There is a change to lease accounting coming down the road. Regardless of the type of organization, leasing transactions represent a common business activity. New accounting guidance is being issued that will impact the financial statements of both lessees and lessors.
Keep in mind that the accounting and reporting changes presented herein do not directly apply to income tax accounting and reporting. Currently, no changes to tax laws affecting leasing activities are involved; however, companies will be required to revisit their calculations of Federal and State deferred taxes and tax expense, as they relate for financial reporting under U.S. generally accepted accounting principles.
Why a Change to Lease Accounting is Being Considered
The current practice of accounting and reporting for leases was standardized in 1976 by the Financial Accounting Standards Board (FASB). Lease transactions were classified as capital or operating leases and each had different accounting and reporting models. Typically, leasing transactions escaped balance sheet recognition, with the affect that certain leased assets were not recorded in the financial statements of the lessee. Over the years, the accounting and reporting model came under question as to whether the true essence of the transaction was being captured and presented appropriately (i.e. was the potential financing aspect underlying the lease transaction evident). Long-standing questions about “off balance sheet“ lease transactions escaping recognition have plagued theaccounting for leases.
In 2006, the Financial Accounting Standards Board (FASB) began theprocess of studying existing standards for the purpose of improving the accounting and reporting of leasing transactions to more accurately reflect the true economics of the transactions. Since then various renditions of a better and improved method to handle lease transactions have been considered.
Accounting for Leasing Transactions: Reporting and Recording
The basic premise underlying the new proposed standards is that lease transactions need to be recorded with the recognition of an asset and a liability. Consistent with previous practice, the Type A and B lease classifications would continue. Type A leases would represent a transfer of control and usage of an asset by the lessor to the lessee. Leases that do not transfer control, coincidental with the associated risks and rewards, to the lessee will be classified as Type B.
With some minor exceptions, Type A leases represent most consumable assets (i.e. utilized for the significant portion of the asset life); Type B leases represent the consumption of only an insignificant portion of the asset life, as an example, real property rental arrangements.
The proposed guidance suggests, for all leases with terms greater than 12 months, an asset and liability will be recognized on the balance sheet. Lease terms would include any option periods for extension if a viable economic benefit to the lessee and a presumption of on-going usage exists.
Both Type A and B leases would be recognized on the Balance Sheet with the right-of-use assets and liabilities recorded at the present value of the lease payments associated with the leasing transactions.
Differences in lease classification will appear in the income statement. For Type A leases, income statement recognition would reflect interest on the lease liability, and amortization cost associated with the capitalized, right-of-use asset. For Type B leases, a singular lease cost factor would be reflected, representing the combined interest and amortization value, calculated on a straight-line basis.
Valuation and recording of the related lease assets or liabilities would be based on the sum of fixed payments. However, for variable payment plans, the assets and liabilities will be based on the index in effect at the lease commencement date. No re-measurement by the lessee of the liability would be required, unless prescribed by the agreement. No recognition of index changes would apply to lessors.
The significant aspects of prior recording requirements for lessors are retained. Lessors would evaluate the lease as to whether the lease is a sale or financing transaction, evaluating the transfer of risk and rewards related to the transaction. Sales-type and direct-financing leases would continue as Type A, and operating leases would be classified as Type B. Leases where collection may be deemed an issue, and where asset control is not transferred as a part of the lease would be recognized as operating, Type B leases.
Subsequent Lease Modifications
Specific rules apply for the accounting of subsequent lease modifications dependent upon the original classification of the lease at lease inception. If a leased asset is purchased by the lessee during the term of a lease (whether Type A or B), rather than recognize a gain or loss on the transaction, the carrying amount of the leased asset is adjusted for the difference between the purchase price and the lease liability amount at the time of asset purchase. The lessor would recognize the asset sale (i.e. that of a non-financial asset) in accordance with existing reporting requirements.
Specific guidance applies to evaluating a lease modification for the purpose of determining the appropriate method of recording. The recording of a new lease would be applicable in those instances where modifications are based on additional right of use and the related pricing adjustments.
Accounting for the lease modification is predicated on the outcome of that evaluation and its conclusion with prescribed recording methods based on whether the lease is a type A or B. Separate recording and reporting guidelines are prescribed for the lessor and the lessee for lease modifications that alter the scope or consideration of the original lease.
In addition, the proposed pronouncement addresses prescribed methods for handling such matters as additional lease costs associated with the contract, sublease agreements, and sale and leaseback transactions.
Financial Statement Presentation and Disclosure
Financial statements must provide, within the context of the financial statements and/or the footnotes, the essence of the leasing transactions (i.e. identify the Type A & B assets and liabilities). Type A and B assets and liabilities cannot be presented on the same line item on the financial statements. In addition, footnote disclosures will include lease expenses for Type A & B leases, weighted average remaining lease terms, and discount rates to name a few.
Income Tax Implications
Currently, the new guidance has no changes to tax treatment of leasing activities. However, companies will be required to revisit their calculations of Federal and State deferred taxes and tax expense for financial reporting purposes. Additionally, the revised accounting standards may promote reassessment of lease contract arrangements in light of the change in financial accounting and reporting practices.
A movement to the new accounting standard would require a recasting of the existing lease portfolio for all periods presented.
In an effort to provide a certain degree of relief to lessees, FASB will provide transition guidance to include a definition of certain predefined existing or expired contracts and/or leases which may be excluded from the reassessment process.
Issuance of the final FASB pronouncement on leasing standards is expected during Q4 2015. The effective implementation date will be announced at a later date with it currently anticipated to be January 1, 2017 for calendar year-end companies.
Pre-implementation efforts are already underway in various sectors impacted by these changes. Various software companies supporting customer lease database information and processing have already designed the software programs capable of converting, recording and tracking leasing portfolios to the new proposed guidelines.
Suffice it to say, this is a significant event for the financial accounting and reporting of lease transactions. And the changes will promote consideration of the structure of future lease agreements and their impact on overall financial planning and desired economic outcomes.