The purpose of accounting rules is to communicate financial information in a transparent and economically neutral manner. Traditionally, operating leases were reflected as periodic charges on a lessee’s income statement and did not appear on the balance sheet, since the lessee did not own the asset but was only using it in exchange for rent. However, it became increasingly clear that leased assets could be important, even essential, to an enterprise. Furthermore, the lease accounting rules were easily manipulated to achieve a kind of “off-balance-sheet financing,” rendering the financial statement picture of some organizations misleading. While the requirement of “capitalized lease” accounting for certain arrangements ameliorated some of these concerns, the Financial Accounting Standards Board decided that lease reporting warranted a complete facelift and so in 2016 issued its new rules on accounting for leases.
For non-public companies these changes go into effect for reporting years beginning after December 15, 2021 (the rules went into effect for public companies in 2019). The new lease accounting rules apply to all organizations issuing GAAP financial statements and to virtually all leasing arrangements, regardless of whether real or personal property is involved. One significant exception is for leases that have a term of twelve months or less. However, the guidance requires the inclusion of all likely renewal periods, so simply casting a long-term arrangement as a twelve-month lease with successive twelve-month renewal periods will not avoid application of the new rules.
The most significant difference in the new lease accounting rules is the balance sheet recognition of a “right-of-use” asset by the lessee. The concept is that a lease represents probable future economic benefits and therefore meets the definition of an asset. Note that whether or not something is an asset for financial reporting depends on accounting rather than legal characteristics; thus, the fact that the lessee does not legally own the asset is no impediment to recognizing it as an asset. The value of the right-of-use asset is tied to the total amount of the payments that will be made under the lease, so generally the newly recognized asset will be offset by a newly recognized lease liability. The specific manner of amortizing the right-of-use asset depends on whether the lease is characterized as an operating or financing lease. In latter case an interest expense component must be calculated. For more details on the new methods of lease accounting, join me for the upcoming Aurora webinar GAAP for Leases on November 11, 2021.