In February 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited standard to update the accounting requirements for leases on the books of lessees (lessor accounting remains largely unchanged). This new standard, ASU 2016-02, comes after a decade-long joint project with the International Accounting Standards Board (IASB) and will have some minor differences from the IASB-issued standard that was most recently updated in January 2016. ASU 2016-02 addresses off-balance sheet financing concerns and will require organizations to report an asset and a related liability for most long-term leases (over one year) that have previously been considered operating leases and were, therefore, only mentioned in note disclosures to the financial statements.
This new accounting will be similar to how capital leases have been reported. The new standard applies to all leases of property, plan, and equipment. Leases of intangible assets, biological assets, inventory, and assets under construction are excluded. ASU-2016-02 goes into effect for fiscal years beginning after December 15, 2019, unless you’re a public company, in which case the standard goes into effect for fiscal years and interim periods beginning after December 15, 2018. Early implementation is permitted.
In determining whether or not this new standard is applicable for your organization, the following questions should be asked to ensure that you actually do have a lease:
Is the leased asset specifically identifiable, either explicitly or implicitly? If no, it is not a lease.
Does the organization, as lessee, have the right to obtain substantially all of the economic benefits from the use of the asset? If no, it is not a lease.
Does the lessee have the right to direct how and for what purpose the identified asset is used? If no, it is not a lease.
Does the lessee have the right to operate the asset without the lessor having the right to change the operating instructions? If no, it is not a lease.
The specifically identifiable clause does not prohibit the lessor/supplier from substituting the asset under certain conditions. For example, if the lessee is leasing a bus and the bus needs to be serviced or repaired, the lessor may be required to provide a substitute bus of the same type. This would be a reasonable condition of a lease agreement.
Sometimes, there can be a fine line between a lease agreement and a service contract. For example, a contract may require the supplier to transport school children by using a specified type of passenger bus in accordance with the school’s daily schedule. The supplier may have the option to provide any one of a pool of similar buses that meet the requirements of the contract. The supplier may also be free to provide transportation services to other schools or organizations. The supplier maintains custody of the buses when they are not in use. This contract does not identify a specific asset; the economic benefits from the use of the buses are retained by the supplier; the supplier continues to direct the daily purpose of the buses; the supplier has the right to change the daily operating instructions of the asset. Cleary, this represents a service contract instead of a lease.
At the commencement of the lease, the lessee recognizes a “Right of Use” asset and a corresponding lease liability on the balance sheet (statement of financial position for nonprofits). The asset includes any initial costs such as legal fees and lease incentives and this total basis amount is amortized over the life of the asset on a straight-line basis. The annual amortization of this asset hits the income statement as amortization expense. The lease liability, then, is measured at the present value of future lease payments (i.e. the gross liability, less the present value discount). This net present value discount, then, is amortized using the effective interest method at the organization’s incremental borrowing rate (the rate at which it could borrow its next dollar). The annual amortization of the discount hits the income statement as interest expense.
If the lessee is required to pay certain amounts at the inception of the lease (for example, direct costs or a Year 1 lease payment up front), this would cause the asset and the liability to be recorded at different amounts with the difference being the cash paid at inception.