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Heads Up — FASB's new standard brings most leases onto the balance sheet

Published on: Mar 01, 2016

Download PDFMarch 1, 2016
Updated July 12, 2016
Volume 23, Issue 5

by James Barker, Trevor Farber, Stephen McKinney, and Tim Kolber, Deloitte & Touche LLP

As a result of discussions with the FASB staff after the issuance of this publication, we have revised our interpretive guidance on the income recognition pattern related to lessor accounting for operating leases.

After working for almost a decade, the FASB has finally issued its new standard on accounting for leases, ASU 2016-02.1 The IASB issued its own version, IFRS 16,2 in January, and although the project was a convergence effort and the boards conducted joint deliberations, there are several notable differences between the two standards. We have highlighted those in the table below.

The primary objective of the leases project was to address the off-balance-sheet financing concerns related to lessees’ operating leases. However, developing an approach that requires all operating leases to be recorded on the balance sheet proved to be no small task. During the process, the boards had to grapple with questions such as (1) whether an arrangement is a service or a lease, (2) what amounts should be initially recorded on the lessee’s balance sheet for the arrangement, (3) how to reflect the effects of leases in the statement of comprehensive income of a lessee (a point on which the FASB and IASB were unable to converge), and (4) how to apply the resulting accounting in a cost-effective manner.

Accordingly, the FASB’s new standard introduces a lessee model that brings most leases on the balance sheet. The standard also aligns certain of the underlying principles of the new lessor model with those in ASC 606, the FASB’s new revenue recognition standard (e.g., evaluating how collectibility should be considered and determining when profit can be recognized). Furthermore, the ASU addresses other concerns related to the current almost-40-year-old leases model. For example, it eliminates the required use of bright-line tests in current U.S. GAAP for determining lease classification. It also requires lessors to provide additional transparency into the exposure to the changes in value of their residual assets and how they manage that exposure.

The new standard, which is effective for calendar periods beginning on January 1, 2019, for public business entities and January 1, 2020, for all other entities (see the Effective Date section for more information), represents a wholesale change to lease accounting, and as a result, entities will face significant implementation challenges during the transition period and beyond, such as those related to:

  • Applying judgment and making estimates.
  • Managing the complexities of data collection, storage, and maintenance.
  • Enhancing information technology systems to ensure their ability to perform the calculations necessary for compliance with reporting requirements.
  • Refining internal controls and other business processes related to leases.
  • Determining whether debt covenants are likely to be affected and, if so, working with lenders to avoid violations.
  • Addressing any income tax implications.

See Appendix F of the Heads Up for more information about an entity’s implementation considerations.

This Heads Up provides a comprehensive overview of the FASB’s new leases accounting model under ASU 2016-02 and highlights a number of implementation considerations. The Heads Up also contains the following appendixes, which expand on certain key aspects of the standard:

  • Appendix A — Evaluating Whether an Arrangement Is or Contains a Lease.
  • Appendix B — Other Significant Provisions. (Topics discussed include lease modifications, separating lease and nonlease components, and accounting for sale-and-leaseback transactions.)
  • Appendix C — Presentation Requirements.
  • Appendix D — Disclosure Requirements.
  • Appendix E — Transition.
  • Appendix F — Implementation Considerations.

A Snapshot of the New Guidance

The table below highlights the key provisions of the new leases accounting model under ASU 2016-02 and IFRS 16.

Key Provision

ASU 2016-02

IFRS 16

Scope

Scope includes leases of all property, plant, and equipment (PP&E) and excludes:

  • Leases of intangible assets.
  • Leases to explore for or use nonregenerative resources.
  • Leases of biological assets.
  • Leases of inventory.
  • Leases of assets under construction.

Scope includes leases of all assets (not limited to PP&E). Exceptions are similar to those in ASU 2016-02. Also, lessees can elect to apply the guidance to leases of intangible assets.

Short-term lease

A lessee may recognize the payments on a short-term lease on a straight-line basis over the lease term (in a manner similar to its recognition of an operating lease today). These leases would not be reflected on the lessee’s balance sheet.

A short-term lease is defined as a lease that has a lease term of 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise.

A lessee may recognize the payments on a short-term lease on a straight-line basis over the lease term (in a manner similar to its recognition of an operating lease today). These leases would not be reflected on the lessee’s balance sheet.

A short-term lease is defined as a lease that has a lease term of 12 months or less and does not include a purchase option.

Definition of a lease

A lease is defined as a “contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.“

A lease is defined as a “contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.“

  • A leased asset must be specifically identifiable either explicitly (e.g., by a serial number) or implicitly (e.g., the only asset available to satisfy the lease contract).
    • Substantive substitution rights will need to be considered.
    • A physically distinct portion of a larger asset could represent a specified asset (e.g., one floor of a building).
    • A capacity portion of a larger asset will generally not represent a specified asset (e.g., percentage of a storage tank).
  • A lease contract conveys the right to control the use of the identified asset for a specified period of time. A customer controls an identified asset when the customer has both of the following:
    • The right to obtain substantially all of the economic benefits from its use.
    • The right to direct its use.

Leases of low-value assets

No exemption under U.S. GAAP. However, the FASB believes that an entity will be able to adopt a reasonable capitalization policy under which the entity will not recognize certain lease assets and liabilities that are below a certain threshold.

A lessee may recognize the payments on a lease of low-value assets on a straight-line basis over the lease term (in a manner similar to its recognition of an operating lease today). These leases would not be reflected on the lessee’s balance sheet. IFRS 16 does not define “low value“; however, when the IASB was discussing the exception during deliberations, the Board referred to assets that were less than $5,000.

In addition, an entity will be able to adopt a reasonable capitalization policy under which the entity will not recognize certain lease assets and liabilities that are below a certain threshold.

Lessee accounting

As of the lease commencement date, a lessee recognizes:

  • A liability for its lease obligation (initially measured at the present value of the future lease payments not yet paid over the lease term).
  • An asset for its right to use the underlying asset (i.e., the right-of-use (ROU) asset) equal to the lease liability, adjusted for lease payments made at or before lease commencement, lease incentives, and any initial direct costs.

The lessee will use the effective interest rate method to subsequently account for the lease liability.

Two approaches are used for subsequently amortizing the ROU asset: (1) the finance lease approach and (2) the operating lease approach.

Under the finance lease approach, the ROU asset is generally amortized on a straight-line basis. This amortization, when combined with the interest on the lease liability, results in a front-loaded expense profile in which interest and amortization are presented separately in the income statement. By contrast, the operating lease approach generally results in a straight-line expense profile that is presented as a single line item in the income statement.

The determination of which approach to apply is based on lease classification criteria that are similar to the current requirements in IAS 17.3

The lessee will use the effective interest rate method to subsequently account for the lease liability.

A single approach (similar to the FASB’s finance lease approach) is used to subsequently amortize the ROU asset.

Lessor accounting

Retains the current lessor accounting approach for operating and capital (direct financing and sales-type) leases.

However, the lease classification criteria will change, and the treatment of dealer’s profit, if any, will be affected:

  • A dealer’s profit would be recognized up front if the arrangement is a sales-type lease (i.e., the transaction qualifies as a sale under ASC 606).
  • A dealer’s profit resulting from a direct financing lease, if any, would be deferred and recognized as interest income over the lease term.

Eliminates leveraged lease accounting going forward (existing leveraged leases are grandfathered).

Retains the current lessor accounting approach for operating and finance leases. A dealer’s profit for a finance lease is recognized up front without regard to the revenue guidance in IFRS 15. 4

Lease term

Lease term is the noncancelable period in which the lessee has the right to use an underlying asset together with optional periods for which it is reasonably certain that the lessee will exercise the renewal option or not exercise the termination option or in which the exercise of those options is controlled by the lessor. Lessees will be required to reassess the lease term after lease inception if (1) there is a significant event or change in circumstances that is directly attributable to the actions of the lessee, (2) a contract term obliges the lessee to exercise (or not exercise) an option to extend or terminate the lease, or (3) the lessee elects to exercise (or not exercise) an option to renew or terminate the contract that it had previously determined was not reasonably certain to be exercised.

A lessor is not required to reassess the lease term unless the lease is modified and the modified lease is not a separate contract.

Lease term is the noncancelable period in which the lessee has the right to use an underlying asset together with optional periods for which it is reasonably certain that the lessee will exercise the renewal option or not exercise the termination option. Lessees will be required to reassess the lease term after lease inception if (1) there is a significant event or change in circumstances that is directly attributable to the actions of the lessee or (2) the lessee elects to exercise (or not exercise) an option to renew or terminate the contract that it had previously determined was not reasonably certain to be exercised.

A lessor is not required to reassess the lease term unless the lease is modified and the modified lease is not a separate contract.

Lease payments

Lease payments include:

  • Fixed payments (including in-substance fixed lease payments).
  • Variable payments that are based on an index or rate (e.g., LIBOR or the consumer price index (CPI)) calculated by using the index or rate that exists on the lease commencement date (i.e., the spot rate).
  • Amounts that it is probable will be owed under residual value guarantees (for lessees), and amounts at which residual assets are guaranteed by a lessee or by a third party (for lessors).
  • Payments related to renewal or termination options that the lessee is reasonably certain to exercise.

Lease payments do not include variable lease payments that are based on the usage or performance of the underlying asset (e.g., a percentage of revenues).

Variable payments based on an index or rate would only be reassessed when the lease obligation is reassessed for other reasons (e.g., change in the lease term, modification).

Variable payments based on an index or rate would be reassessed whenever there is a change in contractual cash flows (e.g., the lease payments are adjusted for a change in the CPI).

Discount rate

  • Lessees use the rate charged by the lessor if the rate is readily determinable. If the rate is not readily determinable, lessees will use their incremental borrowing rate as of the date of lease commencement.
  • Lessors use the rate they charge the lessee.

Private-company lessees can elect to use a risk-free rate.

No exemptions provided for private-company lessees.

Lease modifications

A lease modification is any change to the contractual terms and conditions of a lease.

  • A lessee/lessor would account for a lease modification as a separate contract (i.e., separate from the original lease) when the modification (1) grants the lessee an additional ROU asset and (2) the price of the additional ROU asset is commensurate with its stand-alone price.
  • Lessees would account for a lease modification that is not a separate contract by using the discount rate as of the modification effective date to adjust the lease liability and ROU asset for the change in the lease payments. The modification may result in a gain or loss if the modification results in a full or partial termination of an existing lease.
  • Lessors would account for a lease modification in a manner generally consistent with the modification guidance in ASC 606 or IFRS 15.
  • See Appendix B for more information.

Sublease

The intermediate lessor would classify a sublease by using the underlying asset of the head lease.

The intermediate lessor would classify a sublease by using the ROU asset of the head lease.

Sale-and-leaseback arrangements

The transaction would not be considered a sale if (1) it does not qualify as a sale under ASC 606 or (2) the leaseback is a finance lease.

  • A repurchase option would result in a failed sale unless (1) the exercise price of the option is at fair value and (2) there are alternative assets readily available in the marketplace.
  • If the transaction qualifies as a sale, the entire gain on the transaction would be recognized.

The transaction would not be considered a sale if it does not qualify as a sale under IFRS 15.

  • A repurchase option would always result in a failed sale.
  • For transactions that qualify as a sale, the gain would be limited to the amount related to the residual portion of the asset sold. The amount of the gain related to the underlying asset leased back to the lessee would be offset against the lessee’s ROU asset.

View the full Heads Up in the attachment below.

____________________

1 FASB Accounting Standards Update No. 2016-02, Leases. The ASU supersedes FASB Accounting Standards Codification (ASC) Topic 840, Leases, and creates ASC 842, Leases. For titles of additional ASC references, see Deloitte’s "Titles of Topics and Subtopics in the FASB Accounting Standards Codification."

2 IFRS 16, Leases. For more information on the IASB’s standard, see Deloitte’s January 13, 2016, IFRS in Focus.

3 IAS 17, Leases.

4 IFRS 15, Revenue From Contracts With Customers.

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