FASB Releases Updates on Accounting for Leases
By: Sara Crabtree, Senior Manager
Previous lease accounting practices have been criticized for failing to provide accurate financial statements. Those practices did not require the recognition of the assets and liabilities resulting from operating leases to be on the balance sheet. On February 25, 2016, the Financial Accounting Standards Board (“FASB”) released Topic 842, Leases. The purpose of this update is to increase the transparency and comparability of entities which engage in leasing activities who previously kept their leasing obligations off the balance sheet. The Board’s intention is to require enough information on an organization’s financial statements so users may have a clearer understanding of the organizational structure, leasing practices, and financial standing.
Accounting Standards Codification (“ASC”) Update 842 provides a revised definition of a lease:
“…a contract, or part of a contract, that conveys the right to control the identified assets for a period of time in exchange for consideration.”
Under the updated guidance, to determine if a contract is a lease, the customer must have both the right to obtain substantially all the economic benefits from the asset and have the right to direct the use of the asset. While Topic 842 retains a distinction between financial and operating leases (previously defined as capital and operating; dual lease model) the core principle of ASC 842 is the new requirement to recognize the asset and liability which arises from operating leases.
All leases create an asset and liability, thus this new recognition provides more financial accuracy than previous Generally Accepted Accounting Principles (“GAAP”). Lessees must recognize a “right of use” asset along with the “lease” liability. This means the liability will be equal to the present value of the lease payment. The asset will be based on the liability, such as for the initial direct costs. Because stakeholder feedback focused on the lessee accounting, lessor accounting will not materially change from previous guidance. Furthermore, the update provides new guidance on lease and non-lease separation in contracts, exemptions for short-term leases, and new qualitative disclosures.
Another area that could have an impact on government contractors is in embedded leases. An embedded lease exists when there is an implicit or explicit asset in the contract where the customer controls the use of the asset. This can exist in a manufacturing contract where there is significant outsourcing involved, where bundled services with equipment is provided, or in data center and hosting contracts. When an embedded lease exists, the contract needs to be separated into its lease and non-lease components, and allocation considerations for each must be made. Under the new guidance, balance sheet amounts will be misstated if embedded leases are not identified and accounted for appropriately.
While early adoption of ASC 842 is permitted and encouraged, the implementation deadline for public companies is December 15, 2018. The deadline for private entities goes into effect the following year, December 15, 2019. To make the transition, entities will be required to take a retrospective approach. Lease accounts will be measured at the present value of the remaining lease payments on the contract. Management must remember that leasing is not limited to property. Equipment leasing offers more options and greater flexibility when changes are needed. Government contractors in the medical, information technology, and construction industries should be taking advantage of leasing because of the ever-changing regulation requirements, constant tech updates, and high asset purchase prices. The flexibility in asset management allows entities to maintain their competitive advantage by always having state of the art capital assets.
Depending on the volume of leasing and the segmentation of the organization, some may require complex and extensive contract lease reviews and evaluations. New processes and internal control implementation will be required to analyze current lease data and track future leases for financial reporting. The new recognition will affect entity financial ratios and change the presentation of the balance sheet, thus stakeholders must be informed of these changes before they are issued. For instance, organizations with substantial operating leases will have an increase in financial leverage when compared to previous years. Because of these effects, entities will have to increase the attention given to their leasing practices as they are no longer excluded from the published financial statements.