Accounting

Implementing the New Standards of Lease Accounting

Katie Byrd, Audit Director

October 25, 2018

Implementing the New Standards of Lease Accounting

During the first quarter of 2016, the Financial Accounting Standards Board (FASB) issued a new standard on leases. This move was intended to improve financial reporting, transparency and accountability. The new standards go into effect for fiscal years beginning after December 15, 2018 for public companies and December 15, 2019 for all others. Although the new standard is relatively close to the GAAP standards, there are a few things you should know to stay compliant during the transition.

Leases Under the New Standard

According to the main principles of the new standard, a lease must:

Be an identified asset, which is either explicitly or implicitly specified, and
Include a right to control use through decision-making authority with the ability to obtain all the economic benefits from its use

The lease can be one of two kinds: finance or operating. A finance lease can be determined by applying five tests which are similar to those used to determine a capital lease under prior GAAP:

Is there a transfer of ownership at the end of lease?
Is there a purchase option that the lessee is reasonably certain to exercise?
Does the present value of lease payments exceed substantially all of fair value?
Is the lease term for the major part of the economic life?
Is the underlying asset specialized in nature?

If the answer to any question above is yes, then the lease qualifies as a finance lease. Otherwise, the lease qualifies as an operating lease.

Considering Initial and Subsequent Measurements

Under the new standard, all leases will be recorded on the balance sheet, regardless of type. Companies may elect to exclude short-term leases, or leases with terms under 12 months, from this treatment and instead expense as incurred.

Initial Measurements

Leases will be recorded as a right-of-use asset and a lease liability. To determine the value of the lease liability, you will need to know the lease payments, lease term, and discount rate. Lease Payment

Lease payments are only included in the calculation if they are fixed or escalating
Variable lease payments (such as a percentage of sales) would be excluded from the calculation.

Lease Term

The lease term should include all non-cancelable periods and all extension options that the lessee is reasonably certain to exercise

Discount Rate

When choosing a rate, you have three options: implicit rate, incremental borrowing rate and risk-free rate.

Determining Rates

When choosing a rate, you have three options: implicit rate, incremental borrowing rate and risk-free rate.

Implicit Rate

This rate is the rate implicit in the lease agreement. Most often, this is the most difficult rate to determine and therefore, is not generally used.

Incremental Borrowing Rates

These are rates of interest a lessee would have to pay to borrow funds on a collateralized basis over a term similar to the lease and would be equal to lease payments existing in a similar economic environment. They require historical data but may be useful in group leases with similar characteristics.

Risk-Free Rates

The easiest of the rates to determine, risk-free rates can only be elected by private companies and must be used for all leases if elected. They result in the largest initial assets and liabilities, but must match the lease term. Risk-free rates can only be elected by private companies and must be used for all leases if elected. While this is the easiest rate to determine, they result in the largest initial assets and liabilities.

Subsequent Measurements

The right-of-use asset and lease liability will be systematically reduced after each rent payment. For finance leases, the recording will be similar to the approach used under prior GAAP. For operating leases, rent expense will be recorded using the straight-line method and the asset and liability will be reduced according to an amortization schedule. Ultimately, the new lease standard should have no impact on the income statement from prior GAAP. However, the standard will have an impact on certain debt covenants your company may have. This is due to the right-of-use asset being recorded in the same manner as a fixed asset (i.e. noncurrent) and the lease liability being recorded in the same manner as debt (i.e. with a current and long-term portion). Therefore, the adoption of the standard will likely reduce your current ratio as you will be increasing current liabilities with no corresponding increase to current assets.

Practical Expedient: Modified Retrospective Approach

You do have an option for practical expedience in both types of leases. For finance leases, you may maintain existing value at transition of the asset. For operating leases that are in existence at the initial adoption, measure based on the present value of remaining minimum rental payments over the life of the lease. For operating leases that have expired before initial adoptions, no transition accounting is required.

Achiever, Includer, Woo, Communication, Positivity

Katie Byrd

Audit Director

Katie Byrd is an Audit Director at Lutz. She began her career in 2014. She provides assurance services to businesses focusing on the retail, service, manufacturing, nonprofit, and franchise industries. In addition, Katie assists with transaction advisory services and employee benefit plan audits.

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About

Implementing the New Standards of Lease Accounting

Leases Under the New Standard

Considering Initial and Subsequent Measurements

Initial Measurements

Determining Rates

Implicit Rate

Incremental Borrowing Rates

Risk-Free Rates

Subsequent Measurements

Practical Expedient: Modified Retrospective Approach

Katie Byrd

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