In this post we will address the differences between current GAAP, otherwise known as ASC 840, and the new FASB lease accounting standard, ASC 842, with a focus on lessees. There are some very important differences between the current standard and the new lease accounting rules.
For instance, there are differences that could cause a company to end up with a different liability when the exact same lease is capitalized under the new lease accounting rules versus capitalization under current GAAP. These differences could have a significant impact on your lease portfolio during the transition period. Let’s get started:
Differences in GAAP capitalization rules for leases
You’ve probably heard that under the newly proposed lease accounting rules, the lease payments will be capitalized similar to capital leases under today’s rules. While this is correct, note that the amounts that will be capitalized could be different. Under current rules, you capitalize the “minimum lease payments.”
Under the new proposed rules for lease accounting, you capitalize the “lease payments.” The difference here is that “lease payments” under the new lease accounting rules could include insurance and tax payments that are “fixed” for the term of the lease. Under current GAAP all executory costs are excluded from the calculation of the lease liability.
Thus, depending on how the lease is structured, you could end up with a larger liability when you capitalize a lease under the new lease accounting rules than you would when you capitalize a lease under current GAAP, even when you use the “bright-line” tests (i.e. the 90% and 75% tests).
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When is lease classification determined?
Under current GAAP, lease classification (that is, determining if a lease is a capital or operating lease) is determined when the lease is executed. Under the newly proposed rules, the lease classification (finance or operating) is determined at lease commencement. This difference in timing could result in a different classification under ASC 840 vs ASC 842.
Try our free capital vs. operating lease test for ASC 840:
A new (fifth) test for capital lease classification
Under current lease accounting rules, there are 4 tests to determine lease classification (ownership transfer, bargain purchase option, term greater than 75% of life, and present value of minimum lease payments greater than 90% of fair value).
Under the new lease accounting rules, there is a fifth test for highly specialized assets. Under this test, if the leased asset is so specialized that at the end of the lease term it will have no alternative use to the lessor, then the lease is a finance lease under the new lease accounting rules.
Once again, this test is not included in current GAAP for lease accounting and as such could result in a lease being classified as a finance lease under the newly issued lease accounting rules when it would have been an operating lease under current GAAP.
Fair value adjustment
Under current GAAP rules for lease accounting, a lessee cannot record an asset under a capital lease that is greater than the fair value of the asset. In such scenarios under current GAAP, companies are required to increase the discount rate to an amount that will reduce the asset – and the concomitant liability – to an amount equal to the fair value of the underlying asset (recall that increasing the discount rate has the opposite effect on the liability and asset calculation).
Under the new lease accounting rules, the asset should be recorded at the amount calculated using the appropriate discount rate (the rate implicit in the lease if known, or the company’s discount rate), even if the ensuing amount exceeds the fair value. The asset will then be tested for impairment and written down.
Difference in the discount rate used
Current GAAP requires companies to use the lesser of the rate implicit in the lease (if known) or the company’s incremental borrowing rate. The new lease accounting rules would ALWAYS require companies to use the rate implicit in the lease if known, even if that rate is greater than the company’s incremental borrowing rate.
Let us stress, however that the rate implicit in the lease is usually very difficult to determine, as such we believe companies will continue to use their incremental borrowing rate to determine the lease liability even under the new lease accounting rules.
Residual value guarantees
When calculating the capitalized lease liability under current GAAP, the entire amount of any residual value guarantees should be included in the minimum lease payments. Under the new lease accounting rules, however, only the amounts expected to be owed at the end of the lease term should be included in the capitalized amounts. This relates primarily to equipment or vehicle leases.
Accounting for subleases
Under the new lease accounting rules for subleases, subleases are accounted separately from the original (head) lease. Under current GAAP, the liability from the head lease is effectively netted against sublease income. If that previous remark sounds odd to you, it is because you are currently accounting for sublease accounting incorrectly. You are in good company though. The vast majority of companies account for subleases incorrectly. Read our follow-up blog to learn correct way to account for subleases under current GAAP rules. It explains how to account for scenarios when an original lessee ceases use of the asset and subleases it to a third party, but is still making payments to the original landlord. Most organizations are accounting for this incorrectly.
Now you should understand the key differences between lease accounting under current GAAP and accounting for leases under the new lease accounting rules. Feel free to contact us or leave a comment if you have any questions.
LeaseQuery provides software that helps businesses comply with both ASC 840 and ASC 842. If you’d like to learn more, schedule a demo by clicking the link below.