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Why Is the FASB Issuing This Accounting Standards Update (Update)?

The FASB is issuing this Update to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. To meet that objective, the FASB is amending the FASB Accounting Standards Codification® and creating Topic 842, Leases. This Update, along with IFRS 16, Leases, are the results of the FASB's and the International Accounting Standards Board's (IASB's) efforts to meet that objective and improve financial reporting.
Leasing is utilized by many entities. It is a means of gaining access to assets, of obtaining financing, and/or of reducing an entity's exposure to the full risks of asset ownership. The prevalence of leasing, therefore, means that it is important that users of financial statements have a complete and understandable picture of an entity's leasing activities. Previous leases accounting was criticized for failing to meet the needs of users of financial statements because it did not always provide a faithful representation of leasing transactions. In particular, it did not require lessees to recognize assets and liabilities arising from operating leases on the balance sheet. As a result, there had been long-standing requests from many users of financial statements and others to change the accounting requirements so that lessees would be required to recognize the rights and obligations resulting from leases as assets and liabilities.
Many of the criticisms associated with previous leases guidance related to the accounting for operating leases in the financial statements of lessees, and addressing those concerns with lessee accounting was the main focus of the Boards. As such, the Boards decided to not fundamentally change lessor accounting with the amendments in this Update. However, some changes have been made to lessor accounting to conform and align that guidance with the lessee guidance and other areas within generally accepted accounting principles (GAAP), such as Topic 606, Revenue from Contracts with Customers.

Who Is Affected by the Amendments in This Update?

Topic 842 affects any entity that enters into a lease (as that term is defined in this Update), with some specified scope exemptions. The guidance in this Update supersedes Topic 840, Leases.

How Do the Main Provisions Differ from Current Generally Accepted Accounting Principles (GAAP) and Why Are They an Improvement?

The main difference between previous GAAP and Topic 842 is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. During redeliberations, the Board considered the feedback received throughout the project and in response to the different models proposed in the FASB Discussion Paper, Leases: Preliminary Views, the 2010 proposed Accounting Standards Update, Leases (Topic 840), and the 2013 proposed Accounting Standards Update, Leases (Topic 842). The Board decided that, consistent with all three proposals, lessees should be required to recognize the assets and liabilities arising from leases on the balance sheet. Throughout the project, the Board consulted extensively on the approach to lease expense recognition and considered a number of alternatives. The feedback received indicated that stakeholders had various views about the economics of lease transactions. The Board ultimately reached the conclusion that the economics of leases can vary for a lessee and that those economics should be reflected in the financial statements; therefore, Topic 842 retains a distinction between finance leases and operating leases. The classification criteria for distinguishing between finance leases and operating leases are substantially similar to the classification criteria for distinguishing between capital leases and operating leases in the previous leases guidance. The result of retaining a distinction between finance leases and operating leases is that under the lessee accounting model in Topic 842, the effect of leases in the statement of comprehensive income and the statement of cash flows is largely unchanged from previous GAAP.
Other differences between the previous leases guidance and Topic 842 are described below. Throughout redeliberations, the Board introduced a number of simplifications from what were previously proposed; some of those simplifications were to keep the requirements in Topic 842 similar to those in the previous leases guidance in order to reduce the cost and complexity of transition to the new guidance. In addition to simplifications from the previous leases proposals, certain aspects of lease accounting have been simplified in Topic 842 as compared with the previous leases guidance in Topic 840.

Lessee Accounting

The core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise from leases. All leases create an asset and a liability for the lessee in accordance with FASB Concepts Statement No. 6, Elements of Financial Statements, and, therefore, recognition of those lease assets and lease liabilities represents an improvement over previous GAAP, which did not require lease assets and lease liabilities to be recognized for most leases.
A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. When measuring assets and liabilities arising from a lease, a lessee (and a lessor) should include payments to be made in optional periods only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. Similarly, optional payments to purchase the underlying asset should be included in the measurement of lease assets and lease liabilities only if the lessee is reasonably certain to exercise that purchase option. Reasonably certain is a high threshold that is consistent with and intended to be applied in the same way as the reasonably assured threshold in the previous leases guidance. In addition, also consistent with the previous leases guidance, a lessee (and a lessor) should exclude most variable lease payments in measuring lease assets and lease liabilities, other than those that depend on an index or a rate or are in substance fixed payments.
For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.
The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from previous GAAP. There continues to be a differentiation between finance leases and operating leases. However, the principal difference from previous guidance is that the lease assets and lease liabilities arising from operating leases should be recognized in the statement of financial position.
For finance leases, a lessee is required to do the following:
  1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  2. Recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income
  3. Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows.
For operating leases, a lessee is required to do the following:
  1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  2. Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis
  3. Classify all cash payments within operating activities in the statement of cash flows.

Lessor Accounting

The accounting applied by a lessor is largely unchanged from that applied under previous GAAP. For example, the vast majority of operating leases should remain classified as operating leases, and lessors should continue to recognize lease income for those leases on a generally straight-line basis over the lease term. However, some changes to the lessor accounting guidance were made to align both of the following:
  1. The lessor accounting guidance with specific changes made to the lessee accounting guidance. For example, certain glossary terms that are applied by lessees and lessors and that will affect a lessee applying the lessor guidance as a sublessor were updated so that lessees and lessors apply the same terms.
  2. Key aspects of the lessor accounting model with the revenue recognition guidance in Topic 606. Leasing is fundamentally a revenue-generating activity for lessors, and many aspects of the previous lessor accounting guidance aligned with, or were derived from, the revenue recognition guidance that preceded Topic 606 (for example, specific aspects of the lessor accounting guidance for real estate assets were designed to conform with the revenue recognition guidance specific to sales of real estate, and both the previous leasing and certain revenue recognition guidance in GAAP utilized a risk-and-rewards principle for determining when the sale of an asset occurred). Topic 842 retains alignment in key respects between the lessor accounting guidance and the revenue recognition guidance in Topic 606. For example, whether a lease is similar to a sale of the underlying asset depends on whether the lessee, in effect, obtains control of the underlying asset as a result of the lease (consistent with the transfer of control principle for a sale in Topic 606), and a lessor is precluded from recognizing selling profit or sales revenue at lease commencement for a lease that does not transfer control of the underlying asset to the lessee. Also consistent with the guidance in Topic 606, the lessor accounting model in Topic 842 does not differentiate between leases of real estate and leases of other assets.

Leveraged Leases

In addition to the changes outlined above, the previous accounting model for leveraged leases continues to apply only to those leveraged leases that commenced before the effective date of the guidance in this Update. The accounting model for leveraged leases in Topic 840 is not retained for leases that commence after the effective date of the guidance in this Update.

Definition of a Lease

At inception of a contract, an entity should determine whether the contract is or contains a lease. Topic 842 defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. Control over the use of the identified asset means that the customer has both (1) the right to obtain substantially all of the economic benefits from the use of the asset and (2) the right to direct the use of the asset.
Under the lessee accounting model in previous GAAP, the critical determination was whether a lease was a capital lease or an operating lease because lease assets and lease liabilities were recognized only for capital leases. Under Topic 842, the critical determination is whether a contract is or contains a lease because lessees are required to recognize lease assets and lease liabilities for all leases—finance and operating—other than short-term leases (that is, if the entity elects the short-term lease recognition and measurement exemption). Topic 842 provides detailed guidance and several examples to illustrate the application of the definition of a lease to assist entities in making this critical determination.

Components

Topic 842 requires an entity to separate the lease components from the nonlease components (for example, maintenance services or other activities that transfer a good or service to the customer) in a contract. Although this was a requirement in previous GAAP, Topic 842 provides more guidance on how to identify and separate components than previous GAAP. Only the lease components must be accounted for in accordance with Topic 842. The consideration in the contract is allocated to the lease and nonlease components on a relative standalone price basis (for lessees) or in accordance with the allocation guidance in Topic 606 (for lessors). Consideration attributable to nonlease components is not a lease payment and, therefore, is not included in the measurement of lease assets or lease liabilities. Entities should account for nonlease components in accordance with other applicable Topics. Activities that do not transfer a good or service to the lessee or amounts paid solely to reimburse costs of the lessor are not components in a contract and are not allocated any of the consideration in the contract.
The above notwithstanding, Topic 842 provides a practical expedient for lessees as it relates to separating lease components from nonlease components. Lessees may make an accounting policy election by class of underlying asset not to separate lease components from nonlease components. If an entity makes that accounting policy election, it is required to account for the nonlease components together with the related lease components as a single lease component.

Sale and Leaseback Transactions

For a sale to occur in the context of a sale and leaseback transaction, the transfer of the asset must meet the requirements for a sale in Topic 606. If there is no sale for the seller-lessee, the buyer-lessor also does not account for a purchase. Any consideration paid for the asset is accounted for as a financing transaction by both the seller-lessee and the buyer-lessor. There could be circumstances in which a transaction would have qualified for a sale under the previous leases guidance but will not qualify for a sale under Topic 606, or vice versa. In particular, many sale and leaseback transactions involving real estate will qualify for sale and leaseback accounting that would not have qualified for sale and leaseback accounting under the previous leases guidance. In contrast, some sale and leaseback transactions involving assets other than real estate that previously would have qualified for sale and leaseback accounting will not qualify for sale and leaseback accounting under Topic 842. Topic 842 includes implementation guidance to assist entities in determining whether the transfer of an asset in the context of a sale and leaseback transaction is a sale. In particular, Topic 842 specifies that if the leaseback is classified as a finance/sales-type lease, no sale has occurred. Topic 842 also specifies that a repurchase option (that is, for the seller-lessee to repurchase the asset from the buyer-lessor) precludes sale accounting unless (1) the asset is nonspecialized and (2) the exercise price of the option is the fair value of the asset on the date the option is exercised.
For transactions previously accounted for as a sale and a leaseback under previous GAAP, the transition guidance in Topic 842 does not require an entity to reassess whether the transaction would have qualified as a sale and a leaseback in accordance with Topic 842.

Disclosures

Disclosures are required by lessees and lessors to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. To meet that objective, the Board decided to require qualitative disclosures along with specific quantitative disclosures. The Board's intention is to require enough information to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity's leasing activities.

Transition

In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. These practical expedients relate to the identification and classification of leases that commenced before the effective date, initial direct costs for leases that commenced before the effective date, and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset.
An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessee's are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.
The transition guidance in Topic 842 also provides specific guidance for sale and leaseback transactions, build-to-suit leases, leveraged leases, and amounts previously recognized in accordance with the business combinations guidance for leases.

When Will the Amendments Be Effective?

The amendments in this Update are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, for any of the following:
  1. A public business entity
  2. A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market
  3. An employee benefit plan that files financial statements with the U.S. Securities and Exchange Commission (SEC).
For all other entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
Early application of the amendments in this Update is permitted for all entities.

How Do the Provisions Compare with International Financial Reporting Standards (IFRS)?

The leases project began as a joint project with the IASB, and many of the requirements in Topic 842 are the same as the requirements in IFRS 16. The main differences between Topic 842 and IFRS 16 are in relation to certain aspects of the lessee accounting model. In contrast to the lessee accounting model in Topic 842, which distinguishes between finance leases and operating leases in the financial statements, the lessee accounting model in IFRS 16 requires all leases to be accounted for consistent with the Topic 842 approach for finance leases. Consequently, leases classified as operating leases under Topic 842 will be accounted for differently under GAAP than under IFRS and will have a different effect on the statement of comprehensive income and the statement of cash flows under IFRS 16 than under previous IFRSs. The following are the other notable requirements of IFRS 16 that are not consistent with the requirements in Topic 842:
1. Lessee accounting model
a. IFRS 16 has a lessee recognition and measurement exemption for leases of assets with values of less than $5,000.
2. Lessor accounting model
a. IFRS 16 does not distinguish between sales-type and direct financing leases; therefore, IFRS 16 permits recognition of selling profit on direct financing leases at lease commencement.
b. IFRS 16 does not include any explicit guidance on collectibility of the lease payments and amounts necessary to satisfy a residual value guarantee.
c. IFRS 16 applies a model to modifications of sales-type and direct financing leases that is predicated on IFRS financial instruments guidance.
3. Measurement of the right-of-use asset
a. IFRS 16 allows alternative measurement bases for the right-of-use asset (for example, the fair value model under IAS 40, Investment Property, or at a revalued amount in accordance with IAS 16, Property, Plant and Equipment).
4. Variable lease payments
a. IFRS 16 requires reassessment of variable lease payments that depend on an index or a rate when there is a change in the cash flows resulting from a change in the reference index or rate (that is, when an adjustment to the lease payments takes effect).
5. Subleases
a. When classifying a sublease, IFRS 16 requires an intermediate lessor to determine the classification of the sublease with reference to the right-of-use asset arising from the head lease.
6. Sale and leaseback transactions
a. IFRS 16 does not include application guidance on whether the transfer of an asset in a sale and leaseback transaction is a sale, other than to state that if the seller-lessee has a substantive repurchase option regarding the underlying asset, then no sale has occurred.
b. IFRS 16 restricts the gain recognized by a seller-lessee in a sale and leaseback transaction to the amount of the gain that relates to the buyer-lessor's residual interest in the underlying asset at the end of the leaseback.
7. Private companies
a. IFRS 16 does not have guidance specifically for private companies; however, Topic 842 permits an accounting policy election for private companies to use a risk-free rate to discount the lease liability for each lease.
8. Statement of cash flows
a. IFRS 16 accounts for payments of interest in accordance with IAS 7, Statement of Cash Flows. IAS 7 allows interest to be classified within operating, investing, or financing activities.
9. Disclosure
a. IFRS 16 has similar but not identical qualitative and quantitative disclosure requirements to Topic 842.
10. Transition
a. IFRS 16 has different transition provisions than Topic 842 as a result of the differences in the lessee and lessor accounting provisions.
11. Existing differences in other areas of GAAP and IFRS that affect the accounting for leases
a. The key areas of difference are the existing requirements for impairment (of financial instruments and long-lived assets other than goodwill) and the accounting for investment properties.
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