The implementation deadline for the Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2016-02, Leases, is quickly approaching. It is effective for non-public entities for fiscal years beginning after December 15, 2021 on a modified retrospective basis for the periods presented in their financial statements.
The new standard aims to bring operating leases onto the balance sheet as a right of use asset and lease liability. While the evaluation of leases under the new standard will take some leg work, FASB did give us some transition relief in the form of practical expedients. These expedients are not automatic. They are elected by management and these elections will need to be disclosed in the financial statements when management chooses to take advantage of them in the adoption process.
The following elections should be strongly considered when adopting the new lease standard. When considered they should save time and ease the transition.
- Lessees can elect to run off existing leases and not evaluate them under the new standard. Under this election, you would present value the future lease payments that are already disclosed in the notes to the financial statements. You would record that calculated present value as a right-of-use asset and lease liability. This allows the organization to narrow their focus on applying the new standard to agreements entered into during the year of adoption.
- When the rate of the lease is not included in the terms, lessees can elect to use a risk-free rate (Federal T Bill Rates) for present valuing future payments, rather than trying to determine the Organization’s incremental borrowing rate. Because the Organization’s incremental borrowing rate would take additional time and judgement to determine, this risk-free rate would save the lessees time.
- Lessees can elect to not separate lease and non-lease components, saving them time in evaluating agreements. Non-lease components could include service or maintenance, which is provided to the agency as part of the lease price. A breakdown of these costs is not always provided, leaving the organization to determine allocations without this election.
- Lessees can elect to exclude short-term leases of 12 months or less. This allows an organization to reduce the amount of agreements they need to evaluate under the new standard.
- As a package the lessee can elect to adopt the following:
- The need to not reassess whether an existing contract contains a lease. This will reduce the risk that a lease required to be included is missed.
- The need to not reassess lease classifications of operating or capital for existing leases. The lease standard comes with new guidance for evaluating an operating vs financing (formally capital) lease and this election relieves the burden of reassessing existing leases against the new definitions.
- The need to reassess initial direct costs for any existing leases. These costs would have generally been expensed when paid, and it relieves the Organization from bringing those costs back on the books as an asset that is amortized.
But with the upside of time savings and simplification, we find ourselves asking are there down sides to these expedients? Not specifically, but consideration should be given. Electing to use the risk-free rate of return for discounting, along with not separating out non-lease components, will increase the amount of the lease asset and liability on the balance sheet; however, this is likely going to be worth the trade-off. In addition, electing to exclude short-term leases will bring those potential assets and liabilities back down. Management will want to consider any debt covenants that may be affected by asset and liability balances when determining expedients to elect. For the vast majority, expedients will be welcomed relief in this transition.
For more information and transition guidance the full text of the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases, can be found at https://www.fasb.org/. You can also feel free to reach out to us at One River CPAs.
