A fter a nearly 10-year collaboration to develop a converged standard on leasing, on Jan. 13, 2016, the IASB issued IFRS 16, Leases, and on Feb. 25, 2016, FASB issued Accounting Standards Update (ASU) 2016-02, Leases—Topic 842. The two standards differ on some points, but each accomplishes the joint objective of recognizing that leases give rise to assets and liabilities that should appear on the balance sheets of lessees. The purpose of this article is to introduce the main features of the new FASB standard and provide illustrations of how accounting and financial statement presentations for lessees will change.
The first significant effort to cope with lease accounting came in November 1976, when FASB issued Statement of Financial Accounting Standards (SFAS) 13, Accounting for Leases, based on the principle that a lease “that transfers substantially all of the benefits and risks incident to the ownership of property should be designated a capital lease and accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing by the lessor.” Leases not meeting this definition were classified as operating leases, requiring only note disclosure.
To identify the characteristics that distinguished a capital lease from an operating lease, SFAS 13 established four criteria:
- A lease that transfers ownership of the leased asset to the lessee at the end of the lease term
- A lease containing an option allowing the lessee to purchase the leased asset at a bargain price at the end of lease term
- A lease term greater than or equal to 75% of the asset’s economic life
- A lease where the present value of the minimum lease payments (including any required lessee guarantee of residual value of the leased asset to the lessor at the end of the lease term) was greater than or equal to 90% of the fair value of the leased asset at the inception of the lease.
If any single criterion was met, a lease was deemed to be a capital lease for the lessee, requiring the leased asset and the related lease liability to be listed on the balance sheet. For the lessor, it was deemed either a sales-type lease or a direct financing lease, to be reflected on the balance sheet as a lease receivable. Leases not meeting any of the four criteria were considered operating leases for both lessees and lessors.
The Flaws in SFAS 13
Lessees quickly found easy ways to elude the four criteria for designation as a capital lease. Simply excluding transfer and purchase features from a lease could circumvent the first two criteria, and the “bright lines” of the remaining two criteria were sidestepped with terms, interest rates, and other stipulations engineered to stay below the 75% and 90% thresholds. Consequently, most lease agreements qualified as operating leases and avoided balance sheet presentation.
Lessors also had good motivation to avoid operating lease classification, as most lessors were financial institutions subject to regulations that allowed them to keep leased assets on their books only briefly, not long-term. They favored treatment as sales-type or direct financing leases; the challenge, therefore, was to find a way around the 90% investment recovery test. Discovery of a solution did not take long:
- If the lessor’s implicit interest rate (the interest rate the lessor used to determine the lease payments for the leased asset) was either “unknown” to the lessee or could not be determined, it was allowed to use its higher incremental borrowing rate to produce a present value of the minimum lease payments that fell below the 90% investment recovery test
- If the lessee obtained an insurance policy from a third-party guarantor to guarantee the residual value of the leased asset to the lessor at the end of the lease term, it could exclude the guaranteed amount from its minimum lease payments calculation so as to stay below the 90% investment recovery test threshold. At the same time, the guaranteed residual value would remain part of the lessor’s minimum lease payments calculation, allowing it to exceed the 90% barrier (Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield, Intermediate Accounting, 16th ed., Wiley, 2016).
Changing lease accounting to reflect the economic reality of lease obligations on lessees’ financial statements meant overcoming the vested interests of powerful interest groups.
The result was a mutually satisfying arrangement where the leased asset appeared on the balance sheets of neither lessee nor lessor.
The Catalyst for Change
Changing lease accounting to reflect the economic reality of lease obligations on lessees’ financial statements meant overcoming the vested interests of powerful interest groups. These obstacles appeared insurmountable until the accounting scandals and corporate failures of 2001 and 2002 brought to light the prevalence of deceptive off–balance sheet arrangements. In response, Congress quickly passed the Sarbanes-Oxley Act of 2002 (SOX). SOX section 401(c) proved particularly helpful to advocates for transparency in corporate accounting, requiring the SEC to conduct a study of off–balance sheet arrangements to determine “the extent of off–balance sheet transactions, including assets, liabilities, leases, losses, and the use of special purpose entities; and whether generally accepted accounting rules result in financial statements of issuers reflecting the economics of such off–balance sheet transactions to investors in a transparent fashion.”
The SEC’s report to Congress was released on June 15, 2005. The SEC staff presented the results of an empirical study which determined that approximately 63% of issuers reported off–balance sheet operating leases, with associated undiscounted future cash flows of nearly $1.25 trillion (Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers,http://bit.ly/2tnZ3Eq).
The SEC report suggested that FASB undertake a project to revise lease accounting standards, further stating that the project would be more effective if it were a joint effort with the IASB. Accordingly, in 2006 FASB and the IASB began to work together to produce a converged standard that would finally deliver the reporting transparency absent from earlier accounting standards. It was a difficult task, but the lease convergence project bore fruit in February 2016.
The New Standard
ASU 2016-02, which is effective for publicly traded companies after Dec. 15, 2018, states that all leases, whether classified as operating or capital leases (called “finance leases” under the new standard), create a right-of-use asset and a liability that should appear on the lessee’s balance sheet. The only exception is for leases with a term of 12 months or less. For such short-term leases, a lessee is permitted to make an accounting policy election not to recognize leased assets and lease liabilities, and instead recognize lease expenses on a straight-line basis over the lease term, consistent with the accounting for operating leases under SFAS 13.
There are now five criteria for determining if a lease is a finance lease. The criteria from SFAS 13 have been slightly modified by dropping the phrase “bargain purchase option” from the second criterion and removing the bright lines of the 75% of economic life lease test and the 90% fair value investment recovery test. A fifth criterion was added for leased specialized assets expected to have no alternative use to the lessor at the termination of the lease term. Interestingly, this added criterion was previously considered for inclusion in SFAS 13, but was rejected because it was considered too difficult to objectively define.
Thus, under the new standard, a lease is a finance lease if any of the following conditions is met at inception:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset, unless the commencement date of the lease falls at or near the end of the economic life of the underlying asset.
- The present value of the sum of lease payments and any residual value guaranteed by the lessee not already reflected in lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
In addition, the new standard does not permit the lessee to exclude a guarantee of residual value from the lease payments by obtaining an insurance policy for the benefit of the lessor. While these changes make the criteria more principles-based and avoid the “on-off” switches of SFAS 13, the distinction between an operating and a finance lease is less vital for the lessee because all leases greater than 12 months must appear on its balance sheet.
Lessee Accounting for Finance and Operating Leases
Accounting for finance leases is generally consistent with the current guidance for capital leases. The lessee’s balance sheet must show a right-of-use asset and a lease liability initially recorded at the present value of the lease payments (plus other payments, including variable lease payments and “amounts probable of being owed by the lessee under residual value guarantees”). The discount rate is the lessor’s implicit rate or, if not determinable, the lessee’s incremental borrowing rate for a similar collateralized loan in a similar economic environment. On its income statement, the lessee must recognize interest expense on the lease liability calculated using the effective interest method. The interest expense should be reported separately from the amortization of the right-of-use asset. Finally, interest payments and variable lease payments are shown in the operating activities section on the statement of cash flows, while principal payments on the lease liability should appear in the financing activities section.
For operating leases with a term greater than 12 months, lessees must show a right-of-use asset and a lease liability on their balance sheets, initially recorded at the present value of the lease payments calculated the same way as required for finance leases. On its income statement, the lessee does not record interest expense and amortization expense for the right-of-use asset separately. Rather, the lessee must recognize a single lease expense (which includes both interest and amortization) allocated over the lease term on a straight-line basis (or other rational and systematic basis if more representative of benefits received from the leased asset). All cash payments must appear in the operations section of the lessee’s statement of cash flows.
The following illustrations demonstrate the basics of how lessees will be required to account for finance and long-term operating leases and present them on their financial statements under the new standard.
Exhibit 1 illustrates a finance lease, including the calculations, amortization table, and required journal entries. Exhibit 2illustrates an operating lease, including the calculations, amortization table, and required journal entries.
Illustration of Lessee Accounting for a Finance Lease
Illustration of Lessee Accounting for an Operating Lease
Financial statement presentation includes a few more rules for lessees.
For finance and long-term operating leases, the following must be presented on the balance sheet (or disclosed in the footnotes) separately from one another and from other assets and liabilities:
- Finance lease right-of-use assets and operating lease right-of-use assets
- Finance lease liability and operating lease liability.
This is demonstrated in Exhibit 3.
Balance Sheet Presentation for Finance and Operating Leases
For finance leases, interest on the finance right-of-use liability and amortization (depreciation) on the finance right-of-use asset are not shown separately from other interest and depreciation expenses on the income statement. Rather, they are presented in the same manner as the entity presents all other interest and depreciation expenses on similar assets. For operating leases, lease expense will be included among operating expenses. These requirements are demonstrated in Exhibit 4.
Income Statement Presentation for Finance and Operating Leases
Statement of cash flows.
For finance leases, cash payments for interest on the lease liability are treated the same way as those paid to other creditors and lenders and should appear in the operating activities section of the statement of cash flows. Principal repayments of the finance lease liability should appear in the finance activities section. For operating leases, cash payments are included in the operating activities section, as well as variable lease payments and short-term lease payments not included in the lease liability. Cash payments for costs incurred to put the leased asset in a condition and location required for its intended purpose and use should appear in the investing activities section. For both finance and long-term operating leases, disclosure of non-cash investing and financing activities is consistent with current guidance when “obtaining a right-of-use asset in exchange for a lease liability.” These requirements are demonstrated in Exhibit 5.
Statement of Cash Flows Presentation for Finance and Operating Leases
Transitioning to the New Standard
Early adoption of the new standard is permitted, and the transition requires lessees with operating leases longer than 12 months to restrospectively recognize right-of-use assets and lease liabilities at each reporting date, based on the present value of the remaining minimum rental payments reported under the current guidance. Even though the new standard does not take effect for public companies until 2019, preparers will want to start assembling the 2017 and 2018 data they will need to present on their 2019 comparative financial statements.
Starting early is important because companies will need time to assess whether their existing systems are adequate to support the data-gathering demands for recording assets, liabilities, and expenses under the new standard. First, companies must be certain that the entire population of leases is identified. Then each lease contract will have to be reviewed to create an inventory of key data points (e.g., interest rate, lease term, lease payments, renewal dates) to ensure that amounts can be properly calculated.
How prepared are public companies to meet this challenge? Companies with good lease management software and centralized data systems will have a headstart over those with decentralized data systems that rely on spreadsheets for tracking their lease data. Recent surveys by PricewaterhouseCoopers and Ernest & Young (http://pwc.to/2vlq78v and https://go.ey.com/2un5rzM) found that most companies relied on spreadsheets to track and account for leases. EY’s study concluded that spreadsheets were so prevalent because most companies had operating leases, which were off the balance sheet, and saw little need to develop more sophisticated systems to track them. Given the demands of the new standard, however, that logic no longer applies, and companies will have to address the shortcomings their systems long before 2019.
Because the new standard requires the lessee to record an asset and a liability on its balance sheet for all leases greater than one year, the long overdue goal of reporting transparency for lease obligations appears to have finally been achieved. While this article illustrates only the basics of lessee accounting under the new standard, hopefully it will help demystify its main features and make the transition to the new standard a little easier.