On February 25, 2016, the Financial Accounting Standards Board (FASB) finally issued Accounting Standards Update (ASU) 2016-02, Leases. This long-awaited guidance, which had been under development for almost ten years, incorporates feedback on two exposure drafts from 2010 and 2013, and is listed as Topic 842 within the Accounting Standards Codification (ASC). The FASB issued ASC 842 in response to a growing need by stakeholders for transparency into previously off-balance sheet leasing obligations, which are estimated to be over $1.25 trillion in aggregate. The guidance supersedes ASC 840 – Leases. ASC 842 is not fully convergent with International Accounting Standard (IAS) 17 – Leases.
The most material difference between the new ASC 842 and current practice is the gross-up of an entity’s balance sheet to recognize an asset and liability for operating leases. ASC 842 defines leases as either Finance or Operating, as opposed to Capital or Operating under ASC 840. As stakeholder feedback mainly focused on lessee accounting, lessor accounting has remained largely unchanged.
Lessees must now recognize assets and liabilities associated with all leasing contracts under the following model:
For Finance Leases, the Lessee will:
For Operating Leases, the Lessee will:
Lessor Accounting will remain largely unchanged from the previous guidance under ASC 840. Lessors will continue to recognize operating income and cash flows from Operating Leases, and will recognize an asset and liability in relation to Finance Leases.
For Finance Leases, the Lessor will:
For Operating Leases, the Lessor will:
ASC 842 includes other changes, such as:
ASC 842 will affect any entity engaging in lease transactions, and reporting its financial statements under U.S. Generally Accepted Accounting Principles. The guidance will come into effect on December 15, 2018 for public entities, and December 15, 2019 for non-public entities.
When making the transition to ASC 842, entities will be required to take a retrospective approach to adjusting their financial statements. In particular, lessees engaged in operating leases under previous guidance will be required to recognize the associated assets and liabilities on their balance sheets. These accounts should be measured at the present value of remaining lease payments on the contract.
For many entities, transitioning to the new guidance will require substantial gross-ups of long-term assets and liabilities. This will have impacts on the presentation of the balance sheet, as well as many of the financial metrics stakeholders use to evaluate entity performance. Companies should pay particular attention to their debt covenant ratios to ensure that the new standard does not trigger any non-compliance.
With the addition of a liability amortization component to Operating Lease Expenses, lessees will also experience a skewed distribution of lease expense toward the front of the lease term. As such, entities engaged in substantial operating lessee contracts can anticipate a decrease in short-term earnings versus prior forecasts, and a corresponding increase in long-term earnings.
Entities should begin to pro-forma the impact of these changes.
Entities must be aware of the new guidance and make the necessary preparations to ensure a smooth transition, including:
Guidehouse’s professionals have deep leasing experience and the requisite knowledge and skills necessary to help clients implement complex accounting standards across multiple business units, legal entities, and geographies. Guidehouse is dedicated to assisting clients in achieving optimal results. Our
experts have extensive experience working with clients as they revisit internal processes to modify or adjust how processes are conducted or data captured and reported according to new or expanded requirements. Guidehouse provides solutions for the most challenging aspects of this proposed guidance including: