Implementations of the New Lease Standards Under the ASC 842
Mark Sloan, CPA, CFO Consulting Partners
On February 25, 2016, the FASB issued new guidelines under ASC Section 842 regarding the recognition and financial reporting of leases. The new standard will impact both lessees and lessors, with the most significant impact falling upon lessees. The standard is effective for years beginning after December 15, 2018 for public firms and December 15, 2019 for nonpublic firms.
This is one of the most comprehensive changes to accounting principles in many years, almost 250 pages long, and it will require major effort of firms to understand and implement its impact.
Due to the complexity of this pronouncement, this update will focus on the impact the new standard will have on lessees; a future update will focus on the impact on lessors.
In summary, the significant effect of this standard on lessees is as follows:
- Transactions which had been previously reflected as rent expense on the income statement will now require a right-of-use asset and a related lease liability being reflected on the balance sheet;
- Service arrangements for the use of assets over a period of years need to be evaluated and, if certain criteria is met, there needs to be a segregation of elements that are considered either lease components or non-lease components;
- Lease liabilities must be continually evaluated for the occurrence of significant events and revised accordingly, and;
- Criteria under previous guidance for determining a lease to be either an operating lease or a financing lease has been changed for the following:
- eliminating specific guidance regarding thresholds for determining economic life and fair value of leased assets;
- replacing such guidance with transaction specific judgement, and;
- adding a criteria that the leased asset has no alternative use to the lessor at the end of the lease term.
As a result of the new standard, it is expected that balance sheets will increase with over $1.5 trillion of additional assets and liabilities.
As a starting point, contracts for services must be reviewed, and both the lease and non-lease components must be identified and segregated. In its simplest terms, the standard states that if a contract conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration, without significant control or substitution rights by the lessor, then a lease exists.
This will be among the most challenging aspect of the new standard. There must also be an analysis to determine whether there are multiple lease components which need to be accounted for separately and whether there are multiple non-lease components which should be accounted for under other appropriate GAAP. Also, there needs to be an ongoing evaluation of contracts to determine when an event occurs that may change the recognition or measurement of the lease, and that the entity distinguish whether there is a modification of an existing lease or the recognition of a new lease arrangement requiring separate accounting.
In addition to arrangements which clearly demonstrate a lessee/lessor relationship (such as the lease of office space), other arrangements must be carefully evaluated to determine if a lease exists. Such arrangements may include:
- Advertising agreements
- Service agreements
- Transportation agreements
- Construction agreements
- Related party arrangements
It is important to identify lease and non-lease component of a service arrangement. The arrangement must be carefully evaluated for any asset that could be construed to be a lease in nature. One example is a data storage arrangement with a service provider. If the service contract includes the installation of a server on the location of the lessee, the lessor has no substantive substitution rights and the lessee derives most of the benefit of the asset over the lease term, then the server represents a lease component. An allocation of the rent payments need to be made between the server (the lease component) and the data storage (the non-lease component). The lease component must then be evaluated for either an operating lease or a finance lease and treated accordingly. The major difference between the two types will be that the income statement effect of the operating lease will be through rent expense while the income statement effect of the financing lease will be through interest expense and amortization expense.
Similar to previous guidance, leases meeting certain criteria will be considered a finance lease and there will need to be a right-of-use asset with a corresponding lease liability reflected on the balance sheet. The two amounts will be initially set up as the present value of the lease payments discounted at an appropriate interest rate (e.g., the lessee’s incremental borrowing rate).
A lease meeting any of the five following criteria will need to be classified as a finance lease:
- Ownership of the leased asset transfers at the end of the lease term;
- A bargain purchase option (i.e., one that is reasonably certain to be exercised) for the leased asset exists;
- The lease term, which does not commence near the end of the economic life of the leased asset, is primarily the remaining economic life of the leased asset;
- The sum of the present value of the lease payments and the residual value guarantees is equal to, or more than, substantially all of the fair value of the leased asset, and;
- The leased asset has no alternative use to the lessor at the end of the lease term because of its specialized nature.
What is important to bear in mind is the new pronouncement removes the 75% (for criteria #3) and 90% (for criteria #4) that former GAAP had provided as guidance and, instead, the lessee will need to take positions as to determining the remaining economic life or substantially all of the fair value of the leased asset. Also new is criteria #5 which needs to be taken into account in the determination of the character of the lease. The right-of-use asset will be amortized on a straight line basis (or any more systemic approach) over the term of the lease and the lease liability will be extinguished using the effective interest method. The income statement will reflect amortization expense for the reduction of the right-of -use asset and interest expense for the interest component of the lease payments.
If a lease arrangement is identified and considered not meeting the above criteria for a finance lease, then such operating lease will reflect, on the balance sheet, a right-of-use asset and a corresponding liability recorded at the present value of the rent payments, using an appropriate interest rate such as the lessee’s incremental borrowing rate. Both the amortization of right-of-use asset and the accreted interest on the lease liability will be reflected in rent expense on the income statement.
If an entity has both finance leases and operating leases, then the right-of-use asset and the lease liabilities must be presented separately for each type of lease.
If there are elements in the lease arrangement for step-up in rent payments, initial direct costs, payments of residual values, etc., such elements must be taken into account in calculating the right-of -use asset and corresponding liability.
Leases with terms of 12 months or less will be exempt from the standard as it relates to reflecting a balance sheet impact. Such leases will continue to be accounted for as under previous guidance, i.e., off balance sheet and footnote disclosure only.
As part of the transition process for the standard, there are practical expedients that an entity may elect, as a package and applied consistently, to all of its leases which commenced prior to the effective date of the standard:
- An entity need not reassess whether any expired or existing contracts are or contain leases;
- An entity need not reassess the lease classification (i.e., operating versus finance lease) made under previous GAAP for any expired or existing leases, and;
- An entity need not reassess initial direct costs for any existing leases.
If an entity foregoes these practical expedients, then it must apply the standard to all previous periods presented for which there are leases or contracts which contain lease and non-lease components.
On January 5, 2018, the FASB issued an Exposure Draft revising some of the provisions of ASC 842. The Board is requesting comments to this Exposure Draft no later than February 5, 2018.
The two issues on which the Board is seeking comments are as follows:
- Comparative reporting for initial adoption, and;
- Separating and allocating lease and non-lease components in a contract.
As it relates to comparative reporting for initial adoption, the Board has proposed recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. As it relates to separating and allocating lease and non-lease components in a contract, this proposed amendment would be applicable to lessors only. The amendment would provide lessors with a practical expedient that is currently available to lessees, which is to not separate non-lease components from related lease components for identified classes of underlying assets. This practical expedient would be available only upon meeting certain requirements, i.e., (i) the timing and pattern of revenue recognition for the non-lease component(s) and related lease components are the same, and (ii), the combined single lease component would be classified as an operating lease.
A subsequent newsletter will provide an update to the standard once the comment period has expired and the Board has finalized any revisions to ASC 842 regarding the aforementioned issues.
As can be seen from this brief summary, the new pronouncement on lease accounting will have a deep and profound effect on most entities. While the implementation date is still some time off, it would be prudent to begin to assess the effect this pronouncement will have on your financial statements. We here at CFO Consulting Partners have an extensive understanding of the new standard and stand ready to assist in evaluating and implementing this standard.