Monday, December 14, 2015

Overview of the new standard

With the final decisions made, and just waiting for the official final document, what is the new regime for lease accounting? Most importantly, what is changing from the current standards?

US GAAP: FAS 13/ASC 840 to ASC 842

Lessee leasing: The most significant change, of course, is that all leases (except for those with a term of 12 months or less) must be put on the balance sheet. This was the primary reason for the whole project, and despite complaints from some quarters, there was never any real question that it would be implemented. However, the FASB chose to largely leave the distinction between capital and operating leases in place. (While for much of the deliberations the boards used the terms Type A and Type B, that nomenclature has fortunately been jettisoned; however, perhaps for convergence reasons, capital leases will now be called finance leases, while operating leases keep that name.)

One modest difference for classification is that the FASB added a capitalization criterion that was previously in IAS 17: whether the asset is so specialized that it cannot reasonably be repurposed. An example would be equipment installed at a remote mine which would be cost-prohibitive to move.

An operating lease is capitalized using the present value of the rents; the interest rate used is the implicit rate if known, otherwise the lessee’s incremental borrowing rate. (This is a change from FAS 13, which uses whichever rate is lower.) Since accurately knowing the implicit rate requires knowing the lessor’s unguaranteed residual, it’s most likely to apply only with leases that specify a purchase option. For simple leases, the asset and liability will be the same at any point during the life of the lease. If there are scheduled rent increases, the rent leveling effect will be reflected in the asset. Initial direct costs are added to the asset and amortized over the lease life.

While operating leases go on the balance sheet, the FASB specified that it should be treated as a “non-debt liability.” Thus, debt covenants should be unaffected by the change. It is nonetheless true, though, that certain financial ratios (current ratio, quick ratio, and return on assets) will be depressed by the addition of both assets and liabilities. (Terminology has changed from “obligation” to “liability.”) A second benefit to the separate accounting for operating leases is that expenses will generally be recognized straight line, rather than front-loaded as the depreciation + interest expense profile for a capital/finance lease works. This was a big deal to many lessees, virtually eliminating the impact of accounting on profit and loss calculations, equity, and tax vs. book timing differences.

Initial direct costs are no longer expensed as incurred. Instead, they are amortized straight-line over the lease life. However, this is limited to incremental costs, which effectively means only externally billed costs (commissions, legal fees, etc.), rather than rebilling internal costs.

Variable lease payments: Changes to rent due to future events (such as a change in an index or rate, or charges for excess use) remain contingent rents that are expensed as incurred. These can be positive or negative. If a lease must be recalculated due to other changes, though (such as a term extension or a revision to the base rent), the new variable lease payment level must be used for recalculation.

Lessor leasing: Almost unchanged, except that leveraged leasing (U.S. only) is being eliminated. Existing leveraged leases, however, will be grandfathered, including deals completed up to the implementation date.

Initial direct costs on sales type leases are recognized over the life of the lease unless the lease contains sales profit or loss.


The IASB decided that all leases should be recognized using finance lease accounting. Thus, the present value of the rents must be capitalized; the liability is amortized using the interest method, while the right of use asset is depreciated, usually straight-line. This means that current operating leases will have a new front-loaded expense profile (because interest expense in a mortgage-style amortization is more at the beginning than at the end). However, short term leases (12 months or less) and low-value leases are considered out of scope. The IASB also scoped out “small ticket leases,” defined as having a value of $5,000 or less. (It’s interesting that a dollar amount is used for a standard that doesn’t apply in the U.S.)

The impact of front-loaded expenses will be the most significant for rapidly growing organizations; if the leasing portfolio is rolling over fairly consistently, the aggregate impact on P&L will be small, though individual cost centers may face significant impacts depending on where in the lease’s life they are. However, all entities will see an equity impact that grows fairly quickly after implementation until it potentially reaches equilibrium when leases start expiring at the end of a full term under the new regime. From the very beginning, though, most financial ratios will take potentially significant hits, due to adding equal amounts of assets and liabilities. (EBITDA is one exception; since expenses will now be reported as interest and depreciation, they will be absent from EBITDA.) Some companies will double their reported liabilities, which (even with a substantial equity balance) will make them look percentage-wise much closer to the margin. Many lessees with substantial portfolios will need to talk to their lenders about revising the debt covenants on loans.

Variable lease payments: If a lease has variable rents based on an index or rate (such as interest based on LIBOR), its liability must be recalculated whenever the rent changes. However, since the index rate is also usually used for the PV calculation, in most cases the liability won’t substantially change, though the expense reported as interest will increase.

Retirement obligations associated with leases are reported in accordance with IAS 37. The asset side of the provision (equivalent to what US GAAP, in FAS 143, calls an asset retirement obligation) is added to the right of use asset for the lease; subsequent changes to the provision result in adjustments to the ROU asset, which cannot be reduced below zero (if further adjustments are required because the liability is reduced, a gain is recorded).

Lessor leasing: Almost unchanged, except that determining the finance vs. operating classification will explicitly use the bright line tests of FAS 13: whether the lease term is 75% or more of the economic life, and whether the present value of the rents is 90% or more of the fair value of the underlying asset.

Shared by ASC 842 and IAS 17

The definition of a lease is “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.” This includes a requirement of a specified asset; if the lessor can swap assets at will, for its own benefit (not counting the replacement of a non-functioning asset), the agreement is considered a service contract, not a lease.

All lease/rental agreements are out of scope (i.e., do not need to be reported according to the standard; you can simply expense the rent as paid, with no balance sheet impact nor footnote disclosure of future rents) if they are for a term of 12 months or less. In a change from the current standards, the definition of the lease term can include business practice as well as contractual obligations in determining whether options should be included, though the new standard of “reasonably certain” that the option will be exercised is considered functionally equivalent to the current “reasonably assured” term.

If the rent contains non-lease components, a lessee should allocate the rent to lease and non-lease expenses, using observable standalone prices for the services, if available, or estimating if necessary. ("Non-lease components" is a subset of "executory costs" in current accounting; passthrough costs such as taxes and insurance are now lease expenses and are capitalized with the base rent.)
Residual guarantees are capitalized at their expected, rather than maximum, value. Since this amount is usually zero, it will significantly reduce the likelihood that TRAC leases will be considered capital for US GAAP.

Sale/leaseback accounting has been tightened. The transaction must meet the requirements for a sale in FASB Topic 606 (IAS 15), the revenue recognition standard. If there is a fixed-price purchase option, sale/leaseback treatment is not permitted unless the lessee does not control the asset at the time of the transaction and is acting as an agent for the original owner. If the leaseback qualifies as a finance lease, then no sale/leaseback has occurred. A failed sale/leaseback remains on the lessee’s books as an asset with the leaseback accounted for as debt.

Subleases: The “head lease” (intermediary’s lessee lease) is accounted for separately from the sublease unless the transactions meet specific contract combinations guidance. Rent income and expense should not be offset, unless the intermediary serves as an agent under Revenue Recognition rules.

A modification of a lease is treated as a new lease if the lessee receives an additional right-of-use (i.e., additional assets), which is priced commensurately with a standalone price. Otherwise, a modification is treated as an adjustment to the existing lease, including an extension of the term. If the scope of the lease increases or stays the same, the current methodology of adjusting the asset and liability by the change in the present value of the rents still applies. If the scope of the lease decreases, a gain or loss is recognized in proportion to the decrease in scope. So if you have a lease covering ten trucks and you return one, you would recognize 1/10 of the current difference between asset and liability (if any) as a gain.

A lessor modifying a finance lease adjusts the discount rate to keep the net investment the same with the new terms.

Implementation: The new standard must be implemented effective January 2019 (the FASB styles it as “fiscal years starting after Dec. 15, 2018,” since some companies use fiscal calendars that start the same day of the week each year, which might be in the last week of December). Privately held companies have an additional year to comply. Earlier implementation is permitted, though the IASB requires implementation of the new revenue recognition standard, IFRS 15, no later than the same time.

The plan is for the final official documents to be released in January. Then the work of implementation begins. 

Obviously, there are more details, some of which are not yet explicitly stated. But there shouldn't be any significant surprises when the final document is released. More details are available on the FASB project page.

FCS is working on updating our EZ13 software to meet the new requirements. We will provide a fully compliant update for all current users with active support contracts, so you can implement the software now and be confident of a smooth path to upgrading. We've been at this for forty years, longer than almost anyone else offering lease accounting software, so you know that our solution will be thorough, well tested, and comprehensive.

(This post was updated 3/10/16 to correct the relationship of non-lease components and executory costs.)


  1. How are TI Allowances supposed to be treated? I understand that under the new rules timing of the payment matters.

  2. I'm not aware of any change in treatment of tenant improvement allowances under the new standard. They are recognized straight-line over the lease term, generally as a reduction of rent.
    Note, though, that the definition of the lease term may include option periods if the improvements are substantial enough that they financially compel renewal. This is part of existing GAAP (it's an issue that blew up in 2005, when the SEC's Chief Accountant wrote a letter to the AICPA emphasizing it, causing a number of companies to have to make material restatements of their lease portfolios).

    1. Ok, thanks! Per the initial draft, Incentives were initially supposed to reduce the ROU asset only. This treatment made complete sense. However, in subsequent meetings, they concluded that the timing of payment of the incentives matter. Incentives received prior to commencement reduce both the Asset and the liability, while incentives received after reduce the asset only (I may have reversed these). Either way, the accounting (journal entries) for reducing both the asset and liability simply does not work out.

  3. Looking at this a bit more, I think my Dec. 26 answer was inaccurate. I misread the section on transition as referring to new leases. For leases carried over from the current standard, the recognition would still be straight line (as it is now), but calling it a reduction of rent is inaccurate, since there is no rent expense in the new standard; it's "lease expense," for a combination of the calculated interest and depreciation taken. For leases entered into under the new standard, I think your understanding is correct.

    To make the journal entries work when the incentives are known at inception, think of the incentive as negative rent, reducing the first rent payment. So instead of the first rent payment being a debit to liability and credit to cash (first day of lease, so no interest has had time to accrue), there is an additional debit to cash, reflecting the incentive. (You can, if you wish, combine the two cash entries, but separating them makes it easier to see what's happening.) As the incentives are used, you would credit cash and debit leasehold improvements (to be amortized over their life), or simply expense them.

    With an adjustment like this, the asset and liability get set up at inception equal to each other, and there are no further issues later in the lease life. The liability and asset might actually not change, if the imputed interest rate is high; the result of recognizing the TIA would simply be a reduction in the calculated interest (both rate and dollars paid).