There is a lot of misinformation regarding the new lease accounting rules. IFRS 16 and ASC 842 are summarized in another blog, but this post addresses the most common misconceptions about the lease accounting updates.
1. Lease capitalization is required for every lease
The first prevalent myth is that all leases must be capitalized, or recorded on the balance sheet with an asset and a liability. While it is true that the vast majority of leases require capitalization under the proposed lease accounting rules, there are some exceptions. Leases with a term equal to or less than 12 months will be exempt from capitalization. In those instances, the leases will continue to be straight-lined, similar to the current rules on accounting for operating leases. Under ASC 840 and the old lease accounting rules, capitalization was only required on capital leases. However, the new lease standards require that operating leases are also capitalized, which is why capital leases will now be referred to as finance leases under both ASC 842 and IFRS 16.
2. All leases are capital leases under ASC 842
The new lease accounting standard still designates two types of leases. Under the old standard, the two types of leases were capital and operating leases. Now, the two types of leases are operating and finance. Though the consideration for operating leases is the same, the consideration for finance leases has slightly changed. Previously, there were only four criteria to use to determine if a lease was a capital lease. Now, there are five criteria to consider for finance leases:
- Transference of title/ownership to the lessee
- A purchase option that the lessee is reasonably certain to exercise
- Lease term and the remaining economic life of the asset
- Present value vs fair value of the asset
- Asset specialization: Would it provide any value to the lessor after the lease term?
If a lease does not meet any of the five criteria, it is an operating lease. Unlike the old standards, both leases must be accounted for on your balance sheet.
3. There will be an exemption for low-value assets
Under the FASB rules, there is not a standard exemption for low value assets. Any assets that are leased would be subject to capitalization under the new lease rules, except, as stated above, if the lease term is less than or equal to 12 months. There is, however, a method by which lessees can elect to exclude certain low-value assets. To learn more about this, see the first section of our lease accounting transition guide:
The IASB, on the other hand, has an optional lessee exemption for leases of assets with a value of $5,000 or less when new, even if the leases are material in aggregate. Once again, the low value exemption only applies to IFRS 16.
To read about some more notable differences between ASC 842 and IFRS 16 as well as a full summary of the standards, read our blog, IFRS 16 vs. US GAAP Lease Accounting: What Are the Differences?.
4. The new lease accounting rules will cause an increase in debt
This is probably the biggest misconception about the new lease accounting rules. Under ASC 842, the obligations for operating leases will be recorded as liabilities on the balance sheet, but those liabilities will not be deemed debt. This is another instance in which there is a significant difference between the FASB and IASB rules. IFRS 16 states that all leases are to be treated as finance leases, and those liabilities will be classified as debt.
5. EBITDA will be affected
Under FASB’s rules, the amortization of the liability for operating leases will not result in interest expense, and the amortization of the concomitant right of use (ROU) asset will not be deemed depreciation expense. As a result, there will be no difference in EBITDA under FASB’s proposed rules and under current lease guidelines.
6. Existing leases will be exempt from the new rules
There will not be exemptions for existing leases. Any leases outstanding as of December 31, 2019 (2021 for non-public entities) will need to be accounted for under the new lease accounting rules. As a result, it is imperative that companies evaluate the impact of the new lease accounting rules for leases that are currently being signed. There is a practical expedient, however, for grandfathering of lease classification. This practical expedient is a part of what’s known as “the package of practical expedients.” If you elect it, any leases that were classified as a capital lease under 840 will remain capital leases and the same applies for operating leases. However, lease capitalization is still required on all that have lease terms greater than 12 months.
7. Discount rates and incremental borrowing rates
Believing that one size fits all when it comes to discount rates under ASC 842. The reality is that not every discount rate available will work for every lease. So when should you select a discount rate such as the incremental borrowing rate or, if you’re a private company, the risk-free rate? The incremental borrowing rate is what a lessee would pay to borrow, on a collateralized basis, over a similar term, an amount equal to the lease payments in a similar economic environment. The risk-free rate is the rate of return of an investment with zero risk. It cannot be elected for companies reporting in IFRS. The incremental borrowing rate requires complex calculation, while the risk-free interest rate does not. However, liability may be higher with the risk-free rate and if your company plans to go public, it may be best to utilize a different discount rate.