Released in early 2016, ASC 842 and IFRS 16 are the culmination of a nearly 10-year process to revise the lease accounting standard. The primary purpose of the revision was to put operating lessee leases on the balance sheet, as it was felt that showing them only in footnote disclosures hid the significance of obligations that companies had, and led to balance sheets that did not accurately reflect the capital and debt structure of the companies involved. Other, more minor changes were intended to align the standard better with evolving principles of accounting, and to converge U.S. and IFRS standards. Convergence was not fully realized, as the U.S. Financial Accounting Standards Board decided to maintain the distinction between capital (now called "finance") and operating leases, while the International Accounting Standards Board decided to make all leases finance (except for short-term and "low-value" leases). There are also minor differences in disclosures. However, most of the concepts, such as definitions, how to value leases, how to handle modifications, and the like, are consistent between the two standards.
GASB 87, for U.S. governments, is based on ASC 842 and IFRS 16, taking aspects of each (most significantly, IFRS 16's decision to make all lessee leases finance, and ASC 842's original requirement, since modified, to restate prior years) along with a few distinct choices.
IFRS users have two choices to transition to IFRS 16:
1) Full retrospective implementation: As of the implementation date (usually the beginning of fiscal year 2019), all leases are restated from inception using the new standard. The difference between existing and new assets and liabilities is charged to retained earnings.
2) Cumulative catch-up: Existing finance leases continue unchanged. Existing operating leases are converted to finance leases with respect to the remaining rent as of the implementation date. Any deferred rent liability is applied to the right-of-use asset for the new finance lease. If a lease has 12 months or less remaining term, it can be treated as a short-term lease.
GASB 87 prefers restating leases back to the first comparative year, but permits a transition on the implementation date "if restatement for prior periods is not practicable."
For US GAAP/ASC 842 users, existing lessee leases transition to the new standard in the following way:
- Capital/finance leases: Continue with no changes.
- Operating leases: Initial liability at transition is the present value of the remaining rents, using the incremental borrowing rate at the date of initial application. The right-of-use asset is the initial liability, plus any unamortized initial direct costs, minus any unamortized lease incentives, minus any deferred rent (or plus any accrued rent) due to leveling scheduled rent changes. Capitalized rent excludes payments that under FAS 13 would have been characterized as executory costs. If the lease has a guaranteed residual, only the portion of the residual that the lessee expects to actually pay is included.
Subsequent to initial setup, ASC 842 recognizes a single lease cost as the expense for the lease, straight-line over the life of the lease. IFRS 16 converts the lease from operating to finance and continues with normal finance lease reporting.
If a lease is modified after the transition, full application of the new standard is required. For instance, executory costs are replaced by nonlease components; since the latter has a more restrictive definition, manual updating is required.
Important changes to lease accounting - FAS 13/ASC 840 to ASC 842
Taxes, insurance, and other passthrough costs related to the asset leased are no longer excluded from capitalization. While all of these are valid executory costs, nonlease components are only payments which transfer a separate good or service. Examples include common area maintenance, a service contract, or supplies. If taxes and insurance are billed to the lessee at whatever the actual costs are (a "net lease"), they are considered variable lease payments and excluded; however, if they are fixed costs (whether or not the amount is specified; a "gross lease"), they are part of the lease component of the rent, not a nonlease component.
For some leases, the the asset and liability at inception are not the same. Initial direct costs and prepaid rent are added to the asset, while lease incentives are subtracted. Technically, the standard calls for a payment made on the first day of the lease to be excluded from the initial liability, but the effect of including it in the initial liability, then immediately recording the payment, is essentially identical, and the activity flows more clearly shown that way, so EZLease continues this methodology (which is identical to FAS 13/IAS 17).
Only the portion of the guaranteed residual that the lessee expects actually to pay is capitalized (though the full amount is used to compare the present value of payments to the underlying asset's fair value for ASC 842 classification).
Initial direct costs are defined to include only those expenses which would not have occurred had the lease not been completed. Thus, overhead costs, legal fees, and the like no longer qualify; commissions and incentives paid only upon completion, however, do.
If known, the lessor's implicit interest rate in the lease is used as the lease's discount rate. If unknown, the incremental borrowing rate is always used; no longer is a higher discount rate calculated if needed to make sure the asset & liability for the lease are no larger than the fair value of the underlying asset.
The discount rate on a finance (or ASC 842 operating) lease can change when the lease is revised, set to the new incremental borrowing rate (or implicit rate) as of the revision date.
When an ASC 842 lease is revised, any variable lease payments that depend for their magnitude on an index or rate (such as a CPI-based increase) are updated to the current rate at the time of revision. IFRS 16 leases with such payments are updated as soon as the rent changes.
A number of terms have changed:
- "Gross asset" is "right-of-use asset"
- "Obligation" is "liability"
- "Capital" lease is "finance" lease
- "Capital rate" is "discount rate"
- "Tenant allowance" is "lease incentives"
- "Contingent rent" is "variable lease payments"
- "Executory costs" are replaced by "nonlease components," but the definition is more limited