The new lease accounting standards
The new standards covering accounting for leases include, but are not limited to, ASC 842, IFRS 16, and GASB 87. This article provides a brief summary of each of these along with some information on the differences between them and where you can find accounting examples, guides, and other resources. The last section is a summary of our 12-step Lease Accounting Transition Guide, detailing how to begin the process, collect all your lease information, and successfully transition to the new standards.
ASC 842: The new lease standard for US GAAP
ASC 842, Leases, was issued by the Financial Accounting Standards Board (FASB) in February of 2016. For all public business entities, ASC 842 is effective for reporting periods that begin after December 15, 2018. For private businesses, the FASB standard is effective for reporting periods that begin subsequent to December 15, 2019.
Like ASC 840, the new standard uses a two-model approach, categorizing every lease as either a finance lease or an operating lease. The term “finance lease” is new and is replacing the term “capital lease,” used under 840. Additionally, there is a change to the criteria that defines a finance/capital lease under ASC 842. The criteria now include an additional new test under 842.
ASC 842 requires capitalization of the vast majority of leases. Lessees who are reporting under FASB ASC 842 are required to recognize the assets and liabilities that arise from leases and measure them as the present value of lease payments. The most significant change to lease accounting under this standard is that operating leases must also be recorded as lease assets and lease liabilities. The asset represents the lessee’s right to use the underlying asset (right-of-use asset) and the liability represents lease payments over the lease term. When measuring the assets and liabilities, the lessee (and the lessor) should also include “reasonably certain” lease extension periods beyond the current lease term and “reasonably certain” asset purchase options.
Exceptions for certain leases
For leases with terms of 12 months or less, or where the underlying asset is of low value*, lessees can elect to not recognize lease assets and liabilities but should recognize lease expenses on a straight-line basis, generally, over the term of the lease. While the recognition, measurement, and presentation of lease expenses and cash flows has not significantly changed from previous GAAP rules, the principal difference under FASB 842 is that even operating leases require recognition of lease assets and liabilities on balance sheets. Existing capital leases will continue to be treated as capital leases, but they will be referred to as finance leases.
*Note: ASC 842 does not technically provide an exemption for low-value assets, but there is a method by which lessees can elect to exclude certain low-value assets. For more detail on this, see the first section of the LeaseQuery Transition Guide.
Finance lease accounting under ASC 842
When accounting for finance leases, lessees must:
- Recognize interest on the lease liability and amortization of the right-of-use asset as separate line items on the income statement
- Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows.
Operating lease accounting under ASC 842
When accounting an operating lease, the lessee must:
- Recognize a single lease cost allocated over the lease term on, generally, a straight-line basis
- Classify all cash payments within operating activities on the statement of cash flows.
Lessor accounting under ASC 842
For lessors, lease accounting practices remain largely unchanged. Additionally, FASB 842 outlines changes to leveraged leases as well as sale-leaseback transactions.
IFRS 16: The new international lease standard
IFRS 16 was issued by the International Financial Reporting Standards Foundation (IFRS Foundation) in February of 2016. This standard introduces a single lessee accounting model, treating all leases as finance leases and requiring lessees to recognize assets and liabilities for each. However, the standard allows for the following exemptions:
- Leases with a term equal to or less than 12 months are exempt
- Low-value assets, or those with a value of $5,000.00 or less when new, are exempt
For both public and private entities, IFRS 16 is effective for reporting periods beginning after December 15, 2018.
GASB 87: The new governmental lease standard
GASB 87, Leases, was issued in June of 2017 by the Governmental Accounting Standards Board (GASB). Lessees reporting under GASB 87 are required to recognize a right-of-use asset and a liability for each lease agreement. Like IFRS 16, the new governmental standard classifies all leases as financing arrangements.
GASB 87 also introduces changes to lease accounting for lessors. For each lease, the standard requires lessors to recognize a deferred inflow of resources as well as a lease receivable.
Like ASC 842 and IFRS 16, GASB 87 allows both lessees and lessors an exemption for short-term leases (those with a lease term equal to or less than 12 months) as well as a few more exemptions, including leases in which ownership of the leased asset is transferred.
IFRS 16 vs ASC 842
These new lease accounting standards were developed as part of a joint effort between the International Accounting Standards Board (IASB) and the US FASB. As a result, there is a lot of overlap between ASC 842 and IFRS 16. Their main differences relate to how lessees will record leases.
For instance, while ASC 842 distinguishes between finance leases and operating leases in financial statements, IFRS 16 requires that all leases be treated as finance leases. Hence, accounting for operating leases under IFRS 16 will not be the same as it is under ASC 842.
- IFRS 16 exempts lessees from recognizing and measuring leases valued at less than $5,000
- Under IFRS 16, lease asset values may be calculated using alternative methods other than Present Value
- Under IFRS 16, a change in lease cash flows triggers a reassessment of variable lease payments that depend on a reference index or a rate
- In sale-leaseback transactions, IFRS 16 does not specify whether the asset transfer should be classified as a sale unless the seller (lessee) has a material repurchase option on the underlying asset
- While FASB 842 allows private companies to use a risk-free rate to calculate the lease liability, IFRS 16 does not provide specific guidance
- While FASB 842 requires interest payments to be listed within operating activities on the statement of cash flows, IFRS 16 allows the listing of interest within either operating, investing or financing activities
For more information on this topic, read our blog, IFRS 16 vs. US GAAP Lease Accounting: What Are the Differences?
Lease accounting changes: Why were they made?
Companies have over $3 trillion in leases outstanding, of which only a limited amount show up on the balance sheet. An operating lease, for instance, is not shown on the balance sheet but represents a real liability and should be clearly presented so users of financial statements can assess the amount, timing, and uncertainty of cash flows arising from leases. For example, during the financial crisis of 2007, several firms with huge leasing liabilities went bankrupt even though they had clean balance sheets.
According to IASB and FASB, given the widespread prevalence of leasing, the new lease accounting rules will improve financial reporting and increase transparency and comparability across organizations while also disclosing vital information about leasing arrangements to investors. For instance, airlines that buy and own planes carry heavy debt on their balance sheets, but airlines that lease their planes have misleadingly clean balance sheets despite having materially similar lease obligations.
The new rules also address criticism of previous lease accounting rules for failing to meet the needs of users of financial statements by not always providing clarity on leasing transactions.
While companies will balk at the added cost, implementing these rule changes should give management better insight into the true extent of their lease obligations and lead to better capital allocation and lease vs buy decisions. Moreover, the new rules are not expected to hurt leasing companies because leases will continue to offer a very flexible way of financing and using assets without all the risk of owning them.
New lease accounting standard examples
We have several full accounting examples of the correct treatment for leases under the new standards, along with journal entries and screenshots of the calculations in Excel:
ASC 842 operating lease examples
You can find the correct treatment of an operating lease under ASC 842 in the following blogs. The first article provides a comprehensive transition example of an operating lease to the new rules and the second one provides some additional information on the right-of-use asset and the treatment of operating leases under ASC 842.
- Operating Lease Accounting under the New Standard, ASC 842: Full Example and Explanation
- Right of Use Asset and Operating Lease Accounting under ASC 842: Full Guide and Example
Finance lease accounting example
We’ve provided a full example of accounting for a finance lease under ASC 842 in the following blog. It also includes a summary of the changes from capital leases under 840 to finance leases under the new standard.
IFRS 16 examples
Under IFRS 16, all leases are treated as finance leases, but there are a few different approaches that a lessee can use. The following blog includes both an example of a lease using the full retrospective approach as well as a separate example demonstrating the use of the modified retrospective approach, also known as the cumulative effect approach.
GASB 87 examples
We provide three detailed examples of lease accounting under GASB 87. The first article is an example of accounting for a new lease agreement under GASB 87 and the second includes two full transition examples.
- GASB 87: Summary and Example of Accounting for a New Lease Arrangement
- GASB Lease Accounting Transition Examples
When should you start your transition to the new standards?
The impending lease accounting changes give corporations and other entities a limited amount of time to understand the technical requirements of the new rules, take inventory of all their leased assets, accurately determine what their remaining lease terms are, and figure out how to value them for the new standards. This is no trivial task.
For example, companies that have a large volume of leases are finding that the initial step of identifying and locating all their lease contracts is a substantial task in itself, particularly when lease records are not centrally maintained. Corporate accounting teams will also need time to understand contract provisions such as extension options and variable payments. This leaves little time to wait.
Additionally, for entities that elect to apply practical expedients to the identification and classification of leases that commenced before the effective date, ASC 842 states that “lessees are required to recognize a right-of-use asset (ROU asset) and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.” In simpler terms, this means that if a company decides to present comparative period financial statements of fiscal years prior to the effective date of 842, those prior year financials will have to reflect ROU assets and lease liabilities. Therefore, if a company typically presents two prior years of comparative financials, it would have to present the impact of ASC 842 on the financials of those two years when comparatively presented with 2019 financials.
It’s imperative that companies act now in order to fully understand the new standards and the required accounting in time. If you’re unsure how, read the LeaseQuery Transition Guide for ASC 842 and IFRS 16, which we have summarized below.
How to transition to the new lease accounting standards in 12 steps
*Note: What follows is a summary of our 12-step Transition Guide. To download the full guide, click the image below.
1) Understand your lease portfolio and determine which leases are in scope
Companies typically lease several items of daily corporate use, such as computers and office equipment, which are valued at less than $5,000 apiece, and accounting for all of them as ROU assets can quickly become a nightmare. While IFRS 16 allows an exemption for all “small ticket items” with a fair value of less than $5,000 each (even if, when combined, those assets could be deemed material), ASC 842 does not provide an exemption for low-value assets.
However, there is a workaround. Your organization must establish a written policy to exempt leased assets below a certain dollar-value threshold that you deem appropriate, with good reasoning and justification. Then, you must present the policy to your external auditors for their feedback and approval. If you can get approval from your auditors on your exemption policy, you will not have to list out small ticket items. This will save your business a lot of time and money while still being compliant with ASC 842.
Now that you have a standard lease exemption policy in place, it’s time to put together a team, across relevant departments and multiple locations, which will help your organization transition to the new rules.
2) Identify a point person to lead the transition
Start by appointing a Transition Team Leader to head the transition project, ideally in the corporate controller’s office. Then, have the Team Leader identify potential departments in your company that have or know about any leases or leased assets, and assign a Transition Team point person at each department. Such departments include Real Estate (typically in larger companies), Purchasing/Supply Chain, IT, Legal, Finance, Accounting and Treasury.
3) Compare and select lease accounting software
Lease accounting software is a critical component of a successful transition. Be sure to give yourself and your team ample time to properly evaluate the available lease accounting systems and ensure they satisfy the needs of your organization.
Also, keep in mind that lease accounting software is not the same as a lease management software. Lease accounting software, such as LeaseQuery, is developed specifically for the accounting and financial reporting aspects of leases, whereas lease management products were developed to manage the logistics of leases such as payments. These systems were not primarily designed to address the needs of accountants.
For example, lease accounting software can:
- Distinguish between short-term and long-term deferred rent under GAAP
- Handle amortization of initial direct costs and tenant improvement allowances
- Handle the accounting of premature lease terminations or modifications
- Change borrowing rates on modified capital leases
- Handle foreign currencies, and more
For more information, download our lease accounting software comparison guide, which includes 15 questions to ask vendors during a demo as well as a list of essential accounting features and functionalities:
4) Identify the departments that have or know about any leases or leased assets
Once you have your lease transition team in place, it’s time to get everyone working together on developing a list of leased assets across the organization, along with lease contract details. The list should include details such as:
- Lease start and end dates for each leased asset
- Monthly lease payment amounts
- The current accounting treatment of the lease
- Borrowing costs associated with the lease, if any (this could help calculate ROU asset value)
- Optional lease extension clauses and the likelihood that leases might be extended
- Optional asset purchase clauses
- Whether the lease is embedded on other contracts, such as with IT outsourcing partners.
Aside from boiler-plate legalese, the more information you have on lease details, the better. Often, companies contract with specialized lease brokers, so your point person may have to reach out to them (and to former or reassigned employees) to get a thorough and accurate listing of all leases. Make sure to select team members with attention-to-detail and good communication skills to make sure nothing slips through the cracks.
Download a free lease asset tracking spreadsheet that you can share with your team members:
5) Get a listing of all your leased assets
Every department should provide the Team Leader with a full listing of all the assets they lease along with the following information:
- Lease start date
- Lease end date
- Payment information
For more information on what data each department should be instructed to collect, download the full Transition Guide or read our blog, Lease Data for Accounting: How and What to Collect.
6) Identify all your leased and owned locations. Choose a point person to head the transition at that location.
For companies with multiple locations, the team leader should identify a “Location Leader” to collect detailed information on all leases at that location. This person should ideally be in a finance role (such as the Corporate Controller who is intimately familiar with the location’s operations and accounting details) and have a reputation for working well with other departments.
7) Send out a lease tracking template for the point person at each location to complete
Once all locations have been identified, and point persons assigned at relevant departments at each location, your transition team is in place and ready to move ahead.
To get them all started, the Team Leader should develop a Lease Tracking Template (or download the LeaseQuery template) and send it out to Location Leaders for further dissemination to Lease Coordinators at relevant departments at each location, along with a realistic reporting deadline.
8) Reconcile the lease data you’ve collected and create a lease inventory
The transition point person should reconcile the data that your team has gathered in steps 5-7 to eliminate duplicate records. You should now have a good listing of all your leases and you need to ensure the completeness of this listing.
To learn more about the procedures covered in steps 5-8, read our blog, How to Conduct an Inventory of Your Leases.
9) Validate the completeness of your inventory and use the 5-year commitment schedule
Next, from your financial reporting department, get details on all 5-year lease commitments. These are typically disclosed in Notes to financial statements and should be easy to collect, especially from 10-Q and 10-K filings for public companies. You will also need to get details on the following items:
10) Get the details on rent expense for your most recent year-end audit
You will also need the details on rent expense for the most recently completed year-end audit. This information is a required disclosure on audited annual financial statements. In larger organizations, this information can be obtained from the financial reporting department.
11) Perform a reasonableness test for rent expense
The following is your reasonableness test:
Use your final lease inventory to calculate straight-line rent expense on all your leases. Then, compare your calculated number to what was listed on your most recent, audited annual financial statement (from Step 10).
If your calculated number is significantly lower than what is in the audited financials, you’re probably missing a few leases, so try and track them down. On the flip side, if your calculated number is significantly higher, then there’s either another G/L account where rent expense is recorded, or your accounting team made a mistake in its rent expense calculations for the audited financials (it’s rare, but mistakes do happen, where leases get missed and overlooked year after year).
12) Record your transition adjustments
Once you’ve completed the previous 11 steps, your company should have a complete inventory of its leases. You can now begin the process of recording the transition entry to adopt the new lease accounting guidance (ASC 842 or IFRS 16).
By this point in your process, you should have your lease accounting software fully up and running. With all your organization’s leases collected and entered into the system, it should calculate the transition journal entries necessary for compliance and a seamless transition.