After years of consideration, the Financial Accounting Standards Board (FASB) revised lease accounting by issuing Accounting Standards Update (ASU) 2016-02, Leases (Topic 842). In the eyes of the FASB and users of the financial statements, leases in the financial statements of lessees represented valid assets and obligations as a result of the lessee receiving the right to use certain assets while receiving the economic benefits of using such assets. Consequently, essentially all leases (of 12 months or more) will be recorded on a company’s balance sheet.
Under ASU 2016-02, there are two types of leases: 1) Finance Leases and 2) Operating Leases. As stated in ASU 2016-02, one of the following criteria must be met for a lease to be classified as a Finance Lease:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
If a lease does not meet one of the criteria noted above, the lease is classified as an Operating Lease. It is important to note that ASU 2016-02 has removed “bright-line” tests, specifically related to criteria #3 and #4 above, that were previously used to determine if a lease should be classified as a capital lease. With this change, professional judgment plays a more important role in the lease classification determination, as a result of the financial statement impact varying by lease classification.
For Finance Leases and Operating Leases, a lessee must recognize a lease obligation equal to the present value of the related lease payments, which includes fixed payments, variable payments based on a market index, residual value guarantees and the price to purchase the leased asset at the conclusion of the lease if reasonably certain that such option will be exercised, among other potential considerations noted in the lease, as defined and discussed in ASU 2016-02. Additionally, for both types of leases, a lessee must also recognize a right-of-use (ROU) asset equal to the sum of the lease obligation (see above), initial direct costs (commissions, etc.) and prepaid lease payments, less any lease incentives. Such lease obligations and ROU assets should be presented separately in the balance sheet and should be classified as current or non-current in the balance sheet based on existing accounting principles generally accepted in the United States of America (GAAP).
For Finance Leases, subsequent to initial measurement, the lease obligation is amortized using the effective interest method while the ROU asset is amortized on a straight-line basis over the shorter of the useful life and the lease term, unless it is reasonably certain the lessee will purchase the ROU asset in which case the lessee should amortize the ROU asset to the end of its useful life. Such interest and amortization expense are recognized separately in the income statement for Finance Leases. For Operating Leases, subsequent to initial measurement, the lease obligation is amortized using the effective interest method while the amortization expense for the ROU asset is determined by calculating the sum of straight-line rent expense and the lease obligation reduction, less the lease payment. Only a single lease cost, equivalent to straight-line rent expense, is recognized in the income statement for Operating Leases. Under ASU 2016-02, the lease obligations are being amortized at the same rate; however, the ROU assets under Finance Leases are generally being amortized more rapidly than those under Operating Leases, which leads to greater expense in earlier periods for Finance Leases and greater expense in later periods for Operating Leases. Further, in the cash flow statement, repayments of principal under Finance Leases should be presented in financing activities whereas cash payments under Operating Leases should be presented in operating activities.
Note that ASU 2016-02 also discusses various other technical accounting and presentation issues, inclusive of lease modifications, lease reassessments, related party leases, sale-leaseback transactions and qualitative and quantitative disclosures required in the lessee’s financial statements, as well as lessor accounting.
As stated in ASU 2016-02, the effective date of transition for this guidance is as follows:
- Fiscal years beginning after December 15, 2018, including interim periods, for:
- A public business entity
- A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed or quoted on an exchange or an over-the-counter market
- An employee benefit plan that files financial statements with the United States Securities and Exchange Commission
- Fiscal years beginning after December 15, 2021 for all other entities*
- Early adoption is permitted for all entities
In transitioning to ASU 2016-02, the guidance states that a lessee must use the modified retrospective approach, which requires the lessee to value all leases and recognize such leases in the financial statements as of the beginning of the earliest period being presented. ASU 2016-02 does allow for multiple practical expedients, which may reduce the burden of transition and should be explored by all affected lessees to ensure the most efficient and effective transition approach is utilized based on the size, structure and complexity of each lessee’s business.
As the effective date of ASU 2016-02 approaches, it’s important to take an inventory of all existing leases, forecast potential new and/or renewing leases, determine the most practical transition method, consider any information technology investments that may be needed to track such leases, and consider the overall impact on the financial statements, which may, and most likely will, require communication with various stakeholders. Most notably, financing arrangements have the potential to be significantly impacted, given the financial covenants stipulated therein. Financial covenants relating to limitation of indebtedness, working capital restrictions, capital lease limitations, and financial ratio restrictions will need to be discussed, and most likely amended, with the applicable financer in anticipation of the transition to ASU 2016-02. As with all things, effective planning is the key to a successful transition to ASU 2016-02!
* Please note that this date has been extended due to COVID-19.