THE IMPACT OF NEW LEASE ACCOUNTING STANDARD

WHAT HAS HAPPENED?

To enhance transparency and comparability of financial statements and minimize off-balance sheet items, the Financial Accounting Standards Board (FASB) issued its long-awaited new accounting requirements for leases (“ASC 842”) in early 2016. There are elements of the new accounting requirements for leases that could impact almost all entities to some extent, although lessees will likely see the most significant changes.

ASC 842 is effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. All others must follow a year later—for fiscal years beginning after December 15, 2019. Early adoption of the requirements is permitted for all organizations. The new standard provides a new definition of a lease based on whether one party obtains the right to control the use of an identified asset for a period of time in exchange for consideration. It also classifies all leases as either finance or operating and there is no scope exception for leases of low value assets such as personal computers or copiers. However, lessees can elect an accounting policy to not recognize the lease terms that are for 12 months or less duration and where there is no option to purchase the underlying asset.

Accounting used by lessors will remain largely unchanged from current generally accepted accounting principles (“ASC 840”). The new standard does make some targeted improvements, updates revenue recognition requirements (for example, assessment of collectability in order to qualify for sales-type lease or direct financing lease), and adds disclosures.

The new standard will cause major changes in lessees’ balance sheets (or statements of financial position) and disclosure requirements. ASC 840 does not require assets and liabilities to be recognized for most lessees. Under ASC 842, all lessees must report in their balance sheets a “right-of-use” asset, representing the right to use the underlying asset during the lease term, and a liability to make lease payments over the lease term. Recognition, measurement, and presentation of expenses and cash flows in the lessees’ other financial statements won’t change significantly.

A SIMPLE OPERATING LEASE EXAMPLE FOR LESSEE

A lessee enters into a three-year lease contract for an office located on the 38th floor and agrees to make the following annual payments at the end of each year: $10,000 in year 1, $15,000 in year 2, and $20,000 in year 3.The initial measurement of the right-of-use asset and liability to make lease payments is $38,000 at a discount rate of 8%.

First, the contract contains an identified asset, the office space located on the 38th floor, and the lessee has the right to use the office space for 3 years. The lessee determined that there is no other nonlease component in the contract and determined it is an operating lease since none of the following criteria is met for qualifying as a finance lease:

• Lease transfers ownership at end oflease term;
• Lease grants lessee an option topurchase the asset that lessee isreasonably certain to exercise;
• Lease term is for a major part ofremaining economic life of asset;
• PV (lease payments + residual valueguarantee) > = substantially all of theFV (fair value) of the asset (Paymentsrelated to optional periods or earlytermination options should beincluded only if lessee is reasonablycertain to exercise the option.);
• Asset is of such a specialized naturethat it is expected to have noalternative future use to the lessor atend of lease term.

At the commencement date (assuming January 1, 2019), the lessee will recognize right of use asset and lease liability in the amount of $38,000.

At the end of first year, record interest expense ($3,038) and amortization ($15,000-$3,038=$11,962) together as a single cost (rent expense: $15,000) on a straight-line basis.

TRANSITION

There are two transition approaches available; (1) Modified retrospective approach to each prior reporting period presented that is intended to maximize comparability and be less complex than a full retrospective approach; and (2) Transition relief option with the cumulative effect recognized at beginning of the period of adoption. For example, a public business entity for which the standard becomes effective on January 1, 2019 would under the modified retrospective approach, recognize an adjustment for the effects of the transition as of January 1, 2017 (i.e., the date of initial application). Under transition relief option, the company would recognize the effects of applying ASC 842 as a cumulative-effect adjustment to retained earnings as of January 1, 2019 and apply ASC 840 in the comparative periods.

BUSINESS IMPLICATIONS

The business implications are broad and it is important to communicate the changes and impact to all stakeholders such as accounting, treasury, information technology, internal control and creditors. The major changes are the treatment of operating leases for lessees and more judgement required for the assessment of lease agreements. As a result, appropriately identifying a lease, especially service contracts that may contain embedded leases, becomes important because it could cause a financial misstatement. The company should begin to consider creating a transition timeline and action plan which should include:

• Form an implementation teamto evaluate the new accountingrequirements for leases;
• Inventory lease agreements, includingkey terms;
• Evaluate how the leases will beaccounted for over the lease termand the adoption method to be usedand its impact for financial reportingpurposes;
• Identify improvements needed infinancial reporting and internalcontrol processes to capture, accountfor, and evaluate lease agreements;
• Assess the impact on financialcovenants and creditworthinesswith its lenders, investors and ratingagencies.

For more information on how this standard will affect your business, contact your UHY LLP partner.