A decade ago, the Financial Accounting Standards Board (FASB) participated in a joint working group with the International Accounting Standards Board (IASB) to produce a significantly improved standard on leasing. After two exposure drafts, 1,700 comment letters, 700 meetings with financial statement users and preparers, more than 40 meetings with a diverse group of stakeholders, and much debate, the FASB’s long-awaited guidance on accounting for leases has been issued. Accounting Standards Update (ASU) 2016-02 — Leases will apply to all public and private companies and non-profit organizations that lease assets. This guidance does not apply to any entities subject to the Governmental Accounting Standards Board (GASB) accounting pronouncements.
Under current U.S. generally accepted accounting principles (GAAP), a lessee organization applies a classification test to determine the accounting for leases. Some leases are classified as finance leases, also known as capital leases, whereby the lessee recognizes lease assets and liabilities on the balance sheet. Other leases are classified as operating leases, whereby the lessee does not recognize lease assets or liabilities on the balance sheet. The current operating lease model has been criticized for not providing a faithful representation of operating leasing transactions since they are essentially “off-balance sheet” financing obligations. A 2005 study by the SEC, prior to deliberations about lease accounting, indicated there were $1.25 trillion of unrepresented obligations on public company balance sheets due to the accounting treatment for lease transactions.
Consistent with current U.S. GAAP, the recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee will depend primarily on the lease’s classification as a finance lease (capital lease) or an operating lease. However, unlike current U.S. GAAP, the ASU requires lessees to recognize a right-of-use asset and a lease liability at the present value of the lease payments for both capital leases and operating leases with terms of more than 12 months. Lessor accounting under the new standard will remain largely unchanged from current lessor accounting under U.S. GAAP.
Throughout the deliberations, most stakeholders agreed conceptually that obligations from leases belong on the balance sheet. The more significant debate involved how to account for items on the income statement. The final U.S. standard requires that finance leases present amortization expense of the right to use assets separately from interest expense, whereas operating leases will present a single lease expense line item on a straight-line basis. This differs from IASB guidance, which treats all leases as finance leases.
Effective Dates and the Need to Prepare
For public companies, which can include certain non-profit entities, the ASU is effective for the calendar year 2019 and fiscal years thereafter. For all other organizations, the ASU is effective for the calendar year 2020 and fiscal years thereafter. Though this may sound far away, there are several reasons organizations need to begin to think about and prepare for implementation. Consider the following:
- Compensation agreements can be based on financial metrics that undoubtedly will be impacted by this change.
- Certain contracts, including debt agreements, could be renegotiated to address the impact on debt covenants of reporting lease liabilities on the balance sheet.
- Total assets will increase and have an effect on net-worth ratios.
- Strategic decisions on whether to lease or buy may change.
Our professionals at Selden Fox can assist you with any questions you might have, and with implementation of the new standard for lessee and lessor organizations.