August 8, 2019
The new lease accounting standard will soon be effective for all entities, public and nonpublic. What are the new changes included in this standard? Has your organization started preparing for the new standard? This overview will discuss some of the major changes included in this new standard.
The new lease standard (Topic 842) brings about several changes, primarily affecting lessee accounting. The main change you will now see going forward is that, virtually all leases, financing and operating leases, will go on the statement of financial position (balance sheet).
Let’s take a look at some of the high level changes the new lease standard brings about for lessee accounting:
When is the new lease standard effective?
Topic 842 is effective for fiscal years beginning after December 15, 2018, including interim periods, for public business entities, certain not-for-profit entities, and employee benefit plans that that file with the SEC.
For all other entities, the new lease accounting standard is effective for fiscal years beginning after December 15, 2019 and interim periods within fiscal years beginning after December 15, 2020.
Early adoption is allowed for all entities.
Who does the new standard affect? Does it affect all entities?
In short yes, the new lease standard is applicable to all leases, however, there are certain scope exceptions, such as: 1
- Leases of intangible assets
- Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources
- Leases of biological assets, including timber
- Leases of assets under construction
Moreover, a lessee has an option and is allowed to make an accounting policy election by class of underlying asset to not recognize a lease asset or related liability, provided the term of the lease is 12 months of less. However, there are certain factors that must be considered before adopting this policy. Furthermore, if this option is elected, lessees would be required to recognize a lease expense which would be calculated on a straight-line basis over the term of the given lease.
How do you identify a lease?
The new standard states that an entity should determine if the contract they have or are entering into is or contains a lease at the inception of the contract.
FASB has defined a lease as, “A contract, or part of a contract, that conveys the right to control the use of an identified plant, property and equipment for a period of time in exchange for consideration.” 2
In order to determine whether or not a contract conveys the right to control the use of the identified asset for a period of time, entities are required to evaluate throughout the period of use, if they have both: 3
- The right to obtain substantially all of the economic benefits and risks from the use of the identified asset, AND,
- The right to direct the use of the identified asset
What are the main changes introduced by the lease standard?
As we are aware, the old lease standard classified leases as either a capital lease or an operating lease, wherein the capital lease was capitalized and included on the statement of financial position (balance sheet) with a corresponding liability for the same. On the other hand, operating leases were not included on the statement of financial position (balance sheet), however, disclosures for minimum lease payments up to five years or more were required to be disclosed in the footnotes to the financial statement for organizations having an operating lease.
The new lease accounting standard also includes two types of leases - finance lease and an operating lease. However, unlike the old standard, now, virtually all lessees will have to recognize a right-to-use asset and a lease liability on their statement of financial position (balance sheet).
How do you differentiate between a finance lease and an operating lease under the new guidance?
It is important to classify a lease as a finance lease or an operating lease. But how does one do that? FASB has provided us with the following criteria that will help entities distinguish between the two types of leases and classify them accordingly: 4
- Does the lease transfer ownership of the underlying asset to the lessee by the end of the lease term?
- Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise?
- Is the lease term for the majority of the remaining economic life of the underlying asset?
- Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equal to or exceed substantially all of the fair value of the underlying asset?
- Is the underlying asset 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 the answer to ANY of the above questions at lease commencement is “Yes”, then a lessee would classify that lease as a finance lease. If NONE of the above questions are applicable, then the lessee would classify that lease as an operating lease.
As seen above, the new lease accounting standard has brought about many changes which will require entities to carefully consider and evaluate the impact leases will have on their organization. The most important change being that, going forward, virtually all leases (finance and operating leases) will go on the lessee’s statement of financial position (balance sheet).
Moreover, given that all leases now go on the statement of financial position (balance sheet), this could potentially affect other important areas like ratio analysis, EBITDA, etc. Furthermore, this could also lead some entities to reevaluate their decision between buying and leasing an asset since in both cases the respective asset is included in the statement of financial position (balance sheet).
If you would like to learn more about how the new lease standard will impact your organization, including recognition, measurement, and disclosures, or you would like to discuss the potential impacts to your organization’s ratio analysis, EBITDA and other important areas, feel free to call us at 713-590-3000. We would be happy to work with you to successfully implement this new lease standard together.
About the author
Gaurav is a member of the Audit department at Reimer, McGuinness & Associates, PC. Gaurav earned his Bachelor of Business Administration in Accounting & Finance from the University of Houston. He is also currently pursuing his Master of Science in Accountancy at the University of Houston. His primary responsibilities include preparing financial statements, performing audit test work, and assisting with the timely completion of audit engagements. Outside of the office, Gaurav enjoys watching sports, and spending time with family and friends.
1. “FASB, Financial Accounting Standards Board.” Update 2016-02-Leases (Topic 842) Section A-Leases: Amendments to the FASB Accounting Standards Codification®, 13. www.fasb.org/cs/ContentServer?cid=1176167901010&d=&pagename=FASB%2FDocument_C%2FDocumentPage
2. Ibid., 24.
3. Ibid., 13.
4. Ibid., 30-31.