During the first quarter of 2016, the FASB will issue its new standard on Leases. While the standard will represent a significant improvement to financial reporting, it also will be a change for many organizations—particularly those who engage in significant activities as a lessee.
Under the new standard, lessor accounting is fundamentally consistent with existing GAAP. What follows is a snapshot of what a lessee should know at this stage to facilitate a successful transition to the new guidance.
The new leases standard will increase transparency and comparability among organizations that lease buildings, equipment, and other assets by recognizing the assets and liabilities that arise from lease transactions. In other words, current off-balance sheet leasing activities will be required to be reflected on balance sheets so that investors and other users of financial statements can more readily and accurately understand the rights and obligations associated with these transactions.
“The standard will increase transparency and comparability among organizations that lease buildings, equipment, and other assets by recognizing the assets and liabilities that arise from lease transactions.”
The FASB lessee accounting model retains two types of leases, and is consistent with the lessee accounting model under existing GAAP.
One type of lease (finance leases) will be accounted for in substantially the same manner as capital leases are accounted for under existing GAAP.
The other type of lease (operating leases) will be accounted for (both in the income statement and statement of cash flows) in a manner consistent with operating leases under existing GAAP. However, as it relates to the balance sheet, lessees will recognize lease liabilities based upon the present value of remaining lease payments and corresponding lease assets for operating leases with limited exception.
The new leases standard also will require lessees and lessors to provide additional qualitative and quantitative disclosures to help financial statement users assess the amount, timing, and uncertainty of cash flows arising from leases. These disclosures are intended to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an organization’s leasing activities.
Early action is key to a successful transition. As soon as possible—even prior to the issuance of the new leases standard—preparers should consider creating a transition timeline and action plan.
For public companies, the new standard will be effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2018.
For private companies, the new standard will be effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
Early application will be permitted for all organizations upon issuance of the standard.
The Board decided that a modified retrospective approach for transition, as opposed to a full retrospective approach, provides an appropriate balance between minimizing costs of transition and providing users of financial statements with comparable financial information. The practical expedients related to transition, if elected, should further significantly reduce the costs associated with transitioning to the new requirements.
The new standard is not industry-specific, so it will not necessarily affect one industry more than others. However, as mentioned earlier, the more significant the leasing activity, the greater the potential for a significant balance sheet impact.
“As soon as possible—even prior to the issuance of the new leases standard—preparers should consider creating a transition timeline and action plan.”
In many respects, the final standard can be thought of as moving operating lease obligations from the footnotes to the balance sheet; basically a change in display. Based on substantial outreach with financial statement preparers, the FASB expects that most lessees will be able to meet those reporting and disclosure requirements by leveraging existing systems and processes.
In leveraging existing systems, organizations will need to make sure financial reporting personnel are educated regarding the application of the new standard as there are changes in the details. For example, the definition of a lease (while generally consistent with GAAP today) may, for a subset of less common transactions, require organizations to undertake activities to ensure they have appropriately identified all of their leases.
Furthermore, implementation of the new standard may be a good opportunity for organizations to challenge the efficiency and effectiveness of existing processes and controls, particularly those related to ensuring all material leasing activity is accounted for.
While initial implementation activities will require some level of effort for lessees, the ongoing costs of providing the information are expected to be consistent with the costs of complying with existing GAAP.
That’s because, under existing GAAP, organizations are similarly required to:
Evaluate each lease to determine the applicable accounting model to apply (capital or operating), and
Subsequently account for each lease, including meeting the ongoing disclosure requirements about cash flows from leases.
The new standard will not substantially change this level of effort.
As a part of transition planning, organizations may want to form a transition team that includes individuals from departments other than accounting and external reporting.
For example, with the addition of leases to the balance sheet, organizations should review existing contractual agreements, such as lending covenants, to seamlessly adjust to the new standard. Accordingly, it may be wise to include treasury, legal departments, and others as part of a transition team.
Finally, but perhaps most importantly, organizations will want to explain the effects of the changes in accounting for leases on the organization’s financial statements to boards of directors, investors, and other users of financial statements.
More information can be found on FASB the project page. Article reprinted with permission of the Financial Accounting Standard Board.
“As a part of transition planning, organizations may want to form a transition team that includes individuals from departments other than accounting and external reporting.”