Earlier this year, the Financial Accounting Standards Board (FASB) released its much-anticipated update on the proper treatment of leases under U.S. Generally Accepted Accounting Principles (GAAP). The revised standard — known as Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) — will apply to all organizations that lease assets such as real estate, vehicles, and construction and manufacturing equipment. While real estate lessors will experience little change when it comes to accounting for those leases, they could be affected if they lease vehicles, equipment or other property from other organizations.
What lessees need to know
Currently, lessees account for a lease based on whether it’s a capital (also known as finance) lease or an operating lease. They recognize capital leases (for example, a lease of equipment for nearly all of its useful life) as assets and liabilities on their balance sheets. Operating leases (for example, a lease of office or retail space for 10 years) aren’t recognized on lessees’ balance sheets and show up on financial statements only as a rent expense and disclosure item.
Under ASU 2016-02, lessees must recognize assets and liabilities for all leases with terms of more than 12 months, whether capital or operating. Lessees will report the right to use the leased asset on the balance sheet as an asset and the obligation to pay rent, discounted to its present value, as a liability.
A lessee’s recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee will still depend primarily on its classification as a capital or operating lease:
Capital leases. Lessees will amortize right-to-use assets separately from interest on the lease liability on the statement of comprehensive income. On the statement of cash flows, they’ll classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities.
Operating leases. Lessees will recognize a single total lease cost, computed so that the cost of the lease is allocated over the lease term on a generally straight-line basis. They will classify all cash payments within operating activities on the statement of cash flows.
The new standard also requires lessees to make additional disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows related to leases, including information about variable lease payments and options to renew and terminate leases.
What lessors need to know
The new standard won’t bring much change to lessors’ financial reporting. But it does include some “targeted improvements” intended to align lessor accounting with both the lessee accounting model and the revised revenue recognition guidance published in 2014 (ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606)).
For example, lessors might need to recognize some lease payments they receive as liabilities if the collectibility of the lease payments is uncertain. Users of financial statements will have more information about lessors’ leasing activities and exposure to credit and asset risk related to leasing.
A contract may come with both lease and service contract components (for example, maintenance services). Under ASU 2016-02, organizations will continue to separate the lease components from the nonlease components, and the standard provides additional guidance on how to do so.
The consideration in the contract is allocated to the lease and nonlease components on a relative standalone basis for lessees. For lessors, the consideration is allocated according to the guidance in the revenue recognition standard. Consideration related to nonlease components isn’t considered a lease payment, so it’s excluded from the measurement of lease assets or liabilities.
Public companies must adopt the new standard for interim and annual periods beginning after December 15, 2018. All other organizations will need to comply for annual periods beginning after December 15, 2019, and for interim periods beginning a year later. Early adoption is permitted. We can help you make the necessary preparations to ensure your financial reporting is in compliance by the applicable effective date.