How would you like your balance sheet to blow up by $18.2 billion? That’s the amount of Verizon’s minimum future rental payments under non-cancelable operating leases reported in their most recent Form 10-K. Delta Air Lines reported $12.8 billion and Starbuck’s Corporation reported $5.7 billion. According to the Effects Analysis issued by the IASB in January 2016, listed companies using either U.S. GAAP or IFRS disclose approximately $3 trillion in off- balance sheet lease commitments. These amounts are currently only disclosed. However, under the new lease accounting standard (ASC 842), the vast majority of these operating leases will now be reported on the balance sheet. The Wall Street Journal reported that corporate balance sheets could swell by as much as $2 trillion.
In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02 Leases (ASC 842). This ASU, along with IFRS 16 Leases, was a joint effort by the FASB and the International Accounting Standards Board (IASB) to improve financial reporting of leasing transactions by requiring companies to recognize lease assets and lease liabilities on the balance sheet. Although these standards aren’t effective until 2019 (for public business entities with calendar year ends), companies face significant changes. Both lessees and lessors need to evaluate the effect of the new standard on their business processes, financial statements, and internal controls prior to implementation.
We’ve identified the following top five biggest changes companies face as a result of implementing the new leasing standard under U.S. GAAP.
- Operating leases recognized on the balance sheet
Under current U.S. GAAP, operating leases are “off-balance sheet.” This treatment required investors to estimate the effect of operating leases on financial leverage and earnings. However, as we’ve discussed, ASC 842 requires lessees to recognize a liability to make lease payments and a right-to-use (ROU) asset representing their right to use the underlying asset for the lease term.
The result? Companies are going to see huge impacts on their balance sheets, although the expense recognized in the income statement will most likely not be affected. Retailers, drug stores, restaurants, supermarkets, airlines, and telecommunications companies are examples of companies that will feel the biggest impact of the new leasing standard. There is an exception from balance sheet recognition for leases with a term of 12 months or less.
- Determining whether the arrangement is a lease
Under current U.S. GAAP, meeting certain “bright line” tests means classification as an operating lease and off-balance sheet treatment. However, under ASC 842, all leases, except for short-term leases as previously discussed, are reported on the balance sheet. Therefore, the only way to get off-balance sheet treatment is if the arrangement does not meet the definition of a lease. Identifying so-called "embedded leases" in contracts is one of the most judgmental areas of the new standard.
The criteria for determining whether an arrangement meets the definition of a lease under ASC 842 are similar to current U.S. GAAP. However, there are important differences, specifically whether or not a lessee has the right to control the identified asset. If the lessee does not have the right to control the use of an identified asset, then the arrangement may not qualify as a lease.
- Lease payments: What is included?
Lease origination costs capitalized under ASC 842 will most likely differ from current U.S. GAAP. Specifically, there is a new definition of indirect costs, which will most likely result in fewer indirect costs that are capitalized under the new leasing standard. Additionally, under current U.S. GAAP, all executory costs, such as those for property taxes or insurance, are excluded from minimum lease payments. However, under ASC 842, these types of costs are part of lease payments used to calculate the lease liability and ROU asset.
- Sale-leaseback transactions
Under ASC 842, sale-leaseback accounting is substantially different than current U.S. GAAP. Under the new standard, for a sale to occur, the transfer of the asset must meet the revenue recognition requirements in ASC Topic 606 Revenue from Contracts with Customers. If there is not a sale of the asset from the seller-lessee perspective, the buyer-lessor does not account for a purchase of the asset. As a result, both the seller-lessee and the buyer-lessor account for any consideration paid for the asset as a financing transaction. In addition, ASC 842 provides new guidance on determining when a lessee controls an underlying asset before lease commencement, resulting in fewer built-to-suit arrangements subject to sales-leaseback accounting requirements.
- Increased financial statement disclosures
To be honest, disclosure requirements under current U.S. GAAP for leases are pretty weak. The new leasing standard will require a significant amount of new financial statement disclosures, both quantitative and qualitative, for both lessees and lessors. This includes information about significant judgments and assumptions. Before implementing ASC 842, companies need to ensure that they have the appropriate systems, procedures, and controls in place to provide this new information.
Implementing the new lease accounting standard will be a challenge for companies, but we’re here to help! In this post we provided a listing of accounting resources to assist companies with implementation. In future posts, we’ll explore the changes outlined above in further detail.
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.