What Is the New Lease Accounting Standard?

The new lease accounting standards, including FASB ASC 842 in the United States and IFRS 16 internationally, have significantly changed how companies report lease agreements on their financial statements. These regulations fundamentally altered the previous accounting treatment for leases. The standards aim to enhance the transparency and comparability of financial reporting. By requiring lessees to recognize most leases on their balance sheets, they provide a clearer financial picture for investors and other stakeholders.

The Fundamental Shift in Lease Accounting

The core principle behind the new lease accounting standards involves bringing nearly all leases onto a company’s balance sheet. Previously, many operating leases were treated as “off-balance sheet” financing, meaning the related assets and liabilities were not formally reported. This practice often obscured a company’s true financial obligations and control over leased assets.

The new approach introduces a “Right-of-Use” (ROU) asset and a corresponding lease liability for most arrangements. An ROU asset represents a lessee’s right to use an identified asset for the lease term, while the lease liability reflects the obligation to make lease payments over that period.

This fundamental shift aims to provide a more accurate and complete representation of a company’s financial position. It ensures that both economic resources controlled (ROU assets) and obligations undertaken (lease liabilities) are visible on the balance sheet. The Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) globally developed these standards.

Identifying and Categorizing Lease Agreements

Under the new standards, determining what constitutes a lease begins with identifying if an arrangement conveys the right to control the use of an identified asset for a period. Control is present if the customer has both the right to direct the use of the identified asset and to obtain substantially all of its economic benefits. This assessment is made at the inception of the contract.

Once confirmed as a lease, it must be categorized as either a Finance Lease or an Operating Lease. A lease is classified as a Finance Lease if it meets any one of five specific criteria, indicating the lessee effectively obtains control of the underlying asset:

• Ownership of the underlying asset transfers to the lessee by the end of the lease term.
• The lease includes a purchase option the lessee is reasonably certain to exercise.
• The lease term covers a major part of the underlying asset’s remaining economic life (typically 75% or more).
• The present value of the lease payments equals or exceeds substantially all of the underlying asset’s fair value (often 90% or more).
• The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

If none of these criteria are met, the lease is classified as an Operating Lease.

Measuring and Recognizing Lease Assets and Liabilities

Once a lease is identified and categorized, it is initially measured and recognized on the balance sheet. The lease liability is generally measured at the present value of future lease payments. These payments include fixed payments, variable payments dependent on an index or rate, the exercise price of a purchase option if reasonably certain to be exercised, and any penalties for terminating the lease if reasonably certain to do so.

Lessees should use the rate implicit in the lease if determinable. If not known, the lessee’s incremental borrowing rate is used. This rate represents the interest rate a lessee would pay to borrow funds on a collateralized basis over a similar term for a similar asset.

The Right-of-Use (ROU) asset is typically measured at the initial lease liability amount. This amount is adjusted for initial direct costs, lease incentives received, and costs to dismantle or restore the asset at the end of the lease term.

Subsequent measurement varies by lease classification. For Finance Leases, the ROU asset is depreciated over the shorter of the lease term or the asset’s useful life. Interest expense on the lease liability is recognized each period using the effective interest method, leading to a front-loaded expense pattern. Operating Leases result in a single, straight-line lease expense recognized on the income statement over the lease term. Although both an ROU asset and a lease liability are recognized on the balance sheet for operating leases, the income statement impact is designed to mimic the previous off-balance sheet treatment, providing a more consistent expense recognition.

Practical Steps for Adoption

Companies adopting new lease accounting standards must first collect all relevant lease agreements. This includes explicit contracts and “embedded leases” within service or supply agreements that grant control of an identified asset. Identifying embedded leases requires careful review of existing contracts.

Implementing the new standards often requires changes to a company’s systems and internal processes. Many companies adopt specialized lease accounting software to manage data, perform calculations, and track modifications. New internal controls are also important to ensure the accuracy and completeness of lease information.

Management must also make accounting policy decisions regarding the standards’ application. This includes electing practical expedients offered by the guidance, which can simplify the transition. Examples include the short-term lease exemption for leases 12 months or less with no purchase option, and an exemption for low-value assets (those with an underlying asset value of $5,000 or less when new).

Companies also choose a transition method. A common approach is the modified retrospective approach, where the new standard is applied at the beginning of the earliest period presented in the financial statements. This method requires a cumulative-effect adjustment to retained earnings at the beginning of the period of adoption.