On Thursday, February 25, the Financial Accounting Standards Board (FASB) issued the much-anticipated (and often criticized) lease accounting standard. In 2006, the FASB and the International Accounting Standards Board (IASB) identified major convergence projects intended to improve and converge U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). As part of that effort, the two Boards issued two proposals to revise lease accounting, one in 2010 and a revised proposal in 2013. Although some aspects of the initial proposal have changed, and convergence between the FASB and IASB was not realized, the key objective to bring most leases on balance sheet is achieved in the final standard.
Lessee Accounting Model
The FASB decided on a dual approach for classifying leases based on criteria similar to current U.S. GAAP—rejecting classification based on the nature of the underlying asset, as had been proposed in the 2013 revised proposal. Under this approach, a lessee will account for most existing capital/finance leases as Type A leases (that is, recognizing amortization of the right-of-use (ROU) asset separately from interest on the lease liability) and most existing operating leases as Type B leases (with costs presented as lease expense and recognized on a straight-line basis in the income statement over the lease term).
The new standard requires a lease to be classified as a Type A lease when (1) payments represent substantially all of the fair value of the asset, (2) the lease term is for a major portion of the asset’s economic life, (3) purchase of the asset is considered a bargain, or (4) title transfer is automatic at the end of the lease. The fair value and economic life tests are similar to the 90% and 75% tests under existing U.S. GAAP guidance, albeit without the bright lines.
The lessee will recognize a ROU asset and a lease liability for both Type A leases and Type B leases. The only exception to this presentation will be for short-term leases (i.e., a term of one year or less), which would not be recognized on a lessee’s balance sheet.
OBSERVATION: Although there is dual approach related to income statement impact, all leases (other than short-term leases) will result in recognition of an asset and liability on the balance sheet.
Lessor Accounting Model
A lessor will determine lease classification (Type A versus Type B) on the basis of whether the lease is effectively a financing or a sale rather than an operating lease (i.e., on the concept underlying existing U.S. GAAP). A lessor would make that determination by assessing whether the lease substantially transfers all the risks and rewards incidental to ownership of the underlying asset. For financing arrangements (Type A leases) or sales, the balance sheet would reflect a lease receivable and the lessor’s residual interest. Lessors would classify all other leases as Type B, with income statement and balance sheet treatment similar to today’s operating leases.
The new lease standard will be implemented using a modified retrospective approach. Under this approach, lessees and lessors will compute lease assets and liabilities based on the remaining payments for leases existing at or entered into after the beginning of the earliest comparative period presented in the financial statements (the date of initial application). In addition, a lessee may elect specified transition relief provisions. These relief provisions, which must be elected collectively and applied consistently, would allow lessees to:
- Not reassess whether any expired or existing contracts are, or contain, leases
- Not reassess the lease classification for any expired or existing leases (i.e., capital leases could be assumed to be Type A leases and operating leases Type B)
- Not reassess initial direct costs for any existing leases (that is, whether those costs would have qualified for capitalization under the new standard)
OBSERVATION: The relief provisions come at a price. There may be times when it would be beneficial to reassess whether a lease is present. However, doing so would require a reassessment of the classification of all leases. Companies will need to consider whether the overall benefit of the relief outweighs the potential benefit of removing certain types of arrangements from being accounted for under the new guidance
For public companies, the new standard will be effective for fiscal years (and interim periods within those fiscal years) beginning after December 15, 2018; for private companies, the standard will be effective for annual periods beginning after December 15, 2019. Early adoption is permitted for all companies and organizations.
Companies that have not done so already will want to think through the potential impact, particularly in light of the requirement to retrospectively apply the standard to previously issued financial statements. Elliott Davis Decosimo is ready to answer your questions and provide the resources and training that you need. Watch for upcoming announcements about webcasts and whitepapers. In the meantime, if you have questions, please contact your Elliott Davis Decosimo adviser.