Changes to Operating Leases Under the New Lease Accounting Standards
During the last financial crisis, a few companies that appeared to have solid balance sheets went broke because they couldn’t manage their huge operating lease liabilities. By some estimates, about 85 percent of the $3.3 trillion in future lease commitments are nearly invisible, since they’re not on balance sheets.
FASB’s new lease accounting standard, ASC 842, is intended to provide a more accurate view of the contractual liabilities a company may have. Previously, only capital leases were on the balance sheet. Operating leases only appeared as footnote disclosures in financials, which led some companies to engineer leases so that they would qualify as operating leases, even if in substance they were capital leases.
Now, under the new lease standards, which are effective for public companies starting in 2019 and for non-public companies in 2020, all leases will appear on the balance sheet with associated assets and liabilities.
In general, a lease gives a lessee the right to use a specific asset for a specified period of time in exchange for consideration. In contrast to a sale, this asset is still owned by the lessor for the duration of the lease, or until a lessee exercises an available purchase option.
The most common type of operating lease is a real estate lease. Under an operating lease for real estate, the lessee has the right to use the leased space for the period of the lease. This intangible right to use the leased property is the asset associated with an operating lease.
The changes to the lease accounting standards maintain the distinction between operating leases and financing leases. Operating leases are defined by exclusion: leases that don’t qualify as financing leases are operating leases. ASC 842’s definition of financing leases is similar to that of capital leases under the old guidance. A lease is a financing lease if any of the following is true:
- Ownership is transferred from the lessor to the lessee by the end of the lease term by exercising an option.
- The option typically has such favorable terms that it’s likely to be exercised.
- The lease term covers the majority of the useful remaining life of the asset, unless the asset is near the end of its useful life.
- The present value of lease payments plus any residual value transferred to the lessee equals or exceeds the current fair market value of the asset.
- The leased asset is of such a specialized nature that it would be of no use to the lessor at the end of the lease.
If the lease doesn’t meet any of these conditions, this is an operating lease.
How are the balance sheet items valued for an operating lease?
Lease liability. This is the easiest piece to understand. At inception of the lease, the value of the lease liability is the present value of the future lease payments. The discount rate is either an implicit rate given in the lease, or the lessee’s incremental borrowing rate, if no rate is included in the lease. Any variable payments that are based on future indices, such as the Consumer Price Index, are calculated at the current index rate.
Lease asset. Valuations of intangible assets can be tricky, so how do you put a value on the right to use a suite of office rooms or a piece of equipment? Under the new lease standards, this is done by reference to the value of consideration to be paid by the lessee. Therefore, at inception, the value of the right to use the leased asset equals the lease liability, adjusted for any prepayments, lease incentives or other direct costs for the lease. If there aren’t any prepayments, incentives or other costs, the lease liability and asset are equal.
Over on the income statement, a single item for a straight-line lease expense is recorded. This lease expense is actually a combination of the amortization of the lease asset and interest on the lease liability.
Any modifications to the lease which result in a change to the lease liability require a re-measurement of that liability. Any such changes to the lease liability are offset to the lease asset. Baker Tilly has a nice walkthrough of journal entries and examples for operating leases.
Companies that have begun implementing the new lease standards report that it’s much more time consuming than they anticipated, so it’s vital for advisors to take a proactive approach with their clients to help them with these changes.