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Lease accounting standards guide

By February 12, 2020Lease Accounting

Table of Contents

An all-encompassing guide to lease accounting standards (including FASB ASC 842, IFRS 16, GASB 87), changing accounting guidelines, implementation and lease accounting software.

Introduction

Making a successful transition to the latest lease accounting requirements, including ASC 842 and IFRS 16, is a threefold process of:

  • Understanding the changes to the standards and what those changes mean to a business and its accounting practices
  • Identifying and gathering all of the necessary data
  • Implementing a lease accounting solution that will aid in achieving and maintaining compliance

This guide is designed to provide information and resources you need to thoroughly understand the new lease accounting requirements, to not only meet all compliance deadlines but also improve your leasing policies and procedures for the long term.

 

Lease accounting FAQs

What is lease accounting?

Lease accounting is the process of recording and reporting on all of the leased property, equipment, and other non-owned assets that a business or other organization holds. Generally, these contracts are categorized as either operating leases or finance leases.

Under the requirements of the latest lease accounting standards — ASC 842, IFRS 16, and GASB 87, as well as local versions of each — all leases and similar contracts (not just capital leases) must now be accounted for as assets and liabilities on the balance sheet. Therefore, lease accounting requires the ability to gather accurate lease data and update the information as the terms change (when lease terms are renewed, canceled, and so on).

The use of a software solution for tracking, updating, and managing leases helps to ensure the accuracy of the data that is needed for disclosure reports, both for initial adoption and for long-term reporting.

New lease accounting standards

ASC 842

ASC 842 effective date
Effective date for public companiesFiscal years beginning after December 15, 2018
Effective date for private companiesFiscal years beginning after December 15, 2021
ASC 842 summary

The Financial Accounting Standards Board (FASB) published the lease accounting standard ASC 842, which replaces the lease accounting standard ASC 840.

The purpose of ASC 842 is to increase disclosure and visibility into the leasing obligations of both public and private organizations. Where previously most leases were not included on the balance sheet, the new ASC 842 lease accounting standard requires companies to report right-of-use (ROU) assets and liabilities for almost all leases.

These changes to financial statements make it easier for investors, vendors, government agencies, and  business stakeholders to (1) see a company’s exposure to risk and true financial position, and (2) make comparisons between organizations.

In addition, ASC 842 aligns more closely with the new international lease accounting standard IFRS 16 (below), especially in the way a lease is defined. This makes financial reporting more consistent for organizations with both U.S. and international lease assets.

For more differences between between the new standards, take a look at our IFRS & FASB Lease Accounting Changes page for a quick reference to all of the improvements.

ASC 842: financial statement impacts

Under ASC 842, almost all leases must be represented on the balance sheet with a liability and a ROU asset. ASC 840 capital leases and ASC 842 finance leases are substantially the same. Both are capitalized on the balance sheet, and the method for doing so is similar under both standards. Discover how the new ASC 842 standard impacts the balance sheet

ASC 842 Compliance Software

ASC 842: additional reading

What to know about the rules of ASC 842

How does ASC 842 change the balance sheet?

Previously, only capital leases — those leases that are essentially purchase agreements — needed to be recorded on the balance sheet. But under ASC 842, most leases except for short-term leases must also be included on the balance sheet.

In addition, FASB has changed the treatment of all leases to be intangible assets. This changes the terminology for capital leases, or leases that represent a purchase agreement. These leases are now called finance leases.

That means companies must report ROU assets and lease liabilities for operating leases as well as for finance (capital) leases under ASC 842. So now IT and office equipment, vehicles, construction equipment, and other leased assets must appear on the balance sheet along with real estate leases.

All the leases recorded under ASC 842 will now be part of the total reported assets and liabilities on an organization’s balance sheet — significantly changing the company’s financial statements.

What is considered a lease under ASC 842?

A lease is defined as a contract or element of a contract that convey the right of use (ROU) of a physically distinct identified asset for a specified period of time in exchange for payment.

The identified asset can be property, plant, equipment, or other tangible assets. The period of time can be described in terms of the amount of use of the identified asset, such as the number of production units a piece of equipment will be used to produce, rather than in terms of time per se.

However, ASC 842 does not include assets that are covered in other standards:

  • Intangible assets (ASC 350)
  • Minerals and biological assets including timber (ASC 930, 932)
  • Inventory (ASC 330)
  • Assets under construction (Covered under ASC 360)

How has lease classification changed under ASC 842?

Besides renaming capital leases “finance leases,” ASC 842 added a fifth lease classification question (“Is the asset so specialized that it is only useful to the lessee?”) to the test that determines whether a lease is a finance lease or an operating lease.

Essentially this question says that after the asset is returned to the lessor, if the asset will have no value to anyone else without a major overhaul by the lessor, then the lease would be classified as a finance lease.

In addition, ASC 842 removed the so-called bright lines for the lease classification test. Previously these percentages were used to indicate what constitutes a “major part” of economic life (75%) or “substantially all” of the fair market value (90%); now these percentages are considered guidelines and you can elect whatever percentage you choose to use.

  • Transfer of title test: By the end of the lease term, will ownership of the asset transfer from the lessor to the lessee?
  • Bargain purchase option test: Is there a purchase option in the lease that the lessee is reasonably certain to exercise?
  • Lease term test: Does the lease term encompass the major part of the remaining economic life of the underlying asset?
  • Present value test: Is the present value of lease payments plus RVG (residual value guaranteed by the lessee) greater than or equal to substantially all of the fair market value of the asset?
  • Alternative use test: Is the asset so specialized that it is only useful to the lessee?

What does a lease classification test tell you?

Although almost all leases must be capitalized on the balance sheet under ASC 842, it is still necessary to classify them as either a finance lease (previously capital) or an operating lease. That’s because finance leases and operating leases are measured differently.

The lease classification test determines whether a leased asset is essentially an alternative method of financing the purchase of an asset, or if the majority of the life and/or value of the underlying asset is controlled by the lessee; if so, it must be classified as a finance lease. Otherwise, the lease must be classified as an operating lease.

Is there a low-value lease threshold under ASC 842?

Under IFRS 16, there is a threshold under which leases can be considered “low value” and do not have to be capitalized on the balance sheet. However, FASB has not specified a low-value threshold for excluding leases from the balance sheet under ASC 842. If this is an issue for your organization, you can discuss it with your auditors to determine if you can use a materiality threshold.

What is lease liability and how is it calculated under ASC 842?

Lease liability represents the current value of minimum future lease payments. To calculate it, you need to make assumptions about:

  • The likely amounts owed under residual value guarantee
  • Whether you are reasonably certain to exercise lease renewal options, termination options, or purchase options

The discount rate to use for the calculation is either the rate implicit in the lease (if known) or your organization’s incremental borrowing rate (IBR). Privately-held firms have the option to use a risk-free rate.

Keep in mind that the assumptions you make about lease options at the beginning of the lease often change over time. If during the term of a lease you change your mind about whether you are likely to exercise any lease options, you will need to remeasure both your lease liability and your ROU asset.

How is ROU calculated under ASC 842?

The ROU asset is calculated as the lease liability, plus or minus these adjustments:

  • Plus initial direct costs and prepaid lease payments
  • Minus lessor incentives, accrued rent, and ASC 420 liability at transition date

The ROU is amortized linearly over the life of the lease. All of the assets and liabilities that adjust the ROU asset are now reclassed from the balance sheet and included as one number to show the total leased asset.

IFRS 16

IFRS 16 effective date

Effective date for companiesFiscal years beginning on or after January 1, 2019

IFRS 16 summary

The International Accounting Standards Board (IASB) published the new IFRS 16 lease accounting standard, which replaces IAS 17. For the global community, IASB is responsible for developing and promoting the International Financial Reporting Standards (IFRS) for accounting.

IFRS 16 changes the way companies account for leases in their financial disclosures, including balance sheets and income statements. Under IFRS 16, all leases are considered finance leases.

Here’s what Ernst & Young (EY) says about the changes: “Whether you report under International Financial Reporting Standards (IFRS) or U.S. GAAP, you are likely to be facing significant changes in reporting requirements as you assess the impact of new standards for revenue recognition, financial instruments, and lease accounting. And these changes are not just impacting organizations reporting under IFRS and US GAAP — many national accounting standard setters are also aligning local standards to IFRS.” Read more here: IFRS Compliance Software & New IFRS Lease Accounting Changes

IFRS Compliance Software

IFRS 16: additional reading

GASB 87

GASB 87 effective date

Deadline for companiesFiscal years beginning after June 15, 2021

GASB 87 summary

In 2017, the Governmental Accounting Standards Board (GASB) published the lease accounting standard GASB 87. The organization is the source of the accounting principles (GAAP) used by state and local governments in the United States.

GASB 87 was created to increase visibility into lease obligations and remove ambiguity around lease obligations in financial disclosures, particularly balance sheets and income statements.

GASB 87 Compliance Software

GASB 87: additional reading

Summary of other national standards

While many countries are adopting the IFRS 16 standard, some nations are making minor adjustments to the global standard. For example, in 2016, the Australian Accounting Standards Board (AASB) published the lease accounting standard  AASB 16, which replaces AASB 117 in Australia.

AASB 16 removes the ability for operating leases to be reported in the footnotes of financial  statements. Based on IFRS 16 with a few variations, AASB 16 requires all operating leases to now be  accounted for as finance leases. With small adjustments to the data inputs, the Visual Lease platform provides Australian firms with compliance under AASB 16.

Why use lease accounting software

What is lease accounting software?

Lease accounting software helps you manage and optimize leases. Lease software helps to streamline your organization’s lease portfolio management and seamlessly generate accurate financial calculations. With changing compliance standards it is essential to have a simple way to stay compliant and control all lease aspects.

How does lease accounting software impact financial statements?

The new ASC 842 and IFRS 16 lease accounting standards require significantly more assets and liabilities to appear on the balance sheet. In fact, the standards specify more than 40 different types of data that must be tracked to do the required calculations.

Lease accounting software provides tools to input and report on all the financial aspects of leases to meet the new compliance requirements. The technology performs critical accounting calculations and automates the process of adding information to the balance sheet, including ROU assets, interest expenses, liabilities, practical expedients, and other elements required under FASB and IASB guidance.

What common risks does lease accounting software solve?

Without a lease accounting solution to help with lease tracking, reporting, and management, your business may  be exposed to a number of risks, including:

  • Inconsistencies in the way assets are accounted for
  • Human error in calculations or in migrating data from one source to another
  • Widely dispersed lease records rather than a central data repository
  • Lack of visibility into lease terms, changes, and important dates
  • Missing details such as embedded leases that are part of a larger contract
  • Lack of a structured change management process
  • Mistakes in complex calculations for common area maintenance (CAM) and other costs
  • No record of what changes have been made to leases, when, and by whom
  • Increased odds of failing an audit

This is because lease documents and the standards contain many intricacies.  

The new lease accounting standards are complex of necessity, to capture the challenging and dynamic nature of the underlying agreements. Therefore, reporting on assets and liabilities is extremely difficult without software.

Leases also may contain both lease and non-lease components, which in turn affects how leases are calculated.

The best lease accounting software simplifies all those risks and more. It puts a secure system in place for capturing all the necessary data, tracking changes, and reporting lease costs in accordance with your accounting policies and procedures as well as with ASC, IFRS, or GASB requirements.

Get more details in our blog: Lease accounting auditing risks multiply without software.

Lease accounting standards impact on legal teams

For most corporate attorneys, FASB ASC 842 compliance and accounting changes in general are an accounting exercise that doesn’t impact their responsibilities. What most attorneys don’t know is that there are significant ASC 842 legal implications that put companies, as well as their officers and boards, at risk.

Visual Lease is a lease accounting solution that was developed by attorneys & accountants, so our software platform is designed to avoid the potentially disastrous legal consequences of lease accounting mistakes. At virtually all the companies we talk to every day, the FASB ASC 842 compliance effort is driven by accounting and SEC compliance teams with very little input from the legal department. Learn more about the legal implications of FASB ASC 842 compliance efforts.

The different types of leases and lease components

What are finance (capital) leases and how are they treated under ASC 842?

A finance lease is one that essentially represents a purchase agreement or uses substantially all of the life or value of the underlying asset, and qualifies according to at least one of the lease classification test questions (above).

Although the name has changed, the way finance leases are capitalized on the balance sheet under ASC 842 is essentially the same method used for capital leases under the previous (840) standard.

When you transition existing leases to the new standard, you need to reclassify capital lease assets and capital lease liability (840) as ROU assets and lease liabilities (842). Any prepaid rents, lease incentives, and initial direct costs should be rolled up into the ROU asset.

What is an operating lease and how is it capitalized?

An operating lease is defined as a lease in which the lessee gets control over the use of the underlying asset without ownership. Previously, operating leases were unrecorded liabilities, so the balance sheet only included prepaid or deferred rent.

Now, all operating leases (except for short-term leases) must be capitalized as ROU assets and lease liabilities on the balance sheet, in the same way you record finance (previously called capital) leases.

The operating lease liability is accounted for using an amortized cost basis. Amortization of the ROU asset is calculated as the difference between straight-line rent and interest expense for the period. These two expenses added together give you the total lease expense to book on your P&L.

How do you measure a finance lease vs. an operating lease?

When measuring a finance lease, the ROU is amortized on a straight-line basis, and the lease liability is amortized using the effective interest. The lease liability is increased by the interest incurred in the period, and the carrying amount is reduced by the lease payment.

When measuring an operating lease, a single lease cost is calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis. This single cost includes the interest charge and ROU amortization; the straight-line lease expense is calculated by dividing the undiscounted payments by the lease term.

What is a short-term lease and how is it treated under ASC 842?

According to ASC 842, a short-term lease is one that has a term of 12 months or less at commencement, and that does not have a renewal or purchase option that the lessee is reasonably certain to exercise.

While you don’t have to include short-term leases on the balance sheet under ASC 842, you can recognize short-term lease payments on a straight-line basis over the lease term. However, this option must be elected at the asset class level. In other words, you can’t pick and choose which leases to define as short term; you need to define the entire asset class as a practical expedient.

What is an embedded lease?

An embedded lease is a component within a contract for other goods or services, which includes the use and control of a particular related asset. An embedded lease can exist within a contract even though the contract never uses the word “lease,” sometimes making it easy to overlook lease elements.

For example, embedded leases are often found in IT service contracts where a vendor provides service-related equipment (such as onsite servers). Embedded leases may also be found in supply contracts, dedicated manufacturing capacity contracts, and advertising agreements.

Why do embedded leases have a bigger impact under ASC 842?

Previously, because operating leases were not on the balance sheet, embedded leases little impact on the income statement since the expense was usually being straight-lined. But now that all leases must be capitalized on the balance sheet, you need to:

  • Examine all contracts to find any embedded leases within them
  • Separate the lease components (for use of assets) from non-lease components (payments for the service) within the contract

Identifying embedded leases and their components is a complex task that takes time, judgment, experience, and consistency. It is another area where you might want to enlist the help and guidance of an accounting advisor.

What are lease components?

When a contract contains one or more leases, ASC 842 requires that the contract be separated into the various components. According to ASC 842, a contract can contain the following:

  • Lease components — the right to use an underlying asset, such as the rent for the right to use office space
  • Non-lease components — an activity that transfers a good or service to the lessee, such as CAM charges on office space
  • Non-components — costs that are incurred regardless of whether a lease exists, such as property taxes on the lease

Note that under ASC 842, non-lease component costs/revenues are accounted for under different standards rather than according to lease accounting guidance.

Got questions about CAM? Check out these FAQs.

What is a direct finance lease?

In a direct financing lease, the lessor acquires an asset and leases it to a customer/lessee to generate revenue from the resulting interest payments. Under this arrangement, the lessor recognizes the gross investment in the lease and the amount of related unearned income.

Under a direct financing lease, the lessor cannot be a manufacturer or dealer. This type of arrangement is usually offered by financing institutions, such as equipment leasing companies.

What are initial direct costs?

These are costs that would not have been incurred without the execution of the lease. In other words, they are costs that are directly attributed to negotiating and arranging the lease. For example, payments made to an existing tenant to terminate a lease and real estate commission payments are deemed initial direct costs.

What are prepaid lease payments?

These are lease payments made by the lessee to the lessor before or at the commencement of a lease.

What are lease incentives?

These are (1) payments made by the lessor to or on behalf of the lessee, or (2) any losses incurred by the lessor from assuming a lessee’s pre-existing lease with a third party.

Reporting with new lease accounting standards

Under ASC 842, disclosure reports must provide more qualitative and quantitative details, including:

  • Weighted average discount rate
  • Weighted average remaining lease term
  • Cash paid for amounts included in lease liabilities
  • A more descriptive maturity analysis, which must be also be tied back to the balance sheet

Lease accounting software provides reporting capabilities to support compliance and data management.

What are the different types of standard reports (disclosures) under ASC 842/IFRS 16?

Lease accounting disclosure

A Lease Accounting Disclosure report provides the required values for quantitative reporting as prescribed by the latest lease accounting standards. It includes sections for lease expense, other information including ROU assets obtained in exchange for lease liabilities, and maturity analysis.

Lease accounting standard

A Lease Accounting Standard report provides a detailed view of the calculation inputs and resulting lease schedules for the lease accounting calculations included for a specific date range.

Journal entry summary

A Journal Entry Summary report that detailed journal entries for the calculations included for a specific date range. It typically includes totals for debits and credits by calculation and period.

Change log

A Change Log report provides a detailed audit log of records and selected fields that have been added, edited, or deleted within a specific date range. Data points include the user who made each change, the date/time of each change, and the field name, as well as the old and new values. This type of report allows the user to track/audit changes that impact lease accounting calculations, such as useful life or fair market value.

Want to learn more about ASC 842 balance sheet changes and how to prepare for compliance? Download our white paper 15 things to know about ASC 842.

Understanding financial aspects of a lease

What is a right-of-use (ROU) asset?

This new feature of the lease guidance represents the unused value of the leased asset remaining over the lease term. It is measured by taking the lease liability, adding in the initial direct costs and any prepaid lease payments, and then subtracting any lease incentives.

What is lease liability?

The lease liability is the current value of all outstanding lease payments that are not yet paid. It is discounted by using the incremental borrowing rate (IBR) or the implicit rate in the lease and calculated using an NPV (net present value) of all known payments that are unpaid.

What are discount rates?

A lease accounting discount rate is the implicit lease discount rate or the incremental borrowing rate (IBR) used to measure your operating and finance lease liabilities under ASC 842.

What is an incremental borrowing rate (IBR)?

According to FASB, IBR is “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”

What is an interest expense?

In the accrual method of accounting, this is the amount of interest incurred on debt during a particular period of time and appearing as a separate line on a company’s income statement for the period cited. The interest expense is also used, along with depreciation, when a lease is capitalized and posted as an asset on the balance sheet.

What are disclosures?

The purpose of lease disclosures is to provide clarity around financial statements, giving users insight into the “amount, timing, and uncertainty of cash flows arising from leases.” Under ASC 842, lessees must disclose quantitative and qualitative information about their leases, including the judgments made in measuring leases and the amounts recognized in their financial statements.

What are practical expedients?

Practical expedients are options created by FASB to simplify certain practices under the latest ASC 842 lease accounting standards. Read more in our blog ASC 842 practical expedients and transition requirements.

What is the importance of lease transitions?

The transition from the previous lease accounting standards to ASC 842 compliance requires making decisions about a variety of practical expedients that affect how leases are defined and accounted for moving forward. Without these transition relief options, companies must reassess all existing contracts to (1) determine which ones contain leases and (2) classify (or reclassify) those leases.

What is the impact of different currencies on lease accounting?

For companies that do business outside of the United State, some leases might contain figures in a currency other than U.S. dollars — bringing exchange rates into ROU asset remeasurements and other lease accounting processes.

Download a white paper from Visual Lease accounting partner KPMG for SEC guidance on exchange rates and lease accounting.

What are lease remeasurements?

When there is a material change to a lease — something that causes a change in either the payments or the value of the lease asset itself — it triggers the need for lease remeasurements. For example, remeasurements may be needed due to abandonments, asset impairments, and other causes.

Any remeasurements will affect how you do your lease accounting entries moving forward. Read more in our blog 6 frequently asked questions about lease accounting remeasurements.

What is an amortization expense?

An amortization expense is the write-off of an intangible asset over its expected period of use, representing consumption of the asset and resulting in a decline of the residual asset balance over time.

Amortization is generally calculated on a straight-line basis. The write-off amount appears in the income statement, usually in the depreciation and amortization line item.

What are lease terminations?

A lease termination occurs when you are not using a leased asset and the lessor agrees to let you out of the lease agreement. Termination triggers the need for a remeasurement including any one-time termination fee you might pay, along with writing down the asset and the liability.

Implementing new lease accounting standards

What are the secrets to a successful lease accounting platform implementation?

  • Start your lease inventory ASAP.
  • Pinpoint what lease data you need to track.
  • Create a compliance team that represents all the stakeholder departments.
  • Educate yourself and your team.
  • Set a realistic timeline.
  • Keep the lines of communication open.
  • Start NOW!

For more details, read our blog how to prepare for lease accounting implementation: 7 essential tasks.

What’s next? Get the readiness checklist.

Obviously, there is a lot to consider when evaluating lease accounting software and getting ready for FASB, IASB, and other compliance requirements.

Are YOU ready to make the transition? Start today by downloading the Lease Accounting Milestone Planner.

About Visual Lease

Visual Lease is the #1 lease optimization software for managing, analyzing, streamlining and reporting on lease portfolios. Developed by industry-leading lease professionals and CPAs, it combines GAAP, IFRS and GASB-compliant lease accounting controls with easy, flexible and automated lease management processes.  More than 700 of the world’s largest publicly traded and privately-owned corporations rely on Visual Lease to control their lease portfolios, integrate with their existing business systems and maintain regulatory compliance. Committed to ongoing innovation and unparalleled customer service, Visual Lease helps organizations transform their lease compliance requirements into financial opportunities. For more information, visit visuallease.com.

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