In February 2016, the Financial Accounting Standards Board issued the long awaited new standard on lease accounting. As we start digesting the 485-page standard, this series of articles will break down the major areas of change for companies with leasing activities. While the standard does not become effective until 2020 for private companies, modified retrospective transition required by the new guidance will be applied at the beginning of the earliest period presented in the financial statements. Additionally, some lessors may find it beneficial to adopt the changes early and concurrently with the adoption of the new revenue recognition changes, which become effective for private companies in 2019.
Although some of the leasing terminology has changed, many of the concepts are similar to existing guidance. The biggest impact is to the lessee will be the requirement to record leases with terms of greater than one year on its balance sheet. Both capital leases, which are now referred to as finance leases, and the traditional off-balance sheet operating leases will be reflected on the balance sheet as right-of-use assets and lease liabilities. Companies should start examining their existing and new long-term leasing agreements to identify lease components which may be required to be analyzed under the new standard. Other long-term contracts should also be reviewed as leases in the form of service contracts may be embedded within those agreements.
A lease is defined as a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. If the agreement does not specify who controls the asset, the party who directs how the asset is utilized and obtains benefits from the use of the asset is considered the lessee. For example, a contract with an auto dealer to use a fleet of trucks for a period of time is a lease since a lessee controls how the trucks are used. Conversely, a service contract under which delivery trucks are shared with other customers, with the lessor in control of both how the trucks are utilized and which routes they take, would likely not be a lease.
Once the leases are identified, an evaluation of the benefits received under the lease needs to be made in order to segregate any non-lease service components, such as maintenance, cleaning or other repair services, to determine the right-of-use asset amount. That evaluation should use relative standalone prices of the separate lease components. To make this evaluation easier, the standard allows the lessee the option not to separate lease and non-lease components within a contract. However, electing this option will result in recording a larger right-to-use asset and lease liability.
Variable Lease Payments
All variable lease payments are evaluated to determine if they should be recognized in the initial right-of-use asset and lease liability. All variable payments based on an index or rate (such as a market interest rate) are measured at the lease commencement date. Other variable lease payments not based on a specified rate (such as payments based upon performance or future use of the asset) are not included as lease payments. Similar to current guidance, a payment made based on a percentage of sales is excluded from lease payments and expensed as the obligation is incurred.
Renewal options may be included as part of the lease term if the lessee is reasonably certain to exercise the option to extend the lease. The payments for those periods would be included in determining the right-to-use asset and the lease liability. Generally, leases with a term of 12 months or less meet the short-term exception, do not need to be recognized on the balance sheet and are recorded on a straight-line basis as lease expense over the lease term.
Initial Direct Costs
The new standard defines initial direct costs as incremental costs that would not have been incurred if the lease had not been obtained. While certain commissions, legal fees and similar costs may qualify to be capitalized as initial direct costs, other allocated costs (such as fixed employee salaries), which would be incurred regardless of whether a lease was obtained, will generally be expensed.
What to Do Now
Be sure you have a complete inventory of leases, including lease terms, other associated costs and renewal options. Determine if any existing leases have separate components that need to be evaluated. Establish controls and procedures for capturing information for new leases and renewal of existing leases. This will give you a head start on determining the impact the new standard will have on your financial statements.
Stay tuned for the next article in this series on lease accounting, which will take a close look at the income statement impact of an operating lease compared to a finance lease as well as the impact on debt covenants of a lessee.
Stephanie McGuire is a Principal in the Audit, Accounting and Consulting Department of Ellin & Tucker. With more than a decade of expertise, Stephanie has helped develop the firm’s not-for-profit, manufacturing and distribution industries, as well as employee benefit plans, both nationally and internationally. In addition to her financial reporting and business consulting expertise, Stephanie is a leader in Ellin & Tucker’s quality control standards department, which provides the latest accounting pronouncements and standards updates to professionals in the firm. She may be reached at email@example.com.