Vedder Thinking | Articles Coming to a Financial Statement Near You: New Lease Accounting Standards
During the first quarter of 2016, after nearly a decade of planning, the Financial Accounting Standards Board (FASB), which governs U.S. generally accepted accounting principles (GAAP), and the International Accounting Standards Board (IASB), which governs international accounting standards (IAS), issued their new lease accounting standards. The new standards are designed to increase transparency and comparability among lessees by requiring them to put assets and liabilities on their balance sheets for all leases. FASB’s new rules are contained in Topic 842, and IASB’s new rules are in IFRS 16. FASB and IASB have adopted different lessee lease accounting models with IFRS 16 applying a single method of accounting (i.e., one modeled on current finance lease treatment), while Topic 842 utilizes a dual method of accounting that distinguishes between finance leases and operating leases. The revised standards will become effective on January 1, 2019 for IFRS users1 and the fiscal year beginning after December 15, 2018 for public companies using GAAP. Private companies using GAAP must begin using the new standard for the fiscal years beginning after December 15, 2019.
Under current GAAP and IAS standards for lessees,2 a lease that substantially transfers all of the risks and rewards incidental to ownership of the underlying asset from the lessor to the lessee is classified by the lessee as a "capital lease"3 and must be reported on the lessee's balance sheet. All other leases are classified by lessees as "operating leases" and are not reported on the lessee's balance sheet.4 In 2005, the U.S. Securities and Exchange Commission estimated that its registrants held approximately US$1.25 trillion in off-balance sheet lease obligations, and the IFRS Foundation estimates that listed companies around the world have in excess of US$2.8 trillion in off-balance sheet lease obligations. As a result, analysts and investors often make adjustments to the amounts reported on a lessee's balance sheet and income statement to estimate the company's off-balance sheet lease obligations.5 The new lessee accounting standards are expected to reduce the need for such adjustments by requiring most leases to be disclosed on the balance sheet and thus make it easier to understand and compare lessees’ financial commitments regardless of how lessees choose to finance the assets used in their businesses. Lessor accounting is largely unchanged, so this article will focus primarily on the changes in lessee accounting.
Lessee Lease Accounting
Lessee Balance Sheet Accounting
Under the new rules, on the commencement date of a lease the lessee must recognize a right-of-use asset and a lease liability. The right-of-use asset is a depreciating nonfinancial asset that represents the lessee's right to use the underlying asset for the lease term, while the "lease liability" represents the present value of the lessee's obligation to make the lease payments arising from the lease.6 At lease commencement, (i) the lease liability's cost is the present value of the lease payments not yet paid, discounted at the discount rate for the lease, and (ii) the right-of-use asset's cost consists of (x) the initial measurement of the lease lability, (y) any lease payments made at or before the commencement date less any lease incentives received and (z) any initial direct costs incurred by the lessee.7 Subsequent measurements of the right-of-use asset and lease liability under Topic 842 depend on whether the lease is an operating lease or a finance lease.8 For operating leases, (i) the lease liability is the present value of the lease payments not yet paid, discounted using the discount rate for the lease established at the commencement date,9 and (ii) the right-of-use asset equals the amount of the lease liability with several adjustments.10 For finance leases, (i) the lease liability is measured after the commencement date by increasing the carrying amount to reflect interest on the lease liability and reducing the carrying amount to reflect the lease payments made during the period, and (ii) the right-of-use asset is measured at cost less any accumulated depreciation and accumulated impairment losses. The lack of a finance lease/operating lease distinction is especially relevant for IFRS lessees because the carrying value of the right-of-use asset for a formerly off-balance sheet lease will typically be lower than the lease liability throughout the lease term. In other words, the implementation of these rules will likely lead to an increase in both gross and net liabilities for companies with significant leased assets. This is because the right-of-use asset is typically depreciated on a straight-line basis whereas the lease liability is (i) reduced by the amount of lease payments made and (ii) increased by the interest reducing over the life of the lease, resulting in differing values for the asset and liability. On the balance sheet, lessees are required to present right-of-use assets and lease liabilities separately from other assets and liabilities.11 Short-term leases (leases with a term of 12 months or less at the commencement date) are exempted from the new accounting requirements under both Topic 842 and IFRS 16.
Current IAS treatment for off-balance-sheet leases generally requires lessees to recognize lease expenses as operating expenses (typically on a straight-line basis). In contrast, IFRS 16 requires lessees to present the implicit interest rate in lease payments for these leases separately from the depreciation charge for the right-of-use asset in the income statement. Because a portion of the lease expense will now be included in financing costs instead of operating costs, EBITDA and operating profit will likely increase for companies that have material off-balance-sheet leases. Further, because the interest expense on a lease is highest at the beginning of the term and decreases over time as the lease liability gets smaller, the result is a front-loaded expense profile. For companies with evenly distributed lease portfolios.12 IASB predicts a neutral overall income statement effect from adopting IFRS 16. In contrast, companies with unevenly distributed lease portfolios may see an impact on profit and loss from the implementation of IFRS 16. This is in contrast to the Topic 842 standard for operating leases, which requires lessees to recognize a single lease cost allocated over the lease term (generally on a straight-line basis) as an operating expense. The requirement is generally consistent with current GAAP, and thus the new GAAP standard will not likely have an impact on a company’s statement of comprehensive income.
Statement of Cash Flows
Because the new accounting standards do not affect the amount of cash transferred between lease parties, there is no change to the total amount of cash flows reported in the statement of cash flows under either IFRS 16 or Topic 842. However, IFRS 16 will change the way former off-balance-sheet leases are presented in the statement of cash flows. Operating cash outflows will decrease and financing cash flows will increase because principal repayments are included with financing activities while interest payments can be included within operating, investing or finance activities. The new Topic 842 standard for finance leases is identical to IRFS 16.13 In contrast, however, operating lease payments under Topic 842 are included in operating activities.
Notes to Financial Statements
Both IFRS 16 and Topic 842 require additional quantitative lease disclosure compared to past guidance. Among the disclosure items specifically required by both new standards are the following:
- The interest expense on lease liabilities14
- Depreciation/amortization charges for right-of-use assets15
- Short-term lease expenses
- Variable lease term expenses
- Income from subleasing right-of use assets
- Gains or losses arising from sale and leaseback transactions
- Lease liability maturity analysis
IFRS 16 also requires lessees to disclose total cash outflow for leases, additions to right-of-use assets and the carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset. Because Topic 842 uses a dual lessee accounting model, it requires separate disclosure of the weighted-average discount rate for operating leases as well as the beginning and ending balances of operating lease liabilities. Topic 842 also mandates certain qualitative disclosures, including general lease descriptions, restrictions or covenants imposed by leases, and information about significant assumptions and judgments made in applying the new Topic 842 standard.16
Both FASB and IASB considered the effects that changes in lease accounting guidance would have on the lease market (e.g., cost of borrowing and debt covenants, noting that a company’s financial commitments will be the same regardless of the change in accounting guidance). On balance, FASB and IASB estimate that many companies will benefit from the additional disclosures because analysts and credit rating agencies often overestimate a company's liabilities when they utilize common adjustment and estimation techniques to get a sense of the company's off-balance sheet lease liabilities. Further, both FASB and IASB noted studies from the United States and Europe showing that virtually all credit agreements include "frozen GAAP" or "semifrozen GAAP" clauses that protect companies from changes in accounting standards,17 and, in any case, banks are unlikely to jeopardize a good customer relationship by calling a loan because of a technical default arising solely from an accounting standards change.
Lessor Lease Accounting
Lessor lease accounting is largely unchanged from that applied under previous GAAP Topic 840 and IAS 17. Thus the operating lease/finance lease distinction is carried forward under IFRS 16, and the operating lease/direct financing lease/sales-type lease distinction continues under Topic 842. Dissimilarities between lessor accounting treatment under Topic 842 and IFRS 16 are largely carried forward from their predecessor standards.18 Nevertheless, IFRS 16 requires lessors to provide some additional disclosure items compared to prior guidance, including a table of lease income, information about exposure to residual asset risk and information about assets subject to operating leases. Topic 842's changes to lessor accounting primarily incorporate recent updates in revenue recognition guidance and align the lessor accounting framework with specific changes in lessee accounting guidance.
Sale and Leaseback Transactions
In a sale and leaseback transaction, a seller-lessee sells an asset to a buyer-lessor and simultaneously leases it back from the buyer-lessor. Current GAAP and IFRS requirements for sale-leaseback treatment are substantially different regarding whether an asset sale occurs and how to recognize any gain or loss on that sale in a sale-leaseback transaction. Under the new standards, a transfer should be accounted for as a sale-leaseback transaction only if it meets the requirements for "sale" accounting treatment. The result is that some sale and leaseback transactions that would previously have qualified for sale-leaseback accounting will no longer qualify. The new standards differ with respect to how much of the gain or loss on the sale can be recognized: IFRS 16 permits the seller-lessee to recognize only the amount of gain that relates to the rights retained in the underlying asset at the end of the leaseback, while Topic 842 requires the seller-lessee to account for any gain or loss on the asset consistent with the guidance that would apply to any other sale of an asset.
Both IFRS and GAAP will require intermediate lessors to account for a head lease and a sublease as two separate contracts, applying both lessee and lessor accounting requirements. This is because an intermediate lessor's head lease obligations are generally not extinguished by the terms and conditions of the sublease. Topic 842 and IFRS 16 differ, however, in their approaches to classifying a sublease as a finance lease or an operating lease by the intermediate lessor. IFRS 16 requires evaluation of the lease by reference to the right-of-use asset arising from the head lease, whereas Topic 842 refers to the underlying asset.
Current GAAP permits a specialized form of accounting, commonly referred to as "leveraged lease accounting," for certain leases financed with substantial non-recourse debt from a third-party financial institution and in which the lessor's net investment declines in the beginning of the term and increases thereafter. Leveraged lease accounting allows for these leases to be accounted for on a net basis (only the lessor's net investment is shown on the balance sheet and the debt is not reflected), and income is booked on the net investment (which results in a front-loaded booking of earnings). FASB decided not to retain the special accounting model for leveraged leases in its Topic 842 update. However, FASB decided to grandfather leveraged lease accounting for existing leveraged leases during the transition period.
Though off-balance sheet accounting treatment will no longer be an option for lessees, the other benefits of leasing (e.g., lower initial capital outlays, the transfer of obsolescence risk and certain tax benefits) are unchanged. In any case, studies reveal that off-balance sheet accounting treatment is not a primary factor for lessees choosing to lease rather than purchase assets. In fact, many lessees will benefit from disclosing formerly off-balance sheet leases because creditors and investors will be able to make decisions based on the lessee's actual lease liabilities rather than relying on crude estimates that often turn out to be overestimates. For these and other reasons, leasing remains a useful asset financing option.
If you have any questions regarding the topics discussed in this article, please contact Jonathan H. Bogaard at +1 (312) 609 7651, Chad E. Voss at +1 (312) 609 7629 or your Vedder Price attorney with whom you have worked.
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1 Early adoption is permitted if IFRS 15, Revenue from Contracts with Customers, has been applied.
2 ASC 840-10-25-1; IAS 17, ¶¶ 8, 20.
3 Referred to as a “finance lease” under IAS 17.
4 ASC 840-20-20; IAS 17, ¶ 8.
5 IASB, BASIS FOR CONCLUSIONS ON IFRS 16, ¶ BC3(a) (2016); FASB, BACKGROUND INFORMATION & BASIS FOR CONCLUSIONS, LEASE (Topic 842) (2013).
6 ASC 840-20-30-1; IFRS 16, ¶¶ 22, 26.
7 ASC 840-20-30-5; IFRS 16, ¶ 24(a)–(c). IFRS 16 also includes an estimate of the costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease (unless those costs are incurred to produce inventories) in the cost of the right-of-use asset. IFRS 16, ¶ 24(d).
8 This distinction is irrelevant for purposes of IFRS 16.
9 Unless a change in the underlying lease liability requires an updated discount rate. For example, "a change in the lease term or assessment whether the lessee will exercise an option to purchase the underlying asset, a change in the amounts probable of being unwed by the lessee under a residual value guarantee, or a change in the lease payments resulting from the resolutions of a contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based." ASC 842-20-35-5.
10 ASC 842-20-35-3.
11 Topic 842 further requires lessees to present finance lease right-of-use assets and operating lease right-of-use assets separately from each other and to present finance lease liabilities separately.
12 Defined as a portfolio with an equal number of leases starting and ending in any one period with identical terms and conditions.
13 Under GAAP.
14 GAAP finance leases only.
15 GAAP finance leases only.
16 IFRS 16 does not mandate qualitative disclosures but rather sets out objectives and requires companies to determine the information that would satisfy those objectives.
17 Such clauses state that a change in a lessee's financial ratios resulting solely from changes in accounting guidance either (1) will not constitute a default or (2) will require both parties to negotiate in good faith when a technical default occurs as a result of a change in accounting standards.
18 For example, IFRS 16 (like IAS 17) does not distinguish between sale-type leases and direct financing leases and thus permits recognition of selling profit on direct financing leases at lease commencement, whereas Topic 842 (like Topic 840) prohibits selling profit recognition at lease commencement on direct financing leases and requires any selling profit at lease commencement to be deferred and recognized as additional interest income over the lease term.