Lease Classification: New Accounting Rules for Leases
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 lease classification or Finance lease classification ASC 842 (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 lease accounting 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.
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.
Learn about “Lease accounting practical expedients” in our recent blog post.
ValuD’s team of lease accounting experts can assist you in understanding the lease accounting guidelines and set you on the path of FASB lease accounting compliance. For more information, contact us at firstname.lastname@example.org.