The new lease accounting rules (Accounting Standards Update N0. 2016-02; Topic 842) will require the recognition of lease assets and lease liabilities for those leases classified as operating leases under existing GAAP. For public companies, the new standard is effective for fiscal years beginning after December 15, 2018.
While complexities can arise, the new standard defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration.
Finance Leases versus Operating Leases
From a lessee’s perspective, there are two types of leases – finance leases and operating leases. Finance leases are treated in a manner similar to capital leases under existing GAAP. The new standard requires a lessee to recognize lease assets and liabilities for both finance leases and operating leases. One basic difference in treatment between finance leases and operating leases is that expense recognition is accelerated for finance leases while expense under an operating lease are generally recognized on a straight line basis.
A lease is classified as a finance lease if it meets any of the following criteria at lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion is not used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- 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.
Lessees classify any lease that does not meet the criteria of a finance lease as an operating lease.
When determining lease classification, one reasonable approach to assessing the above criteria would be to conclude:
- Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
- A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
The lease term is the non-cancellable period of the lease, together with all of the following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option.
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.
At the commencement date, the lease payments include the following payments relating to the use of the underlying asset during the lease term:
- Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee.
- Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.
- The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option.
- Payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease.
- For a lessee only, amounts probable of being owed by the lessee under residual value guarantees.
A lessee recognizes a right-of-use asset and a lease liability at the lease commencement date.
The lease liability is calculated using at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement. For a lessee, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate.
The cost of the initial right-of-use asset consists of the following:
- The amount of the initial measurement of the lease liability.
- Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received.
- Any initial direct costs incurred by the lessee.
After the commencement date, for an operating lease a lessee recognizes all of the following in profit or loss (impairments are not addressed here for simplicity):
- A single lease cost, calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset.
- Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred.
After the commencement date, for an operating lease, a lessee measures both of the following:
- The lease liability at the present value of the lease payments not yet paid discounted using the discount rate for the lease established at the commencement date.
- The right-of-use asset at the amount of the lease liability, adjusted for the following:
- Prepaid or accrued lease payments.
- The remaining balance of any lease incentives received.
- Unamortized initial direct costs.
The following example demonstrates the application of the rules set forth above:
Lessee enters into a 10-year lease of an asset, with an option to extend for an additional 5 years. Lease payments are $50,000 per year during the initial term and $55,000 per year during the optional period, all payable at the beginning of each year. Lessee incurs initial direct costs of $15,000.
At the commencement date, Lessee concludes that it is not reasonably certain to exercise the option to extend the lease and, therefore, determines the lease term to be 10 years. Lessee also determines the lease is an operating lease.
The rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 5.87 percent, which reflects the fixed rate at which Lessee could borrow a similar amount in the same currency, for the same term, and with similar collateral as in the lease at the commencement date.
At the commencement date, Lessee makes the lease payment for the first year, incurs initial direct costs, and measures the lease liability at the present value of the remaining 9 payments of $50,000, discounted at the rate of 5.87 percent, which is $342,017. Lessee also measures a right-of-use asset of $407,017 (the initial measurement of the lease liability plus the initial direct costs and the lease payment for the first year).
Lessee determines the cost of the lease to be $515,000 (sum of the lease payments for the lease term and initial direct costs incurred by Lessee). The annual lease expense to be recognized is therefore $51,500 ($515,000 ÷ 10 years).
At the end of the first year of the lease, the carrying amount of Lessee’s lease liability is $362,093 ($342,017 + $20,076; the $20,076 represents accrued interest on the lease liability), and the carrying amount of the right-of-use asset is $375,593 (the carrying amount of the lease liability plus the remaining initial direct costs, which equal $13,500).
As an accounting policy, a lessee may elect not to apply the recognition requirements of the new standard to short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred. The accounting policy election for short-term leases is made by the class of underlying assets to which the right of use relates.
A short-term lease has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.