Lease Classification

It has now been well over a year since both the FASB and IFRS organizations have finalized their guidance on the future of lease accounting which is effective beginning in 2019 for publicly traded companies. The tasks to move a company’s leases onto their Balance Sheet can be overwhelming considering all the necessary steps to reach this goal. Fortunately, the decisions related to lease classification have not drastically changed.

US FASB Topic 842

The US FASB Topic 842 will continue to allow for lease classification as either Operating or Finance (previously considered Capital Leases under Topic 840). However, a 5th criteria was added to the existing four possible criteria that could render a Finance classification. In addition, the prior bright lines from Topic 840 no longer exists. The new standard will require more judgement but also allow more flexibility in the classification decision.

If any one of the five below criteria are met, a lease would be considered a Finance Lease. If none are met, the lease would be considered an Operating Lease:

  • Ownership of the underlying asset transfers to the Lessee by the end of the Lease Term.
  • The lease continues a Purchase Option which the Lessee is reasonably certain to exercise.
  • The lease term is for a major part of the remaining economic life of the underlying asset.
  • The present value of the lease payments and any residual value guaranteed by the Lessee is greater than or equal to substantially all the fair value of the asset.
  • The asset is of such a specialized nature that it will not have an alternative use for the Lessor at the end of the Lease Term. (new criteria)

As mentioned above, previous bright lines for application of these criteria have been abandoned under the new guidance. However, there are guidelines for the application of these new terms:

Major Part >/= 75%
Substantially all >/= 90%
Reasonably certain >/= 90%

The elimination of bright lines was intended to allow additional factors to be considered in applying judgement to classification decisions that cannot be when bright lines are mandated.

No matter which lease classification is determined, both types of leases will require a Right of Use Asset and a corresponding Lease Liability be calculated and presented on the Balance Sheet.

One of the practical expedients a company may elect under Topic 842 will prevent the reassessment of lease classification of existing leases during the two-year transition period prior to the adoption date. Leases classified as Capital Leases under 840 will become Finance Leases. Operating Leases will remain as Operating Leases but will require the application of Topic 842 treatment.

On a final note, a company may elect to treat leases with a lease term of 12 or less months and no purchase option which the Lessee is reasonably certain to exercise, as short-term leases. These short-term leases will not be reported on the Balance Sheet.

IFRS 16

One of the major differences between US FASB Topic 842 and IFRS 16 is the classification of all leases under IFRS 16 as Finance Leases. A lease classification test will not be the determining factor of whether a lease will be presented on the Balance Sheet. Instead, any lease contained in a contract must be reflected on the Balance Sheet as a financing arrangement.

IFRS 16 also allows companies to elect by class of underlying asset that leases with a term of 12 or less months may remain off the Balance Sheet.

ValuD’s team of lease accounting experts can assist you in understanding the lease accounting guidelines and set you on the path of FASB compliance. For more information, contact us at info@valudconsulting.com.

Lease Accounting Practical Expedients

The scope of the new Lease Accounting Standards for both U.S. and international accounting can have a significant impact on companies with any number of leases. Attempts were made by both the U.S. governing body, Financial Accounting Standards Board, and the international body, International Accounting Standards Board, to converge the leasing guidance, but were not successful. During the deliberation period, both boards met with financial statements users to understand their needs and what changes to financial statements would enhance their comparability. Feedback was also received from preparers to grasp the impact and feasibility of the original requirements. From those meetings a set of practical expedients were established that will decrease the burden on financial statement preparers while still providing sufficient information for financial statement users.

FASB Topic 842 Practical Expedients

The FASB guidance, ASU Topic 842, does allow two sets of accommodations as a means of sufficing the needs of users and preparers. Two packages of practical expedients have been established which are applicable only to the comparative transition period for both the lessee and lessor. In addition, new accounting policies can be elected which are applied to both the transition period and all subsequent periods under the new standard.

The first package of practical expedients has three components that must be applied in their entirety as a package to all leases that commenced prior to the adoption date[1].  The purpose of these allowances is to reduce the undue burden of reviewing the details of every existing contract.

  • The first component in this practical expedient package will allow an entity to accept the original determination of whether or not a contract contained a lease and will not require a subsequent review of all existing or expired contracts.
  • In addition, the original lease classification may be accepted so that operating leases will convert as operating leases under Topic 842 and capital leases will convert to finance leases.
  • Finally, under the new standard, the definition of Initial Direct Costs has changed. However, the entity will not have to reassess the Initial Direct Costs assigned to leases under the previous leasing guidance to extract those components no longer included, but may accept the values initially assigned.

The second practical expedient may be elected independent of the first practical expedient but should also be applied to all existing and expired leases from the Lessee and Lessor perspective. This election will allow the entity to use hindsight in judgements that impact the lease term, such as the renewal and purchase option, as well as any asset impairment that would impact the asset valuation[2] .

The second set of accommodations are elections that would be established as accounting policies.  The lessee may elect to not apply the new standard requirements to Short-term leases. These would be identified as leases with a term of 12 or less months which are not reasonably certain of exercising any available renewal options that would extend the term past 12 months[3].  The application of this policy would be based on the class of underlying asset and would not be lease specific. Instead, Short-term leases would be straight-lined over the lease term.

The other accounting policy election would allow a Lessee to consolidate lease and nonlease components into one lease component, instead of separating them[4]. This policy also must be established for a class of underlying assets and cannot be applied to specific leases. Even though this policy would appear to reduce the burden of breaking these items out, the offset is nonlease components will be reported on the Balance Sheet. If nonlease components are a significant value, the impact to the Balance Sheet could also be significant.

IFRS 16 Practical Expedients

Similarities and differences exist between the practical expedients provided under the new standards between US GAAP and IFRS. Like US GAAP, IFRS 16 allows an election for the Lessee/Lessor to “grandfather” the lease assessment applied to contracts with an effective date prior to the adoption date[5].  IFRS 16 must still be applied to those contracts identified as containing leases.

Two accounting policy elections are also available under IFRS 16[6]. Similar to the Short-term policy election under US GAAP Topic 842, IFRS 16 allows for an accounting policy to exempt leases with a term of 12 or less months from the application of the new standard based on the underlying asset class during the transition period and all periods subsequent to the application date.

However, IFRS 16 offers an additional accounting policy election for low value assets that may be applied on an individual lease basis. Even though this policy is not applied on the basis of underlying asset classes, it should establish the criteria for low-value items (suggested bright-line of $5,000 USD). The application of the accounting policy would need to be on a consistent basis during the transition and subsequent periods. The valuation criteria would not include an aggregate value of the assets included on a lease, but rather each asset could be viewed on an individual unit cost. Therefore, even significant purchases of low-value assets could still be exempt from the application of the IFRS 16 guidance.

Under IFRS 16, there are restrictions on the practical expedients which can be applied based on the implementation approach. There are two approaches; the Retrospective Approach and the Modified Retrospective Approach. If IFRS 16 will be adopted using the Retrospective Approach, none of the practical expedients or accounting policy elections are available. Thus, one would be required to review all expired and existing contracts during the comparative and transition periods for strict application of IFRS 16 for lease classification and valuation of the leases. However, if implementing under the Modified Retrospective Approach, all the practical expedients and accounting policy elections are available.

There are pros and cons to the practical expedients and accounting policy elections available under each set of standards that must be weighed by each company to determine which ones benefit them without compromising the comparability of their financial statement.

[1]FASB ASU 2016-02, Topic 842, Leases, 842-10-65-1(f)
[2]FASB ASU 2016-02, Topic 842, Leases, 842-10-65-1(g)
[3]FASB ASU 2016-02, Topic 842, Leases, 842-20-25-2
[4]FASB ASU 2016-02, Topic 842, Leases, 842-10-15-37
[5]IFRS 16.C3, C4
[6]IFRS 16.5–8