January 3, 2019

Lease Accounting Update: Answers to Questions about Reporting Leases

The Financial Accounting Standards Board (FASB) has issued a new Accounting Standards Update (ASU) 2018-11 to provide more direction for entities implementing the new leases standard.  However, to fully understand this ASU, one must first be familiar with an earlier ASU, 2016-02, issued in February 2016 (Topic 842).

Topic 842

Topic 842 was designed to help organizations gain clarity on recognizing lease assets and lease liabilities.  According to the summary of ASU 2016-02, “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 other words, lessees were not required to recognize lease assets or lease liabilities when they had a right or obligation resulting from leases.  Topic 842 differentiates itself from previous Generally Accepted Accounting Principles (GAAP), as it forces any lessee to now recognize those rights or obligations that are derived from any lease considered to be an operating lease under the previous provisions of GAAP guidance.

Introduction of 2018-11

The release of Topic 842 (which addressed the recognition of lease assets and lease liabilities for lessee, stakeholders, and users of financial statements) generated additional questions surrounding reporting leases.  Leasing is a broad subject, as it encompasses mitigating risks of owning an asset, gaining ownership of assets, and financing.  As a result, questions arose, mainly related to comparative reporting requirements for the retrospective transition and the lessors’ struggle to separate components of a contract.

Comparative Reporting Requirements

When the FASB originally implemented the new leases standard, entities were required to apply it using a retrospective transition method.  In reference to the Topic 842 transition method, ASU 2018-11 states that “…an entity initially applies the new leases standard…at the beginning of the earliest period presented in the financial statements.”  To address complications with that transition method, ASU 2018-11 affords an additional transition method.  Entities can apply the new leases standard at the adoption date, which would be January 1, 2019, for calendar-year-end public business entities.  Those that use the additional transition method may then recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption.  If comparative financial statements are presented, leases for the comparative periods are presented in accordance with the previous lease guidance.

Separating Components of a Contract

In accordance with Topic 842, lease and non-lease components of a contract must be separated by a lessor.  However, ASU 2018-11 offers lessors a “practical expedient” (the election) to forego separating non-lease components from the associated lease component in certain situations.  This was not previously outlined in Topic 842.  A combination of the lease and non-lease components is permitted if both of the following are met:

  1. The timing and pattern of transfer of the non-lease component(s) and associated lease component are the same.
  2. The lease component, if accounted for separately, would be classified as an operating lease.

If the non-lease component is the predominant of the two combined, Topic 606 must be followed to account for the combination.  Topic 606 is the new guidance for recognizing revenue using five steps:

  1. Identify the contract with a customer.
  2. Identify the performance obligations in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract.
  5. Recognize revenue when the entity satisfies a performance obligation.

The FASB clarifies that any entity electing the practical expedient must disclose, by class of underlying asset:

  1. The fact that an election was made.
  2. The class or classes of underlying assets to which the election was made.
  3. The nature of the combination of the components or ineligibility of combination, and to which topic the entity applies, 842 or 606.

Moving Forward

Only entities with lease contracts that choose the additional transition method or qualify for the practical expedient would look to ASU 2018-11 for guidance.  The new transition method applies when the entity initially adopts the new leases standard.  For separating components of a contract, entities that have not yet adopted Topic 842 will follow the same date and transition requirements afforded in ASU 2016-02.  If an entity has adopted Topic 842, the practical expedient can be elected retrospectively or prospectively in the first reporting period following either the issuance of ASU 2018-11 or that entity’s Topic 842 effective date.

For more information on this ASU, or for guidance in implementing these changes, contact a PYA executive below at (800) 270-9629.

 

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