are contingent will be recognized annually or when the contingency ripens. Fixed rental payments will include lease payments subject to an index, but at the index rate existing at lease inception. If and when the initial assumptions made by the lessee turn out to be inappropriate, such as when an option is exercised or not exercised contrary to initial expectations, there will be a prospective re-measurement required. The minimum payments are discounted using the rate implicit in the lease (same as FAS 13 definition) or, if not known, the lessee’s incremental borrowing rate. So in short: Lessees will now be required to reflect information which heretofore was presented as cash flow data in the footnotes as assets/liabilities on the balance sheet.
The lessee’s income statement treatment for leases will vary depending on the nature of what is being leased. A financing type lease (closely analogous to today’s capital leases) is present when, among other matters, the asset is being leased for a substantial portion of its economic life or has an end-of-term title transfer or a bargain purchase option as in today’s practice. However, there are no other bright lines such as today’s 75% or 90% tests. The liability set up for such leases will wind down in the same manner as an installment obligation would (i.e., the lease “payments” will be apportioned between interest and principal; the right-of use asset will be generally amortized on a straight-line basis unless some other method better reflects the pattern of its use). In place of straight-line rent under current practice, you will end up with interest expense and depreciation/amortization. The geography on the income statement will be affected and the net impact would also result in a front-loading of expense rather than the straight line pattern generally seen today.
If the lease does not qualify as a financing type lease, it will be accounted for on the income statement much the same way as today’s operating leases -- expense recognized as rent on a straight-line basis. Most leases of real estate will fall into the operating category and most equipment leases will fall into the finance category).
In the case of an operating lease, how do you achieve the above-mentioned income statement result if you are setting up a liability and an asset on the balance sheet? The way the standard gets there is by winding down the liability set up in the same manner as for financing leases, except that the “interest” component of each payment will be classified as rent and the “amortization” of the right-of-use asset -- which will also be called rent -- will be adjusted (“plugged” to use an inelegant term) to achieve a result such that the total rent expense recognized would result in the same amount which would have been recognized under straight-line operating lease accounting under present practice.
As if that wasn’t enough, lessees AND lessors will have to cope with another concept. All will be required to cull out from their leases all non-lease components, such as services embedded in the lease (think of office cleaning in a space lease, or maintenance included in an equipment lease) and separately account for those under GAAP relevant under the circumstances, for those service components are excluded from lease accounting. How will these separable items be carved out? Lessees will be required to allocate based on the relative ”stand alone” prices of each of the services included in the lease and lessors will be required to use the “transaction” price as provided in the new revenue recognition guidance. IMPORTANT: There are practical expedients provided in updates to the ASU, including those issued in 2018, which substantially relax the hunting that reporting entities will be tasked with for insubstantial items. So -- before commencing with your document review --become familiar with all the requirements and potential relief available in the practical expedients.
Lessor accounting is somewhat less involved. Effectively, a lessor will determine whether a lease is a sales type lease much the same way a lessee would. If the lease is a sales type lease the accounting would involve de-recognition of the leased asset and full profit recognition (generally) at the outset of the transaction. If the lease is not a sales type, it either is a direct financing type (again much like today’s capital leases but without the bright-line tests) or an operating lease. Direct financing leases also involve de-recognition of the leased asset by the lessor, but the selling profit is deferred and recognized over the lease term. The present value of the lease payments (including guaranteed residual value) as well as the unguaranteed estimated residual value is recognized by the lessor over time on the interest method. Operating leases require no adjustment to the balance sheet nor income statement from the lessor viewpoint and will result in minimal change from current practice -- in other words, real estate owner/lessors will not be significantly impacted by the new standard in terms of their own accounting (particularly if the leases qualify for practical expedient treatment as mentioned above), but they will have to deal with a different set of potential problems/issues. For example, lessees or tenants may be tempted to negotiate shorter term leases or take other measures to mitigate the impact of the new leasing on their balance sheets. In the real world the extent of lessor’s or landlord’s flexibility and ability to cope with these demands (or largely ignore them) will be governed by the strength or lack thereof of the market for their respective properties -- old fashioned supply and demand for the space.
Retrospective application once adopted will be required, albeit with a somewhat modified practical expedient approach as provided in the standard. Early application is permitted. If you are a public company, that option is by the boards unless you adopt in 2018.
A few other notes: Sale-Leaseback accounting per se will go away. If you have a bona fide sale in accordance with the new revenue recognition standards the seller would record the sale and gain in full. Upon the leaseback, if it qualifies as an operating type lease it will be separately accounted for as such. There will no longer be delayed profit recognized by the seller/lessee over the term of the lease. A leaseback which would not qualify as an operating lease would void the entire sale accounting and would end up being accounted for as a financing transaction by the ”seller.” Relatedly, build-to-suit accounting (quite complex) is going away as well.
Since all lessees will be impacted and will see their balance sheets balloon with debt, all existing loan documents containing measured financial covenants should be examined NOW (by both lessees and lessors) and reviewed closely for measurement modifications which will be required. Many ratios and financial indices will be impacted, both balance sheet (debt/equity for example) and income statement (EBITDA for example in the case of finance lessees) so early recognition of this issue and discussions with lenders is critical. Also, because retrospective application will be required, BOTH lessors and lessees need to determine if their existing accounting systems and controls are adequate to identify and properly account for leases during the transitional period and -- most critically -- on an ongoing basis in the future. The requirement to disaggregate service or other non-lease elements from each and every new lease going forward will likely constitute a heavy burden for many and should be planned for now, subject to potential relief provided by the practical expedients.
This piece is not intended to be exhaustive and is merely a summary of a very comprehensive standard with a more than fair amount of complexity. Consult with your friendly CPA firm for implementation guidance when and wherever practical. Get it done ASAP!!