The growing concern around the previous lease guidance, Accounting Standards Codification (“ASC”) 840, has finally been addressed as the Financial Accounting Standards Board released its long-awaited leasing standard, ASC 842, Leases, in February 2016. The main criticism of the previous lease guidance is that it did not always provide a faithful representation of leasing transactions. The main objective of ASC 842 is to increase transparency and comparability among organizations by recognizing a right-of-use (“ROU”) asset and a lease liability on the balance sheet and disclosing key information about leasing arrangements. This gives the users a comprehensive and understandable picture of the company’s leasing activities. The guidance is also one of several joint projects with the International Accounting Standards Board aimed at converging the US Generally Accepted Accounting Principles (“GAAP”) and International Financial Reporting Standards.
Definition of a lease. A lease is a contract that conveys the right to control the use of an identified asset to a lessee for a period of time in exchange for consideration. Control over the use of the identified asset means that the customer has both (1) the right to obtain substantially all of the economic benefits from the use of the asset and (2) the right to direct the use of the asset.
Whether a contract is or contains a lease is critical under ASC 842 because lessees are required to recognize ROU assets and liabilities for essentially all leases. Under ASC 840, the critical determination was only whether a lease was a capital lease or an operating lease because only capital leases are recognized in the statement of financial position.
Lease classification. Lease classification is now determined at the commencement date instead of the lease inception date. ASC 842 provided for the application of dual lease model – operating lease and finance lease (either direct financing or sales-type lease for lessor). Under ASC 842, a lessee shall classify a lease as a finance lease, and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following requirements:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, suppose the commencement date falls at or near the end of the underlying asset’s economic life. In that case, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- 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.
The four criteria to determine the lease classification generally remain from ASC 840, with the addition of the 5th requirement above. Notice that the bright lines related to the concept of “the major part of the remaining economic life of the underlying asset” and “lease payments representing substantially all of the fair value of the underlying asset” are now removed under ASC 842, which will entail a higher level of judgment from the management. Despite the removal of the bright lines, ASC 842 acknowledges that one reasonable approach in determining whether the lease term is for the major part of the asset’s remaining economic life and whether the lease payments represent substantially all of the asset’s fair value are the 75% and 90% thresholds, respectively, cited in ASC 840.
Initial direct costs. Initial direct costs are broader in scope under the old standard. In ASC 842, initial direct costs only include incremental costs that would not have been incurred if the lease had not been obtained. Costs incurred such as legal fees, cost of negotiating the lease terms, and allocated costs that are capitalizable under ASC 840 will now be expensed under the new standard.
Components. Under ASC 840, executory costs such as insurance, taxes and maintenance are included in minimum lease payments and, consequently, in the lease calculations. In lieu of executory costs, ASC 842 introduced new concepts – lease components, non-lease components, and non-components. Generally, lease consideration is allocated between the lease and non-lease components on a relative standalone price basis. While non-lease components (e.g., common area maintenance) transfer goods and services to the lessees, they do not relate to securing the use of the leased asset. Consideration attributable to non-lease components is not a lease payment and, therefore, is not included in the measurement of ROU asset or lease liability. Companies should account for non-lease components according to other applicable standards unless the company elects the accounting policy to not separate lease and non-lease components. This accounting policy is further discussed in this article.
Activities that do not transfer a good or service to the lessee or amounts paid solely to reimburse costs of the lessor are called non-components and are not allocated any of the considerations in the contract and are usually expensed as incurred. Under ASC 842, executory costs are considered non-components of a lease contract; hence will not qualify for capitalization and are immediately expensed as incurred.
Discount rate. Both lessors and lessees should use the rate implicit in the lease when discounting lease payments. However, if the rate implicit in the lease cannot be reliably determined, lessees should use its incremental borrowing rate (“IBR”). In most cases, lessees use its IBR in its calculation. The disparity arises as IBR is defined differently in both standards. ASC 840, it defines IBR as “the rate that, at lease inception, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset.”
On the other hand, ASC 842 defines it as “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.” This means that the determination of IBR warrants additional effort as companies would typically need to have a specific quotation from a bank or other financial institutions instead of using the treasury discount rates. Practical expedient related to discount rate is discussed further in this article.
Lessee accounting. Perhaps the biggest change we should expect is the recognition of the ROU asset representing the company’s right to use the underlying asset for the lease term and lease liability for essentially all leases. It can be recalled that under the previous lease standard, ROU asset and lease liability was not required to be recognized for operating leases, but rather lease payments are expensed on a straight-line basis over the lease term. Practical expedient on short-term leases is discussed further in this article.
Under both operating and finance leases, lease liability is measured, at the commencement date, at the present value of future lease payments, discounted using the discount rate for the lease. Meanwhile, the right-of-use asset is calculated as the sum of lease liability, lease payments made to the lessor at or before the commencement date, and initial direct cost less any lease incentives received.
Subsequent measurement – Lease liability
After the commencement date, the carrying amount of finance lease liability is increased through accretion of interest expense using the discount rate used at the commencement date and reduced by lease payments made. On the other hand, operating lease liability is measured at the present value of the lease payments not yet paid discounted using the discount rate for the lease established at the commencement date.
Even though the subsequent measurement is worded differently, it will still yield the same lease liability balance for the period.
Subsequent measurement – ROU asset
After the commencement date, finance lease ROU asset is measured at cost less any accumulated amortization and any accumulated impairment losses; whereas operating lease ROU asset is measured at the amount of remeasured lease liability, adjusted for prepaid or accrued lease payments, the remaining balance of any lease incentives received, unamortized initial direct costs and any impairment of the ROU asset.
Income statement effect
The lease-related expense of a finance lease is similar to a capital lease in ASC 840. Interest expense is calculated using the effective interest method. ROU asset is amortized on a straight-line basis, unless another systematic basis is applicable, over the useful life of the underlying asset or lease term, whichever is shorter. Interest expense and amortization expense cannot be combined in the same line item and should be presented in a manner consistent with how companies present other interest expense and depreciation and amortization of similar assets, respectively.
For an operating lease, companies will recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis. This straight-line lease expense is done by dividing the total lease payments over the lease term. Amortization of ROU asset is calculated as the difference between the straight-line lease expense and interest expense on the lease liability. Bear in mind that we only compute amortization and interest expense for subsequent measurement of ROU asset and a lease liability, respectively. The straight-line lease expense calculated above is the one recorded in the books.
Lessor accounting. The fundamentals of lessor accounting under the old standard remain practically the same. Most of the improvements relate to the alignment of the lease standard with ASC 606, Revenue from Contracts with Customers.
Same with the old standard, lessors are required to classify a lease as operating, sales-type or direct financing. The fourth classification, leveraged lease, is eliminated prospectively in ASC 842. Lessors use the same criteria as the finance lease classification for lessees. If at least one of the criteria is met, lessors classify the lease as a sales-type lease. If none is met, the lease is classified as an operating lease unless the lessor obtains a residual value guarantee from an unrelated third party other than the lessee and the guarantee is sufficient to satisfy the “substantially all” criterion (as discussed in the lessee accounting section), in which it should be classified as a direct financing lease.
In a sales-type lease, selling profit or loss is recognized depending on the collectability of the lease payments and residual guarantee provided by the lessee, unlike in the old standard where there is a requirement to recognize selling profit or loss. Another improvement in the new standard is that selling profit or loss could now be recognized for direct financing lease. Selling loss is recognized at lease commencement while selling profit is deferred.
Lease of land and building. A contract typically includes lease of both land and building. Under ASC 842, the land is required to be classified and accounted for as a separate lease component unless the accounting effect of not separately accounting it is insignificant. Under ASC 840, the land is separately classified for the purposes of applying the lease-term criterion when the fair value of the land is 25% or more of the combined fair value of the land and building.
Disclosures. ASC 842 requires significantly more extensive qualitative and quantitative requirements, including the nature of the lease, significant assumptions and judgments made and amounts recognized related to the leases, as opposed to a general disclosure of the leasing arrangement under the old standard.
ASC 842 provides numerous practical expedients and available policy election options to lead the companies into an easier transition to the new standard and reduce the cost and complexity of applying the new standard. The following are the practical expedients allowed:
- Package of practical expedients – Allows lessees not to reassess (1) whether any expired or existing contracts are or contain leases, (2) lease classification for any expired or existing leases, and (3) initial direct costs for any expired or existing leases. This expedient is available for transition only. Companies must apply all of the expedients in the package to all leases.
- Hindsight practical expedient – Permits lessees to use hindsight in determining the lease term (i.e., when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing the impairment of ROU asset. This expedient is available during transition only and must be applied to all leases.
On the other hand, accounting policy election options available are as follows:
- Short-term lease – Permits lessees not to apply the recognition and measurement requirements of ASC 842 for leases with a term of 12 months or less. Note that the 12 months threshold counts from the lease commencement date and not the effective date of the new standard.
- Risk-free-rate – Permits private company lessees to use a risk-free rate as the discount rate for the lease, determined using a period comparable with that of the lease term. Public companies are not permitted to use the risk-free rate.
- Lessee policy election to not separate lease and non-lease components – Lessees may elect not to separate lease from non-lease components and instead account both components together as a single lease component. This means that all of the consideration is allocated to the single lease component.
- Lessor policy election to not separate lease and non-lease components – This allows the lessors to not separate lease from non-lease component if and only if (a) the timing and pattern of transfer of the lease and non-lease component are the same and (b) the lease would be classified as an operating lease if accounted for separately. If the lease component is the predominant component, the combined component (lease and non-lease component) is accounted as an operating lease under ASC 842; otherwise, it is accounted for under ASC 606.
Other considerations on transition include the following:
- Portfolio approach – Companies are permitted to apply the lease guidance at a portfolio level if the company expects that it would not differ materially if the lease guidance is applied on a lease-by-lease or contract-by-contract basis. Companies are not required to quantify the difference, but only a reasonable approach should be taken in determining the appropriate portfolio for its leases.
- Capitalization threshold – Consistent with the practice in other areas of GAAP (e.g., capitalizing property, plant and equipment), companies may adopt reasonable capitalization thresholds below which ROU asset and lease liability is not recognized.
ASC 842 should be adopted by private companies for annual fiscal reporting periods beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Meanwhile, the standard is already effective for public companies and public not-for-profit companies starting the fiscal years beginning after December 15, 2018 and December 15, 2019, respectively.
Upon adoption of ASC 842, companies are prohibited from using the full retrospective approach and are only required to apply a modified retrospective approach. Under the modified retrospective approach, companies will need to apply the requirements of ASC 842 to leases that existed before its effective date. There are two options to choose from when considering when to apply the transition accounting and consequently record the transition adjustments:
- Apply the standard at the beginning of the earliest comparative period presented. Under this option, prior comparative periods are adjusted.
- Apply the standard at the effective date of the standard. Prior comparative periods would not be adjusted under this option.
Private companies should consider the following courses of action in complying with the requirements of ASC 842:
- Inventory the lease contracts and understand the size and complexity of the lease portfolio
- Update chart of accounts for new account titles such as right-of-use asset, lease liability, and other lease-related expenses
- Collect data by reviewing the key terms of existing lease contracts (e.g., lease payment, lease term, escalation rate, extension or termination options)
- Make a timely decision on the practical expedients and policy elections available
- Be wary of new contracts that may contain lease
- Consider the cost-effectiveness of utilizing a lease accounting software
- Obtain assistance as necessary from technical accounting consultants or other field experts
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About the Author
Sherwin G. Longasa
Sherwin is a Supervisor of the Technical Accounting Group of Scrubbed. He assists companies in preparing technical memoranda and performs an extensive review of US GAAP financial statements (i.e., 10-Q and 10-K SEC reports), note disclosures, and account reconciliations. Prior to joining Scrubbed, he has more than three years of professional experience with Reyes Tacandong & Co., handling financial statement audits for public and private companies.