Lease accounting changes are always afoot. The most important changes related to CAM (common area maintenance) accounting, lease accounting journal entries, you name it, are the new lease accounting standards ASC 842, GASB 87 and GASB 96 in the U.S., and IFRS 16 internationally.
In this guide, we will go over everything you need to know now that the lease accounting standards are effective.
If you’re looking for new lease guidance, you’ve come to the right place. Let’s hop right in.
The new lease accounting standards consist of the statements ASC 842 and GASB 87 & GASB 96 in the U.S. and IFRS 16 internationally. These statements released by various lease accounting bodies are meant to change the way leases are documented on financial statements. The new system seeks to ensure that financial statements for all organizations—from public companies to governmental agencies—are more transparent for leases.
Grab this quick reference guide to the new lease accounting standards to provide a summary of key points to your clients, but below we provide a quick run-through of each standard involved in these lease accounting changes.
Lease standard effective date: January 1, 2019
IFRS 16 is an international standard promulgated by the International Accounting Standards Board (IASB) effect in 2019 and requires lessees and lessors to recognize assets and liabilities for leases longer than 12 months. IFRS 16 abandons the use of capital leases and operating leases. Now, leases under IFRS 16 are identified under a single “right-of-use” (ROU) model. Unlike the previous statement, all ROU assets must be displayed on an organization’s balance sheet. This allows organizations to report and represent their lease transactions more properly and transparently.
Lease standard effective date: June 15, 2021
Released by the Governmental Accounting Standards Board (GASB), GASB 87 requires all leases longer than 12 months to be recorded as liabilities and ROU assets, just like IFRS 16, for entities that follow GASB accounting, which includes local municipalities, public school districts, and airports. In addition, GASB 87 leases are generally known as “financings” rather than continuing to distinguish operating and capital leases.
Download a side-by-side comparison guide to GASB 62 vs GASB 87 here.
Lease standard effective date: fiscal years starting after December 15, 2018 - public companies
ASC 842 replaced ASC 840 and requires leases 12 months and longer to be recorded on public companies’ balance sheets.
Lease standard effective date: fiscal years starting after December 15, 2021 - private entities and non-profit organizations. The same standard, ASC 842, has a different effective date for all other U.S. organizations that follow generally accepted accounting principles (GAAP) under the Financial Accounting Standards Board (FASB).
ASC 842 classifies leases as either operating or finance leases. The term “finance lease” replaced “capital lease” in ASC 842 as well as the criteria that defined each. On balance sheets, lessees are required to recognize the assets and liabilities for both operating and finance leases. You can calculate the lease liability as the present value of lease payments. The right-of-use asset is the lease liability, adjusted by prepaid rent, initial direct costs, and lease incentives received. Among lessors, lease accounting predominantly remained the same from ASC 840 to ASC 842. Here are the three classifications of leases under this new lease accounting standard for lessors:
This type of lease calls for a recognition of a profit or loss on a sale because the lessor is assumed to be selling a product to a lessee. The lessor then also derecognizes the asset, recognizes their net investment on the lease, and recognizes any initial direct costs as an expense. The lessor is often a manufacturer or dealer in this case.
For this type of lease, a lessor leases assets to their customers after acquiring them, with the intent of using interest payments to generate revenue. The lessor recognizes the gross investment in the lease and the related amount of unearned income under this arrangement. The lessor is generally not a manufacturer or dealer in this case.
Under an operating lease there is no transfer of ownership of an asset. The asset is leased for a period of time less than its useful life and reclaims the leased asset at the end of its term. This asset stays on the lessor’s balance sheet, unlike the other two lessor lease types.
Lease standard effective date: fiscal years starting after June 15, 2022
GASB 96 lays out the accounting principles for SBITAs. A SBITA stands for a Subscription-Based Information Technology Arrangement. SBITAs are similar to leases, but there are some distinctions between the two. First, SBITAs are not between lessees and lessors. Instead, they are arrangements between government entities and IT vendors. Similar to the rest of the new lease accounting standards, GASB 96 uses the term right-of-use asset. In this case, SBITAs are arrangements that give government entities the right to use a subscription asset at its present service capacity. To learn more about SBITAs and GASB 96, check out our webinar recap.
As you can see, there is a theme with all of these different standards: As each of these standards goes into effect, the way leases are documented and recognized is changing to more accurately reflect committed future lease payments for entities.
Under the previous lease standard, payment obligations of operating leases are not reflected on the balance sheet even if you have committed to many years of payments. In other words, a future debt (a liability) was nearly invisible on financial statements. These payments were mentioned in footnotes, but not prominently like liabilities on the balance sheet.
Many organizations have dozens, or even hundreds, of operating leases, which can result in a huge gap for anyone trying to understand that company’s financial situation via their balance sheets. This is primarily why the FASB, GASB, and IASB made the change.
Since these accounting organizations continually offer new lease guidance regarding lease accounting changes based on stakeholder feedback, it’s important to watch for ongoing updates about the new lease standard.
As you’d expect, implementing the new lease accounting standards by the lease standard effective date means you and your clients must change how you think about and account for individual leases. Here is a list of a few considerations to keep in mind as well:
Changing accounting methods doesn’t change an organization, but it can affect the way financial results are viewed by outside parties. In particular, adding significant lease liabilities can impact compliance with debt covenants. It’s critical that your clients get a handle on the potential impact and start conversations with their bank as early as possible.
The new lease accounting standards require organizations to make policy decisions about how they will handle leases. While practical expedients can simplify implementation, they can also result in a larger liability and asset on the books. Early on, your clients need to review and decide which policies are right for their organization.
In most organizations, operating lease decisions have been fairly decentralized, especially when multiple locations are involved. The new lease standard requires these decisions to be centrally documented and available for accounting, which introduces a need for new systems, processes, and controls. The good news is that organizations are often finding efficiencies and cost savings with this new approach.
For each client, you will need to first identify the lease accounting standard that applies to them specifically, along with the applicable effective date.
With the changes brought on by these new lease accounting standards, many companies find that identifying and analyzing their leases requires more resources and expertise than they have available. Don’t underestimate the requirements for this initial step. In fact, you may want to consider engaging outside advisors from the start to avoid errors and higher costs after implementation.
How do you implement the new lease accounting standards? For a checklist of key steps in the implementation process, download “Are You Ready for the New Lease Accounting Standard?”
And if you’re wondering how prepared your organization is for the new standard, take this quick readiness assessment to find out!
Build a plan for implementation success
Depending on whether your organization is a US public company, a state/local government, or an international entity, you will have a different lease standard effective date. Here’s a quick guide to which lease standard effective date you should follow:
Now that you know your lease standard effective date, you can determine your initial application date. The original guidance for all standards stated that the initial application date would be the first day of the first fiscal year represented in your financial statements. While the FASB now offers a practical expedient so organizations can avoid restating prior years, the GASB did not. These dates would work as follows under the original guidance:
The FASB recognized that the above guidance requires restating prior years, and therefore reporting is a significant amount of work. In order to decrease the difficulties, they issued ASU 2018-11 in July 2018, which amends the new lease standard to allow companies to avoid prior-year restatement. Most organizations do elect to take advantage of this practical expedient. Therefore, sticking with the same example dates above, the initial application date would be calculated as such:
An important date for individual leases is the commencement date, which is the date the underlying asset is available for use by the lessee. It’s important to note that this may not be the date when the lessee enters into the agreement with a lessor. Lease classification and measurement should take place at the commencement date.
Sometimes leases are renegotiated. If this results in a new contract, renewal, or other extension not previously anticipated, it is treated as a new lease. Otherwise, assumptions such as the discount rate, fair value, and remaining economic life of the underlying asset are reviewed and updated as of the modification effective date, with modification gains and losses also recognized as of the same date.
Other times, a triggering event occurs that was not otherwise anticipated. Generally, this is something that requires the lessee to reassess the lease term. The date as of which this triggering event occurs is called the remeasurement date. Note that the lessee should also update the discount rate and any variable lease payments as of the remeasurement date.
Download the guide to learn the importance of data collection to a successful lease standard implementation
A critical part of implementing the new lease accounting standard is reviewing existing contracts, determining what does and doesn’t qualify as a lease, and creating initial journal entries to apply the standard to the balance sheet.
This chapter of our lease accounting changes guide examines what you need to know about what does and doesn’t qualify as a lease, separating lease components, making policy elections, and auditing leases.
Pressed for time? Download the Lease Audit Checklists for Office Space and Vehicle Leases now to get started.
Before reviewing your portfolio of contracts, it’s important to understand exactly what qualifies as a lease under the new lease standard. Under the new lease accounting standards, all leases must be recognized as both an asset and offsetting liability for future lease payments.
This is a big difference from the previous standard, where operating leases were not reflected on the balance sheet. There are a few considerations that help determine if a particular contract is a lease:
One key to knowing that you have a lease rather than another type of contract is whether you have the right to control or use an asset, also called the right-of-use, or ROU Asset. Additionally, the asset itself must be explicitly or implicitly identified, as well as be physically distinct. Also keep in mind that some leases of physical assets are embedded in service arrangements or other vendor contracts.
To properly implement the new lease accounting changes, organizations should review every contract to ensure all leases, regardless of labeling, are properly included in the financial statements.
According to ASC 842-10-15-3: "A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce)."
The embedded lease definition is when there is a contract with a vendor that uses an asset as part of the value provided and the use of that asset meets the definition of a lease. A contract may contain a lease even if it's a service contract.
Our Embedded Lease Identifier is an excellent free tool to make identifying potential embedded leases within contracts vastly simpler and quicker over doing so manually.
Quickly find embedded leases within contracts with our easy-to-use Embedded Lease Identifier tool.
Not all costs related to a lease are included in the leased asset and liability. For example, a lessor may lease a truck and also include a provision to operate the truck on behalf of the lessee. Providing a driver, maintenance, and gas are not related to securing the use of the truck and these costs would be considered non-lease components.
On the other hand, costs attributable to securing the asset itself should be included in the lease payments for both classifying and measuring the lease. For example, a non-refundable upfront deposit would be considered a lease component.
A hallmark of ASC 842 leases is the fact that they require quite a bit of judgment. This means you need to think about the intent of a particular payment to determine whether it should be included or excluded. This is a good starting place when considering how to classify lease-related payments.
A critical part of implementing the new lease accounting standards, including auditing leases, is making the required policy elections, summarized below. For leases shorter than 12 months, entities get to choose whether or not to implement the new lease accounting standards.
Sometimes, the changes in lease accounting can make the recognition of lease payments easier, so it’s worth getting familiar with them in case opting to follow them would save you time and effort in accounting for leases.
Lessees may make a policy election not to apply the standard (that is, not recognize a right of use asset or lease liability) to short-term leases of 12 months or less for all classes of underlying assets.
If this election is made, the lessee would recognize the lease payments as operating expenses straight-lined over the lease term. This election saves time in accounting for these leases, but the disadvantage is that different accounting policies and processes need to be in place for short-term and long-term leases.
A lessee may choose—as a practical expedient for the class of underlying asset—to account for the lease and non-lease components as a single combined lease component. If this election is not made, the lease payments are allocated to the separate lease and non-lease components, using relative standalone prices (estimated if not readily available). While this expedient saves time, the lessee will have a larger liability (and ROU asset) by treating non-lease components as lease components.
At the lease commencement date, lessees determine the present value of the lease payments to calculate the ROU asset and lease liability using the rate implicit in the lease. Because the rate implicit in the lease is almost never readily available, the lessee can also use their collateralized borrowing rate, which would be the rate at which the lessee would borrow money to purchase the same asset with a similar loan term.
It is important to note that an organization cannot use the same discount rate for leases of different items with different terms. For example, the discount rate for a 10-year office lease would likely be different from a 3-year vehicle lease.
Alternatively, non-public companies subject to FASB ASC 842 can elect to use a risk-free rate of return as the discount rate for all leases, regardless if the implicit rate is known. This election saves time and reduces audit risk; however, the risk-free rate will likely be a lower rate than the incremental borrowing rate, creating a larger lease liability.*
This update made by the FASB makes it easier to comply with the new lease accounting standard.
Recognizing the need for additional flexibility on determining the discount rate, the FASB now allows a nonpublic company to elect using the risk-free rate by asset class. While this election and the asset classes to which it applies must be disclosed, this is an important and positive change.
Organizations can now take the extra time to calculate what is likely a higher collateralized borrowing rate for their largest dollar-value leases, such as office space. For lower-value assets, like vehicles or small equipment, the impact of using the more easy-to-determine risk-free rate is twofold: it saves time and the impact to the lease liability is likely far less material.
*Note that this election cannot be used for entities that follow IFRS 16 or GASB 87/96.
