Journey Back to a Simpler Time
Imagine if you will; it’s November 1976. Perhaps you are in your brand-new Oldsmobile Cutlass, listening to Frampton Comes Alive (or Songs in the Key of Life if you have better taste in music), as you drive to the local drive in theater to see One Flew Over the Cuckoo’s Nest or Carrie. You can’t enjoy the triumph of Rocky Balboa or the exploits of Luke Skywalker as Rocky or Star Wars haven’t even been released yet. You can’t stay home and play Missile Command or Centipede on your Atari 2600 as it was almost a year away from release. Microsoft had just been founded the year before and Apple was founded earlier in the year. As for me, I was just founded the month prior in Van Nuys, CA, a babe just a month old. This was also the last time that the FASB addressed lease accounting.
As we all know, the FASB issued Statement of Financial Accounting (SFAS) 13, Accounting for Leases in late 1976, and much like the moon landing and the Kennedy assassination, most people probably remember where they were when the issuance was released. However, if for some odd reason you do not already have it memorized or tattooed somewhere on your body, I will give a brief summary of what SFAS 13 stated.
SFAS 13 stated that all leases fit into one of two categories: A capital lease or an operating lease. Under a capital lease the lessee would record the acquisition of an asset and the incurrence of an obligation on their balance sheet. Under an operating lease the lessee would simply make a note disclosure of the lease agreement and expense the lease payments as paid.
The four criteria for classifying a lease as a capital lease under SFAS 13 are as follows:
- The lease transfers ownership of the property to the lessee by the end of the lease term.
- The lease contains a bargain purchase option.
- The lease term is equal to 75% or more of the estimated economic life of the leased property.
- The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90% of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax accredit retained by the lessor and expected to be realized by them.
These criteria were colloquially known in accounting circles as TT, BPO, 75, or 90; and for anyone who has taken the CPA exam they most likely have the TT, BPO, 75, or 90 jingle running through their minds as they read this. If any single criterion was met, a lease was deemed to be a capital lease requiring the treatment listed above.
A Dark Time for Lease Accounting
But alas, there were those in the land that did not desire to book an asset and liability on their books, for it is easier to simply record lease expenses on the income statement. And those that did not want to book did find a fatal flaw in SFAS 13. The first two criteria for classifying a lease as a capital lease were sidestepped by simply excluding transfer and purchase language from the lease agreement. The last two criteria were sidestepped by adjusting terms, interest rates and other stipulations in order to stay below the 75% and 90% thresholds. Through these techniques most lease agreements qualified as operating leases and avoided the tedious balance sheet presentation of a capital lease.
A New Standard Emerges
On February 25, 2016 the FASB issued ASU 2016-02, Leases (Topic 842) in order to address the issue of lessees sidestepping the criteria listed in SFAS 13. The new standard, like the earlier standard, separates leases into two categories: Finance (similar to capital leases) and operating leases. With the new standard both finance and operating leases will be reported on the balance sheet as a right-of-use asset and a liability for the obligation to make payments. The only leases that escape the new treatment are leases with a term of 12 months or less.
In order to limit lessees sidestepping finance (capital) lease treatment the FASB issued 5 criteria for classifying a lease as a finance lease under ASU 2016-02, and they are as follows:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
As stated above, accounting for a finance lease is fairly consistent with the current treatment of a capital lease. When recording the lease, the lessee with record a right-of-use asset and a lease liability at the present value of the lease payments. The discount rate when calculating present value is the lessor’s implicit rate or if not determinable, the lessee’s incremental borrowing rate for a similar collateralized loan in a similar economic environment. On the income statement the lessee must recognize interest expense on the lease liability calculated using the effective interest rate method. The interest expense should be reported separately from the amortization of the right-of-use asset. The interest payments should be listed under the operating activity section of the statement of cash flows and the principal payments on the lease liability under the finance activity section.
So, as we can see, treatment of finance leases is nearly identical to that of capital leases. The big change comes in how operating leases with a term greater than 12 months is treated. Just like with a finance lease, a right-of-use asset and a lease liability at the present value of the lease payments are recorded on the balance sheet. However, on the income statement the interest expense and the amortization expense of the right-of-use asset are reported together as Lease Expense. The lease expense amount must be allocated over the term of the lease on a straight-line basis. All cash payments must appear in the operating activity section of the statement of cash flows.
The Future is Now (or at Least Very Soon)
ASC 2016-02, Leases (Topic 842) became effective for public entities for periods beginning after December 15, 2018, and for periods beginning after December 15, 2019 for non-public entities. But do not fear as there is not a huge difference from what we have been doing for capital leases for years. Also remember that we are always here to assist you in the transition to the new standard if the need should arise. Please feel free to reach out to us with any questions, comments, or concerns. Also, see below for a couple of quick examples.