On February 25, 2016, the Financial Accounting Standards Board (FASB) released an update to the accounting standards, under codification ASC 842, affecting the way that all leases are reported. In essence, all leases that are one year or longer, including operating leases previously reported off-balance sheet, must now be capitalized on the balance sheet as assets and liabilities. The standard became effective in 2019 for public companies and will be effective for non-public companies in 2021. Market participants have been discussing the potential implications since FASB and the International Accounting Standards Board (IASB) formed a working group in 2006 to jointly develop a new accounting standard for leases. Some of these implications include the estimated increase of U.S. public companies’ liabilities by $2.2 trillion, lower return on assets and potential violations of debt covenants.1 As a result, one of the most tangible effects of this new change is the added operational complexity to reporting leases on the financial statements.
In the next few pages, we will discuss the mechanics of the new standard and highlight some nuances of the lease definition that companies in the physical commodities space must pay attention to with respect to storage, transportation and other long-term commitments.
Reason for the Changes and Considerations of the New Standard
FASB’s intention with the new standard is to improve the transparency and facilitate better comparability of leasing transactions in financial statements. Under ASC 840 (the predecessor to ASC 842), operating leases were not recorded on the balance sheet. In practice, operating leases appeared in the footnotes of the financial statements, while capital leases were reported on the balance sheet. Many companies also chose to not evaluate leases embedded in service agreements. The moving of operating leases to reporting on the balance sheet results in the elimination of one more form of off-balance sheet obligation.
Under the new guidance, a lease is defined as a contract that gives a customer the right to control the use of an identified asset for a period of time in exchange for consideration. Once a lease is identified, it is classified either as a finance lease or an operating lease. Then, it must be capitalized on the balance sheet by adding a liability and a corresponding right-of-use (ROU) asset by discounting future lease payments using the rate implicit in the lease or an incremental borrowing rate.
Transparency and the Office Space Example
For anyone who is reading this in their office, chances are that your office space rental has historically been classified as an operating lease in your company’s audited financial reports. These are very common, long-term obligations employed by businesses of all sizes, that have historically been reported off-balance sheet. The new standard results in the capitalization of the future rental payments on the balance sheet. Thus, comparing financial statements from one business to another is enhanced as both balance sheets now display the capitalized leases, showing the present value of lease payments, previously only mentioned in a footnote.
The New Global Standard: FASB and IASB
Although FASB and IASB joined forces to develop a new accounting standard, the two boards did not converge on a single accounting standard due to certain key differences between ASC 842 and IFRS 16. The most noticeable departure between the two standards is found in how the income statement is affected.
ASC 842 maintains the dual model approach for lease classification, bifurcating them among operating and finance leases (formerly, capital leases). The main difference between the two lease categories is that a finance lease transfers both the risks and benefits of ownership from the lessor to the lessee, for a significant portion of the asset’s life. Alternatively, an operating lease only transfers the right to use the property to the lessee. However, IFRS 16 does not make a distinction and requires a single model, whereby all leases are treated as finance leases.
Finance leases recognize expense in the income statement differently than operating leases. An operating lease expense is a single straight-line operating expense item, whereas a finance lease recognizes both an interest expense and a depreciation expense as separate line items. The finance lease classifications of expenses cause there to be a movement of a portion of the expense below the operating income line, which ultimately increases EBITDA for companies that employ a classified income statement. In other words, the total lease expense for a finance lease will be higher at the beginning of the lease period and lower at the end of the lease period compared to an operating lease which is a straight line expense.
Other differences exist as well; therefore, it is important that companies reporting under both standards familiarize themselves with the long list of diversions between US GAAP and IFRS.
Meeting the Lease Definition Criteria
It is important to understand the conditions that a commitment must meet to count as a lease because this will have a direct effect on the balance sheet. For example, operating leases will not have to be capitalized if they are shorter than 12 months in the term of commitment. As mentioned previously, a lease is a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Below, we focus on the control and identified asset criteria and discuss some examples where both requirements might be tested.
Criterion 1: Control
Control of an identified asset is considered to exist if the customer has (i) the right to obtain substantially all of the economic benefits from the use of the asset and (ii) the right to direct the use of that asset. The numeric threshold to meet the “substantially all” requirement is not stated in FASB’s guidance. However, practitioners have agreed that 90% or more of an asset’s capacity generally provides “substantially all” of that asset’s economic benefits.
Criterion 2: Identified Asset
An asset must be explicitly or implicitly identified in the contract. This can be accomplished by outlining a specific physically distinct portion of a larger asset in the contract. Physical distinctness is different than capacity; and, the specified capacity portion of an asset does not result in an identified asset unless it represents “substantially all” of the capacity of the asset.
Storage and Transportation Commitments: A Primer
Companies that engage in the marketing and trading of energy products and other physical commodities are very familiar with a specific group of commitments related to storage and transportation contracts. Energy traders typically acquire transportation through contracts with pipeline operators or railroads and storage capacity, through contracts with terminals and storage operators, in exchange for monthly payments, which may have a minimum floor as well as fees based on volume and/or capacity utilized. Storage and transportation contracts equip energy marketing companies and traders with the ability to transform physical commodities in time (storage), space (transportation) and quality (blending). Traders may also enter into processing contracts which give them the rationale to transform the physical form of physical commodities. The transformation in time, space and form is accomplished in a variety of different ways, such as by moving product from a location of excess supply to a location where supply is more scarce via pipeline or rail. Alternatively, storage contracts allow traders to acquire inventory when seasonal demand is low in anticipation of rising demand, often driven by weather, in the future. The accumulation of heating oil in the spring and summer in anticipation of rising demand in the winter exemplifies this trading strategy. With the accounting standards changing, many companies are focused on whether previously off-balance sheet storage and transportation commitments will now have to come onto the balance sheet.