In February 2016, the Financial Accounting Standards Board (FASB) issued “ASU No. 2016-02, Leases,” changing the way business in all sectors will account for leases.
This new lease standard will go into effect for public companies and some not-for-profits and employee benefit plans with fiscal years beginning after Dec. 15, 2018. For all other organizations, the standard is effective for fiscal years beginning after Dec. 15, 2019. Early application is permitted.
The most significant change for the new lease standard will be lessees must now recognize operating leases as assets and liabilities on the balance sheet. Prior to the new standard, only capital leases were recognized on the balance sheet, while operating leases were included as expenses on the income statement and disclosed in the financial statements.
The lease term will be another key item to look out for. Any lease shorter than 12 months will not be required to be listed as an asset and liability on the balance sheet, as long it does not have the option to buy the asset at the end of the lease. Lessees are only required to recognize lease assets and liabilities for leases with terms of more than 12 months.
A lessee will generally be required to initially measure both the asset and liability at the present value of the remaining lease payments. Lessees will also capitalize initial direct cost as part of the asset. Subsequent measurements will depend on the type of lease.
For financed leases, a lessee will recognize rental expense in a similar manner to capital leases. A lessee will recognize interest expense based on the interest rate implicit in the lease, its incremental borrowing rate, or the risk-free rate, if applicable, and amortize the asset over the shorter of its useful life or the lease term. For operating leases over 12 months, a lessee will recognize rental expense on a straight-line basis over the lease term.
If you answer yes to any of the following questions, the lease should be classified as a financed lease:
- Do payments represent substantially all of the asset fair value?
- Is the lease term for a major portion of the asset’s economic life?
- Is there a bargain purchase option that the lessee is reasonably certain to exercise?
- Will title transfer automatically at the end of the lease?
- Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessee at the end of the lease term?
This article is intended to provide a broad overview of the new lease standard. If you would like to discuss this topic further, please feel free to contact our trusted CPAs.