Sweeping New Lease Accounting Standards

Overview

The Financial Accounting Standards Board (“FASB”) has released new lease accounting standards under Accounting Standards Update 2016-2 that will be codified under Accounting Standards Codification Topic 842. Such standards become effective for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020, for all entities except public business entities, certain not-for-profit entities, and employee benefit plans that file with the SEC (for which they will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.) Early application is permitted for all entities.

The lease accounting applied by a lessor is largely unchanged. For example, the vast majority of operating leases should remain classified as operating leases, and lessors should continue to recognize lease income for those leases on a generally straight-line basis over the lease term.

For lessees, the main difference between the current standards and the new standards relates to the recognition of lease assets and liabilities by lessees for operating leases. The methodology for determining whether a lease qualifies as an operating lease or a finance lease (formerly called a capital lease) is generally equivalent to the current guidelines for classifying a lease as an operating or capital lease. 

General Guidelines and Examples

Following are examples of how this new accounting standards will impact the lessee’s accounting for leases, assuming monthly lease payments of $50,000 for 15 years with an incremental borrowing rate of 5.881%, and no options to extend the term. The present value of the lease payments is $6,000,000.

Under the new standards, the present value of the lease payments, plus the lessee’s initial direct costs, less any leasehold improvement buildout allowance, equals the asset to be recorded on the balance sheet (the “right-of-use asset”). Option periods are included in the calculation only if the lessee is reasonably certain to exercise an option to extend the lease and not exercise an option to terminate the lease. Similarly, optional payments to purchase the underlying asset should be considered only if the lessee is reasonably certain to exercise that purchase option. The right-of-use asset is recorded by the lessee for both types of leases, operating and finance. At the outset of the lease, the corresponding lease obligation payable is recorded as a liability; the changes in these balance sheet accounts over the lease term will vary according to whether the lease is an operating or finance lease. 

The new accounting standards will apply to preexisting leases, as well as new leases commencing after the effective date. Preexisting leases will be required to be recognized at the beginning of the earliest period presented after the effective date. There are available practical expedients which, if elected, will allow preexisting leases to follow previous GAAP accounting, except that lessees will have to recognize a lease asset and liability for all operating leases at each reporting date, based on the present value of the remaining rental payments as determined under previous GAAP.

Presented below is a summary of the lease accounting under both lease types.  Please note that related party leases are to be treated the same as non-related party leases for purposes of lease classification. Since the new standards become effective soon, they should be considered when negotiating leases as well as loan covenants. FGMK can assist you in planning for the accounting treatment of existing and future leases.

Operating Lease Example

If the lease qualifies as an operating lease, then the annual lease expense is computed using the straight-line method by dividing the total payments (plus initial costs less lessor incentives) by the lease term. In our example, total payments are $9,000,000 over 15 years, which equals $600,000 per year.

The resulting income statement presentation is the same under both standards, as rent expense is recognized using the straight-line method. However, under the new standards, a right-to-use asset and lease obligation payable will be presented on the balance sheet, whereas no such assets or liabilities are recognized under the current standards for operating leases. If a classified balance sheet is presented under the new standards, the current portion of the lease obligation payable would be presented separately from the long-term portion. The table below illustrates the annual results under the new accounting standards.

 

In summary for leases classified as operating leases, lessees will recognize lease payments as rent expense which would reduce EBITDA. Additionally, even though the right-to-use asset and lease obligation payable net to zero, the current portion of the lease obligation payable must be presented separately on the lessees’ balance sheet, which will impact the lessee’s current ratio.

 Finance Lease Example

If the lease qualifies as a finance lease, then the interest portion of the lease payment is recorded as interest expense and the right-to-use asset is amortized on a straight-line basis over the lease term, to the same account to which it would be recorded if the leased asset had been owned by the lessee, typically depreciation expense. Note that if there are any variable lease payments not included in the computation of the right-to-use asset, those would be recognized in the period incurred, in the same manner as short-term lease payments, as a reduction of income from continuing operations (rent expense). The table below illustrates the annual results under the new accounting standards.

 

finance lease

In summary for leases classified as finance leases, lessees will recognize lease payments as interest expense and depreciation expense which would not reduce EBITDA. As with operating leases, the current portion of the lease obligation payable must be presented separately on the lessees’ balance sheet, which will impact the lessee’s current ratio.

Other Considerations – Lease Options, Modifications and Subleases

A lessee must re-measure and adjust lease assets and liabilities upon the exercise of options that were not previously considered to be reasonably certain, and for any lease modifications which are not considered a separate contract. An entity shall account for a modification as a separate contract when the modification grants the lessee an additional right of use not included in the original contract, and the lease payments increase commensurately with the standalone price for such additional right of use.

For subleases, as long as the original lessee is not relieved of its primary obligation under the original lease, the sub-lessor shall continue to account for the original lease in one of the following ways: (1) If the original lease is classified as an operating lease and the sublease is also classified as an operating lease, the sub-lessor shall account for the lease as it did before commencement of the sublease; (2) If the original lease was a finance lease and the sublease is not classified as an operating lease, the sub-lessor shall de-recognize the original right-of-use asset, but continue to account for the original lease liability as it did before commencement of the sublease; (3) If the original lease is classified as an operating lease and the sublease is not classified as an operating lease, the sub-lessor shall de-recognize the original right-of-use asset and, from the sublease commencement date, continue to account for the original lease liability as it did before commencement of the sublease.

If the original lessee is relieved of its primary obligation under the original lease, the sublease is deemed to terminate the original lease and any consideration paid or received upon termination that was not already included in the lease payments would be included in the profit or loss from lease termination.

Conclusion

Because the new lease accounting standards are complex and have new balance sheet disclosure requirements, we recommend that lessees become familiar with these standards quickly to determine their potential impact. FGMK can assist you in assessing the new standards and implementing them in your financial accounting system.

 

About FGMK

FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.

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