After a decade in the making, on February 25, 2016, the Financial Accounting Standards Board (FASB) issued its controversial lease accounting guidance in Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842)

Under this new guidance, lessees now need to recognize lease assets and lease liabilities for those leases classified as operating leases under previous Generally Accepted Accounting Principles (GAAP). 

This change is an important one that could significantly impact loan covenants, bonus plans and other agreements, and could surprise unprepared investors, lenders and other stakeholders.

What does ROU mean in accounting?

ROU stands for Right of Use in accounting, and has considerable activity within the new lease accounting standards.

The new standard applies to leases other than short term leases. At the inception of the lease, the lessee is required to determine whether the lease is a finance or operating lease and record the following:

For finance leases (most equipment, auto, and other than property leases)

  • Record a right of use (ROU) asset and lease liability on the balance sheet, measured at the present value of lease payments over the lease term.
  • Record the amortization of the ROU asset to the income statement.
  • Record the interest expense on the lease liability on the income statement separately from the amortization of the ROU asset.
  • Interest and variable lease payments are classified as operating activities and principal repayments are classified as financing activities in the statement of cash flows.

For operating leases (most property leases)

  • Record a right of use (ROU) asset and lease liability on the balance sheet, measured at the present value of lease payments over the lease term.
  • Reflect a single lease cost on the income statement comprised of both interest on the lease liability and the amortization of the ROU asset.  The amortization of the ROU asset will be the difference between the periodic lease cost and the interest on the lease liability.
  • Payments are classified as operating activities in the statement of cash flows.

For both finance and operating leases

  • The ROU is to be evaluated for impairment in accordance with professional standards.
  • The lease liability is to be reassessed each period for significant changes which are generally recorded as an adjustment to the ROU asset.
  • The leases are to be presented separately or combined with the appropriate class of assets and liabilities. Co-mingling of financing and operating leases is not permitted.
  • Extensive qualitative and quantitative disclosures will be required.

Under the new standard, lessor accounting is largely unchanged from previous GAAP, other than certain changes were made to conform with the new lessee accounting model and Revenue from Contracts with Customers (Topic 606).

Scope, Effective Date and Transition

ASU 2016-2 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years for public companies, employee benefit plans that file with the SEC, or a non-profit entity that has issued or is a conduit bond obligor for listed or traded securities.

All other businesses and nonpublic entities should apply the amendments for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.

Early application is permitted for all public business entities and all nonpublic business entities.

Transition guidance requires the recognition and measurement of the leases at the beginning of the earliest period presented using a modified retrospective approach which includes a number of optional practical expedients the entities may apply.

Next Steps

Companies should proactively evaluate the effects of this standard well in advance of the effective date to ensure they and their stakeholders are well-prepared.

Companies should:

  • Form an implementation team to evaluate the lease standard.
  • Identify and inventory lease agreements, beginning with the most significant.
  • Evaluate how the leases will be accounted for throughout the lease term.
  • Assess the impact to the company’s financial statements. Pay attention to equity, loan covenants and bonus agreements.
  • Communicate with lenders and other stakeholders as to the effects of the standard and consider planning and restructuring opportunities.
  • Identify improvements needed in financial reporting and internal control processes to capture, account for and evaluate lease agreements.
  • Consider having the implementation team evaluate leases for early adoption at the same time as the new revenue recognition standard to best coordinate implementation efforts and resources.

For more information, please contact your Briggs & Veselka Co. representative.

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