On February 25, 2016, the Financial Accounting Standards Board (FASB) issued ASU No. 2016-02, which is the culmination of a multi-year collaboration with the International Accounting Standards Board (IASB) to improve accounting for leases.
ASU No. 2016-02 requires that leases with terms over 12 months be reported on the balance sheet. Because current GAAP only requires capital leases (not operating leases) to be reported on the balance sheet, this change could significantly impact the asset and liability portions of an entity’s GAAP financial statements. FASB Chair Russell G. Golden says “[ASU No. 2016-02] ends what the U.S. Securities and Exchange Commission and other stakeholders have identified as one of the largest forms of off-balance sheet accounting, while requiring more disclosures related to leasing transactions.”
For public entities, the standard is effective for fiscal years beginning after December 15, 2018. For all other entities, the standard is effective for fiscal years beginning after December 15, 2019.
While the details and disclosures are extensive, a general summary is that the new balance sheet must show a right-of-use asset and a related lease liability, measured using the present value of the future lease payments. The asset is amortized over the shorter of the term of the lease or useful life of the asset; if the lessee is reasonably certain it will obtain ownership of the asset after the lease, it should amortize the asset over its useful life. The liability is treated like debt and reduced by lease payments after an adjustment for an interest component.
The income statement treatment is similar to the current GAAP treatment: a dual model that depends on the type of lease. The new criteria used to classify a lease as either a finance (or capital) lease, which transfers substantially all risks and rewards of ownership, or an operating lease are similar to the current GAAP criteria. Under ASU No. 2016-02, both types of leases recognize expense for (1) amortization of the right-of-use asset and (2) interest on the amount financed. However, how this expense is recognized differs between the two lease classifications. For an operating lease, the amortization and interest for the entire term of the lease are combined and amortized on a straight-line over the lease term. For a finance lease, the amortization and interest are recognized separately with the asset amortized equally on a straight-line basis over the lease term and the interest recognized according to the effective interest rate in proportion to the amount of outstanding debt. As a result, more interest expense is recognized upfront when the loan balance is highest. While the total expense to be recognized is the same for finance and operating leases, by comparison, the effect is to front load expense on finance leases.
New lessor accounting is fundamentally the same as existing GAAP. For operating leases, the lessor still keeps the asset on its books and recognizes the lease income over the life of the lease. For sales-type and direct finance leases, the lessor de-recognizes the asset and recognizes a net investment in the lease and a profit or loss on the sale. However, ASU No. 2016-02 does introduce minor changes to align lessor accounting with the new lease accounting, such as glossary terms, and with the new revenue recognition standard.
ASU No. 2016-02 also requires extensive qualitative and quantitative disclosures, which will require careful consideration.
ASU No. 2016-02 requires a modified retrospective transition in that all existing leases, even those presented in the earliest comparative periods, must be accounted for as right-of-use assets. The exception is for leases that expire before the initial ASU effective date, which need not be presented differently. Entities should start early, tracking their existing leases and new leases to ease the transition upon implementation.
Contrast with Statutory Accounting for Insurance Enterprises (SAP)
SSAP No. 22 Leases states that all leases by lessees and lessors (other than leveraged leases) shall be considered operating leases and shall be charged directly to expense over the lease term. Historically, GAAP differed from SAP in situations when a company would have a capital lease under GAAP that would be capitalized on the balance sheet but would receive operating lease treatment, or be kept off the balance sheet for SAP. Once the new GAAP lease standards become effective, all operating leases will be placed on the balance sheet, resulting in SAP to GAAP adjustments for all leases.
For insurance companies that also prepare GAAP financial statements, it is critical to evaluate the impact the new lease standards will have on their entity. Placing a lease on the balance sheet may impact the users of an entity’s financial statements in many ways. Surplus notes or loan agreements may contain covenants or prohibit an entity from taking additional debt or liabilities. It is critical for companies to review existing agreements and anticipate the impact new GAAP lease accounting may have prior to its adoption.
The new reporting requirements implemented in ASU No. 2016-02 are complex and represent a significant change to annual reporting procedures. Looking for assistance implementing these new guidelines?