The New Lease Accounting Standard (#213)
/In this podcast episode, we discuss various aspects of the new lease accounting standard. Key points made are noted below.
Primary Differences from the Old Standard
The main difference from the previous lease accounting is that you now have to report a lease asset and liability on the balance sheet of the lessee. Under the old accounting, both the asset and the liability could be kept off the balance sheet, which allowed companies to look like they had less debt than was really the case. Putting this extra information out in the open is a good idea; it definitely cleans up an area where businesses used to park liabilities off their balance sheets. Unfortunately, it comes at a cost, which is the calculation of the lease asset and liability. The lease liability is calculated as the present value of the lease payments.
The lease asset is called the right-of-use asset, which, as the name implies, is the right to use the underlying asset for the term of the lease. The calculation of the right-of-use asset is more complicated. It’s the initial amount of the lease liability, plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.
Difficulty for Smaller Organizations
This will probably not be a problem for a larger organization that has a well-trained accounting staff. My concern is the smaller companies that only have bookkeeping support. There is no way I can see them getting this right. And even if they get the initial calculation right, they then have to adjust the asset and liability over time, which introduces the risk that they’ll make incorrect subsequent entries.
Lease Types
The entries depend on whether a lease is classified as a finance lease or an operating lease. You must call a lease a finance lease when the ownership of the underlying asset shifts to the lessee by the end of the lease. Or when there’s a purchase option for the lessee to buy the asset, and it’s reasonably certain to make the purchase. Or when the lease term covers 75% or more of the remaining economic life of the asset. Or when the present value of the lease payments is at least as much as the fair value of the asset. Or when the asset is so specialized that there’s no alternative use for the asset once the lease is over.
When none of these criteria apply to a lease, then it’s designated as an operating lease. When a lease is an operating lease, this implies that the lessee has obtained the use of the underlying asset for only a period of time, and then has to return it.
So when a lease has been designated as a finance lease, the lessee has to recognize the ongoing amortization of the right-of-use asset, and the implied interest expense on the lease liability, and any impairment of the right-of-use asset, and any extra variable lease payments that are on top of the regular lease payments.
If a lease is instead designated as an operating lease, the lessee has to recognize a lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis. The lessee also has to recognize any impairment of the right-of-use asset, and any extra variable lease payments that are on top of the regular lease payments.
For both a finance lease and an operating lease, the right-of-use asset and liability are derecognized at the end of the lease. If there’s a difference between the two figures at the end of the lease, then the difference is recognized as a gain or loss. If the lessee buys the asset at the end of the lease, any difference between the purchase price and the lease liability is recorded as an adjustment to the carrying amount of the asset.
Initial Direct Costs
In addition, we have initial direct costs. These are costs that are only incurred if a lease agreement occurs. This usually means broker commissions. These costs have to be capitalized at the start of the lease, and then amortized over the term of the lease.
Options to Reduce the Workload
Luckily, there are a couple of minor options for reducing the work load. One is that you don’t have to recognize a right-of-use asset and liability if the lease term will be for less than 12 months.
Another option applies to situations in which a contract contains both a lease and a non-lease component. The standard rule is to separate out these components and account for them individually. There’s an option to not separate the components, and just account for the whole thing as a lease.
Parting Thoughts
My general thought on the new standard is that it’s absolutely comprehensive – which is good. However, there’s a difference between adopting the most theoretically correct way to do something and adopting the most practical approach. The old accounting for leases was practical, while the new approach is theoretical. Which means that the accounting for this one could hurt.