Preparing for the new lease accounting standard

Don't wait to take action

Matt Waller, CPA

It took eight years for the United States to land a man on the moon. It took a decade for the Financial Accounting Standards Board (FASB) to issue the new lease accounting standard, ASU 2016-02 Leases. Needless to say, this new standard presents dramatic changes to the balance sheets of lessees and now is the time to start paying attention to it.

Overview

This comprehensive overhaul of lease accounting requires all lessees to reflect a lease liability and a right-of-use asset on their balance sheet for all leases with a term of more than one year. This means that virtually all companies, even if they rent only office space or copiers, will have a large increase in their liabilities.

Effective date

For non-public companies, the standard is effective for fiscal years beginning after December 15, 2019, with early adoption permitted. If you have a calendar year-end, that means the effects of this standard should be reflected on your balance sheet starting January 1, 2020.

Adoption

Luckily, the FASB just issued new guidance in ASU 2018-11 that permits two methods of adoption. You can either adopt the standard using a full retrospective approach, which means the application of the new guidance would be implemented to the earliest period presented in the financial statements; or you can use a modified retrospective approach, which means that only the current year is adjusted. So, if you have a calendar year-end that requires comparative financial statements, you can either restate your prior year results to reflect the new rules so that your income statements are consistent; or, you can elect to apply the lease standard only in the current year and charge the opening balance of retained earnings in the current year presented for the life-to-date impact of the change.

Complexities

The standard is complex; however, this article is designed to give you the general idea of what will be required when the new standard is effective. There are many additional nuances that have not been covered here, such as:

  • Consideration of leases containing non-lease components
  • Accounting for initial direct costs
  • Variable lease consideration
  • Lease modifications and terminations
  • New disclosure requirements
  • Plus many, many more

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New types of leases

The new lease standard still has several categories of leases that are accounted for differently:

Short-term leases. Leases with terms of less than one year. The lessee may elect to expense these lease payments in the income statement as incurred. However, signing a series of one-year leases that are highly probable of renewal will not get you out of adopting the new standard.

Finance lease. Think of this as the old “capital lease.” The criteria to evaluate whether a lease is a finance lease is similar to the old criteria; however, the FASB removed the bright line tests. A finance lease has at least one of the following characteristics:

  • The lease transfers ownership of the asset at the end of the lease.
  • The lease includes an option to purchase the underlying asset that the lessee is reasonably certain to exercise (Bargain Purchase Option).
  • The lease term is for the major part (not 75%) of the remaining economic life of the underlying asset.
  • The present value of the sum of the lease payments equals or exceeds substantially all (not 90%) of the fair value of the underlying asset.
  • The underlying asset is of such specialized nature that it is expected to have no alternative use to the lessor.

Operating lease. If it is not a short-term lease or a finance lease, it is an operating lease. Under the old standard, these would be expensed as incurred. Under the new standard, these are capitalized on the balance sheet.

Nuts + bolts accounting

At the start date of a finance or operating lease as defined above, the lessee records:

  1. A right-of-use asset, and
  2. The lease liability of the present value of the payments not yet paid, discounted using the interest rate of the lease.

If the interest rate is not explicitly stated in the lease, you should use your incremental borrowing rate (the rate you would expect to borrow money to finance a similar purchase).

Determining the lease term for the calculation has also changed under the new standard. You should calculate the lease term as the non-cancellable period of the lease, plus:

  • Periods covered by an option to extend, if the lessee is likely to exercise,
  • Periods covered by an option to extend the lease in which exercise of the option is controlled by the lessor, and
  • Reduced for periods covered by an option to terminate the lease if the lessee is reasonably certain to exercise that option.

Once the payment stream, duration, amounts (whether fixed or variable) and discount rate are determined, the lease amount equal to the present value of the cash flows is recorded as a liability (split between current and noncurrent), and the offsetting debit is recorded as the right-of-use asset (typically noncurrent).

Example: initial recording

The initial recording of the transaction is the same whether the lease is a finance or operating lease. On January 1, 2020, Company XYZ enters into a three-year lease for office space with annual payments of $118,700. The lease includes an option to extend for two years that the Company believes they will exercise. Assume the Company’s incremental borrowing rate is 6%.

Calculation: Since the Company is reasonably certain to exercise the option to extend the lease, the calculation of the lease liability is the present value of five annual payments of $118,700 with a 6% discount rate which equals $500,000. The accounting entry is:

 DebitCredit
Right of use asset$500,000
LT Lease liability$411,302
ST lease liability$88,698

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Example: subsequent measurement

The subsequent accounting for the transaction will vary depending on whether the lease was identified as a finance lease or operating lease:

  • Finance lease – Amortization of the right-of-use asset is expensed on a straight-line basis over the lease term and the lease liability is reduced for principal payments and recognition of interest expense in the income statement. The P&L charge must be split between the use and financing components.
  • Operating lease – A single combined lease expense is recognized and calculated so that the remaining cost of the lease is allocated over the lease term on a straight-line basis.

Here’s a summary of the accounting for the next five years of the example lease when treated as a finance lease versus an operating lease:

Finance lease

Balance Sheet
DateRight of use asset balanceLease liability balance
Inception500,000(500,000)
12/31/2020411,302(411,302)
12/31/2021317,282(317,282)
12/31/2022217,621(217,621)
12/31/2023111,979(111,979)
12/31/2024(0)0
Journal entries dr./(cr.)
Right of use assetLease liabilityLease expenseCash
500,000
(500,000)
(88,698)
88,698
118,698
(118,698)
(94,020)
94,020
118,698
(118,698)
(99,661)
99,661
118,698
(118,698)
(105,641)
105,641
118,698
(118,698)
(111,979)
111,979
118,698
(118,698)

Operating lease

Balance sheet
DateRight of use asset balanceLease liability
Inception 500,000
(500,000)
12/31/2020
400,000
(411,302)
12/31/2021
300,000
(317,282)
12/31/2022
200,000
(217,621)
12/31/2023
100,000
(111,979)
12/31/2024
0
0
Journal entries dr./(cr.)
Right of use assetLease liabilityCashInterest expensesDepreciation expenseAccumulated depreciation
500,000
(500,000)
(88,698)
88,698
(118,698)
30,000
100,000
(100,000)
(94,020)
94,020
(118,698)
24,678
100,000
(100,000)
(99,661)
99,661
(118,698)
19,037
100,000
(100,000)
(105,641)
105,641
(118,698)
13,057
100,000
(100,000)
(111,979)
111,979
(118,698)
6,719
100,000
(100,000)

Big takeaways

Your accounting team will be able to handle the calculations involved in this new standard, but the things to be most aware of from a business perspective are:

  • Your organization’s balance sheet will have additional “debt” in the eyes of creditors and other users of your financial statements.
  • The standard will increase your current liabilities with no offsetting current asset.
  • Significant differences will exist between classification as a finance lease versus an operating lease, particularly the recognition of expense. An operating lease will recognize expense on a straight-line basis in expenses from continuing operations, while a financing lease has an interest component that is not reflected in continuing operations.
  • The new standard eliminates the concept of deferred rent assets/liabilities for variable lease payment streams as these will be baked into the calculation of the lease liability.

Things to do now

There are a couple of things that you should be doing now to prepare for the effects of the new standard:

  1. Perform an inventory of your company’s leases. Make sure you have signed copies of the agreements and begin to model the effect of the new lease standard on your balance sheet.
  2. Think about how the new standard will impact the users of your financial statements, including financial covenants, and start conversations now about how those will need to be modified.
  3. Talk to your Henry+Horne accountant about the standard and get ahead of it.
  4. DON’T PANIC. IT’S JUST ACCOUNTING.

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Matt Waller, CPA, Senior Manager, specializes in providing audit, review, compilation and agreed upon procedures services to construction, real estate, manufacturing and distribution clients. You can reach Matt at (480) 839-4900 or MattW@hhcpa.com.