Lessees will be required to recognise assets and liabilities on the balance sheet for the rights and obligations created by all leases with terms of more than 12 months under a new financial reporting standard issued Thursday by the US Financial Accounting Standards Board.
Accounting Standards Update (ASU) No. 2016-02, Leases, will apply to both types of leases—capital (or finance) leases and operating leases. Previously, US GAAP has required only capital leases to be recognised on lessee balance sheets.
As under current US GAAP, the recognition, measurement, and presentation of expenses and cash flows arising from a lease for lessees primarily will depend on its classification as a finance or operating lease:
- For capital or finance leases, lessees will recognise amortisation of the right-of-use asset separately from interest on the lease liability.
- For operating leases, lessees will recognise a single total lease expense.
For both types of leases, lessees will recognise a right-of-use asset and a lease liability. Lessor accounting under the new standard will remain similar to lessor accounting under current US GAAP. The new standard does contain targeted changes that are intended to align lessor accounting with the lessee accounting model and the revenue recognition standard issued in 2014.
Improvements in transparency and comparability will result from the new standard, FASB Vice Chairman James Kroeker said.
“It’s pretty easy to say it’s a win for financial reporting when you increase both transparency and comparability of one of the largest—if not the largest—source of current off-balance-sheet financing,” Kroeker said in a telephone interview.
The ASU also will require disclosures designed to give financial statement users information on the amount, timing, and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative information.
The standard will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15th 2018. For all other organisations, the ASU on leases will take effect for fiscal years beginning after December 15th 2019 and for interim periods within fiscal years beginning after December 15th 2020. Early application will be permitted for all organisations.
“In my view [the standard] strikes the right balance of increasing transparency and comparability but does it in a way that’s cost-effective and cost-efficient by allowing companies to leverage their existing systems,” Kroeker said.
The standard arose from a desire to give financial statement users more information about leases, and the effort goes back many years. In a 2005 report, the staff of the US Securities and Exchange Commission (SEC) suggested that FASB undertake a project to re-examine accounting for leases. The SEC staff said creating transparency about leases for users would be worthwhile even though it would generate controversy and require a considerable expenditure of resources.
FASB and the International Accounting Standards Board (IASB) commenced in 2006 with work on the standard, and the project required considerable effort. The two boards worked jointly for many years in the hope of converging standards for US GAAP and IFRS.
Although the boards agreed on many points, including placing all leases of more than 12 months on lessee balance sheets, they differed on some issues, including lease classification. FASB decided on the dual-reporting model for lessees.
The IASB, which issued its leases standard in January, chose a single-classification model that requires lessees to account for all leases as finance leases.
As financial statement preparers begin to read the final standard for the first time, Kroeker suggested that companies may want to consider:
- Starting right away. Companies can get started by putting together a team to work on implementation. The team may need to include a wide range of functions, including finance and accounting and legal personnel. If compensation agreements are based on leverage, those may need to be considered, Kroeker said. “While you might think it’s a seemingly long runway, ‘Don’t wait until the end to take a look at it,’ is really good advice,” he said.
- Reviewing legal agreements and debt covenants. Particularly for private companies, changes to the balance sheet may affect contractual agreements or loan covenants. Many times these agreements have “frozen GAAP” clauses that state that they will be based on US GAAP at the time they are signed, but Kroeker said it’s worth thinking about these types of effects beyond the accounting.
- Thinking carefully before purchasing a complex or costly system. “You might ask yourself, ‘Is that really necessary?’ ” Kroeker said. FASB constructed the standard with the goal that companies would be able to leverage their existing systems to perform the necessary accounting and reporting, Kroeker said.
- Evaluating leasing processes. While changing the accounting for leases, companies may want to consider their leasing processes, Kroeker said. For example, if their lease processes are decentralised, companies may wish to centralise them for improved efficiency or cost-effectiveness. “It’s a good time to start thinking about those questions,” he said. “Implementation doesn’t just have to be the accounting.”
- Reaching out for help. If preparers are struggling or having difficulty understanding the standard, Kroeker asked that they contact FASB. “We don’t want this to be one of the things where there’s some unintended consequence,” he said. “… We want this to be a successful implementation.”
—Ken Tysiac (email@example.com) is a CGMA Magazine editorial director.