LUTZ BUSINESS INSIGHTS
Implementing the New Standards of Lease Accounting
KATIE BYRD, AUDIT MANAGER
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.
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 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.
- The lease term should include all non-cancelable periods and all extension options that the lessee is reasonably certain to exercise
- When choosing a rate, you have three options: implicit rate, incremental borrowing rate and risk-free rate.
When choosing a rate, you have three options: implicit rate, incremental borrowing rate and risk-free 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.
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.
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.
ABOUT THE AUTHOR
KATIE BYRD + AUDIT MANAGER
Katie Byrd is an Audit Manager at Lutz with over four years of related experience. She provides assurance services to businesses with a focus on the retail, service, distribution, nonprofit, and franchise industries. In addition, Katie assists with transaction advisory services and employee benefit plans.
AREAS OF FOCUS
- Employee Benefit Plans
- Transaction Advisory Services
- Retail Industry
- Services Industry
- Manufacturing & Distribution Industry
- Nonprofit Industry
- Franchise Industry
AFFILIATIONS AND CREDENTIALS
- American Institute of Certified Public Accountants, Member
- Nebraska Society of Certified Public Accountants, Member
- Certified Public Accountant
- BSBA in Accounting, University of Nebraska, Lincoln, NE
- University of Nebraska-Lincoln School of Accountancy Junior Advisory Board, Board Member
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