For years, lease accounting has been criticized as a means of structuring off-balance sheet financing, particularly as it related to the airline industry. In response to this feedback, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) initiated a joint project to overhaul accounting for leases in 2008, which was one of the cornerstone projects of a path towards convergence. The FASB issued an exposure draft in 2010, but it received such heavy criticism from multiple parties that it didn't issue the final standard until early 2016. Accounting Standards Update 2016-02, Leases (ASC Topic 842) may be cumbersome to implement as it affects all leases (i.e. property, equipment, copiers) with only a few, minor scope exceptions. It also removes any differences between leases of equipment and real estate that exist in today's U.S. generally accepted accounting principles (GAAP).

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Lessees in particular will need updating on several
aspects of lease accounting. Implementing the
standard may also affect debt covenant compliance,
evaluation of leasing alternatives, accounting and
finance departments and lease negotiations, which
could have a significant impact on your future planning.
Summary of Major Changes
The leasing standard brings the definition of a lease
in line with the recent changes to revenue recognition,
clarifying that a lease exists as a contract or part of
a contract when a party has a contractual right to
control an identified property, plant and/or equipment
for a period of time in exchange for consideration. In
addition, if a party has the right to obtain substantially
all of the economic benefits from using the asset and
the right to direct the use of the asset, then a contract
is or contains a lease.
Lessees will classify a lease as either operating or
financing. Capital leases under current practice will
be considered finance leases under the new leasing
standard.
To determine whether you have an operating lease or
a finance lease, the new leasing standard is similar
to current practice. A new criterion has been added,
however. Lessees will be required to consider whether
theunderlyingassetintheleaseisofsuchaspecialized
nature that it is expected to have no alternative use to
the lessor at the end of the lease term. Meeting this
criterion would result in a conclusion that the lease is
a finance lease.
For years, lease accounting has been criticized as
a means of structuring off-balance sheet financing,
particularly as it related to the airline industry. In
response to this feedback, the Financial Accounting
Standards Board (FASB) and International Accounting
Standards Board (IASB) initiated a joint project to
overhaul accounting for leases in 2008, which was
one of the cornerstone projects of a path towards
convergence.
The FASB issued an exposure draft in 2010, but it
received such heavy criticism from multiple parties
that it didn’t issue the final standard until early 2016.
Accounting Standards Update 2016-02, Leases
(ASC Topic 842) may be cumbersome to implement
as it affects all leases (i.e. property, equipment,
copiers) with only a few, minor scope exceptions.
It also removes any differences between leases of
equipment and real estate that exist in today’s U.S.
generally accepted accounting principles (GAAP).
The new guidance is effective for public business
entities for fiscal years beginning after December 15,
2018 (2019 calendar year). The effective date for most
other entities is deferred one year (2020 calendar
year). Early adoption is permitted for all entities.
August 2016
Four Repercussions of the New Leasing Standard

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Impact on Rental Leases
The type of lease will impact how you report rental
expense in your income statement. By and large,
you follow the same guidance as current GAAP to
determine whether you have an operating lease or a
finance lease. For most operating leases, a lessee
will recognize rental expense on a straight-line basis
over the lease term. For finance leases, a lessee
will recognize rental expense in a similar manner to
capital leases under current lease accounting. The
new standard removes the bright lines that currently
exist in the capital versus operating lease criteria.
It’s likely that companies will continue to use the
traditional 75 percent and 90 percent thresholds as a
starting point, which is referenced in the new leasing
standard as a reasonable approach to assess certain
of these criteria.
Factoring renewal options into the lease classification
process is not expected to be difficult. Any renewal
options that are reasonably certain to be exercised
should be included in the lease term. This more or
less gets us to the same place we are today. The
conclusion requires reassessment upon triggering
events.
Effect on Debt Covenants
Lessees will find that most leases will be recognized
on their balance sheet when they enact the new
leasing standard. Operating and finance leases are
recognized on the balance sheet through right-of-use
(ROU) assets and related lease obligations.
Debt covenants may also be affected. Banks are
likely already using a factor to adjust operating
lease payments in situations where these payments
are a significant expense, such as with retailers.
Nevertheless, classifying leases as liabilities
may affect certain metrics for your debt covenant
compliance, particularly if your debt covenants include
balance sheet tests. You should account for these
changes and determine their potential impact. If you
find that the standard has a substantial effect on your
debt covenants, you should discuss the lease liability
classification with your bank.
Most credit arrangements include a provision stating
that GAAP reporting should be used in order to comply
with the debt covenants. Both borrowers and lenders
will need to determine if definitions or amendments
need to be made to debt agreements that will be in
existence when the new leasing standard takes effect.
Impact on Types of Leases
Many in the industry wonder if the changes to lease
accounting will trigger more synthetic lease structures,
or structures where a special purpose entity is created
and “owns” the leased asset and leases the assets
to an operating entity. These lessor entities, as well
as similar entities employed by a lessee, should
be evaluated to determine whether they should be
consolidated by the lessor or lessee. However, we
expect that given their highly specialized nature, we
will primarily see synthetic leases in sophisticated
investment markets rather than used broadly.
A demand is also expected for other types of alternative
lease structures because of the effect this will have on
companies’ financial statements. For example, short-
term leases are defined as those that are 12 months or
less and the lease does not contain a purchase option
that the lessee is reasonably certain to exercise. A
lessee is permitted to forgo recognizing a right-of-
use asset and related lease liability on its balance
sheet for short-term leases. Other companies may
be deterred from leasing and consider buying assets
instead, though the number of companies who forgo
leasing all together is expected to be minimal.

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The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation.
Please contact your MHM auditor to further discuss the impact on your audit or audit report.
Tenant improvements may also be affected
because some companies may find that funding the
improvements themselves is more economical than
including them in the lease.
Additional Responsibilities for Accounting
and Finance Departments
Accounting and finance departments should get
familiar with the leasing standard because it requires
consideration of certain leasing elements.
Embedded leases will be critical to identify. Previously,
if leases embedded in contracts were missed, the
only impact would be misclassification of operating
expenses (i.e. cost of goods sold (COGS) vs. rent).
However, because leases are now required to be
presented on the balance sheet, there is a much
greater risk to not properly identifying embedded
leases, which can be challenging at a granular
contract level.
Identifying the appropriate unit of account by which
to measure the lease and distinguishing between
lease and non-lease components will also require
heightened involvement from the accounting and
finance functions.
Finally, impairment models will need to change
to address the new lease related assets and
consideration must be given to how cash flows are
calculated and compared to the asset base.
More Time Needed for Lease Negotiations
Particularly in the beginning of the roll-out, you will
need to allow more time for lease negotiations. More
individuals are going to be involved with the leasing
decisions, and given the potential effect on your
financial statements, alternatives to leasing may be
explored in more detail than they were in the past.
It is also recommended that you engage your broker
early in the leasing negotiations so you can understand
how debt covenants may change after the leasing
standard is implemented. For upcoming renewals or
new deals, be sure your projections and those of your
bank include the accounting standard’s effect on debt
covenant compliance and that you understand if there
any policies or procedures the bank has adopted
because of the new leasing standard.
In the interim, you can get prepared for the leasing
standard by learning about its provisions through live
training, webinars or leasing standard publications.
Consider whether you need to modify your internal
controls to help ensure compliance with the new
requirements and have the appropriate, audit-ready
documentation to comply with the new standard. You
should also evaluate whether the relevant system
solutions you are using are capable for accounting for
your leases with the new guidance.
Leasing is not the only major accounting change
that will be going into effect in the next few years.
Major updates are coming to revenue recognition
and accounting for financial instruments, and you
should factor this into your new accounting standards
implementation planning.
For more information about the new leasing standard,
please contact Brad Hale of MHM’s Professional
Standards Group. Brad can be reached at
727.572.1400 or bhale@cbiz.com.