Leases will now be recorded on the balance sheet, so companies will present a new amount of debt that was not previously disclosed.
In 2006, the Financial Accounting Standards Board (FASB), together with the International Accounting Standards Board, initiated a project to update leasing standards. The results of their work will transform the way leases are presented in a company’s financial statements and will impact the company’s deferred taxes, borrowing capability, and many other aspects of the business.
The FASB was long overdue for a change in leasing presentation and disclosures. The original standards were issued in 1976, and financial statement users wanted more transparency and comparability of leasing transactions. Accounting Standards Update (ASU) 2016-02, Leases, was issued in February 2016 in response to the users’ needs. This ASU supersedes Accounting Standards Codification (ASC) Topic 840 and is now ASC Topic 842.
In general, and with few exceptions, all leases that are one year or longer for property, plant, or equipment will be presented on the balance sheet. The lease asset will be referred to as a right-of-use (ROU) asset. The liability will be referred to as a lease liability. This standard will be effective for privately held companies with fiscal years beginning after December 15, 2019 (2020 for calendar year-end entities).
Since most leases will now be recorded on the balance sheet, companies will present a new amount of debt that was not previously disclosed. This will create challenges to their leverage amounts and may necessitate updates to covenant calculations with their lenders.
Definitions
The new standard defines two types of leases: financing leases and operating leases. Financing leases (formally referred to as capitalized leases) are those types of leases where the lessee effectively owns the asset by the end of the lease term. This is accomplished by any one of the following:
- Ownership is transferred to the lessee at the end of the lease.
- The lease provides a purchase option which is expected to be exercised.
- The lease term is a major part of the remaining economic life of the asset.
- The present value of the lease payments equals or exceeds the fair value of the asset.
- The underlying asset is so specialized in nature that only the lessee can use it.
With the exception of item 5, the above conditions are consistent with the legacy definitions of capitalized leases without the bright line tests of 75 percent of the useful life or 90 percent of the fair market value.
Operating leases are those leases where the asset will revert back to the lessor at the end of the lease term.
Operating lease example
Although both types of leases will appear on the balance sheet, the accounting is different for each. Assume the following facts in both situations:
- Three-year lease term with monthly payments of $5,000 ($180,000 total lease payments) beginning on January 1, 2020
- Discount rate of 4 percent
- Present value of the payments is $169,365
- Interest amount for year 1 is $5,788
The accounting for an operating lease is as follows:
- Record the asset at January 1, 2020, at its present value:
Right-of-use asset $169,365
Lease liability $169,365 - Record the payments for the three years. The entries are shown as cumulative; however, in reality they would be recorded monthly:
| December 31, 2020 | December 31, 2021 | December 31, 2022 | Total | |
|---|---|---|---|---|
| Lease expense | $56,455 | $56,455 | $56,455 | $169,365 |
| Right-of-use asset | ($56,455) | ($56,455) | ($56,455) | ($169,365) |
| Lease liability | $60,000 | $60,000 | $60,000 | $180,000 |
| Cash | ($60,000) | ($60,000) | ($60,000) | ($180,000) |
| Lease expense | $5,788 | $3,579 | $1,268 | $10,635 |
| Lease liability | ($5,788) | ($3,579) | ($1,268) | ($10,635) |
As noted above, the interest factor (the third entry) is recorded as part of the lease expense and not shown separately as interest expense.
Financing lease example
Assuming the same facts, a financing lease entry would look like this:
Record the asset at January 1, 2020, at its present value:
Right-of-use asset $169,365
Lease liability $169,365
| December 31, 2020 | December 31, 2021 | December 31, 2022 | Total | |
|---|---|---|---|---|
| Amortization expense | $56,455 | $56,455 | $56,455 | $169,365 |
| Right-of-use asset | ($56,455) | ($56,455) | ($56,455) | ($169,365) |
| Lease liability | $60,000 | $60,000 | $60,000 | $180,000 |
| Cash | ($60,000) | ($60,000) | ($60,000) | ($180,000) |
| Interest expense | $5,788 | $3,579 | $1,268 | $10,635 |
| Lease liability | ($5,788) | ($3,579) | ($1,268) | ($10,635) |
In general, the accounting for the two leases is the same except for the presentation of the expenses. For operating leases, both interest expense and amortization expense are included in lease expenses, and in operating cash flows on the statement of cash flows. For financing leases, interest expense is reported separately and is included in operating cash flows on the statement of cash flows. Amortization expense is reported separately from interest expense and is reflected as an add back to income in operating cash flows.
Special considerations for construction industry
Many construction companies lease equipment and property from a related party, and it is not uncommon to see these leases structured as month-to-month leases. In this type of leasing arrangement, it is important to look at the intent of the lessor and lessee to determine if the arrangement is truly month-to-month. Indicators of a longer-term lease can include:
- The lessee has made significant improvement to the property and is depreciating those improvements over a period of time.
- The lessee is the sole user of the ROU assets and provides the necessary cash flow for the lessor to service the debt.
- The lessee is guaranteeing the debt of the lessor.
- It would be economically disruptive for the lessee to relocate to a new facility.
In these types of cases, the lessee should recognize an ROU asset and the related liability and include a realistic estimate of the number of years that the lease will be in force.
Special considerations for the architecture and engineering industry
With respect to the federal acquisition rate calculation and allocation, architecture and engineering firms’ lease expenses are typically considered a component of indirect costs that can be allocated. These types of costs include computer and computer-aided design and drafting costs, and leasing of company vehicles.
Although the amortization associated with the new lease accounting should be allowable, it is not clear if the interest will be.
Tax effects
In general, the new standard does not change the treatment of leases for income tax purposes. That is, companies with leases that are considered operating leases under the new standard will continue to get a tax deduction for actual amounts paid under the lease. The company will not recognize an ROU asset for tax purposes.
This difference in treatment means that the book ROU will not have any tax basis and companies will need to consider recording deferred taxes on the temporary timing differences this will generate. State apportionment should also be considered, since some states include the book basis of property as part of the calculation to allocate income.
How we can help
Implementing the new standards is a challenge, and companies with significant numbers of leases need to start early to adapt to the changes. CLA can help organizations identify leases that qualify and help them understand how to account for them.