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Lease Accounting – Lessors, Are You Prepared?

November 23, 2016, 07:00 AM

Big news hit the accounting world earlier this year: the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) at long last issued new lease accounting standards, that will bring most equipment and real estate leases onto the balance sheet.

Existing guidance only requires companies to capitalize leases that resemble the purchase and financing of the leased assets. Leases are only required to be capitalized if they meet certain criteria, such as the lease term being 75%+ of the asset’s remaining useful life or the present value of the lease payments being 90%+ of the asset’s market value at lease commencement. Now with the new standards, companies must capitalize all leases with contract terms greater than one year, bringing substantially all leases onto the balance sheet.

Finance and accounting professionals have known for ten years now that changes to lease accounting would be coming down the pipeline – after nearly 40 years without major adjustments to the U.S. GAAP model. Yet despite great anticipation, many finance executives feel rather unprepared for complying with the new rules: only 9.8 percent of respondents to a Deloitte survey from March reported that their company is prepared for compliance.

For equipment finance professionals, whether at a bank or in a lessee’s accounting function, this statistic should be cause for concern, particularly since the new rules represent a wholesale change to the lease accounting process. The impact of the new standard is going to be fairly substantial when it comes to financial reporting, and even data management – which means that getting ahead of the curve will prove essential in the months to come.

How Prepared is Your Organization?
Below are some key considerations regarding the rules changes that the new standards are ushering in, as well as tips for organizations to get ready for the looming compliance deadlines (2019 for public company financial reporting, 2020 for private companies):

  • All leases are NOT created equal: Although the FASB and IASB agreed on the lessee’s initial measurement of a lease – e.g. the right of use asset approach (ROU) which puts lessee leases on the balance sheet – they differed on the lessee’s subsequent measurement of the ROU asset (see next bullet). That is, there is now a single classification model under the International Financial Reporting Standards (IFRS) guidance and a dual classification model under the U.S. GAAP guidance. The classification test used under U.S. GAAP removed the bright-lines from the existing guidance and added one additional criteria related to the specialized nature of the underlying asset. This change could result in a higher volume of equipment leases falling into either category, potentially leading to more complicated tracking issues for institutions and concerns around issuing correct financial statements. To help navigate this problem, institutions should take a close look at their equipment lease transactions and institute internal controls to  properly and consistently classify leases.
  • Expense recognition differences between U.S. GAAP & IFRS: The primary objective of lease accounting standards is to address the off-balance-sheet financing concerns related to lessees’ operating leases. Both the IASB and FASB boards achieved this, despite the dual model versus single model difference. The FASB ultimately decided to retain the dual classification model because it was believed there are two distinct types of leases. The economics of one type of lease was thought to be more akin to purchase; the income statement of a finance lease reflects this with the recognition of interest expense on the lease liability that is separate from amortization expense on the right-of-use asset. The economics of the other type of lease was thought to be for equal access or benefit over time; the income statement of operating leases reflects this through a single straight-line expense. On the contrary, the IASB thought leases give rise to a nonfinancial right-of-use asset at lease commencement, and a lessee should account for these right-of-use assets in a manner consistent with other nonfinancial assets. As such, all leases are accounted for like the FASB’s finance lease (like other purchases of non-financial assets).
  • Current U.S. GAAP is not entirely behind us…yet: And because of this, it means that data needs to be monitored and tracked under two standards during the “comparative reporting” period (the 2 years preceding formal adoption). During this time, companies may desire to record leases under both existing U.S. GAAP and the new standard. Organizations should consider if they have the appropriate infrastructure in place to dual record lease data and if not, assess what capabilities are needed  before the first financial reporting of 2017 begins.
  • Don’t forget about guarantees around residual values: As with most items, leased equipment only diminishes in value over time. Many leases carry guaranteed residual values, which require lessees to make additional payments in property and/or cash when the leases terminate. As new leases come onto the balance sheet, companies need to be cognizant of possible guaranteed residual values connected with their leases, which can represent additional liabilities that are required to be paid at the end of their terms. Key thoughts to consider here center around management of added exposures and changes to liabilities based on residual values as a company’s probable exposure changes over time.

Suffice it to say, there are many changes coming down the pipeline for both financial institutions and companies that lease equipment. As few organizations feel prepared to comply with the new standards, the process of working toward compliance should begin now so they don’t face regulatory hurdles. To learn more about the new lease accounting rules and how they will impact the industry, check out our “Heads Up” document.

Photos of Sean Torr and James Barker of Deloitte & Touche, LLP

Sean Torr & James Barker
Deloitte & Touche, LLP
Sean Torr (pictured) is a Deloitte Advisory managing director in Deloitte & Touche LLP, where he leads the Lease Accounting Services group. Torr has nearly 20 years of experience assisting large, complex clients with accounting convergence implications and financial reporting requirements.

James Barker is a senior consultation partner in Deloitte’s National Office where he leads Deloitte’s leasing and real estate subject matter team.
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