The Financial Accounting Standards Board (FASB) released a new accounting standard that fundamentally change the rules that govern accounting for substantially all leases, including equipment and real estate leases. This new standard improves transparency and gives financial statement users a better understanding of the businesses they rely on. Implementing this standard takes proper planning and early preparation.
ASU 2016-02 Leases (Topic 842)
On February 25, 2016, FASB released Accounting Standards Update (ASU) 2016-02, Leases (Topic 842). Effective for reporting periods beginning after December 15, 2018 for public entities and December 15, 2019 for nonpublic entities, the new guidance applies to all leases of property, plant and equipment excluding intangible assets, energy exploration and usage, biological assets, and inventory assets under construction. Early application is permitted.
Lessees are not required to present operating leases on their balance sheet under the current standards. Some users found that presentation misleading as they could not see all obligations at glance. The new standards address this problem by requiring all leases to be capitalized.
Types of Leases
Under the new guidance leases are classified as a finance lease or an operating lease. The lessee classifies the lease as a finance lease if any of the following criteria are met at lease commencement:
- 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 the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such specialized nature that there is no expected alternative use to the lessor at the end of the lease term.
Note that the new standard removes the specific tests for 75% of the economic life or 90% of the fair value of the underlying asset, and instead uses the broader language of “major part” and “substantially all”, respectively. However, the implementation guidance states that these benchmarks are still a reasonable approach.
What a Lessee Needs to Know
For both operating and finance leases, the initial measurement is virtually the same. The liability is measured at the present value of the future lease payments, and the right-of-use asset is measured at cost.
Under operating leases, the asset and liability are both amortized on a straight-line basis over the term of the lease. However, under finance leases, the useful life of the asset is used if the lessee is reasonable certain to purchase the asset, or if ownership transfers at the end of the lease.
What a Lessor Needs to Know
There are no significant changes to lessor accounting.
The standard must be applied using a modified retrospective approach, which applies the new standard as of the earliest comparative period presented. That means for nonpublic entities presenting two years of comparative financials and with December 31 year-ends, the new guidance should be effective starting in 2019.
If you have any questions regarding new lease standards and how they may impact you and your business, or require any other assistance with your tax planning and compliance needs, please call or email one of our knowledgeable team members:
Greg Hext (firstname.lastname@example.org)
Albina Albikova (email@example.com)