Hello again everyone. This is now part 5 of my five-part series. In my previous blogs I took an expanded look at our lease example by illustrating the required journal entries and expanding my lease example with different financial terms. In my closing blog, I’d like to do some wrap-up discussion and discuss next steps for applying the new lease accounting standards. Again, for your reference, here is the complete list for the five-part series:
- Blog series introduction and New lease accounting terminology
- Basic lease accounting example
- Expanded lease accounting discussion – I
- Expanded lease accounting discussion – II
- Blog series wrap-up & next steps
Lease Classification (ASC 842)
In this blog series, I have mentioned classifying leases as either a finance or operating lease. Let’s take a more in-depth look on the test guidelines for classifying a lease. The five tests are listed below. If the answer is yes to any of these tests, then the lease should be classified as a finance lease.
- Ownership transfer to lessee
- Purchase option is reasonably certain
- Lease term = major part of asset life
- Lease payments = substantially the asset fair market value
- Specialized, customer specific asset
Overall, these tests are identical to the current standards so, in general, how your organization classifies leases should not change materially under the new accounting standards. The only exception is test #5 which has been added to the new standards. In addition, the current standards specifically mention the 75% and 90% bright-line tests whereas the new standards do not specifically mention these levels. However, the new standards do allow for those bright-line test levels to be applied as a guideline for tests 3 & 4 respectively.
Looking further at classification, a lease may apply to more than one asset. If feasible, each asset should be subject to the 5 tests above independently and it is possible that one of the assets could be capitalized under the finance lease classification rules and the other asset(s) could be capitalized under the rules for an operating lease classification.
Now let’s talk about lease disclosures for lessees. Under the current lease accounting standards, your disclosures include your future minimum lease obligations. However, with the new standards that will change since lease obligations will now be reported on the balance sheet as lease liabilities. But that does not mean the disclosure requirements under the standards will go way completely. Some disclosure items that will be required include a general description of your lease, maturity breakdown, related party lease transactions, operating lease vs capital lease breakdown, average term length & average interest rates for calculating present value.
As part of the transition process, it would be best to first establish your disclosure requirements and then make sure you are tracking all the necessary data to meet those requirements. By performing this planning upfront, you should benefit by having this information automatically available for reporting.
Financial statement impacts
Next, let’s discuss the impacts to your financial statements. Organizations may have target goals for certain financial ratios such as return-on-investments, return-on-assets, and/or debt-to-equity. All of these ratios will be impacted. Taking the time to organize your lease data and being able to analyze the financial statement impacts upfront will be valuable and will allow your organization to be prepared for the impacts when the new lease accounting standards take place.
First and foremost, as you begin the transition towards the new lease accounting standards, gather and consolidate your list of leased assets now. Regardless of the transition approach that you take, this will be a necessary step. By beginning this step now, it will put you in better position to make the transition smoothly. Looking further into next steps, I have outlined these in a previous blog, Preparing for the new Lease Accounting changes with PeopleSoft Lease Administration. As a summary, here is a high-level list of those steps. But for more details please click on the link above to read my blog.
- Identify all your leases and identify all the related assets for those leases.
- Know your business processes and assemble your transition team.
- Begin working with the latest updates in PeopleSoft Lease Administration.
- Know your reporting requirements.
In closing, my intent was to provide a solid foundation as you begin your research and establish your new lease accounting policies to meet the upcoming accounting standards. For those of you that have already begun the process, I hope that this series has provided you with good reinforcement as well.
Thank you for reading and be sure to read our other Lease Administration Blogs.
Steven Brenner, CPA
Senior Principal Consultant