On February 25, 2016, the Financial Accounting Stan­dards Board (FASB) issued its long-awaited new financial accounting and reporting stan­dards for leases, Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). Under development for a decade, Topic 842 will drastically affect the financial statements of many businesses by requiring them to report operating lease obligations as a liability on their balance sheets. Historically operating lease obligations have been reported in the footnotes where they do not affect the leverage and solvency analyses performed by lenders, investors and others. Effective with years beginning after December 15, 2018 for public companies and after December 15, 2019 for other entities, Topic 842 will put an estimated $2 trillion in lease liabilities onto balance sheets. Early application of the changes in this standard are permitted, however few companies are likely to adopt the standard early because of its complexities and the significant changes involved and also the confusion it would cause users of the financial statements who are not familiar with the new reporting rules.

Some of the major provisions of Topic 842 are:

  • Leases lasting more than 12 months are subject to the rules of Topic 842. Leases with terms less than 12 months are not subject to Topic 842 and are recorded as expenses as paid, similar to current guidance, although short term lease cost is disclosed in the footnotes.
  • Topic 842 creates lease liabilities and corresponding “right-of-use” lease assets, measured initially at the present value of the lease payments, which include option terms “reasonably certain” to be exercised. For operating leases, the expense is reported as a single amount over the lease term on a straight-line basis, while finance leases will separately recognize lease and interest expense. Interest expense and amortization of the right-of-use asset will be grouped with interest expense and depreciation expense, respectively on the statement of comprehensive income, with the principal portion of lease payments reported as a financing activity on the statement of cash flows and the interest portion of lease payments reported as an operating activity.
  • The right-of-use asset can be subject to impairment in the same manner as any other long-lived asset. In this case, the right-of-use asset and lease liability will have different carrying values and amortizations in periods following the impairment.
  • Modifications of direct financing leases will require a re-measurement of the lease liability and right-of-use asset, and for financing leases, a gain or loss recognized in income. Modification of operating leases is treated as the extinguishment of the original lease and the start of a new lease. However, in either case if the modification can be treated as a separate lease, it will be treated as a new lease and the original lease will remain in place for accounting purposes.
  • Lessor accounting is largely unchanged, although changes were made to conform with the new revenue recognition rules of Topic 606, which is itself a blockbuster pronouncement. There are also some differences for sub-lessors.
  • Leases which contain embedded non-lease components, such as maintenance services or assets transferred to the lessee must have their costs segregated and the non-lease component accounted for in accordance with its relevant GAAP. This is consistent with the model established by Topic 606 and may have a profound influence on personal property leases. However, an entity may elect, on an underlying class basis, to not separate lease and non-lease components and present the components as a single amount.
  • Sale-leaseback transactions must meet the standards of Topic 606 before Topic 842 can be applied. Since Topic 606 has more strict recognition requirements than existing GAAP, some sales that currently qualify as sales will not when Topic 606 becomes effective, now scheduled for 2018 for public companies and 2019 for other entities. Transition guidance does not require the reversal of a previously recognized sale.
  • Topic 842 contains transition guidance which offers practical expedients for existing leases, which is important because the new guidance requires information that may not have been collected for existing leases. The practical expedient is largely a continuation of current GAAP except for the recognition of the lease liability and right-to-use asset.
  • Disclosures under Topic 842 are greatly expanded and include: the basis, terms and conditions of variable lease payments such as for Consumer Price Index increases and percentage rent, options to extend or terminate the lease, the discount rate used to value the lease liability, a description of the allocation between lease and non-lease cost, short-term lease cost, purchase options expected to be exercised, and maturity of future lease payments.
  • In 2005, when the lease project was first discussed, a goal was to make the project part of the larger movement to confirm US and international GAAP (IFRS.) It was even a joint project between the US FASB and the international IASB. But differences arose and each organization issued its own standard. One of the major differences is in the basic model –IFRS rules requires that all operating leases be accounted for in the manner the US accounts for finance leases. IFRS rules do not distinguish between sales-type leases and direct financing leases, which permits more frequent recognition of sales profit at lease inception. There are several other differences, including a de-minimis threshold of $5,000 in asset value before applying lease accounting rules.

The FASB intends for Topic 842 to bring new transparency to the balance sheets of lessees. However, in the short term it will have profound implications throughout the financial system, including:

  • Banks and other lenders frequently include covenants in their loan agreements requiring certain financial ratios that must be maintained and the new lease liabilities will create technical defaults in many of them.
  • Lenders also frequently prohibit their borrowers from incurring large amounts of debt. As currently written, many companies may be unable to enter into or renew leases without defaulting on their borrowing agreements.
  • As borrowers and lenders rewrite their agreements to be Topic 842-compliant, they will encounter certain loans which otherwise would never be modified because of favorable terms or an inability to meet current underwriting standards. How will these situations be handled?
  • Many businesses lease a wide variety of personal property for use in their business, from computers and copiers to vehicles and large pieces of equipment. If leases must go on the balance sheet the same way as loans, will these leases continue to be as popular in the future?
  • The lease liability is a real liability, while the right-of-use lease asset is an intangible asset that cannot be foreclosed upon. How will this affect loan underwriting?
  • Will businesses with new long-term leases and large balance sheet liabilities find it more difficult to obtain financing?
  • Will the new rules affect the demand for new buildings and the construction industry?

By removing the largest source of off-balance sheet financing, Topic 842 will have a profound influence on not only accounting but also the business environment as a whole.