Accounting for Leases
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02 Leases early in 2016. The primary purpose of the new standard is to present on a balance sheet leases that otherwise would have been treated only as an expense in an income statement. The standard impacts those who prepare GAAP basis compiled, reviewed, or audited financial statements. It is effective for calendar year 2020.
Primary take-aways from the new standard are as follows:
- The new standard’s purpose is to capture and recognize lease assets and liabilities on the balance sheet of lessees instead of burying them off-balance sheet.
- Historically capital leases have been recorded on the balance sheet and that doesn’t change with the new standard. What changes is how they are named, which under the new standard is “finance leases.”
- The new standard applies to operating leases as well that have a term, with options to renew, of greater than 12 months.
- Options to renew are included in the lease term if the likelihood of them being exercised is “reasonably certain.”
- A leased asset, whether or not it originates from a finance or operating lease, will be called a “right-of-use” asset on the balance sheet.
- Some leases contain both lease and non-lease (maintenance, cleaning, repair) components. The new and old standards required separating these components, with only the lease component being subject to the standards. The new standard does, however, allow the lessee to make an accounting policy election to leave the two components combined when applying the lease standards.
- The definition of “initial direct costs” is incremental costs of a lease that would not have been incurred if the lease had not been obtained. Lease commissions are an example of this – if the lease had not been obtained, these commissions would not have been paid. These costs are included in the capitalized right of use asset.
- Since the new standards could cause clients to fail some leverage-related loan covenants, clients should consider, during coming loan origination or renewal negotiations, to adopt “frozen GAAP” with regards to the financial covenants. This means that if the new standard causes recognition of a liability that would not have been recognized under the old standard, these liabilities are disregarded when calculating leverage ratios – GAAP is “frozen” at the old lease standard for covenant calculation purposes only.
- Criteria to determine finance vs operating lease under the new standards do not materially vary from the old standards.
- Payments over the lease term for a finance lease are accounted for essentially the same as the old standard – reduce the lease liability and record interest expense. The right of use asset is expensed as amortization over the term of the lease.
- For operating leases, a right of use asset is capitalized at inception of the lease and a lease liability recorded. A single lease cost is recognized, generally on a straight-line basis, as lease payments are made.
- Treat related party leases the same as you would leases with unrelated parties. So, the rules of the new standard apply to related party leases.
In the coming months, we will continue to share information regarding the new lease standard. Please contact us for additional guidance.
Sue Thompson, Partner
Accounting & Assurance Department Head