FASB Accounting Standard Update for Lessees
On February 25, 2016, the FASB (Financial Accounting Standards Board) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842). Under the new standard, Lessor accounting is substantially the same, however Lessees will recognize all lease assets and obligations on the Statement of Financial Position. Effective for all entities for annual periods beginning after December 15, 2022.
The following will mainly explain the lessee accounting treatment and other matters needing attention.
- Short-term leases are not subject to the new standard
For leases with a term of 12 months or less, the lessee may select straight-lined accounting policies without recognizing any lease assets and obligations.
However, it is important to note that a month-to-month lease may not necessarily be intended as a short-term lease. There are several important factors to consider when it comes to short-term leases:
(1)
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It is necessary to take into account the lessee’s ability to renew or terminate the lease, either through options that are highly likely to be exercised or at the discretion of the lessor.
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(2)
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In order to apply a practical expedient, it is necessary to make an election based on the class of the underlying asset. Once this election is made, it should not be revisited unless there is a lease modification.
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(3)
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Variable lease payments are recognized as they are incurred, rather than being included in the straight-line amount.
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(4)
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In the realm of legal agreements, terms can be expressed through written or verbal means, and can be either explicitly stated or implied.
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(5)
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In order to ensure the integrity and validity of related party leases, it is imperative that they are established on the basis of lease terms and conditions that are legally binding and enforceable.
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- Lessee accounting under Topic 842 principles
Under the new standard, for all leases over 12 months, both finance leases and operating leases will generate assets (right-of-use or ROU assets) and liabilities, initially measured at the present value of lease payments and reflected on the balance sheet.
(1)
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The Expense for Finance Leases
For Finance leases, the ROU asset must be amortized on a straight-line basis to recognize the amortization expense.
The lessee must recognize interest expense on the lease liability calculated using the effective interest method.
Expense recognized for Finance leases is highest at the beginning of the lease and decreases over the lease term.
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(2)
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The Expense for Operating Leases
For Operating leases, the ROU asset must be amortized to achieve straight-line total lease expense to recognize the amortization expense.
The lessee must recognize interest expense on the lease liability calculated using the effective interest method.
Expense recognized for Operating leases results in straight-line expense over the lease term.
| It is important to highlight that the lease obligation balance will remain consistent in both finance and operating lease accounting, both at the initial measurement and in subsequent assessments.
- Lessee considerations for lease modifications
A lease modification refers to an alteration made to the terms and conditions of a contract, leading to a modification in the extent or the consideration for a lease. This may involve the inclusion or termination of the privilege to utilize one or more underlying assets, adjusting the timing of lease payments, or extending or reducing the contractual lease duration.
In certain situations, it may be necessary for a lessee, but not a lessor, to reassess its lease liability and make corresponding adjustments to the associated right-of-use asset:
(1)
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An event that serves as a catalyst for altering the level of certainty regarding a lessee’s decision to either renew or terminate a lease agreement or acquire the underlying asset. Additionally, it necessitates the adjustment of the discount rate utilized and prompts a reassessment of the classification of the lease.
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(2)
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A change in the anticipated liability of the lessee pertaining to a residual value guarantee.
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(3)
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The contingency that determines the variability of lease payments is resolved, resulting in the conversion of these payments into a fixed amount.
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- Other considerations
(1)
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As a practical expedient, lessees have the option to adopt an accounting policy based on asset class, wherein non-lease components can be consolidated with the corresponding lease component for the purpose of implementing lease accounting.
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(2)
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In the context of leasing agreements, the lessee has the option to utilize either the implicit borrowing rate or the incremental borrowing rate as the discount rate. However, if the implicit rate is not easily ascertainable, the lessee may resort to the incremental borrowing rate.
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(3)
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The new standard does not provide an explicit exception for “small ticket?leases, so lessees must recognize ROU assets and lease liabilities for all leases.
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