There is a lot of misinformation about the new lease accounting rules. We have summarized ASC 842 and IFRS 16 in another blog, but this post will address the biggest misconceptions about the lease accounting updates.
Myth 1: lease capitalization rules
The first prevalent myth is that all leases will be capitalized, or recorded on the balance sheet with an asset an a liability. While it is true that the vast majority of leases will be capitalized 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, lease capitalization was only required for capital leases. However the new lease standards require that operating leases also be capitalized. This is why a capital lease will now be referred to as a finance lease under ASC 842 as well as under IFRS 16.
Myth 2: exemption for low-value assets
Under FASB’s proposed 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 if the lease term is less than or equal to 12 months as stated above.
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 applies to IFRS 16 and not GAAP.
Myth 3: the new lease 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, however those liabilities will not be deemed debt.
However, this is another instance in which there is a significant difference between the FASB and IASB rules. Under IFRS 16, all leases will be treated as finance leases, and those liabilities will be classified as debt.
Myth 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.
Myth 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 (2020 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.
Myth 6: the boards will postpone the rules
It certainly took the boards a while to finalize the new lease accounting rules – almost a decade. However, the rules are now final. Although two organizations have requested that FASB delay the effective date of the new lease accounting standard for private companies, the effective date passed without delay for public organizations and the same is likely to be true for private ones in January 2020. It’s imperative that any organization that has not begun planning for the transition do so immediately.