New Lease Accounting Standard
The Financial Accounting Standards Board recently released a new standard related to accounting for leases.
The effective date for this is for fiscal years beginning after December 15, 2019, so for those of you with a calendar year end, it will be effective for your year ended December 31, 2020. While it may seem to be something you can delay based on 2020 being a few years out, there are a few items in the new standard that you should be aware of to better plan for the implementation of the new standard.
We will focus on the lessee side. If you are the lessor, please contact us for information on the changes to how a lessor will recognize leases and lease transactions.
General Information About the New Standard
The new lease accounting standard has one significant change from the current lease accounting standard. The new standard requires all leases to be recognized on the balance sheet (statement of financial position), not just capital leases. The standard encompasses both equipment and real estate leases, and requires an asset be recognized which represents the right-of-use of the leased item. It also requires that a lease liability be recognized. The activity that is reported on the income statement (statement of financial activity) is very similar to the current standard.
To implement the new standard in 2020, you will be required to recognize any existing leases with more than twelve months remaining of the lease term on your balance sheet. If you present comparative financial statements, this also has to be presented for 2019. So, if you enter into a lease in the next year that has a term of five years or more, you will need to calculate the right-of-use asset and the lease liability that remains for the end of the lease for presentation in your 2020/2019 financial statements.
Additionally, the right-of-use asset may need to be classified as a non-current asset, while the current portion of the lease liability will be in the current liability section. This will impact ratios such as your current ratio, which may impact any debt or other covenants that your company has for loans or other commitments that may be based on financial ratios.
The new standard does not apply to the following types of leases:
- Leases of intangible assets.
- Leases to explore for or use such things as minerals, oil, natural gas and similar resources.
- Leases of biological assets, including timber.
- Leases of inventory.
- Leases of assets under construction.
You may make an accounting policy election, by disclosing the election in your financial statements, to not recognize leases of twelve months or less by class of the underlying asset.
How to Determine if You Have a Lease, and What Type of Lease It Is, if You Have a Lease
At the start of a contract, you must determine if the contract is a lease or if the contract contains a lease.
A lease is defined as a contract or part of a contract that conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration.
Control over use means the customer has both:
- The right to obtain substantially all of the economic benefits from the use of the asset.
- The right to direct the use of the asset.
It is important to look at the facts and specifications of the contract to determine the benefits and the right to direct. For example, one contract for fiber optic cable may provide three specific identified strands of fiber which are connected into your network, and you have the right to use those three strands for just your traffic and you direct how data is transmitted. This would be a lease. However, if you were given the capacity of three strands of fiber, but you had to connect to the fiber optic cable company to submit your traffic and they determined how the data is transmitted, that would not be a lease.
The contract may include other items which are not a lease, for example, a maintenance contract for the item being leased. You may make an accounting policy election, by disclosing the election in your financial statements, to not segregate out the non-lease components. However, if the value of those non-lease components is significant, that increases the right-of-use asset and the lease liability significantly.
On the lessee side there are two types of leases, a finance lease and an operating lease.
A lease is classified as a finance lease if (all must be true):
- The lease transfers ownership of the 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.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee 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.
If these are not all met, the lease is an operating lease.
The balance sheet now has a new right-of-use asset and a lease liability which is initially recognized as the present value of the future lease payments, plus any payments made to the lessor before the commencement date of the lease, less any incentives paid to the lessee by the lessor and any initial direct costs of the lessee. The present value is determined by using the rate implicit in the lease. If that rate cannot be determined, use the lessee’s incremental borrowing rate. The new standard does allow a practical expedient for non-public companies which allows the use of the risk-free interest rate.
The income statement will now recognize interest expense separately from the amortization of the right-of-use asset.
On the statement of cash flows principal payments on the lease go in the financing section, while interest and any variable payments go in the operating section.
If the lease does not meet all of the requirements above for a financing lease, it is an operating lease.
The balance sheet now has a new right-of-use asset and a lease liability computed the same as a finance lease.
On the income statement there is a single lease cost, generally calculated on the straight-line method.
On the statement of cash flows all activity related to the lease goes into the operating section.
Assistance in Implementing This New Standard:
In the future, we will provide further updates and more detail, including how to account for changes and modifications to contracts that are leases or include leases.
The following links provide additional information on the release of this standard.
Fact Sheet: Accounting Standards Update
If you do have any questions or concerns, please feel free to contact us.