The Financial Accounting Standards Board (FASB) has decided to issue a proposal that would make the much-anticipated lease accounting standard easier to apply. It calls for changes to how companies make the transition to the new accounting and revises the guidance for lessors. Here are the details.
Refresher on lease accounting
The existing lease accounting standard, Leases (Topic 840), requires companies to record lease obligations on their balance sheets if the arrangements are considered financing transactions, such as rent-to-own contracts for buildings or vehicles. Few arrangements get recorded, however, because U.S. Generally Accepted Accounting Principles (GAAP) gives companies leeway to arrange the agreements to look like simple rentals. If an obligation isn’t recorded on a balance sheet, it makes a business look like it is less leveraged than it really is.
After nearly a decade of debate, the FASB issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). The new standard calls for major changes to current accounting practices for leases. In a nutshell, companies will be required to recognize on their balance sheets the assets and liabilities associated with rentals, such as offices, factories, airplanes and heavy equipment. The effects of the new standard are expected to be pervasive, because businesses rent anything from forklifts to photocopiers to recycle bins.
ASU No. 2016-02 defines a lease as a contract (or part of a contract) that conveys the right to control the use of a rented asset. The concept of control is a key change from the definition of a lease. It means that the customer has both the right to realize substantially all of the economic benefits of the asset and the right to direct the asset’s use.
Most existing arrangements that currently are reported as leases will continue to be reported as leases under the new standard. In addition, the new definition is expected to encompass many more types of arrangements that aren’t reported as leases under current practice.
In recent months, public companies and their auditors have started to express concerns that they won’t be ready to follow the new lease accounting by the 2019 compliance date. They’re especially concerned about 1) the lack of commercially available software to help them follow the new recognition and measurement requirements, and 2) the complicated disclosure rules.
So, the FASB has agreed to revise two provisions. The first change relates to how businesses will transition to the new standard from the current guidance. The new standard requires companies to follow a modified retrospective approach. In other words, as businesses adopt the standard, they’ll need to restate two prior years of balance sheets and three prior years of income and cash flow statements with the new accounting.
The retrospective transition requirement is intended to help investors and analysts more accurately compare prior periods. But businesses recently told the FASB that the presentation of the income statements and balance sheets from prior years was a significant undertaking, especially because few software solutions exist yet to help companies apply the new lease accounting standard. So, the FASB has proposed making this requirement optional and, instead, allowing companies upon adoption of the new lease accounting standard to continue to present results using the current lease guidance for prior periods.
The majority of FASB members believe this change will help companies avoid the costs and complexities associated with “looking backward” and give management more time to focus on accounting for current and future transactions. However, one FASB member (R. Harold Schroeder, a former fund manager and securities analyst) voted against revising this provision. He said the proposed change is a disservice to investors and analysts, whose livelihoods depend on their ability to assess investment trends.
The second change relates to the itemized reporting of maintenance charges in rent payments. Lessors and property managers have been especially vocal about the burden of being required to break out the fees for “common area maintenance” charges, such as security, elevator repairs and snow removal. They argued that it’s cumbersome to account for these items separately from the charges associated with renting out land or buildings. So, the FASB has agreed to give lessors the option not to separately account for the fees.
The FASB plans to float the proposed changes for a 30-day public comment period. But there’s limited time for the accounting board to finalize these changes. Public companies have to follow the new lease accounting in 2019, though private companies have a one-year reprieve.
Sidebar: Special exception for land easements
In November, the FASB unanimously agreed to provide a practical expedient to utilities, oil-and-gas companies and energy providers that hold rights-of-way to accommodate gas pipelines or electric wires. Under the revised guidance, companies that hold land easements won’t have to sort through years of old contracts to determine whether they meet the definition of a lease under Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842).
A land easement agreement might, for example, give a company the right to pass a pipeline through a field or run an electric cable over a farm. The owners of the land typically continue to use the land as before. Businesses that hold land easements sometimes account for them as leases, but others account for them under Intangibles — Goodwill and Other (Topic 350), or Property, Plant, and Equipment (Topic 360).
Companies that don’t currently account for their land easements as leases told the FASB it would be a large undertaking to sort through their contracts to determine if they meet the definition of a lease from the new standard. Most easements aren’t expected to fit the definition. Of the easements that do fit the definition, many are prepaid and already recognized on the balance sheet.
This practical expedient applies only to existing land easements, however. Once the new lease standard is in place, companies must determine if new land easements they acquire fit within the standard’s scope.
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