If you think lease accounting is simple, just wait a few more years! Whether it’s the accounting for leases itself or the effect on your financial statements, implementing the FASB’s new lease accounting standard may be a time-consuming adventure. This article provides a high-level overview of the major changes coming and how they differ from existing standards.
ASC 842, Leases, released in February of 2016, takes effect no later than December 15, 2018, for public entities and December 15, 2019, for all other entities, although early adoption is permitted. Leases will incorporate a “right-of-use” model based on the party who holds the risks and affects both the lessor and lessee.
Lessee accounting – operating versus finance leases:
Balance sheet presentation – Regardless of the lease classification, lessees will be required to record an asset and a related lease liability for leases with terms in excess of one year.
Right-to-use assets must be tested for impairment whenever events or changes in circumstances occur that indicate the carrying value may not be recoverable.
Income statement presentation – Operating leases will record lease expense that is calculated using the straight-line basis over the length of the lease, which is then allocated between an amortization and interest component. Finance leases (previously “capital leases”) will record interest expense that is calculated using the effective interest method based on the lease liability and amortization expense on a straight-line method based on the right-of-use asset.
Lessor accounting – sales-type, direct financing, and operating leases:
Balance sheet presentation – Both sales-type and direct financing leases will record (a) the net investment in the lease (the present value of the lease payments and any unguaranteed residual value) and (b) the disposition of the asset, and (c) the resulting gain or loss from disposition, if any. An operating lease will have no effect on the balance sheet of a lessor, since the asset will continue to be depreciated using the asset’s useful life.
Income statement presentation – Sales-type leases will record any profit or loss on the sale of the leased asset at the time of lease commencement, whereas direct financing leases will defer the selling profit, but record the loss at the time of lease commencement. Both sales-type and direct financing leases will calculate interest income using the effective rate of interest. An operating lease will report all lease revenue at the gross amount on the income statement.
Other significant changes in the leases standard include the following:
- Key financial ratios are likely to change, such as return on assets (ROA), debt-to-equity, and total liabilities. Financial statement users, such as banks, may set limits on a company’s ability to borrow based on these types of metrics, so that even if the company’s financial situation is unchanged, its financial statements appear different.
- Enhanced disclosures and presentation requirements
- Leveraged leases are no longer permitted, although pre-existing leveraged leases are grandfathered in until they expire or become modified.
- The new guidance must be implemented on a modified retrospective transition. In other words, Leases must be implemented at the beginning of the earliest period shown on the financial statements. However, there is relief in the form of “practical expedients” that can lessen the burden of the transition.
For more information about lease accounting and how it affects your organization, please contact Patrick Lowrance using the information below.
Patrick Lowrance has been with AGH since 2007, primarily serving clients in the construction, manufacturing, wholesale/distribution, franchisors with multi-state franchising, private equity groups, and financial services industries. He is also responsible for certain quality control processes within the firm. He has various credentials, including being a certified public accountant, one of multiple certified fraud examiners in the firm, and has earned his accreditation in business valuation. Patrick leads the firm’s manufacturing industry team.
His professional memberships include the American Institute of Certified Public Accountants, the Kansas Society of Certified Public Accountants (KSCPA), the Association of Certified Fraud Examiners, and the Construction Financial Management Association. He was named one of the KSCPA’s “20 under 40” young leaders in the accounting profession, and honored as one of Wichita Business Journal’s “40 Under 40” young leaders in the community. Additionally, Patrick serves on the United Way of the Plains allocation and grants committees, as a board member for the Ronald McDonald House Charities - Wichita, and is currently vice-chair of the board for Child Start.
Patrick received both his undergraduate and graduate degrees in accounting from Wichita State University. He also serves as an adjunct instructor for Friends University.