Note that unlike other blogs covering accounting for leases, we won’t simply state the obvious, which is that all leases will be capitalized, no grandfathering, and an exemption for short term leases. Instead, we will actually cover some very important differences between the current and newly proposed lease accounting rules.
For instance, we will address 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:
1) What is capitalized:
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).
2) When is 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 the current versus FASB’s newly issued standard for accounting for leases.
3) New (fifth) test:
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.
4) 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.
5) 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.
6) 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.
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. In fact, our post next week will explain the correct way to account for subleases under current GAAP rules.
We will explain 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. As we stated in the previous paragraph, odds are you are accounting for this incorrectly.
So there you have it, the key differences between lease accounting under current GAAP and accounting for leases under the new lease accounting rules.
We write detailed blogs like this to demonstrate that our experts at LeaseQuery are not just real estate professionals, but lease accounting experts. We understand the challenges faced by real estate professionals, equipment and fleet lease professionals, AND the accounting departments supporting both groups. Our lease management software reflects our expertise.