New FASB Leasing Standard Updates and Guidance
After several adoption date delays, it’s now time to get serious about adopting the new leasing standard. Businesses must begin using the standard in their 2022 fiscal year, and start preparing in 2021.
As a brief reminder, in 2016 the Financial Accounting Standards Board (FASB) issued guidance (ASU 2016-02 Leases, Topic 842) related to lease accounting. The update has significant impact on the balance sheets of lessees. The lessor accounting has also been updated and will align with some of the changes to the lessee accounting and certain aspects of the new revenue recognition standard. The revisions to accounting for leases will impact nearly all business entities.
The standard was originally part of the convergence efforts between the FASB and the International Accounting Standards Board (IASB). However, the final decision was made to issue two separate standards as the two boards could not find common ground. Here is a summary and some important considerations.
Lessee Accounting Basics
The new leasing model requires a lease to be classified as either operating or finance using similar criteria to the existing lease accounting. However, both an operating lease and a finance lease will require recognition of a right-of-use asset and a lease liability on the balance sheet (there is an exception for leases that meet the definition of a short-term lease which is 12 months or less including any renewal periods). The right-of-use asset is initially measured at the present value of the lease payments. Once the right-of-use asset and lease liability are recorded, operating leases will result in a straight-line expense to amortize the right of use asset over the lease term and the lease liability will decrease as payments are made. Finance leases will have amortization expense related to the right-of-use asset but will also have interest expense related to the lease liability which is treated like debt, similar to today’s capital lease accounting. This will result in higher amounts of lease expense recognized early in the lease and lower lease expense in the later years due to the declining liability balance and related interest expense.
Lessor Accounting Basics
The new model does not result in significant changes to the lessor accounting. Lessors will still classify leases as operating, direct financing or sales-type leases. There is a new requirement for the lessor to assess the collectability of the lease payments. The lessor changes align the accounting with the lessee accounting and the lease revenue is subject to the new revenue recognition standard ASC 606.
The revised leasing standard also impacts sale-leaseback transactions by linking the existence of a sale to the new revenue recognition guidance. In the new model, a sale-leaseback transaction will qualify as a sale when:
- It meets the criteria for a sale in the new revenue recognition standard
- The leaseback is not a sales-type or finance lease
- If there is a repurchase option, it is priced at the asset’s fair value on exercise and is not a specialized asset
If the transaction can be treated as a sale, the leaseback is analyzed the same as all other lease transactions; however, if the transaction cannot be treated as a sale, it is recorded as a financing transaction.
The new lease guidance will be effective for private companies in periods beginning after December 15, 2021. The standard requires modified retrospective application.
There are many things to consider in advance of the implementation date to minimize the impact to your business. Because of the additional assets and liabilities that will have to be recorded on the balance sheet there may be significant impacts on many of the financial metrics provided to management, owners and third parties (i.e., debt covenants). Business owners will want to evaluate whether a lease provides the same benefits since it no longer provides off-balance sheet financing.
Here are some steps to take when preparing for the new leasing standard:
- Make sure accounting personnel understands the new standard and can help educate anyone in the organization who may be responsible for negotiating new leases.
- Perform a review of existing leases and record them in a central place.
- Consider service contracts that may have a leasing element or embedded lease within the contract.
- Quantify the anticipated effects of the new standard on existing leases as of the implementation date.
- Put systems and controls in place to capture all data required to properly account for the leases.
- Communicate the impact of the implementation of the standard with the bank or other key stakeholders.
- Determine if a special purpose framework such as the AICPA Framework for Financial Reporting for Small and Midsize Entities (FRF-SME) would be more beneficial to the readers of the financial statements. The new leasing standard and revenue recognition standard will not impact the FRF-SME.
If you have questions about the new FASB leasing standard, we can help. Contact us today to learn more.