How to Account for Finance and Operating Leases

Lease post #3: The lessee's point of view

Most CPAs grapple with leases from the lessee’s point of view, so in this post we’ll take a look at leases from the lessee’s perspective. Under the new lease standard, what are the types of leases? Does the accounting vary based upon the type of lease? Are lease expenses different?

Change in Lease Accounting

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First, let’s start by defining the types of leases and how to classify them.

The Types of Leases

Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. (Under present lease standards a finance lease is referred to as a capital lease.)

Finance Lease

So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
  3. The lease term is for the major part of the remaining economic life of the underlying asset (today we use the 75% rule)
  4. The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

While the bright-line criteria (e.g., lease term of 75% or more of economic life) have been removed, the basis for conclusions in the new lease standard acknowledges some of the old rules of thumb.  It says that one reasonable approach to determining whether the lease is for a major portion of the asset’s life is the 75% threshold. The conclusion goes on to say that “90 percent or greater is ‘substantially all’ the fair value of the underlying asset.” So, in effect, FASB removed the bright-lines as a rule but not in principle–the conclusion says FASB “does not mandate those bright lines.”

Operating Lease

And what is an operating lease? It’s any lease that is not a financing lease.

Accounting Similarities and Differences

Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases is quite different.

Finance Lease Accounting

The accounting for a finance lease is similar to capital lease accounting under present standards.

When a company enters into a finance lease, it will record the right-of-use asset and the lease liability. The amortization of the right-of-use asset will be straight-line and the amortization of the liability will be accounted for using the effective interest method. Consequently, lease expenses are front-loaded (i.e., expenses will decline throughout the lease term). The amortization expense and the interest expense will be presented separately on the income statement.

As we are about to see, operating lease accounting is significantly different, particularly with regard to accounting for the lease expense and the amortization of the right-of-use asset.

Operating Lease Accounting

The primary change in lease accounting lies in the operating lease area. Under ASC 842 a company will book a right-of-use asset and a lease liability for all operating leases greater than twelve months in length. (Under current lease standards, no asset or liability is recorded.) Will the operating lease expense be any different than it has been? No. But the recording and amortization of the right-of-use asset and the lease liability is new.

The Initial Operating Lease Entries

Let’s say a company has a five year operating lease for $1,000 per month and will pay $60,000 over the life of the lease. How do we account for this lease? First, the company records the right-of-use asset and the lease liability by discounting the present value of the payments using the effective interest method.  In this example, the present value might be $54,000. As the right-of-use asset and lease liability are amortized the company will (each month) debit rent expense for $1,000—the amount the company is paying. So the expense amount is still the same as it was under ASC 840.

Amortizing the Right-of-Use Asset and the Lease Liability

Well, how does the company amortize the right-of-use asset and the lease liability? The lease liability is amortized using the effective interest method, and the interest expense is a component of the rent expense. What’s the remainder of the $1,000? The amortization of the right-of-use asset. The $1,000 rent expense is made up of two components: (1) the interest expense for the month and (2) the right-of-use amortization amount which is a plug to make the entry balance. Even though the rent expense is made up of these two components, it appears on the income statement as one line: rent expense (unlike the finance lease which reflects interest expense and amortization expense separately).

Potential Impairments

Due to the mechanics of the straight-line lease expense calculation, the right-of-use asset amortization expense is back-loaded (i.e. the amortization expense component is less in the early part of the lease). One potential consequence of this slower amortization is the right-of-use asset may be subject to impairment, especially toward the end of the lease. The impairment rules do apply to the right-of-use asset.

Your Thoughts

So, what do you think of the new lease accounting? Is it better? Worse?

You can see my first two lease posts here:

Post 1: How to Understand the New Lease Accounting Standard

Post 2: Get Ready for Changes in Leases and the Leasing Industry

Get Ready for Changes in Leases and the Leasing Industry

Lease post #2: The new lease standard will affect accounting and the lease industry

The Leasing Industry will Change

In my last lease post, we saw that bright-line criteria (e.g., lease terms of 75% or more of economic life and minimum lease payments of 90% or more of fair market value) are eliminated in the new lease standard. Consequently, almost all leases—including operating leases—will create lease liabilities. This accounting change will alter the leasing industry.

Lease Standard

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Lessees are presently paying high lease interest rates to obtain operating lease treatment (no lease debt is recorded). Now—with the new lease standard—those same operating leases will generate lease liabilities. So why would the lessee pay the higher interest rate? There is nothing to be gained. Lessees will begin to borrow money from banks (at a lower rate). And they will buy the formerly leased asset, or they will demand lower interest rates from the lessor. Lessees, I think, will obtain better interest rates.

Scope of the Lease Standard

What does the lease standard apply to? It applies to leases of property, plant and equipment (identified asset) based on a contract that conveys control to the lessee for a period of time in exchange for consideration. The period may be described in relation to the amount of usage (e.g., units produced). Also, the identified asset must be physically distinct (e.g., a floor of a building).

Control over the use of the leased asset means the customer has both:

  1. The right to obtain substantially all of the economic benefits from the use of the identified asset
  2. The right to direct the use of the asset

What does the standard not apply to?

The lease standard does not apply to the following:

  1. Leases of intangible assets, including licenses of internal-use software
  2. Leases to explore for or use minerals, oil, natural gas, and similar resources
  3. Leases of biological assets
  4. Leases of inventory
  5. Leases of assets under construction

Operating or Finance Lease

Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. Under present lease standards, a finance lease is referred to as a capital lease.

So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
  3. The lease term is for the major part of the remaining economic life of the underlying asset (today we use the 75% rule)
  4. The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

And what is an operating lease? It’s any lease that is not a financing lease.

Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases will be different (a topic we’ll cover in my next lease post).

Related Party Leases

Leases between related parties will be classified just as any other lease will be. Companies will look to the legally enforceable terms and conditions of the lease to determine the whether a lease contract exists. If a lease contract exists, the agreement will be treated as a lease with the lessor reflecting a sale and the lessee capitalizing the related lease liability and right-of-use asset.

Are there any leases that will not result in a right-of-use and lease liability. Yes, those with terms of twelve months or less.

Leases of Less Than 12 Months

Companies do have the option to not capitalize a lease of 12 months or less. To do so, the company must make an accounting policy election (by class of the underlying leased asset). Companies who use this election will recognize lease expenses on a straight-line basis, and no right of use asset or lease liability will be recorded. If, however, the terms of the short-term lease change, the agreement could become one in which the lease is capitalized, for example, the lessee can exercise a purchase option or the lease term extends to beyond twelve months. (Expect to see plenty of leases with lives of twelve months or less.)

More Lease Information Coming

We’ll continue this series of lease posts next week. So stay tuned. I invite your comments and questions.

To see my first lease post, click here.

How to Understand the New Lease Accounting Standard

Lease post #1: The first in a series of posts concerning the new lease standard

FASB issued a new lease accounting standard.

The existing lease guidance (FAS 13; now ASC 840) came out in 1976. In that standard, FASB defines capital leases with criteria such as minimum lease payments of at least 90% of fair market value or lease periods of at least 75% of the economic life of the asset. Given the bright-line criteria, lessees have asked lessors to construct leases so that they are considered operating and not capital. Why?

Most lessees don’t desire to reflect capital lease liabilities on their balance sheets. So for forty years lessees have controlled assets with a lease agreement and not recorded them on their balance sheets—sometimes called “off balance sheet financing.”

New Lease Accounting

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The Problem: Tailored Leases

As an example under present lease standards, a company leases a building with an economic life of 40 years and desires a lease term of 28 years. Why? Well, 75% of 40 years is 30. Since the lease is less than 30 years, it is an operating lease—one not capitalized, one not recorded on the balance sheet.

What happens if the lease term is 30 years? Then it is a capital lease, and the company records the building and the related debt on the balance sheet. The lessee is fine with the recording of the asset (the building) but wants to keep the debt off the books. However, if a capital lease criterion is triggered, the asset and the debt are recorded on the balance sheet.

The New Trigger: Is This a Contract?

Under existing lease accounting rules, bright-line criteria are used to make the capitalization decision, for example, lease terms of 75% or more of the economic life or lease payments of 90% or more of the fair market value.

But the bright-line criteria is being replaced with a question: Is it a contract? If the lease is a contract, it goes on the balance sheet. If it is not a contract, it does not go on the balance sheet.

Result: Most operating leases will now be recorded on the balance sheet at the inception of the lease.

Recording Leases Under the New Lease Accounting Standard

So what is the accounting entry to record leases under the new standard?

A right-of-use asset is recorded on the balance sheet at the amount of the lease liability. Also, a lease liability is concurrently recorded.

What’s the amount of the lease liability? It is the present value of the lease payments (including options). So, what is a right-of-use asset? It is an intangible that represents the lessee’s right to use the underlying asset. (The right-of-use asset will be amortized over the life of the lease.)

Is there any theory that supports this type of accounting? Yes, in FASB’s conceptual statements.

Congruence with FASB Conceptual Statement

FASB Concept Statement 6 says that assets are probable future economic benefits obtained or controlled by an entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Under the new lease standard, the right-of-use asset and the lease liability are congruent with the definitions in Concept Statement 6. So, if a company leases a truck for three years and the economic life of the vehicle is seven years, it has obtained “probable future economic benefits…as a result of past transactions.” And the company has “probable future sacrifices of economic benefits” arising from the lease obligation. Therefore, the lease should be booked on the balance sheet.

Effective Dates for New Lease Standard

ASC 842 (ASU 2016-02), Leases, replaces ASC 840, Leases.

The effective dates for 842 are as follows:

For public entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those years.

For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.

Early implementation is permissible for all entities.

More Lease Posts

This post is the first in a series concerning the new lease standard. See my next post by clicking here.

 

Lease Accounting – A Seismic Shift

Given that the comment deadline for FASB’s proposed lease standard is September 13, 2013, I’m thinking that approval will soon be forthcoming.

This standard, if passed, will be a seismic shift in accounting.

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Here are a few general observations:

  • Companies making leasing decisions today need to understand the proposed standard – now; operating leases signed today will likely become lease liabilities in the near future.
  • This standard has the potential to change the way companies do business. Less leasing and more purchasing. If the company is going to record a liability anyway, why not just borrow and buy.
  • Debt covenants may need to be revised once the standard is effective (or before then). Companies with operating leases will probably see their debt to equity ratios adversely impacted as present operating leases become liabilities.
  • Creditors need to consider how the new lease accounting will impact their lending decisions.
  • EBITDA will increase for type A (e.g., equipment) leases since you will add back interest and amortization to earnings; not so for type B (e.g., building) leases (which will be recognized as lease expenses).

Now let’s take a look at the proposed lease standard itself.

The Two Ts: Term and Type

The first important T: Term.

The proposed standard has two important Ts – term and type, with term being the more important of the two (at least in my opinion). A lease with a term of more than twelve months will be booked as lease liability while a lease with a term of twelve months or less will be expensed in the year paid.

So the term of the lease will drive whether a lease is recorded as a liability.

Under the proposed standard, you will simply ask, “is the lease term more than twelve months?” If yes, then book the lease liability (using the present value of the lease payments). In addition, you will book a right-to-use asset (again using the present value of the lease payments).

The second important T: Type.

The standard spells out two types of leases:

  • Type A (Other than Property Leases)
  • Type B (Property Leases)

Think of type A as equipment and type B as buildings or land; the critical determinant of classification, however, is whether the lessee will consume a significant portion of the asset (regardless of whether the underlying asset is equipment or a building). If the lessee will consume a substantial portion of the asset, then the arrangement will be a Type A lease.

Balance Sheet

The lessee will record:

  • A right-to-use asset
  • A lease liability

The initial recording of the right-to-use asset and the lease liability will be the same for Type A and Type B leases, and the computation of both the asset and liability will largely be the present value of future lease payments.

The right-to-use asset will be amortized over the life of the lease; this asset will be presented separately on the balance sheet.

The lease liability will:

* grow (through the unwinding of the discount) and
* decrease as payments are made

The liability will be presented separately on the balance sheet.

Income Statement

In the income statement, type A leases will have:

  • Interest expense
  • Amortization expense
  • Higher expense recognition in the early stages of the lease

In the income statement, type B leases will have:

  • Lease expense (equal to the interest and amortization expenses added together)
  • Straight-line lease expense (similar to operating leases today)

Closing Remarks

Again, this is a simplified overview of the lease standard, but hopefully you’ve found it helpful (even if you felt a few tremors).

At this time, there is no effective date for the standard though I expect FASB to provide one soon.

How About You?

Are you and your clients ready for the change in lease accounting?