Lease Accounting

On February 25, 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited standard requiring lessees to recognize all leases with terms greater than 12 months on their balance sheet as lease liabilities with a corresponding right-of-use (ROU) asset. Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), maintains the dual model for lease accounting, requiring leases to be classified as either operating or finance, with lease classification determined in a manner similar to existing lease guidance.

Lessee Accounting Model

Under the ASU, lessees should recognize in their statement of financial position a liability to make lease payments (i.e., lease liability) and an ROU asset representing their right to use the underlying asset for the lease term. Today’s capital leases and new leases determined to be effective installment purchases by the lessee will be classified as finance leases, while current operating leases will retain their classification.

A lessee will recognize the value of the asset created by the lease as an ROU asset and a corresponding lease liability for the minimum lease payments, discounted at the rate implicit in the lease.  If the rate isn’t known, the lessee’s incremental borrowing rate will be used.  Private companies are permitted to use risk-free rates. To help mitigate debt covenant concerns, FASB decided companies should classify lease liabilities as operating obligations in the financial statements, rather than obligations equivalent to debt.

Lessees will maintain substantially the same expense recognition patterns for operating leases and finance leases (i.e., existing capital leases) as under the existing lease standard. Changes come in terms of the balance sheet and ongoing lease administration.

Lessor Accounting Model

Lessor accounting is substantially unchanged – with the exception of targeted improvements aligning lessor accounting with the lessee accounting model and updated revenue recognition guidance issued in 2014 under Topic 606. Lessors will determine lease classification based on whether the lease is effectively a financing or a sale, rather than an operating lease—the concept underlying existing generally accepted accounting principles (GAAP).

Lessors will continue to reflect the underlying asset subject to the lease arrangement on the balance sheet for leases classified as operating; they also will continue to recognize lease income generally on a straight-line basis over the lease term. For financing arrangements (i.e., direct finance or sales-type leases) the balance sheet will reflect a net investment in the lease, representing the sum of the lease receivable and the unguaranteed residual asset. For direct financing leases, the net investment is reduced by any deferred selling profit. 

Disclosures

The ASU requires both qualitative and specific quantitative disclosures to help investors and other financial statement users better understand the amount, timing and uncertainty of cash flows arising from leasing activities.

Effective Date

The new guidance is effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar-year entity). Nonpublic business entities should apply the new guidance for fiscal years beginning after December 15, 2019 (i.e., January 1, 2020, for a calendar-year entity), and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted for all entities.

Transition

Entities are required to use a modified retrospective approach, which includes several optional practical expedients allowing companies, in effect, to continue to account for leases that commence before the effective date in accordance with existing GAAP. However, for operating leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements, a lessee is required to recognize lease assets and liabilities at each reporting date based on the present value of the remaining minimum rental payments the lessee tracked and disclosed under current GAAP. Full retrospective application is not permitted.

The ASU also allows companies to apply the lease guidance at a portfolio level, and provides guidance to help entities meet implementation requirements. 

Next Steps

The new lease standard likely will have significant implications for entities across all industries, and entities should begin gathering lease data. Disaggregated entities and those with leases possibly embedded in other arrangements should begin evaluating their processes for identifying leases, including system enhancements to capture and monitor leases for initial and potential remeasurement requirements. For many entities, this will entail converting to an automated system.

BKD will continue to monitor various aspects of the new standard, including FASB’s plans to provide educational information, respond to technical inquiries and stage workshops. Stay tuned for BKD’s white paper on the leases standard, including an analysis of aspects of the standard likely to require judgment and other external auditor and board discussion topics.

Request a BKD Speaker

Do you want a BKD professional to speak to your group about how the proposed lease accounting changes could affect your organization? Fill out the form below, and BKD will contact you with more information.

John Mather

National Industry Partner
Manufacturing & Distribution
314.231.5544

Tondeé Lutterman

National Industry Partner
Not-for-Profit & Government
816.221.6300

Eddie Marmouget

National Industry Partner
Health Care
417.865.8701

Tim Wilson

National Industry Partner
Construction & Real Estate
816.221.6300

Request a BKD Speaker

Do you want a BKD professional to speak to your group about how the proposed lease accounting changes could affect your organization? Fill out the form below, and BKD will contact you with more information.

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