In about three years there will be a complete overhaul of the accounting rules for leases.
For a quick introduction to the changes, here are a few of the comments in a recent AICPA webinar. I will keep this nontechnical.
“Right of use” asset
The basic concept is that a lease contract gives you the right to control the use of property, equipment, office space, or some other identified asset for a specific period of time. The economic substance is that the asset is yours to use for the term of the lease.
By creating a “right of use”, the lease contract gives you an asset that needs to be reflected on the balance sheet. In addition the liability for future payments needs to be recognized.
There’s an option to exclude leases with a term under 12 months. For all other leases it will no longer be necessary to make that traditional capital versus operating lease in order to decide whether to book the asset and liability. For a leases over 12 months a “right of use” asset needs to be recorded.
If you want a quick illustration of the implications, this means airlines need to book an asset and liability for all their leased aircraft. Small charities need to book an asset and liability for the five year lease of their office space.
Financing and operating
There will be two types of leases: financing and operating.
To over-summarize the distinction between the two, think financing leases when equipment is used for essentially most of its life. These will roughly correlate to leases that are currently treated as capital.
In general, think of operating leases as basically leases which are currently categorized as operating. This would include office space up to a 10 year term. Yes, the lease of your office will be recorded as an asset with the future payments recorded as a liability.
If you want a very rough picture of how to account for the leases after they are recognized on the balance sheet, think in terms of the old capital versus operating lease treatment. Financing leases will be amortized with payments split between a pay down in the principal and interest expense. Operating leases will have a straight-line amortization to expense, which means the right of use asset and liability will both be reduced by the amount of the lease payment.
On the cash flow statement, payments on a financing lease will be split between operating cash flow for interest and financing cash flow for the principal. An operating lease will be reflected entirely in the operating section on the cash flow statement.
Other major changes
The initial measurement of leases will only include optional renewal terms if it is “reasonably certain” the renewals will be exercised. That is a relatively high threshold.
As a wonderful relief from the drafts, valuation of the right of use asset and liability will only be remeasured when there are significant events or changes. Previously there was an annual reassessment of whether lease options would be exercised.
Financing leases will be capitalized at the risk free rate. That translates into interest rates on treasury securities, which are very easy to find. This will be a welcome relief from the current requirement to track down the implicit rate in a lease, and if that’s not available determine the incremental borrowing rate.
Volume of disclosures under the new rules will be increased substantially.
For public companies this will apply for fiscal years beginning after December 15, 2018. That means calendar years ending December 31, 2019 or later.
For other companies, which will include essentially all nonprofit organizations, there is a one-year delay. For those entities the new accounting is required for fiscal years beginning after December 15, 2019. That is calendar years ending December 31, 2020 or later.
For most readers of this blog, that means an effective date of 12/31/20.
While that might be four and a half years from now, it is not too early to start planning.
For more information
That is just a quick introduction so you can get a feel for the overall structure of the new rules.
Here is the technical detail – The actual changes are in FASB’s Accounting Standards Update No. 2016-02, Leases (Topic 842).
The old lease standards were in ASC 840; the new standards will be in section 842.