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Major Changes Under the New Lease Accounting Standards

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The FASB has issued the long-anticipated accounting standards for lease transactions (ASC 842). For the majority of privately held companies, these standards will become effective for fiscal years ending in the year 2020. What has changed under these new standards and how will they impact your lease accounting and related financial statement disclosures? We will address the most significant changes under the new standards for lessees.

Classifications of Leases

Under existing GAAP, leases are classified as operating or capital leases, depending on certain criteria. Under the new standard, a lessee must classify a lease as either operating or financing. A financing lease tends to approximate what is currently considered a capital lease. The definition of an operating lease remains more or less the same. Only now, the FASB will require both be represented on the company’s balance sheet as “right-of-use assets” and a corresponding lease liability. The FASB has concluded that companies should be recognizing these assets and liabilities because leases represent the right to direct the use of lease assets and because the lessee obtains substantially all of the economic benefits of that asset by directing their use. The first type of lease, a financing lease, is considered such if a lease meets any of the following criteria:

  • Ownership of the identified asset transfers to the lessee at the end of the lease or an option to purchase the asset with a high probability of exercise exists.
  • The lease term is for the major part of the economic life of the asset (generally 75% or more).
  • The present value of the lease payments equal or exceed substantially all of the fair value of the asset (generally 90% or more).
  • The leased asset is specialized to the point that it will have no alternative use to the lessor after the lease.

Right of Use Assets & Lease Liabilities

Treatment of both operating and financing leases are somewhat similar under the new guidance – a lessee recognizes a right-of-use asset and a related lease liability. The primary differences in treatment between operating and finance leases include:

  • Operating and financing lease assets and liabilities cannot be included in the same line on the balance sheet under this new standard.
  • Operating lease expenses, including amortization of the “right-of-use asset,” are included in the company’s operating expenses, much like they are treated now in income statements, whereas financing lease expenses must be split between interest expense and amortization expense.
  • Operating leases are included in cash flow from operations on a company’s statement of cash flows, while financing lease payments are presented with cash flow from financing activities, similar to the current presentation of capital leases under GAAP.

The standards allow a company to elect a policy to not recognize the asset and liability for short-term leases of 12 months or less. However, for leases longer than 12 months, these new standard effectively results in the recognition of additional long term assets and liabilities on your balance sheet, which could impact financial ratios and covenants for reporting purposes. It is important for company management to evaluate those impacts now to adequately plan for the implementation of the new standard.