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Accounting for Leases: What’s Going On Here?

by Eric Martinez on October 4, 2016

Virtually all businesses and organizations are parties to any number of leases—real estate, machinery and equipment, copy machines and automobiles, to name some of the most common arrangements. Accounting for leases under accounting principles generally accepted in the US (US GAAP) has been stable and predictable for years, with a basic 4-part test used to determine whether the underlying leased asset should be capitalized on the balance sheet of the organization, or otherwise expensed and disclosed as a commitment in the notes to the organization’s financial statements.

Under current US GAAP, leases are classified as either capital leases or operating leases. Assets acquired through a capital lease are recorded on the organization’s balance sheet at cost and the lease is recorded as a current and/or non-current liability depending on the term of the lease. Property acquired through an operating lease is not recorded on the organization’s balance sheet under the premise that the benefits of ownership have not been effectively transferred to the lessee. The amounts due under operating leases are likewise not recorded as liabilities on the organization’s/lessee’s balance sheet. However, organizations with operating leases, to the extent they are significant (material is the accounting term of art) either individually or in the aggregate, must disclose in the notes to their financial statements the amounts they are committed to pay annually pursuant to the operating leases over the next 5 years and an aggregate amount for any operating lease commitments thereafter.

A primary concern expressed by various users of financial statements and by the Financial Accounting Standards Board (FASB) is that the balance sheets of organizations with operating leases are potentially misleading because such organizations may have material commitments under operating leases that don’t appear on the balance sheets of such organizations. Moreover, for those organizations issuing financial statements pursuant to International Financial Reporting Standards (IFRS), virtually all operating leases are recorded on the balance sheets, such that there has been a significant divergence in the accounting for leases under US GAAP when compared to IFRS. Within this context, FASB instituted the pending changes to US GAAP to converge the related accounting with that of IFRS, which is the predominant global reporting standard.

The pending FASB standard is effective for publicly traded organizations in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years; for all other organizations, the changes will take effect in fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.

Under the pending FASB standard, virtually all leases will be accounted for in a manner similar to the current accounting for capital leases, with attendant assets and related lease liabilities on the balance sheets of the lessee organizations. The classification of a lease as a financing lease or an operating lease will be determined not according to the basic 4-part test referenced above, but rather based largely upon professional judgment with certain of the 4-part test requirements carrying over to the new classification methodology. Leases that don’t qualify as finance leases under the pending FASB standard will be classified as operating leases, which as noted above, will still require the lessee to capitalize the value of the lease asset and recognize a lease liability. There is one exception to the general rule of capitalizing the leased asset and related lease liability: where a lease term is 12 months or less, a lessee can elect not to recognize lease assets and lease liabilities, and “should recognize lease expense for such leases generally on a straight-line basis over the lease term,” which is essentially the same treatment accorded operating leases under current US GAAP.

The new lease guidance is lengthy and far more complex than provided for in this brief synopsis, as evidenced by the 185 pages of related FASB guidance.

A note to lenders: be sure to start discussions with your customers sooner rather than later as it relates to their lease portfolio. To the extent that leases currently classified by their customers as operating leases will require capitalization of the value of the leased asset and recognition of a lease liability under the pending guidance, the related balance sheet changes may significantly change the calculations of financial covenants associated with loans granted by the lenders. Covenants that were met under calculations incorporating the current lease guidance may not be met when the calculations incorporate the pending guidance.

A final note to organizations with leases: the transition guidance promulgated by FASB allows for a number of “practical expedients” regarding leases currently in effect at the time the new guidance goes into effect. Pursuant to the new guidance, “an entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.” In other words, leases classified as capital leases under the existing guidance will be treated as finance leases under the pending guidance, and leases classified as operating leases under the existing guidance will continue to be considered operating leases under the pending guidance, and the reporting entity will need to recognize lease assets and lease liabilities for such operating leases (unless they meet the 12 month exception described above) as of the earliest period presented in the financial statements.

By Eric Martinez, JD, CPA

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