Insights

New Lease Accounting Rules

New Lease Accounting Rules

Jan 05, 2016

Recently, the Financial Accounting Standards Board (FASB) voted to begin the process of issuing new lease accounting rules that, starting in 2020 for calendar year-end private companies, will require all long-term leases to be capitalized. Gone are the old FAS 13 rules that required capitalization of only certain "capital" leases. Under these new rules, all leases will be treated as capital leases with a right-of-use (ROU) asset being recorded and amortized and a corresponding discounted lease obligation being recorded as well.

Lease Models: Type A vs. Type B

All leases will be capitalized and amortized as either a Type A or Type B lease. 

  • Type A leases will be amortized more like the old FAS 13 capital leases, recognizing more lease-related expenses in the early periods of the lease.
  • Type B leases will be amortized on a straight-line basis, resulting in level expenses for all periods of the lease.

All leases will be Type A leases unless the lease term is insignificant in relation to the total economic life of the leased asset OR the present value of the lease payments is insignificant to the fair value of the lease at inception. 

As a result, pretty much only leases of real estate will be Type B leases.

The following tables illustrate the accounting entries that would be made for a lease with lease
payments (cash amounts) capitalized using a discount rate of 5%.



Type A

Initial Entry

Year 1

Year 2

Year 3

Year 4

Year 5

Cash


$(50,000)

$(50,000)

$(65,000)

$(65,000)

$(75,000)


Right-of-Use Asset - Net

$261,360

$(52,272)

$(52,272)

$(52,272)

$(52,272)

$(52,272)


Lease Obligation

$(261,360)

$36,932

$38,779

$55,718

$58,503

$71,429


Amortization Expense - Lease


$52,272

$52,272

$52,272

$52,272

$52,272


Interest Expense - Lease


$13,068

$11,221

$9,282

$6,497

$3,571


Total P&L Expense

 

$65,340

$63,493

$61,554

$58,769

$55,843










Type B

Initial Entry

Year 1

Year 2

Year 3

Year 4

Year 5


Cash

$(50,000)

$(50,000)

$(65,000)

$(65,000)

$(75,000)

Right-of-Use Asset - Net

$261,360

$(47,932)

$(49,779)

$(51,718)

$(54,503)

$(57,429)

Lease Obligation

$(261,360)

$36,932

$38,779

$55,718

$58,503

$71,429


Lease Expense


$61,000

$61,000

$61,000

$61,000

$61,000


Total P&L Expense

 

$61,000

$61,000

$61,000

$61,000

$61,000


 

Lease Obligation Factors

Discount Rate. The rates to be used are very similar to existing lease rules that require lessees to use the lessor’s implicit rate. If that rate cannot be determined, the lessees’ incremental borrowing rate can be used. In addition, nonpublic entities will be allowed to make an election to use a “risk free” rate, provided it is used for all leases, past and present.

Lease Term. The lease term is determined by considering all relevant factors that create an economic incentive to exercise an option to extend or not terminate a lease or to purchase the underlying asset. An entity should include such options in the lease term only if it is reasonably assured that the lessee will exercise the option, having considered the relevant economic factors.

Variable Lease Payments. Only variable lease payments that depend on an index or a rate should be included in the initial measurement of the lease using the index or rate at lease commencement. Changes in the index or rates will not trigger a reassessment of the lease.

Related-Party Leases. Related-party leases will be accounted for based on the legally enforceable terms and conditions of the lease.

Presentation and Disclosure

The ROU asset for Type A and Type B leases can be presented on the face of the balance sheet or disclosed in the notes to the financial statements. However, the ROU for Type A and Type B leases cannot be presented in the same statement line item. Identical provisions apply for the related liabilities.

Disclosures include qualitative and quantitative details regarding an entity’s leases, significant judgments made in accounting for leases, amounts recognized in the financial statements related to leases, and a lease liability maturity analysis. Nonpublic entities are exempt from a requirement to roll forward the lease liability activity.  

Lessor and Sub-Lessor Accounting

The definition of Type A and Type B leases are similar, but not identical, for lessors. Lessors of Type A leases will recognize a discounted right to receive lease payments and residual assets instead of recognizing the underlying assets. Any profit would be recognized at the commencement of the lease. Interest income will be recognized as the discount is unwound over the life of the lease. Type B leases will continue to recognize the underlying assets but will be required to present those assets as their own major class of assets.

Other Provisions

Short-Term / Small-Ticket Item Leases. Leases with terms of 12 months or less need not be capitalized, provided the lease expense is recorded on a straight-line basis. Leases for smaller-ticket items (copiers, etc.) that are longer than 12 months will be required to be capitalized but can be accounted for in a bulk portfolio to ease the administrative burden.

Reassessments/Lease Modifications. When significant terms of the lease are changed or relevant factors impacting the economic incentives related to exercising options change, generally this results in a remeasurement of the recorded amounts of the lease.

Next Steps

A very understandable reaction would be to worry about how this affects your financial statements and how your external stakeholders will perceive these changes. Given the sheer number of organizations that these new rules will impact, all financial statement users, other than perhaps "casual" users, will have to adjust their understanding and expectations regarding financial statement metrics impacted by these changes. To be sure, we will all need to manage the expectations of our external stakeholders between now and 2020.

For now, however, companies should hold off, if possible, on agreeing to any long-term financial performance metrics until they have "modeled out" the impact of the new rules on those metrics. Alternatively, agreements could be structured to contractually "carve out" the impact of these new rules. Finally, we recommend that during 2016 you begin the process of modeling the impact of the new rules on your financial statements.   

The good news is that with a 2020 effective date, we should all have ample time to prepare for the new rules and how they will impact us.

Author(s)

Dan Szidon
Daniel T. Szidon, CPA
Audit and Accounting Practice Leader
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