ASU 2016-02, as amended (ASC 842) – Lease Accounting
A lease is a contract or part of a contract that conveys the right to control the use of an identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A contract is (or contains) a lease when the following two criteria are met:
1. The contract explicitly or implicitly specifies the use of an identifiable asset:
- Asset is physically distinct
- Lessor does not have any substitution rights. A protective right defines the scope of the lessee’s right of use within applicable laws and regulations but does not, in isolation, prevent the lessee (customer) from having the right to direct the use of the asset.)
2. The lessee (customer) controls the use of the asset for that period of use:
3. The lessee has the right to obtain substantially all of the economic benefits from use of an identified asset, and
4. The lessee has the right to direct the use of the identified asset during the period of use. Note that the period of time can be expressed in months or years or it can be expressed in terms of the amount of use of the identified assets such as production units
Lease Classification Criteria
A lessee will classify a lease as a finance lease and a lessor will classify a lease as a sales-type lease when the lease contract meets any of the following criteria at the lease commencement date. This criterion classifies a lease based on whether the lease contract effectively reflects a purchase of the underlying asset:
- 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 (probable) to exercise
- The lease term is for the major part (today 75%) of the remaining economic life of the underlying asset – note that if the commencement date falls at or near the end of the economic life of the underlying asset, this specific criterion should not be used for purposes of classifying the lease
- If a single lease component contains the right to use more than one underlying asset, the reporting entity should consider the remaining economic life of the predominant asset in the lease component for the purpose of applying this criterion
- 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 (today 90%) 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
When none of the criteria for a finance lease are met, a lessee classifies the lease as an operating lease. When none of the criteria for a sales-type lease are met, a lessor will classify the lease as either a direct financing lease or an operating lease. The lessor will classify the lease as an operating lease unless both of the following criteria are met:
- The present value of the sum of the lease payments and any residual value guarantee by the lessee that is not already reflected in the lease payments and/or any other third party guarantee unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset, and
- It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee
When both of the above criteria are met, a lessor must classify the lease as a direct financing lease.
Lessee Implementation Recommendations
Note: Since there were few changes to the lessor accounting model, this section primarily focuses on lessee issues.
The primary objectives that lessee corporate management teams should consider when starting to implement ASC 842, include the following:
- Develop an understanding of the changes to lessee accounting in current GAAP based on ASC 842 (for example, recognition and measurement of long-term leases, pattern of expense recognition, additional disclosures, etc.)
- Develop an understanding of the new standard’s transition guidance and determine how the company will adopt this new guidance
- Develop or find resources to help train the company’s professional accounting staff to ensure the effective implementation of the new standard
- Educate users about the changes that can be expected in the company’s financial statements and disclosures based on the new standard
Specifically, companies should consider the following implementation advice:
1. Form a task force (or designate an individual) of accounting and operational personnel to become experts and take the lead in understanding and implementing the new lease standard. This task force should include accounting, financial reporting, tax, information technology, legal, and human resources personnel. Consider if the company’s external auditor should be part of this process.
2. Part of the task force’s required understanding is the new lessee model based on ASC 842:
- Lessee issues to be understood and applied by the task force include lease identification, lease and non-lease components, lease modifications, variable lease payments, options to extend/terminate existing leases, and initial and subsequent measurement of lease contracts.
- Are the leases long-term or short-term?
- Lessee long-term leases can be finance leases or operating leases. Both types of leases are recorded on the balance sheet as a debit to a RoU Asset and a credit to a Lease Payment Liability based on the present value of the periodic lease payments throughout the lease term.
- The task force needs to understand the differences in the pattern of expenses for finance and operating leases.
3. The task force will have to identify and develop an inventory of all existing lease contracts in the company in order to comply with the new lease accounting standard and create new tracking policies for identifying new leases when they are entered into.
4. The task force should determine what impact placing additional assets and liabilities on the balance sheet will have on other areas of the company (for example, incentive compensation, income taxes, debt covenants, internal controls, information systems and contract issues).
5. In addition to specific lease accounting issues identified in ASC 842, the task force will also need to consider any existing operating leases that will meet the criteria for a finance lease upon the effective date of the new lease accounting standard. These finance leases will experience a different pattern of expense recognition over time that will not only require disclosure but also explanations to user groups.
6. ASC 842 requires reporting entities to recognize and measure leases at the application date as determined by the transition method that the reporting entity elects (either each reporting period or the period of adoption). The task force will need to identify their transition method and then develop an approach to calculate the impact of this method.
7. The task force should determine if the company’s current processes and procedures, and systems and internal controls can support the new lease accounting changes
8. Prior to implementing any changes to processes and procedures, and systems and internal controls, these changes should be first tested to ensure objectives are being achieved and if any other applications are impacted by the changes.
9. The task force should also consider the impact the new lease accounting standard will have on key performance indicators (KPIs) at the company level and other performance/evaluation metrics for business units and individuals. The most significant impact will likely be on long-term contracts (debt agreements, for example) that may have performance compliance measurements based on the amount of debt.
10. The task force should consider the impact of the new lease accounting disclosure requirements and their possible impact on the accounting systems necessary to provide the information to meet the disclosure requirements.
11. As a result of the new lease accounting standard, companies may be forced to evaluate whether leasing is still an attractive alternative to buying the asset. When considering the interest cost embedded in lease contracts, it may be more cost effective for a company to buy the asset rather than lease it. Task forces’ will need to update their existing evaluations of the lease vs. buy decisions that were made prior to the new lease accounting standard.
12. The task force should document their implementation strategies and conclusions. For example:
- Create a lease accounting adoption memo identifying specific issues and conclusions
- Update accounting policies and procedures associated with the company’s leases
- Update SOX compliance procedures including transaction flow charts and internal controls (public companies only)
- Determine policies and procedures for contract identification, lease identification, lease and non-lease components, lease modifications, and the initial and subsequent measurement of long-term leases
- Identify updated disclosure issues
- Describe needed IT changes
- Determine the budget necessary to comply with the new lease accounting standard
13. Implement the new standard
Some privately-held (nonpublic) companies currently on GAAP may want to consider if they will continue preparing and presenting their financial statements on GAAP. Alternatives to GAAP include Income Tax basis and the Financial Reporting Framework for Small and Medium-Sized Entities (FRF for SMEs). The financial reporting and disclosure impact and complexities of both the new lease and revenue guidance may not be needed by many privately-held companies and their users. Privately-held entities currently on GAAP should discuss GAAP alternatives with their outside accountants and practitioners should be prepared to discuss GAAP alternatives with their clients.