Implementation guidance, straight from the source

Both the IASB and the FASB have announced webinars to assist preparers in implementing the new lease accounting standards. The IASB has just posted a web presentation on The Transition to IFRS 16 (focused on transitioning operating leases, and primarily using the cumulative catch-up approach, rather than full retrospective application), along with additional transition/implementation materials available (and soon to be released) shown here.

The FASB will have a webinar on ASC 842 on Tuesday, March 29, 2016, 1-2 PM Eastern time. 1.0 CPE credit hours are offered for CPAs who register. These webinars are typically archived for later viewing, though CPE credit is not available then.

Summary of ASC 842

A nearly 10-year process is complete. The FASB and IASB announced in July 2006 that they would undertake a comprehensive review of lease accounting. the primary purpose was to end the off-balance-sheet status of lessee operating lease accounting, but the boards also wanted to converge their standards, and review other aspects of lease accounting. The original target date for completion was 2009, but it took a Discussion Paper, two Exposure Drafts, over 1700 comment letters, and hundreds of meetings with users and preparers of financial statements, associations of lessees and lessors, accountants, and various other interested parties to finally reach the final document, published by the IASB as IFRS 16 and the FASB as ASC 842. The final result is not converged in some important aspects; most significantly, the IASB has chosen to require all leases to be treated as finance leases, while the FASB is keeping a finance vs. operating distinction for purposes of calculating the expenses (usually recognized straight-line) and asset (equal to the liability for simple leases).

The following is a summary of the most important points, with a particular emphasis on what’s changed from FAS 13. (I will make a later post discussing the significant differences of IFRS 16.)

Lessee operating leases on the balance sheet

All leases with a non-cancelable term of more than 12 months must be capitalized and recognized on the balance sheet (or Statement of Financial Position, to use FASB’s preferred terminology). The liability is calculated as the present value of the remaining rents; the interest rate used is the lease’s implicit rate, if known, otherwise the lessee’s incremental borrowing rate. The asset is calculated starting from the liability, then adjusted by adding any initial direct costs, subtracting lease incentives and impairments, and adding any difference between cash and leveled rent; all these items are amortized straight-line.

What rent is capitalized

The old concept of “executory costs,” which are not capitalized because they don’t reflect recovery of the cost of the asset itself, has been replaced with “nonlease components.” Nonlease components represent payments made which transfer a good or service to the lessee. So charges for a service contract or common area maintenance (CAM) are both executory costs and nonlease components. Charges for taxes and insurance (such as in a gross property lease) are executory costs currently, but do not qualify as nonlease components, and therefore must be included in the capitalized rent.
Land and building leases still qualify for separated treatment, with the land usually not a finance lease. However, the assignment of rent is now proportional to the fair values of the land and building assets, rather than the land rent being calculated based on the incremental borrowing rate.

Classification

While the terminology has changed slightly—FAS 13 capital leases are now called “finance leases,” because all leases are capitalized—the tests to distinguish finance from operating leases are essentially unchanged. While ASC 842-10-25-2 uses “principles” language for the tests (“the lease term is for the major part of the remaining economic life”; “the present value of the … lease payments … equals or exceeds substantially all of the fair value”), 842-10-55-2 says that “one reasonable approach” is to use the 75% and 90% thresholds. We can expect virtually all U.S. preparers to stick with those tried-and-true methods. There is one additional test: “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.” (In such situations, one would expect the lessor to fully recover his investment during the lease, so one of the previous tests would almost certainly be met as well, making the additional test probably insignificant.)

Leases with a non-cancelable term of 12 months or less (including renewal options that are considered reasonably certain of being exercised) may be excluded from capitalization, but their costs (excluding leases with a term of a month or less) must be separately disclosed.
 
Lessors: Leveraged leases have been eliminated (though existing leveraged leases are grandfathered). The distinction between sales-type and direct financing is no longer whether the fair value and carrying amount of the asset are equal, but whether the present value test is met via the rent & residual due from the lessee vs. a third-party guarantee of residual value. A sales-type lease permits immediate recognition of profit; a direct financing lease recognizes the profit from the difference between the fair value and carrying amount though interest income over the life of the lease.

Lessee reporting requirements

Finance leases create an asset and liability, as with current capital leases. The “right of use” asset is depreciated like other PP&E, usually straight line. The liability is amortized using the interest method. Depreciation and interest expense are recognized as currently with capital leases. Accrued interest is immediately booked to the liability account, rather than a separate accrued interest account.
 
Operating leases also create a right-of-use asset and liability, but the liability is called an “operating obligation,” not debt, meaning that it should not be counted as debt for loan covenants and financial ratios. Expenses are recognized in a single lease cost, which is normally straight-line over the lease’s life. For a simple operating lease with the same rent paid for its whole life and no asset adjustments, the net asset and liability are the same at all times. If there are scheduled rent increases, the leveling of rent is recognized as an adjustment to the asset, as are initial direct costs and lease incentives, all of which are amortized straight-line over the lease life.

Finance and operating lease assets and liabilities are reported separately (reflecting their different character; finance lease liabilities typically survive bankruptcy, for instance).
 
Two new disclosures are required: For finance and operating leases separately, the weighted-average remaining lease term (weighted by remaining liability), and the weighted-average discount rate (weighted by remaining lease payments, undiscounted).

Sale-leaseback

Sale-leaseback accounting is permitted only if the “sale” qualifies as a sale under the new Revenue Recognition standard (ASC 606/IFRS 15). This requirement precludes continuing lessee control of the leased asset other than the lease itself; most significantly, if the lessee has a purchase option at a fixed price (rather than fair value at time of exercise), sale-leaseback accounting is not permitted, and the transaction is treated as a financing.

Transition

Implementation is required for fiscal years starting after Dec. 15, 2018, including that year’s interim periods. Private companies may delay until fiscal years starting after Dec. 15, 2019, and need not implement for interim periods until the following year. When implemented, the prior two years must be restated using the new standard, to provide comparable information. Earlier implementation is permitted, but still requires the two-year restatement. (This does not mean refiling prior financial statements, but reporting the prior comparable periods as if the new standard had been in place as of the first comparable period.)

Several “practical expedients” are offered which most lessees are expected to use in transition. On that basis, lease classification is not reassessed; unamortized initial direct costs are carried forward and added to the lease asset without determining whether they qualify as IDC under the new rules. Balances on capital leases are converted to finance lease balances without adjustment (aside from combining accrued interest with liability, and IDC with the asset). Operating leases are set up with the liability equal to the present value of the remaining rents (using the incremental borrowing rate as of the transition date); the asset is the same, adjusted for any unamortized IDC, lease incentives, and deferred rent from leveling scheduled rent increases.

Note that for the two-year lookback period, you will need to retain the data to report leases both ways. In particular, it will be important to record both executory costs and non-lease components of the rent, so that each can be used for the appropriate reporting. 

Proposed changes that were eliminated

The 2010 Exposure Draft called for including all renewal options that were “more likely than not” to be exercised, and for projecting variable lease payments (such as those based on inflation or usage). Vehement disagreement on these proposals led the Boards to remove those proposals.

The 2013 Exposure Draft called for Type A and Type B lease classification based on characteristics of the lease (different rules for real property vs. equipment, in particular). The IASB decided to make all leases finance leases; the FASB decided to return to FAS 13’s classification system.
 
Lessors: The 2010 Exposure Draft called for creation of a Performance Obligation on leases previously considered operating, which would have affected lessor balance sheets. Lessor accounting for operating leases was reinstated virtually unchanged from FAS 13.

We will release later this year an update to our EZ13 lease accounting software which will fully comply with ASC 842. You can use EZ13 right now to forecast the impact of the new standard, because EZ13 includes the ability to treat operating leases as capital on a pro forma basis. For more information about how EZ13 can meet your lease accounting needs, whether you're a lessee or lessor, please check our web site or contact us.

Media coverage of new lease accounting standard

Several articles have been released discussing the FASB's new lease accounting standard:

New York Times: Post-Enron Accounting Rule Requires Companies to Report Leases

Wall Street Journal: New Rule to Shift Leases Onto Corporate Balance Sheets
Wall Street Journal (CFO blog): A Silver Lining to New Lease Accounting Rules: Savings

Accounting Today: FASB Releases Lease Accounting Standard

CFO: New FASB Lease Standard Could Inflate Balance Sheets
(CFO had a prior article on the complications facing companies that have to report under both US GAAP and IFRS: New Lease Standards May Demand Two Sets of Books)

Journal of Accountancy: New FASB leases standard brings transparency to lessee balance sheets

AccountingWeb: The Wait is Over: FASB Issues New Guidance on Lease Accounting

It's here!

Today (Feb. 25) the Financial Accounting Standards Board (FASB) released ASU 2016-02, the final version of the new lease accounting standard. In the Accounting Standards Codification, this is designated Topic 842 (the prior standard, FAS 13, was designated ASC 840). The release, available on the FASB web site, includes Section A, the main text, at 191 pages; Section B, a mind-numbing description of how the new text changes the existing Topic 840 text (148 pages); and Section C, background information and basis for conclusions (152 pages). This completes a process that started all the way back in July 2006 (and was originally expected to be completed in 2009).

Obviously, I can't look through 350 pages in a morning. There's no reason to expect any major surprises in the text. Illustrations are interspersed throughout the text. As a reminder, the new standard takes effect in 2019 (including interim periods in 2019); U.S. private companies get until year-end 2020 (interim periods don't have to use it until 2021).

To assist with understanding the new standard, the FASB released a Costs and Benefits summary, posted a 6-minute video entitled Why a New Leases Standard?, and announced a webinar for March 29, 1-2 PM EDT (1.0 CPE credit for CPAs).

The International Accounting Standards Board (IASB) released IFRS 16, their new lease accounting standard, on Jan. 12, 2016. Unlike the FASB, the IFRS text is not available for free; eventually the basic text will be released free (without the illustrative examples or basis for conclusions), but at the moment it's only available for purchase individually or as part of an eIFRS Professional Subscription.

I'll have more information in the coming days about the details of the new standard. We are working to complete the updates to EZ13 to meet the requirements of the new standard, including the transition from FAS 13. You can use EZ13 right now to forecast the impact of the new standard, because EZ13 includes the ability to treat operating leases as capital on a pro forma basis. For more information about how EZ13 can meet your lease accounting needs, whether you're a lessee or lessor, please check our web site or contact us.

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.

IFRS: IAS 17

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.)

FASB: New leases standard implementation in 2019

As I think most observers expected, the FASB at today's meeting set the implementation deadline as fiscal years starting after Dec. 15, 2018, i.e., calendar year 2019. This matches the IASB decision from last month. The FASB will permit early implementation; they seem to think it most likely that lessors will be early adopters. Given the potential impact on financial ratios, lessees are less likely to want to adopt early. Unlike the IASB, the FASB is not tying early adoption of the new leases standard (ASC Topic 842) to the recently adopted revenue recognition standard. Non-public entities will be given an extra year to comply (i.e., effective 2020).

One more substantive issue came up at the meeting. FAS 13 includes a provision that, if a leased asset is in the last 25% of its economic life, the lease is operating unless there is an ownership transfer or bargain purchase option. The new standard as written lacked any such bypass. Some constituents, particularly lessors, objected to this change, arguing that for lessors whose business model is based on repeated rentals of the same equipment, they could find the anomalous situation of a series of operating leases, followed by a capital lease near the end of the asset's life. Lessees would be potentially caught by the same situation. While there was some concern that this might not properly recognize lessors who are intentionally selling off old assets via lease, the proposed solution for the situation was to skip the economic life test if a lease starts near the end of the asset's life, but to leave the present value/fair value test in place.

With this complete, the deliberations are supposed to be finished. The FASB's news release for today's meeting says the final Accounting Standards Update should be published in early 2016.

Here at FCS, we are working on updating EZ13 to meet the new standard. The current version allows you to treat operating leases as capital, so you can anticipate the effect of putting operating leases on the balance sheet. Complete compliance with the new ASC 842 (and the update to IAS 17 for international entities) will be released next year. We are looking forward to assisting corporations and other reporting entities, both in the United States and throughout the world, in meeting the challenge of the biggest change to lease accounting in 40 years. FCS has been specialists in lease accounting since even before the initial release of FAS 13, and we are happy to put our accumulated expertise to work for customers ranging from Fortune 500 corporations to solo CPAs. Please contact us for more information about how we can help you.

IASB: New leases standard implementation in 2019

At the IASB's October 20 meeting, the board had its final deliberations on the new lease accounting standard. The headline decision is that the board decided that the new standard would be required starting with fiscal years beginning on or after January 1, 2019. Earlier implementation is permitted if an entity also implements IFRS 15, Revenue from Contracts with Customers, on or before the date the leases standard is implemented. While the FASB will make its decision independently, it is highly likely they will choose the same implementation date.

Other items discussed:

a. A lessee, and a lessor with a finance lease, will account for a lease modification that extends the life as a continuation of a lease, rather than a new lease agreement. This means that the impact of the modification is recognized immediately, rather than at the end of the existing lease. The FASB has made the same change.
b. If a lease's rent is based on a floating interest rate, the lease's discount rate should change whenever the rents are updated due to an interest rate change. (In other words, the discount rate for calculating the obligation will track the rate used to calculate the payments, which means that the obligation and asset won't change.)
c. End of lease restoration obligations should be accounted for in accordance with IAS 37, Provisions, Contingent Liabilities, and Contingent Assets. (This is virtually the same as FAS 143, Asset Retirement Obligations.) The asset side of the transaction is added to the right-of-use asset for the lease; subsequent changes in the provision obligation result in adjustments to the right-of-use asset as well.
d. Short-term (12 months or less) and low-value asset leases that are not capitalized can remain uncapitalized in a business combination. The FASB has made the same determination for short-term leases, but does not have a low-value asset exemption from lease accounting.
e. Any leases that are considered within scope of IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, do not require additional disclosures beyond those specified in IFRS 5. (In other words, they are not included in regular lease reporting.)

The IASB says they are finished with all deliberations on leases, and will have a final ballot on the proposed standard before the end of the year.