In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02 (ASU 2016-02). The goal was to increase transparency and comparability of entities’ financial statements by recognizing lease assets and lease liabilities on the balance sheet.
This standard has been deliberated in recent years and will impact all companies with operating leases longer than 12 months. Prior to ASU 2016-02, only leases meeting the capital lease (now referred to as finance lease) criteria were required to be recognized on the balance sheet.
Under the new standard, the biggest impact to companies is the requirement to recognize operating leases in the balance sheet as assets and liabilities for all leases over 12 months. If an operating lease is for 12 months or less and does not include an asset purchase option, the lessee is permitted to make an accounting policy election by class of asset to not recognize the associated asset and liability.
The new standard also addresses the practice of segregating lease components. Some contracts contain both lease and non-lease components. It’s the responsibility of the lessee to determine the value of the separate lease and non-lease component. The lessee is permitted to make an accounting policy election by class of underlying asset to not separate lease and non-lease components and instead treat them as one lease component.
Under the new standard, one additional criterion was added to determine whether a lease should be classified as a finance lease. If the underlying asset is specialized for a specific task and is expected to have no alternative use to the lessor at the end of the lease term, the lease should be classified as a finance lease.
For companies engaged in leasing activities, management should proactively evaluate the impact of ASU 2016-02 on debt covenants and the potential for increased liabilities; specifically, the new standard may cause companies to fail covenants containing leverage ratios. In these cases, we recommend management renegotiate covenants.
ASU 2016-02 does not significantly change the income statement and cash flow statement from existing U.S. generally accepted accounting principles (U.S. GAAP). It does address other topics, such as accounting for initial direct costs, payment of costs related to the lessor’s ownership of the asset, variable lease payments, sale/leaseback transactions, and related party leases.
ASU 2016-02 goes into effect for public companies for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. It is effective for nonpublic companies for fiscal years beginning after December 15, 2019 and interim periods within fiscal years beginning after December 15, 2020. Both public and nonpublic companies can choose to adopt the standard early. Lessees and lessors will use a modified retrospective approach to recognize and measure leases as of the earliest period presented.
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