IFRS 16 and FASB 842
For part two of this guide, click here
The world of Lease Accounting is set for a radical makeover. In January 2016, the International Financial Reporting Standards Foundation issued IFRS 16, and in February 2016, the U.S. Financial Accounting Standards Board issued Accounting Standards Update FASB 842 – both of which significantly change the way companies account for and record leases on their financial statements. IFRS 16 goes into effect on 01/01/2019, while FASB 842 kicks in for fiscal years beginning after 12/15/2018 for public companies and 12/15/2019 for all other entities. The changes are significant and time consuming to properly implement, so it’s imperative that companies revamp their lease accounting and financial reporting systems as soon as possible to be in full compliance with the new rules come December 15, 2018.
What’s Changing Under FASB 842
FASB Topic 842 requires that a lessee recognize the assets and liabilities that arise from operating and finance leases, and measure them as the present value of lease payments. The asset represents the lessee’s right to use the underlying asset (ROU asset) and the liability represents lease payments over the lease term.
When measuring assets and liabilities, the lessee (and the lessor) should also include ‘reasonably certain’ lease extension periods beyond the current lease term and ‘reasonably certain’ asset purchase options.
However, for leases with terms of 12 months or less, or where the underlying asset is of low value, lessees can elect to not recognize lease assets and liabilities but should recognize lease expenses on a straight-line basis, generally, over the term of the lease. While the recognition, measurement, and presentation of lease expenses and cash flows have not significantly changed from previous GAAP rules, the principal difference under FASB 842 is that even operating leases require recognition of lease assets and liabilities on balance sheets. Existing finance leases will continue to be treated as finance leases.
For Finance Leases: Lessees must:
recognize interest on the lease liability and amortization of the right-of-use asset as separate line items on the income statement, and
ii) classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows.
For Operating Leases: Lessees must:
recognize a single lease cost allocated over the lease term on, generally, a straight-line basis, and
ii) classify all cash payments within operating activities on the statement of cash flows.
For lessors, accounting practices remain largely unchanged. Additionally, FASB 842 outlines changes to leveraged leases, and sale-leaseback transactions.
How IFRS 16 Differs From FASB 842
The new lease accounting standards were jointly developed by the International Accounting Standards Board (IASB) and the U.S. FASB. As a result, there is a lot of overlap between FASB 842 and IFRS 16. Their main differences relate to how lessee’s record leases.
For instance, while FASB 842 distinguishes between finance leases and operating leases in financial statements, IFRS 16 requires that all leases be treated as FASB 842 finance leases. Hence, operating leases will be accounted for differently under GAAP and IFRS.
Here are a few other notable differences:
IFRS 16 exempts lessees from recognizing and measuring leases valued at less than $5,000
Under IFRS 16, lease asset values may be calculated using alternative methods other than Present Value
Under IFRS 16, a change in lease cash flows triggers a reassessment of variable lease payments that depend on a reference index or a rate
In sale-leaseback transactions, IFRS 16 does not specify whether the asset transfer should be classified as a sale unless the seller (lessee) has a material repurchase option on the underlying asset
While FASB 842 allows private companies to use a risk-free rate to calculate the lease liability, IFRS 16 does not provide specific guidance
While FASB 842 requires interest payments to be listed within operating activities on the statement of cash flows, IFRS 16 allows the listing of interest within either operating, investing or financing activities
Why Lease Accounting Rules Were Changed
Companies have over $3 trillion in leases outstanding, of which only a limited amount show up on the balance sheet. An operating lease, for instance, is not shown on the balance sheet but represents a real liability and should be clearly presented so users of financial statements can assess the amount, timing and uncertainty of cash flows arising from leases. For example, during the financial crisis of 2007, several firms with huge leasing liabilities went bankrupt even though they had clean balance sheets.
According to IASB and FASB, given the widespread prevalence of leasing, the new lease accounting rules will improve financial reporting and increase transparency and comparability across organizations while also disclosing vital information about leasing arrangements to investors. For instance, airlines that buy and own planes carry heavy debt on their balance sheets while those that lease planes have misleadingly clean balance sheets despite having materially similar lease obligations.
The new rules also address criticism of previous lease accounting rules for failing to meet the needs of users of financial statements by not always providing clarity on leasing transactions.
While companies will balk at the added cost, implementing these rule changes should give management better insight into the true extent of their lease obligations, and lead to better lease vs. buy and capital allocation decisions. Moreover, the new rules are not expected to hurt leasing companies because leases will continue to offer a very flexible way of financing and using assets without all the risk of owning them.
Why You Must Act Now To Get Ready
The impending lease accounting changes give corporations less than a year to understand the technical requirements of the new rules, take inventory of all their leased assets, accurately ascertain what their remaining lease terms are, and figure out how to value them for FASB 842 and IFRS 16. This is no trivial task.
For example, companies with large volumes of leases are finding that the initial step of identifying and locating all of their lease contracts is in itself a substantial task, particularly when lease records are not centrally maintained. Corporate accounting teams will also need time to understand contract provisions such as extension options and variable payments.
So the sooner companies get on this, the better.