Preparing For the New Lease Accounting Standard
When the Financial Accounting Standards Board (FASB) unveiled its new lease accounting standard in February of 2016, the January 2019 implementation date felt like a lifetime away. As the implementation deadline looms closer, we recognize the urgency to buckle down and make some changes. Accounting Standards Update No. 2016-02, Leases, Topic 842 (ASU 2016-02) will fundamentally change how companies account for leases, and its implementation will require buy-in from multiple functional areas of the organization – accounting, tax, financial planning, operations, legal, and information technology, just to name a few. At WNDE, we can answer all of the questions, both big and small, that management is asking about the new standard, and together we can ensure a successful implementation.
Big Picture: Why is the Standard Changing?
The new standard was created to improve the transparency and comparability among organizations that lease buildings, equipment, and other assets. It will help investors and other users of financial statements more readily and accurately understand lessees’ rights and obligations that are tied up in these lease agreements.
There are two different effective dates for complying with this new accounting standard – one for public companies, and one for private companies.
For public companies, the new leases standard is effective for fiscal years that begin after December 15, 2018. For calendar-year entities, this would place their effective date at January 1, 2019.
Private companies get an entire extra year before they have to implement ASU 2016-02, which means that calendar-year private entities would have until January 1, 2020.
The Old vs. the New Standard
The leases model under current Generally Accepted Accounting Principles in the United States (GAAP) deals with two types of leases: capital and operating leases. Capital leases are typically long-term leases of business equipment, and during the lease period, lessees are treated as if they are owners of that equipment. Often, the title of the equipment will pass to the lessee at the end of the lease term. Operating leases, on the other hand, are typically shorter in term and are for property that will be upgraded frequently or switched out often (e.g., computers). Under existing GAAP, both capital leases and operating leases are represented on the income statement, but only capital leases are on the balance sheet. This approach will change under the new leases standard. Going forward, a lessee will recognize both capital leases and operating leases on the balance sheet.
Details on the New Standard
The new standard will separate leases into three categories.
Finance Leases (FKA Capital Leases)
Finance leases will be accounted for in substantially the same manner as capital leases are accounted for under existing GAAP.
Operating leases will be accounted for, both on the income statement and the statement of cash flows, in a manner consistent with operating leases under existing GAAP. However, as it relates to the balance sheet, organizations will have to make some changes. Lessees will represent their operating leases on the balance sheet as (1) a liability to make lease payments, and as (2) an asset representing their right to use the underlying asset for the lease term (commonly called a “right-of-use” asset).
Additionally, leases for assets that are so specialized that they aren’t expected to have an alternative use at the end of the term would need to be reclassified as finance leases. These types of leases have historically been considered operating leases.
Short term leases, which are any leases for a duration of less than 12 months, are treated a bit differently. Lessees can elect not to recognize short-term leases on their balance sheet and instead account for them as “executory contracts.” By doing this, lessees would account for these short-term leases in the same manner that operating leases are accounted for under existing GAAP. They would not be reported on the balance sheet, and would only show up on the income statement.
Careful consideration is required when evaluating the length of a lease. For example, a month-to-month lease may not qualify as a short-term lease if the lessee is economically compelled to renew the lease beyond the next 12 months. This renewal obligation might exist when:
• The leased asset is of a specialized nature and difficult to replace, or
• The leased asset is necessary to fulfill customer orders under a long-term contract, so it’s commercially disruptive to exit the lease.
Correctly classifying and recording the leases is just the beginning. The new leases standard will also require lessees to provide qualitative and quantitative disclosures to help financial statement users assess the amount, timing, and uncertainty of cash flows arising from leases. These disclosures are intended to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an organization’s leasing activities.
Implementing the New Standard: Plan, Plan, Plan
Because the new standard will affect multiple functional areas, we encourage companies to develop a robust project plan that describes their path to implementation. Your plan may look different from others in your industry based on some of the following factors:
• How open your work culture is to the changes (e.g., tone at the top);
• The quality of resources you have to support the plan (e.g., dedicated staff members);
• The complexity of changes you will need to make to shore up your accounting policies;
• How far your existing assumptions and judgements will need to shift; and,
• How ingrained your current data collection, processing, reporting, and disclosures procedures are.
Because this new standard requires you to treat leases differently, you’ll need to make sure you classify your leases appropriately. Ask yourself some of the following questions about each lease to help you assign the correct classifications. And keep in mind that your classifications may differ from your classifications under existing GAAP.
• Does the lease transfer ownership at the end of the lease?
• Is there a bargain purchase option?
• Is the lease term for the majority of the asset’s useful life?
• Does the present value of the lease payments exceed the fair value?
• Is the asset so specialized that it’s expected to have no alternative use after we’re done with it?
Once you have correctly classified your leases, understand how you should account for them, and incorporate those changes into your plan. Operating leases are the ones that will need to be accounted for drastically differently than in years past. You will need to:
• Record the leased asset at fair value on the balance sheet as a right-of-use asset.
• Record a lease liability that represents the present value of the lease payments. Use the implicit rate in this calculation, and don’t forget to include executory costs like property taxes and insurance.
• Throughout the year, record your lease expense on straight-line basis.
• Separate your direct costs from your indirect costs (e.g., the actual lease versus the monthly maintenance costs).
• Organize your balance sheet so that your leased assets are shown separately from the other assets that you own.
This plan may shift and change as time goes on, but it’s important to begin working on it now. Your balance sheet will look significantly different after you implement the new standard, and you want to prepare your key employees, management, and investors for this change. And don’t forget to communicate these plans to your audit committee, as well.
Operating Lease Journal Entry Example
Let’s look at a simple example of how an operating lease will be recorded under the new leases standard.
A private company is leasing a copier for $939.70 per month, and at December 31, 2019, they have 22 payments remaining on the lease. Their interest rate is 4.95%, and the present value of the lease agreement is $19,725.
Journal Entry at Implementation
Because this is a private company, their implementation date is January 1, 2020. On January 1, 2020, they will need to place this finance lease on the balance sheet by making the following entry:
DR: Right-of-Use Asset $19,725
CR: Lease Liability $19,725
this records the lease on the balance sheet at the present value of the lease agreement.
Year 1 Journal Entries
The next year, they will need to record entries to both the income statement and the balance sheet.
DR: Lease Expense $11,276
CR: Cash $11,276
this records the monthly cash outlay, which is similar to how they would have recorded it in the past: $939.70/mo x 12 mo = $11,276
DR: Lease Liability $10,537
CR: Right-of-Use Asset $10,537
this records the annual reduction in the present value of the lease agreement
Year 2 Journal Entries
In Year 2, their lease term comes to an end.
DR: Lease Expense $9,397
CR: Cash $9,397
this records the monthly cash outlay: $939.70/mo x remaining 10 mo = $9,397
DR: Lease Liability $9,188
CR: Right-of-Use Asset $9,188
this records the reduction in the present value of the lease agreement; at the end of the lease term, the lease liability and the right-of-use asset will have been reduced to zero
Other Implementation Considerations
Throughout the implementation process, management will make certain assumptions and estimates that will ultimately need to be disclosed and/or written into the organization’s accounting policies. For example, management might decide that there is one way to determine which contracts are considered leases, or they might make assumptions about how the present values are calculated. These judgments, and the impact of these judgments, should be disclosed to the audit committee and written into the policies and procedures when possible.
Keep in mind that additional disclosures beyond those involving judgments are required. Even before your company adopts the new standard, you should be disclosing:
• what your implementation plan looks like;
• how changes made in the interim period will impact your financials;
• how changes you make after implementation will impact your financials;
• what management’s strategy is for drafting the new disclosures; and,
• what your process is for developing new internal controls.
After implementation, your financials should include the quantitative and qualitative disclosures that ASU 2016-02 demands. These disclosures are robust and far-reaching. The following list represents just a sample of what you will be required to disclose:
• A general description of your leases.
• The options you have available to extend or terminate your leases.
• The terms and conditions of variable lease payments.
• Identification of subleases.
• Information about future leases.
• The allocation of contract liabilities between lease and nonlease components.
• Gain or loss from the sale of leaseback agreements.
Finally, thought should be given to company-specific considerations including control readiness and statutory reporting requirements.
ASU 2016-02 has a lot to say about leases, and it will almost exclusively impact lessees. Lessor accounting won’t change much with this new standard. If you are a lessee of assets or equipment and you are required to conform to GAAP, make sure that you are addressing the issues we’ve discussed today. We suggest you tackle one concern at a time. You can begin by asking yourself some of these questions:
• How will our accounting processes change under the new standard?
• Is my organization on track for successful implementation?
• Do we have an accurate understanding of the lease population (e.g., by type, system, and location)?
• Has the company identified all contracts that are or contain leases?
If you need help answering these questions, or would like an expert to walk you through the implementation process, or need help formalizing your roughly-mapped-out plans, give us a call. Our WNDE CPAs are well-versed in this new standard and are more than happy to help.