The New Leasing Standards: A Closer Look at the Two Different Accounting Methods

Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) released their respective new leasing standards in the first quarter of 2016.

The US standard (ASU 2016-02) is effective for public business entities for annual periods beginning after December 15, 2018. The International standard (IFRS 16) takes effect one year later, in January 2019.

The essence of the two standards requires that leases are to be put on the balance sheet as “Right of Use” (ROU) assets and corresponding liabilities. The purpose of this accounting change is to provide greater transparency in a company’s leverage since leasing is a form of financing. Perhaps the greatest difference between the US standard and the International standard is the question of finance leases versus operating leases. The FASB decided to maintain two methodologies, one for operating leases and one for financing or capital leases. The IASB opted to classify all leases as financing leases. The FASB argued that there was a need to differentiate between the two types of leases to maintain a level of simplicity since most leases wouldn’t meet the criteria for a capital lease. To recap the four criteria are:

1.   The lease automatically transfers ownership of the property to the lessee by the end of the lease.

2.   The lease contains a bargain purchase option.

3.   The lease term equals 75% or more of the estimated economic life of the property.

4.   The present value of the minimum lease payments at the beginning of the lease term equals or exceeds 90% of the fair market value of the property.

Conversely, the IASB opted to classify all leases as financing leases, again arguing for simplicity.

The effect of this difference can be shown in an example. The US standard adapts the accounting for operating leases which essentially takes the net present value of straight line amortization of the lease payments. The US standard does not distinguish between interest expense and amortization expense. The IASB standard differentiates between interest expense and amortization expense. The effect of this approach is to front load financing costs, much like a mortgage. The following example demonstrates the two approaches:

A lessee enters into a three-year lease and agrees to make the following annual payments at the end of each year: $10,000 in year 1, $15,000 in year 2, and $20,000 in year 3. The initial measurement of the right-of-use asset and liability to make lease payments is $38,000 at a discount rate of 8 percent.

The table below highlights the differences in accounting for the lease depending on whether it is classified by the lessee as a financing lease or an operating lease.

Notice the difference in the total lease expense for the financing lease versus the operating lease. In the case of the financing lease, the P&L impact is higher in the first year but lower in the third year. For a long term lease, this asymmetry in P&L could be substantial in the early years.

The new leasing standards will take effect in early 2018. Since the standard requires a two year “look-back” this means that for US public companies they will have to prepare schedules that account for leases in 2016 and 2017. For many companies it is already too late. Fortunately, Visual Lease has the necessary software modules that convert your lease portfolio into the new standard.