By Kay Filler, Principal
More specifically, FASB issued the final guidance on February 25, 2016, but it’s not required for private companies until 2020 for calendar year companies (although earlier adoption-starting now-is permitted). Sounds like a long way off, but not really when considering potential impacts of the dramatically different accounting model for everyday lease agreements.
New Lease Accounting Rules
But first, here’s a summary of key accounting and disclosure components of the new rules:
Short-term leases (defined as those with a maximum term of 12 months or less) may continue to be accounted for the same as under today’s rules; which is to recognize rent expense on the straight-line basis over the lease term.
All other leases give rise to a “Right of Use (ROU)” asset and a lease liability on the balance sheet.
ROU assets are classified as either “financing” (Type A) or “operating” (Type B) based on whether the lease is effectively an installment purchase. Generally, existing capital leases would be “financing” leases.
For financing leases, the ROU asset amortization is recognized separately from the interest expense on the lease liability, and total expense is front-loaded in the income statement.
For operating leases, the ROU asset amortization is recognized together with the interest on the lease liability as rent expense on a straight-line basis in the income statement.
Determining the lease term requires companies to consider all relevant factors that create an economic incentive to exercise an option to extend (or not to terminate) a lease. Options to extend must be included in the lease term if it is “reasonably certain” that the company will extend the lease, considering the relevant economic factors.
Variable lease payments that depend only on an index or a rate are included in initial recording of the ROU asset and lease liability. Other variable payments are excluded.
The discount rate for the lease liability initial measurement should be the company’s incremental borrowing rate. Private companies can elect an accounting policy expedient to use the risk-free borrowing rate (generally a U.S. treasury bond is used).
Non-lease components (e.g., service costs such as taxes, insurance and maintenance costs included with a full-service lease) must be separated and excluded from the measurement of the ROU asset and lease liability. Private companies can elect an accounting policy expedient to not separate lease components from non-lease components.
Initial Direct Costs include only those costs a company would not have occurred if the lease had not been executed (e.g., commissions) and are included in the initial measurement of the ROU asset and lease liability.
For both ROU assets and lease liabilities, amounts attributed to financing and operating leases must be disclosed separately, either as line-items on the balance sheet or in the notes to financial statements.
In the Statement of Cash Flows, for financing leases, cash payments for the principal portion of the lease liability are classified as financing activities, and cash payments for the interest component are operating activities. Cash payments for operating leases are classified as operating activities.
Additional qualitative and quantitative financial statement disclosures are required.
How to transition to the new guidance:
Under a “modified retrospective transition approach”, transition applies to leases existing at or entered into after the earliest comparative period presented in the 2020 calendar year financial statements (or the date of initial adoption).
Listed above are only some of the more pervasive and relevant rules that apply to most lessees. The new guidance also includes extensive rules for lessors, as well as other considerations and interpretations for lessees.
Although adoption of the lease new rules is not required for private companies until calendar year 2020, you should become familiar with the changes to better strategize around leasing transactions that extend into the transition period, which in all likelihood includes some of your current leases.