Changes to the New Lease Accounting Standard: FASB Provides Updates
Portions of this article appeared on Equipment Finance Advisor; additional clarifications have been posted here as information has been made available.
In February, the Financial Accounting Standards Board (FASB) provided updates related to its October 2020 Targeted Improvements Exposure Draft. Changes originally proposed in the draft were part of the FASB’s continued post-implementation review of ASC 842, the new lease accounting standard.
The guidance contained three proposed accounting changes that would:
- impact the recognition of revenue and cost;
- better align Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS); and
- reduce cost and complexity.
Feedback submitted by stakeholders through early December 2020 was considered by the FASB to determine which amendments would be made to the lease accounting standard. Here’s what companies should know about the latest decisions impacting lease accounting standards, with considerations for related transitions.
In February, after considering stakeholder feedback, the FASB issued amendment-related decisions that will impact the new ASC 842 lease accounting standard.
Proposed Change 1: Operating lease classification for lessors
The current standard requires lessors to exclude variable lease payments (e.g., payments based on equipment hours or units produced) when classifying and accounting for a sales type lease. The exclusion of variable lease payments from upfront recognition may lead to an initial loss on a contract with overall positive margins. Under the proposal, lessors are required to classify leases with variable lease payments not dependent on a rate as an operating lease.
- Update for Lessors: On July 25, 2021, as part of its post-implementation review (PIR) of Topic 842, the FASB issued ASC Update 2021-05, “Lessors – Certain Leases with Variable Lease Payments” which amends the lease classification criteria for lessors to align with historical lease accounting practices under ASC 840. Per the amended standard, “Lessors should classify and account for a lease with variable lease payments that do not depend on a reference index or a rate as an operating lease if both of the following criteria are met: (1) the lease would have been classified as a sales-type lease or a direct financing lease in accordance with the classification criteria in paragraphs 842-10-25-2 through 25-3; and (2) the lessor would have otherwise recognized a day-one loss.” For all entities, these amendments are effective for fiscal years beginning after Dec. 15, 2021. If desired, entities are permitted to apply Update 2021-05 earlier than required.
- Entities that have not yet adopted ASC 842 on or before the issuance date of Update 2021-05 should follow the transition requirements within ASC 842-10-65-1.
- Entities that have adopted ASC 842 at the time of issuance can either apply the amendments retrospectively for leases that commenced or were modified after Update 2016-02 or prospectively to leases that commence or are modified after the adoption date of Update 2021-05.
Proposed Change 2: Remeasuring lease liabilities due to a change in payment escalation rate/index
The current guidance does not allow lease liabilities to be remeasured as a result of a change in rate or index (e.g., rent escalations based on Consumer Price Index) used to calculate lease payments. The proposed guidance would better align U.S. GAAP with IFRS by allowing for lease liabilities to be remeasured for a change to the rate used for variable lease payments. Entity-wide application is required, however, if remeasurement due to a change in rate is elected.
- Update: The FASB elected to remove this proposed amendment from its technical agenda.
Proposed Change 3: Contract modification due to partial termination
Under the current standard, a partial termination of a lease contract triggers a lease modification for all components. The proposal provides an exemption from applying lease modification guidance to all lease components when only one or more lease components are terminated. For example, a modification of a railcar lease to reduce the number of railcars would not require application of modification guidance to the remaining railcars. This exemption can be applied only if the termination of the separate lease components does not economically impact the remaining components.
- Update: The FASB elected not to finalize this amendment as additional contract modification improvements were identified in the comment letters. These improvements will be reviewed and considered for incorporation into the current proposed amendments.
Transition guidance will vary depending on whether an entity has adopted ASC 842 at the effective date of these proposed changes. If an entity has not adopted the new standard, then it will transition according to the guidance within ASC 842. If adoption has already occurred, the entity can elect to apply the changes retrospectively to the date of ASC 842 adoption or prospectively to leases that commence or are modified on or after the effective date of these proposed changes. Transition elections can be made on a per issue or topic basis.