Early in 2016, the Financial Accounting Standards Board (“FASB”) issued a Finance Accounting Standard Update (“Topic 842”), ushering changes to how leases will be accounted for on organizations’ balance sheets. The new standard came into effect at the beginning of 2019 for public companies and will go into effect on January 1, 2020 for private companies.
Under the FASB Master Glossary, a lease is defined as;
“A contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration”.
In other words, there must be an identifiable asset that the Lessee both directs the use of, and obtains benefit from the use of, throughout the term.
Prior to the issue of Topic 842, the primary determination of whether a lease would be recognized on the balance sheet was if it was considered a capital or operating lease. Under Topic 842, whether a lease is recognized on the balance sheet is now determined by whether a contract is or contains a lease – effectively making all leases, whether capital/financial or operating, necessary to report up-front.
Under the new treatment, a lease must be classified as a finance lease by the Lessee and a sales-type lease by the Lessor if any of the following criteria are met:
- Ownership of the asset is transferred from the Lessor to the Lessee by the end of the lease term.
- The lease includes a purchase option to the Lessee that the Lessor reasonably assumes will be exercised.
- The lease term represents a major portion of the lease asset’s economic useful life. This is not the case if the lease commences at or close to the end of the asset’s economic useful life.
- The present value of the lease payments, as well as any residual guarantee not reflected in the lease payments, equals or exceeds substantially all of the fair value of the asset being leased.
- The leased asset is of such specialized nature that there is no expected alternative use to the Lessor at the end of the lease term.
According to the FASB, one way to determine whether the third or fourth criteria are met is to conclude that a major portion of an asset’s economic useful life is at least 75 percent, and substantially all the fair value of the asset equals, or exceeds, 90 percent. The first four of the above criteria are very similar to the requirements prior to the introduction of Topic 842. The fifth criterion, new to ASC 842, holds that most Lessors are expected to recover their investment through payments under the lease agreement.
If none of the five criteria are met, the Lessee will account for the lease as an operating lease. However, regardless of how the Lessee accounts for a lease, the Lessor must still consider the present value of the lease payments. In addition, Lessors must determine whether any residual guarantee amounts equal or substantially exceed the fair value of the asset. If this is the case, and it is likely that the Lessor will receive all the payments plus any residual guarantee, the Lessor will account for the lease as a direct financing lease.
Although the new accounting guidelines have more of an effect on accounting for the Lessee, as opposed to the Lessor, it is still important for Lessors to have an understanding of how these new rules affect both their own balance sheets, as well as those of their customers – particularly as the full impact has yet to be seen.
As part of the new standards, there will be a change to how the soft costs associated with a lease would be accounted for. Previously, soft costs, like installation and engineering, would be depreciated along with the hard cost for the subject asset or assets. With the change, there will be more scrutiny on how the hard and soft costs are classified. The ratios and covenants used by the Lessor in the credit approval process will change, but this should not impact the steps and concerns related to the value of the subject asset itself.
The new lease accounting standards have come at a time where digital transformation is upending traditional practices across industries. Stagnation is already a death-knell for organizations in rapidly shifting industries that are particularly vulnerable to this lease accounting change, like retail and manufacturing. For both Lessors and Lessees, increased digitization and automation may be able to help organizations get a handle on their lease holdings and obligations to make more informed business decisions – and more quickly identify cost savings or red flags. As the full force of the lease accounting standard comes into view, automation can provide an opportunity to not just mitigate the negative impacts of regulatory changes but improve operational efficiency regardless of them.
So far, equipment managers and major lessors have yet to feel the impact from the new lease accounting standards, nor has it materially affected their approach or processes for new leases. What has changed is an increase in the level of engagement by Lessees. In many cases, Lessees are looking to others within the industry to help them understand what’s currently in their leases and how exactly the changes will affect them. Both Lessees and Lessors are keeping an eye out for their exposure in the industries that are expected to be impacted the most. These are anticipated to be the retail and manufacturing industries, as they generally have the most obligations for equipment leases.
What has not yet become clear is whether these industries – and others that rely on leasing – find it more economical to purchase the assets outright versus following the traditional leasing methods to obtain access to the assets. As industry acclimates to this new normal, there may be a push during negotiations between Lessors and Lessees for greater flexibility – whether in the form of shorter-term leases or expedited buybacks. Since the accounting changes have only recently come into effect, equipment managers should continue to “wait and see” to get a better understanding on how Lessees are impacted before making any major changes to how they handle the risk associated with the subject assets on lease – however, they would also be prudent to proactively seek tools to increase their own efficiency at the same time.