There is a lot of misinformation regarding the new lease accounting standards. We have summarized ASC 842 and IFRS 16 in another blog, but this post will address the biggest 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 an 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. There will be an exemption for low-value assets
Under FASB’s rules, there is absolutely no 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.
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.
If you would like 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, New Lease Accounting Standards: A Summary of FASB ASC 842 and IFRS 16 Changes.
3. 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.
4. 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.
5. Existing leases will be exempt from the new rules
There will 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. You can read about the practical expedient here. If you elect this expedient, 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.