In February 2016, FASB released Accounting Standards Update (ASU) No. 2016-02, Leases, which substantially changes current accounting treatment for leases. Balance sheets will be significantly impacted, as a right of use asset and lease liability will have to be recognized on most leases.
The update is effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For private companies, the guidance is effective December 15, 2019. A modified retrospective transition method will be used to implement the new standards on financial statements.
New Types of Leases:
- Finance Lease
- Operating Lease
Right-of-use assets and liabilities will be recorded on both types of leases. It’s crucial to determine term of lease, as terms with less than 12 months are not subject to the new rules.
What is a lease?
A contract contains a lease if it gives a customer the right to control the use of the identified asset for a period of time in exchange for consideration. Control exists if the customer has both of the following:
- The right to obtain substantially all of the economic benefits from the use of an identified asset
- The right to direct the use of that asset
Finance Lease
The lease is a finance lease if it meets any of the following criteria:
- 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 assets that 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 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.
Operating Lease
Under the new rules, an operating lease is any lease other than a finance lease.
- In other words, it doesn’t meet any of the criteria listed above.
- It does not include short-term leases (less than 12 months), which is why it is crucial to determine the lease term.
New Disclosures
Lessee’s should disclose in their financial statements
- Separate maturity analysis of its operating lease liabilities and finance lease liabilities (undiscounted cash flows for each of the next five years and a total of the amounts for the remaining years, reconciled to the amounts presented in the balance sheet)
- Cash paid for amounts included in its determination of lease liabilities (segregated between operating and financing cash flows)
- Supplemental non-cash information on lease liabilities arising from obtaining ROU assets
- Weighted-average remaining lease term
- Weighted-average discount rate
What to Do Now
- Determine the impact on business model
- Update lease inventory
- Evaluate impact of balance sheet changes
- Review lease classification policy
- Determine borrowing rates
Key Takeaways
The new standard update significantly alters current accounting treatment of leases. Balance sheets will change significantly and debt-to-equity ratios may be materially impacted.
