In this webinar, Dan Krol, CPA and Audit Partner with Bowers & Company, CPAs, discusses FASB ASU 2016-02 Leases (Topic 842), including:
- An overview of the standard
- What changes to expect
- A guide to implementing the new standards
Why Change Lease Accounting?
With the old lease standards, the capital leases were on the balance sheet, but the operating leases were not. The rules segregated the two and were not very transparent. They wanted to improve this by having some consistency in requiring all leases to be on the balance sheet to make it easier for all users of the financial statements to understand.
These are the main factors for changing lease accounting:
- Increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.
- Previous lease accounting was criticized for failing to meet the needs of users of financial statements because it did not require lessees to recognize assets and liabilities arising from operating leases.
Old Lease Standard
Here is an overview of the old lease standard and the two different types of leases – Capital and Operating.
Capital Lease: The present value of the minimum lease payments using the lessee’s incremental borrowing rate is calculated to determine an asset value and debt value, effectively placing the lease on the balance sheet.
Operating Lease: Monthly lease payments are expenses as incurred.
With capital leases, there is going to be very little change going into this new standard. The calculation is going to be very similar, and it is still going to be on the balance sheet. The only significant change will be the name from capital lease to finance lease.
On the other hand, operating leases will see significant change. Instead of having monthly lease payments that are expensed, you will also have an asset and a liability on the balance sheet which will be similar to the capital leases that you have seen in the past.
If the lease meets any of the following four criteria, it should be classified as a capital lease:
- Transfer of Ownership. The lease transfers equipment ownership to the lessee by the end of the lease term.
- Bargain Purchase Option. The lease contains a bargain purchase option.
- Lease Term. The lease term is equal to 75% or more of the estimated economic life of the leased property.
- Minimum Lease Payments. The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the excess of the fair value of the leased property.
New Lease Standard
These rules are effective now, which means you should be aware of the standards, going through the implementation process and ready for your 2022 year-end audits, compilations, etc.
Here is a four-step process to walk you through the new lease standard:
Step 1: Determine if you have a lease that qualifies under this standard.
- Is there an identified asset?
- Do you have the right to obtain economic benefit from the use of the asset?
- Can you decide how and for what purpose to use the asset?
- Do you have the right to operate the asset throughout the period?
- Did you specifically design the asset, and lessor has no other use for it?
Step 2: Identify the recognition criteria.
- Does the lease transfer ownership of the underlying asset to the lessee by the end of the lease term?
- Is the lease term for the major part of the remaining economic life of the underlying asset?
- Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise?
- Is 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 or exceed substantially all 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 none of the above criteria are met, then the lease should be classified as an operating lease as opposed to a finance lease.
Step 3: Initial measurement of the lease liability and right-of-use asset (same for operating and finance).
- Lease Liability = Present value of Lease payments discounted using the discount rate of the lease.
- Right-of-Use = The initial lease liability + any lease payments to the lessor at or before commencement date + any initial direct costs – any lease incentives received
Step 4: Subsequent measurement
- Amortization of the right-of-use asset
- Interest on the lease liability
- Single lease cost = (total lease payments – incentives + initial direct costs) / lease term
- Lease liability subsequently measured as finance lease
- The right-of-use asset is the difference between lease cost and change in the lease liability
Preparing for the New Lease Transition
There are two different approaches that you can take. Be sure to make this decision early to know its effect on the balance sheet.
Apply these changes retrospectively at either:
Modified Retrospective Adoption. Unless an optional transition method is adopted, companies must recognize and measure leases at the beginning of the earliest period presented in their financial statement.
Optional Transition Method – Recognize cumulative effect adjustment to the opening balance of retained earnings in the period of adoption.
- Short-term leases – election not to apply the standard to leases < 12 months
- Non-lease components – election to account for lease and non-lease components as a single combined lease component.
- Discount rate – election to use a risk-free rate of return as the discount rate for all leases, regardless of the implicit rate. Can be done by asset class.
- Transition Reliefs (elected together) – if elected the Lessee can elect no to assess:
- Whether expired or existing contracts are or contain leases
- Lease classification for any existing or expired leases, and
- Whether initial direct costs would have qualified for capitalization for any existing leases
New Lease Presentation
A lessee shall either present in the statement of financial position or disclose in the notes all of the following:
- Finance lease right-of-use assets and operating lease right-of-use assets separately from each other and from other assets
- Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities.
Right-of-use assets and lease liabilities shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in the classified statements of financial position.
In the statement of financial position, a lessee is prohibited from presenting both of the following:
- Finance lease right-of-use assets in the same line item as operating lease right-of-use assets
- Finance lease liabilities in the same line item as operating lease liabilities
Lease Implementation Challenges
Impact on Debt Covenants. Most banks are aware of the new standards, but it is important to communicate to them what leases you may have and what the effect will be on the balance sheet. That way they can be prepared for how this will change with any debt covenants because you have a lease liability both long term and the current portion, which can significantly affect many of the debt covenants.
- Tracking current leases
- Manage documentation
- Lease calculations and reporting
- Making necessary changes to operations, systems, processes, and internal controls
Discuss impacts with the users and stakeholders of the financial statements
Lease Calculations (LeaseCrunch)
The most challenging part of this process is gathering the information for your leases and determining what payments will need to be calculated in your lease liability. Once you have that information, many software programs can assist you with the calculations.
Here at Bowers, we use LeaseCrunch, an online lease software that allows us and/or the client to input lease information and generate monthly journal entries, amortization schedules, and footnotes disclosures for the financial statements. It is a great resource to assist you with this process.
About Bowers & Company CPAs
Dan Krol, CPA, Partner at Bowers & Company CPAs. Reach him at 315-234-1119 or email@example.com.
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