Advisory Insights: Introducing the New Lease Standard

6/14/2018 - By Erik Opager, CPA

During my years in the financial institution industry, we made every effort to classify any lease agreement we entered as an operating lease as opposed to a capital lease. Not only did we want to avoid recording an asset and its corresponding liability on the entity’s balance sheet, we also did not want to expend the effort of the requisite capital lease accounting afterwards. 

This is no longer necessary, thanks to the new lease standard, ASC 842. This standard is effective calendar year-end 2020, for non-public companies’ financials. The new lease standard retains the distinction between operating and financing (capital) leases, but the critical determination is no longer whether a lease is a capital lease or an operating lease.  The concern of the new determination is whether a contract is or contains a lease. This shift in focus makes it crucial that the lessee understands the definition of a lease. 

Definitions and Recognitions

The current definition of a lease centers around the right to use something (property, plant or equipment) for a stated time period. The new standard defines a lease based on whether or not a contract or part thereof conveys the right to control the use of something for a period of time in exchange for consideration. Thus, we see key differences in the two definitions:

  • The lease must now grant control of the use of something;
  • Consideration must be exchanged, and;
  • A lease may exist as only part of a contract.

All leases with a term of over twelve months will need to be recognized on the balance sheet. If the lessee is reasonably certain to exercise an option to extend the lease beyond twelve months, the lease should be recognized as a lease that is longer than twelve months. If a lessee is able and makes an election to recognize a short-term lease, it should recognize lease expense on a straight-line basis over the lease term and apply such an election consistently for similar leases. 

Finance vs. Operating Leases

If a lease meets any of the following criteria, it is a finance lease: 

  1. Ownership of the asset transfers to the lessee by the end of the lease; 
  2. There a reasonable certainty the lessee will exercise the option to purchase the asset; 
  3. The lease term is for a major part of the asset’s remaining economic life; 
  4. The present value of the lease payments plus the residual value guaranteed by the lessee is greater than substantially all of the asset’s fair value; 
  5. the asset will have no alternative use to the lessor at the end of the lease. 

If a lease does not meet any of the criteria above it is an operating lease.

Under the new standard all lessees must recognize a lease liability and the right-of-use asset (asset) on the balance sheet at the commencement of the lease.  The ongoing accounting for the two types of leases is generally the same except for the calculation of the asset amortization.  For a finance lease the amortization of the asset is recognized over the lease term on a straight-line basis, while the asset amortization for an operating lease is the difference between the straight-line expense and the interest expense.  The straight-line lease expense is equal to the sum of the lease payments and initial direct costs divided by the lease term.  The accounting for the reduction of the lease liability is the same for both types of leases.

If you have any questions about this issue or other related issues for your financial institution, please email me or contact a member of our Financial Institutions team.

About the Author | Erik Opager, CPA
Erik is a consultant in the Financial Institutions Advisory Group of Saltmarsh Cleaveland & Gund, specializing in accounting and operations services. Prior to joining Saltmarsh, Erik worked as an accountant in the financial institution industry for nearly 25 years while also serving in the United States Navy, in a reserve capacity, for 23 years. His primary areas of experience include providing accounting, deposit operations, investment and asset/liability management review services to the firm’s financial institution clients.

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