Need to get your head around the new leasing standard? Watch this video for leasing 101, from the Lessee’s point of view. Hear Jonathan Rhine discuss identification (including embedded leases), classification as operating or financing, how to measure the lease liability and right-of-use asset, and more.
Hi I’m Jonathan Rhine, and today we’re talking about the new leases standard from the perspective of a lessee.The most significant impact of the new standard is that lessees will now recognize both a lease liability and a related asset on their balance sheet for virtually all leases. Although the guidance is not effective for public companies and certain other entities until 2019, the standard will require significant implementation efforts between now and then.
As a lessee, there’re a number of aspects of the new standard, you’ll want to consider, including:
Let’s discuss each of these in a bit more detail.
The first step is to identify the population of leases. Similar to today, certain types of assets are specifically excluded from the leases standard, such as those related to intangibles, inventory, and certain natural resources. A contract not excluded from the scope may be a lease if it provides a customer with the ability to control an asset that’s either explicitly or implicitly specified. The framework for determining whether control is provided, is consistent with the guidance in the new revenue standard and may require judgement.
Although current guidance already requires that companies identify lease arrangements, that determination was not as significant, since operating leases were off balance sheet, and there was often no meaningful impact on expense recognition. Under new guidance however, if an arrangement is a lease, or has a lease embedded in it, you’ll need to recognize the lease on balance sheet, which makes lease identification more important.
Once a lease is identified, you’ll need to classify it as either an operating lease or a finance lease. Although this classification does not impact day 1 recognition, it will impact both the balance sheet and the income statement over the term of the lease.
If a lease meets any of five criteria specified in the standard, it should be classified as a finance lease because control of the asset is effectively transferred to the lessee. Otherwise, it’s an operating lease. The first four criteria are similar to the current model with one notable difference. The FASB removed the 75% and 90% bright-lines that exist in current guidance, making the standard more principles based.
The 5th criteria, now included in US GAAP, was previously part of the IFRS model. Is the asset so specialized that it’s expected to have no alternative use to the lessor at the end of the lease term. Although this criterion is new, it’s not expected to have a significant impact on classification, since a lessor would normally require that it be fully compensated for a leased asset that has no alternative use.
Once lease classification is determined, the lessee must measure the lease liability and right-of-use asset.
The lease liability is calculated as the present value of the expected payment obligations under the lease. The lease asset equals the lease liability, but is adjusted for certain items such as prepaid rent or unamortized initial direct costs.
Determining the expected payment obligation requires judgment. In addition to identifying the predetermined payments for the non-cancellable portion of the lease, you’ll also need to consider other possible payments.
Let’s discuss three common lease provisions and the impact they have:
While lessees will generally be required to reflect operating leases on balance sheet, they may elect not to capitalize leases with an accounting lease term of one year or less. So if, for example, you have a lease with a stated contract term of 1 year, but you also have one or more renewal options, the lease would not qualify for this short-term lease exception if you’re reasonably certain to exercise one or more of the options.
While the new guidance requires that lessees recognize virtually all leases on balance sheet, the expense recognition will differ based on lease classification.
A finance lease will be similar to a capital lease today. Interest expense will be recognized based on the outstanding lease obligation using the effective interest rate method. Additionally, you’ll amortize the leased asset, often on a straight line basis. The combination of interest and amortization, will typically result in a front loaded expense recognition pattern.
Operating lease expense will typically be recognized on a straight-line basis, similar to how operating leases are accounted for today. However, as a lessee is required to reflect a lease liability and right-of-use asset on its balance sheet, there’s a unique process for amortizing the operating lease liability and asset. Interest expense on the outstanding lease obligation is calculated using the effective interest rate method, so you’ll start with the same front loaded recognition pattern as a finance lease. The lease obligation would be accounted for like other interest bearing obligations, cash paid less interest expense, represents a reduction in the obligation.
The right-of-use asset amortization, however, will be a new concept. It’s calculated as the difference between the lease expense and the interest expense in the period. In other words, it’s a plug.
Although, the total lease expense for operating leases economically includes both interest and amortization components, it’ll be reflected as an operating expense; not as interest or amortization.
Notwithstanding the difference in the timing of expense recognition for finance and operating leases, the total expense over the life of a lease is the same regardless of classification.
A final area of change relates to sale and leaseback guidance. There are two important points I’d like to highlight. Currently, the most prescriptive sale and leaseback guidance is applied only to real estate and certain equipment, but the new sale and leaseback guidance will apply to all equipment as well as other tangible assets. Second, the new guidance replaces the current highly prescriptive rules, with a more principles based approach that’s focused on whether control of the underlying asset has been transferred to the lessor.
Judgment will be required to apply many aspects of the standard. Some companies are already starting to think about adoption and transition. Lessees may find that the most significant impact of the new standard will be the effort required to establish robust processes. Those processes will be needed to support the classification and measurement of related assets and liabilities, as well as the significant additional disclosures required.