New guidance from the Financial Accounting Standards Board will change how tenants account for leases in coming years.
THE FINANCIAL ACCOUNTING Standards Board (FASB) issued its long awaited Accounting Standard Update on accounting for leases on February 25, 2016. The main provisions call for all lease transactions (with terms in excess of 12 months) to be recorded on the balance sheet of the lessee (the tenant). In general, this recognition will be accomplished by recording a lease liability. This is determined by calculating the present value using the interest rate implicit in the lease and the expected lease payments, including lease escalators and options, if those options are likely to be exercised. A “right-to-use” asset will then be recognized at the same amount as the lease liability. After initial measurement, the lease liability will be reduced based on the lease payments and the right-to-use asset will be amortized over the life of the lease, normally using the straight-line method.
The FASB retains the current two-lease type model for income statement measurement. Leases meeting the definition of a “finance” lease, using the same criteria in current generally accepted accounting principles (GAAP), will be recognized through interest expense and amortization expense, similar to the current recognition model.
All other leases are defined as “operating” leases and will be recognized on a straight-line basis as the lease payments are made, with the expense recognized as a rent. The standard is quite comprehensive and consolidates all of the various lease guidance that exist currently in Accounting Standards Codification (ASC) 840, Leases. This includes accounting for sale-leaseback transactions and guidance on determining expected lease payments and lease terms. The updated standard contains numerous examples to assist with adoption. It also requires more extensive disclosures than those required by ASC 840.
For public entities, the effective date for the new standard is December 15, 2018. The effective date for non-public entities is December 15, 2019. Earlier adoption is permitted for all entities. The new standard generally has little impact on lessors (landlords), other than conforming terminology developed in ASC 842.
This standard will have a significant impact on all entities that currently engage in leasing activities. The transition to the new standard will require detailed analysis of each lease, with attention paid to options and other features that may lead to variability in the expected term and lease payments. Once this analysis is performed, a detailed discount calculation must be made for each lease. Then decisions must be made to classify each lease as an operating or finance lease, based on the terms of the lease. Thereafter, a schedule for expense recognition must be created for each lease in order to properly report expenses and reduce the carrying amounts on the balance sheet. All entities that enter into leases should consider this carefully when planning for the transition, including necessary adjustments to internal control over financial reporting and changes to information systems to accumulate the requisite data for financial reporting and new disclosure requirements.
For entities that rely heavily on leasing, the change to the balance sheet will be meaningful, with changes in traditional leverage ratios such as debt to equity likely. These changes may necessitate discussions with lenders and investors to manage expectations and to anticipate potential adjustments to covenants and other loan terms. While cash flows will remain the same, it is possible that classifications in the statement of cash flows might differ.