On February 25, 2016, the Financial Accounting Standards Board (FASB) issued the long-awaited standard requiring lessees to recognize substantially all leases on their balance sheets as lease liabilities with a corresponding right-of-use asset. Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), maintains the dual model for lease accounting with lease classification determined substantially in accordance with the guidance in existing lease requirements.

For public business entities, the new guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar-year entity). Nonpublic business entities, including not-for-profit entities, should apply the new guidance for fiscal years beginning after December 15, 2019 (i.e., January 1, 2020, for a calendar-year entity) and interim periods within fiscal years beginning after December 15, 2020. All entities may adopt early.

The basic principle of the update is that leases of all types convey the right to direct the use and obtain substantially all the economic benefit of an identified asset, creating an asset and liability for lessees. (Note that ASU 2016-02 does not apply to leases of intangible assets; leases to explore for or use minerals, oil, natural gas, and similar non-regenerative resources; or to leases of biological assets, including timber, leases of inventory, or leases of assets under construction.)

Under the new standard, lessees will classify leases as either finance leases (comparable to current capital leases) or operating leases (comparable to current operating leases), with the related costs reported substantially as they are today.

Finance leases have front-loading of costs split between amortization and interest costs, while operating leases continue to list a single-level rental expense in the income statement. If the contract duration is equal to or less than 12 months (a short-term lease), then a lessee may make an accounting policy election by class of underlying asset to maintain the off-balance-sheet approach currently used for operating leases.

To help mitigate debt covenant concerns, the operating lease liability will not be classified as debt, but rather as an operating obligation (or “other” liability) and generally will not trigger a technical default under a lessee’s debt limit covenants. Lessor accounting essentially will follow today’s accounting model for sales-type, direct financing, and operating leases, while new guidance will align to the new revenue recognition standard.

This article will identify the scope of the final regulations and present considerations for lessees (e.g., contractors) and lessors (e.g., equipment leasing companies) to prepare for the new standard. See Exhibit 1 for a comparison on legacy and new lease accounting.