Accounting for the New Lease Standard ASU 2016-02

0

How the new standard can affect your balance sheet

Foreword. In February 2016, the Financial Accounting Standards Board issued Accounting Standards Update 2016-02 Leases. This ASU, along with IFRS 16 Leases, was a joint effort by the FASB and the International Accounting Standards Board to improve financial reporting of leasing transactions by requiring companies to recognize lease assets and lease liabilities on the balance sheet.

Background

Under current GAAP, ASC 840, Leases, it divided leases into two categories: operating leases and capital leases. Capital leases are capitalized while operating leases are not.

For a lease to qualify as a capital lease, one of these four criteria must be met:

  1. The present value of the minimum lease payments must equal or exceed 90 percent or more of the fair value of the asset.
  2. The lease term must be at least 75 percent of the remaining useful life of the lease asset.
  3. There is a bargain purchase at the end of the lease.
  4. There is a transfer of ownership.

So, everyone structured leases to ensure they did not qualify as capital leases, thereby removing both the leased asset and obligation from the lessee’s balance sheet.

ASU 2016-02 replaces existing lease accounting rules found in ASC 840, Leases, with newly issued ASC 842, Leases.

The main difference between the two are:

  1. Most operating leases previously kept off balance sheet are now capitalized under the new ASC 842.
  2. In ASC 842, all leases with a lease term more than 12 months must be capitalized, even if those leases have been expensed as operating leases in existing ASC 840.

ASC 842 retains a distinction between finance leases and operating leases, which is similar to the classification criteria for distinguishing between capital leases and operating leases.

The core principle in ASU 2016-02 is that “An entity should use the right-of-use model to account for leases which requires an entity to recognize the assets and liabilities arising from a lease.” Therefore, in accordance with ASU 2016-02, a lessee recognizes assets and liabilities for all leases that have a maximum possible lease term of more than 12 months.

A lessee that has a lease with a term of 12 months or less may use a short-term lease option policy to either keep the lease off balance sheet, or record a lease asset and liability. In order to use the short-term lease option, the lease also must not have a purchase option where it is reasonably possible that the option will be exercised at the commencement date.

Therefore, whether it’s a finance lease or operating lease with a term of more than 12 months, the lease would have to be capitalized on the balance sheet. Option payments and option lease terms are included in the present value calculation if it is reasonably certain that the lessee will exercise the lease extension or lease purchase option. The lease standard does not provide for the grandfathering of existing leases on the lease implementation date. As a result, on the implementation date, active leases must be adjusted to the new standard.

Implementation date

The implementation date is effective for fiscal years beginning after Dec. 15, 2018, for a public business entity, some not-for-profit entities where securities are traded, listed on an exchange or over the counter market, and an employee benefit plan that files with the SEC.

For all other entities, the implementation date is for fiscal years beginning after Dec. 15, 2019, so there is time to do some planning.

You might want to elect as an accounting policy, by class of underlying asset, to not recognize a right-of-use asset and lease liability for a short-term lease. Again, a short-term lease is a lease 12 months or less, with no purchase option and lessee signs a new lease each year. (Lessee/Lessors should not let the lease roll month to month since this could be construed as more than a 12-month lease.)

The effect could be tremendous depending on lease rate, length and number of leases. The asset could be well over a million dollars with a corresponding million-dollar liability. This could definitely affect your equity calculation by your manufacturer or bank. Depending on how the manufacturer and bank community consider this new lease standard in their calculation, it could cause you to come up with cash and equity requirements unforeseen.

So, now is the time to start looking at your leases to see if they can be structured with 12-month or less leases and renewed each year. This can probably be accomplished if the leases are with related parties but might be difficult to change with a third party. Usually, a third party likes a longer lease obligation with the commitment.

Editor’s note: Dealers with questions are encouraged to call Equipment Dealer Consulting, LLC, at 816/561-5323, or consult their CPAs for advice.


Article Written By Curt Kleoppel

CURT KLEOPPEL, CPA, CVA, is the treasurer of the Western Equipment Dealers Association. He also serves as president of Equipment Dealer Consulting, LLC, a long-term association partner. The consulting group was created to provide financial services to association members. For information, visit www.eqdealerconsulting.com or write to curt@ westerneda.com.

 

Share.

About Author

Leave A Reply

six − four =