Learning Your Leases
What FASB’s new lease accounting standard means for businesses and their advisors.
The Financial Accounting Standards Board (FASB) has done it
again. If the new revenue recognition standard wasn’t exciting
enough, FASB’s new accounting standards update (ASU), “Leases”
(Topic 842), should get your blood pumping — or mind numbing.
All organizations that lease assets — aka “lessees” — will be
required to recognize these assets and liabilities on their balance
sheets. Without a doubt, this will introduce profound accounting
changes. (And if you’re up to the task, it might also create some
great consulting opportunities with clients looking to comply with
the new standard.)
“The most significant change impacts lessee accounting, as all
leases in excess of one year will be included on the balance sheet,
regardless if they are a financing or operating lease,” explains
Jeffery Watson, CPA, a principal of quality assurance at Miller
Cooper & Co., Ltd. in Deerfield, Ill., a current member of the Illinois
CPA Society’s Accounting Principles Committee and a former
AICPA PCPS Technical Issues Committee member.
Consistent with current U.S. generally accepted accounting
principles (GAAP), the recognition, measurement, and presentation
of expenses and cash flows arising from a lease by a lessee
primarily will depend on its classification as a finance or operating
lease. But unlike current U.S. GAAP, the new ASU requires both
types of leases to be capitalized on the balance sheet, resulting in
a liability and a corresponding right-of-use asset being recognized.
The ASU also will require disclosures to help investors and other
financial statement users better understand the amount, timing, and
uncertainty of cash flows arising from leases.
For public companies, the ASU is effective for fiscal years, and
interim periods within those fiscal years, beginning after Dec. 15,
2018. For a calendar year company, that means it would be
effective Jan. 1, 2019.
Who’s ready? Not many, according to a recent Deloitte poll of more
than 2,170 C-suite and other executives. In fact, Deloitte found
only 42 percent of public companies and 33 percent of private
companies are on schedule to implement their respective new
standards by their effective dates.
“The clearest part about this standard is that there will be a significant
change,” says Nancy Miller, CPA, senior director of technical
accounting at Reynolds Group Holdings Limited in Lake Forest, Ill. “A significant amount of work needs to go into assessment and
adoption of the standard — it should not be underestimated.”
Both international financial reporting standards (IFRS) and U.S.
GAAP require operating leases to be recognized on a reporting
entity’s balance sheet, with the capitalized asset and lease
liability are initially measured with reference to the fixed portion
of lease payments.
Under IFRS, the capitalized asset is amortized, and the lease
liability unwinds by way of interest and principal, “consistent with
today’s accounting for finance leases,” Miller explains. “Under U.S.
GAAP, capitalized leases continue to be classified as either
capitalized operating leases or capitalized finance leases. The
P&L expense associated with capitalized operating leases
will be the same as today’s expense and will continue to be
reported in EBITDA.”
“Although both operating and finance leases will be recorded on
the balance sheet, the expense recognition pattern will differ for
each,” Miller adds. Under an operating lease, a lessee would
recognize a lease expense on a straight-line basis over the lease
term; under a finance lease, the lessee would recognize both
interest expense (by using the effective interest method) and
amortization expense. “The lessee would generally recognize
greater expense earlier in the life of the lease for a finance lease
than for an operating lease,” she says.
Miller also points out that under both IFRS and U.S. GAAP, most
variable lease payments are excluded from the measurement of the
capitalized asset and lease liability. “The expense associated with
these amounts will continue to be reported within EBITDA,” she
says. “The new rules also call for extensive quantitative and
qualitative disclosures to increase transparency related to revenues
and expenses recognized, and expected to be recognized, from
existing contracts. Companies will want to consider how to gather
the necessary information and how to appropriately communicate
with relevant stakeholders.”
Under U.S. GAAP today, operating leases are not capitalized on
the balance sheet but will be in the future (assuming the lease term
is more than a year). “The impact on income taxes should not be
different than what’s done today for federal income taxes,” Watson
says. “Although, if lease terms and conditions or accounting
policies change as a result of adopting the ASU, they could lead to
timing differences between book and tax that would lead entities
to assess deferred taxes.”
Other tax areas impacted include state taxes, international taxes,
and transfer pricing. State taxes will be impacted where certain
states levy franchise taxes, which are generally based on net worth,
Watson notes. Entities will need to consider how they record the
right-of-use asset — that is, recorded in the same balance sheet
account, or line item as other company owned property?
“For entities with international operations and intercompany
transactions, financial and profitability ratios utilized to assess
transfer pricing may no longer be comparable to periods presented
prior to the ASU’s effective date, raising questions on the validity
of the transfer pricing arrangements,” Watson cautions.
Considering the amount of change the new standard creates, there’s
significant opportunity for advisory firms to step up to help their
clients. According to PwC, businesses are likely to feel the financial
impact of the new standard in several ways:
• Losing the benefit of off-balance sheet financing for operating
leases could merit reassessing lease-buy decisions and trigger the
need to reconsider debt covenant compliance.
• Pre-existing leases won’t be grandfathered, so most outstanding
leases will come onto the balance sheet. Companies may need
new processes, systems, and controls to account for current and
• Any new lease accounting system must address taxes. The new
assets recognized for operating leases will change companies’
book/tax difference computations and could affect certain state
and local tax apportionment calculations and transfer pricing.
• For regulated companies, such as banks, broker/dealers, and
insurers, new assets and liabilities on the balance sheet may
affect regulatory calculations, in some cases requiring more
Consulting and accounting firms will want to help clients get IT,
tax, operations, treasury, and accounting together to ensure
transition and compliance, create an inventory of lease contracts,
and look at service contracts to identify potential embedded leases.
Watson thinks the latter is a potentially troublesome area. “Entities
will be able to identify and catalog their more traditional lease
arrangements but could forget about the balance sheet impact of
embedded leases contained in service contracts,” he warns. “Even
though embedded leases exist in U.S. GAAP today, often these
arrangements are not bifurcated between an operating lease and
service contract but instead are just recorded as a line item, such
as a service contract expense, on the statement of operations.
Under the new lease guidance, not bifurcating a material
embedded lease from a service contract will result in the balance
sheet being misstated.”
To start preparing for the new standard, Miller recommends
companies identify stakeholders as soon as possible. A standard
this far-reaching means many different functions, like IT, legal,
accounting, procurement, real estate, operations, and so on, will
need to be involved.
PwC recommends that advisory firms help clients discover if they
know everything they lease by doing the following:
• Prepare an inventory of lease contracts and gather data on lease
terms, renewal options, and payments.
• In a multi-asset lease, identify and account for each component
as a separate lease. Gather data on lease elements and non-lease
• Estimate future balance sheet amounts for operating leases.
Consider whether debt covenants are affected by the addition of
lease liabilities and assets to the balance sheet.
• Evaluate the leasing strategy for changes (e.g., lease-buy, shorter
vs. longer terms, variable payments, or asset substitution clauses).
In other words, companies and their advisors have their work cut
out for them; we’re talking about a whole new level of learning
leases. “Almost everyone I know is finding out much more than
they originally anticipated,” Miller says.