In February 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standard Update (“ASU”), ASU 2016-02, Leases (Topic 842).
For public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2018. For all other entities, this update is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for all entities, using a modified retrospective approach.
ASU 2016-02 impacts all entities that lease property, plant, or equipment. ASU 2016-02 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 for a period of time, in exchange for consideration.
What will change?
Currently, operating lease obligations (for example, a lease of office space for 10 years) are disclosed in a company’s financial statement footnotes, but not recorded on the balance sheet. Under the new guidance, a lessee will be required to report on its balance sheet assets and liabilities related to lease obligations with lease terms of more than 12 months. This differs from current GAAP, which requires only capital leases to be recognized on the balance sheet.
How will the change impact financial reporting?
Companies will have to report their leases (finance leases and operating leases) as both assets and liabilities on their balance sheets. This must be done regardless of the lessee’s (tenant’s) intent to vacate the space at the end of its lease term. Rent obligations that were previously disclosed in the footnotes of financial statements will be reflected on the balance sheet as debt. Debt impacts a company’s credit, compliance with debt covenants and other capital requirements.
What about the lessor (landlord)?
For lessors, the impact of ASU 2016-02 is largely unchanged from current GAAP. For example, the vast majority of operating leases should remain classified as operating leases. In general, lessors should continue to recognize lease income for those leases on a straight-line basis over the lease term.