Implementation of the New Lease Standards by Lessors Under the ASC 842 (Part 2)
Mark Sloan, Director, CFO Consulting Partners
In our newsletter for January 2018, we discussed the new guidelines under ASC Section 842 regarding the recognition and financial reporting of leases. In that newsletter, the focus was primarily on the lessee, as there are significant changes affecting lessees, e.g., the recognition of a right of use asset and a corresponding liability on the balance sheet, and the concept of embedded leased assets within service agreements, to name a few. In this newsletter, the focus will be on the impact of this standard on lessors.
In addition, during the year, there were updates to ASC 842 providing clarification to the intended application of certain aspects of the standard, correct cross-reference inconsistencies, and provide entities with an additional optional transition method. This newsletter will focus on the additional optional transition method that is available for all entities.
EFFECTIVE DATE OF IMPLEMENTATION:
ASC 842 is effective for public firms, certain not-for-profits and certain employee benefit plans in years beginning after December 15, 2018 (including interim periods) and for all other entities in years beginning after December 15, 2019 and interim periods within fiscal years beginning after December 15, 2020. Earlier application is permitted for all entities.
TYPES OF LEASES UNDER ASC 842:
Under ASC 842, there are three types of leases that a lessor will record:
- Direct financing
A fourth type lease which was allowed under previous GAAP, leveraged lease, has been eliminated under the new ASC.
A lessor will use the same lease classification criteria used by a lessee to determine the type of lease to be recorded. The five criteria are as follows:
1) Ownership is transferred at the end of the lease;
2) A bargain purchase option exists;
3) The lease term approximates the remaining economic life of the asset (assuming the lease term does not commence toward the end of the life of the asset);
4) The present value of the lease payments and any residual value guarantees equal or exceed the fair value of the asset, and;
5) The leased asset has no alternative use to the lessor at the end of the lease. If any of the above criteria is met, the lease will be determined to be a sales-type lease. Assuming the collectability of the lease payments is probable, the lessor will then, on commencement date of the lease, derecognize the carrying value of the underlying asset, and recognize the following:
a) A net investment in the lease, comprised of:
1) The present value of the lease payments to be received and the guaranteed residual value (both discounted using the rate implicit in the lease), and;
2) The unguaranteed residual asset, i.e., the present value of the amount the lessor is expected to derive from the underlying asset not guaranteed by the lessee, discounted using the rate implicit in the lease.
b) Any selling profit or loss arising from the transaction, and;
c) As an expense, any initial direct costs.
After the commencement date of the lease, the lessor will recognize the following:
a) Interest income on the net investment in the lease;
b) Variable lease payments which are not included in the initial net investment as either profit or loss in the period where the changes in facts and circumstance on which the variable lease payments are based occur, and;
c) Impairment of the net investment if such impairment is determined to arise.
If the collection of the lease payments is not probable, then the lessor would continue to reflect the underlying asset on its books, record depreciation expense on such asset and treat the lease payments as unearned income. Such accounting will continue until the collection of the rent payments is deemed probable, the contract has been terminated or the lessor has repossessed the asset. Upon the determination that the collection of the lease payments is probable, the unearned income would be reversed, the carrying value of the asset would be charged off to operations, and the present value of the remaining lease payments, the guaranteed residual value and the present value of the unguaranteed residual value would be recorded as a net investment.
If the transaction does not meet any of the above five criteria, the lease should be evaluated for the following two conditions:
1) 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 and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset, and;
2) It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.
If the lease meets both the above criteria, it shall then be classified as a direct financing lease. The main difference between a sales-type lease and a direct financing lease is the presence of a guaranteed residual value provided by a third party. Also, as opposed to a sales-type lease where initial direct costs are expensed out at the commencement date, under a direct financing lease, such initial direct costs shall be capitalized using separate discount rate and included in the measurement of the net investment in the lease. Another difference between a sales-type lease and a direct financing lease is that in a direct financing lease, the selling profit is required to be deferred at the commencement date and included in the measurement of the net investment in the lease. Such profit will be recognized into income over the terms of the lease. Any loss arising from the transaction will be immediately recognized (similar to a sales-type lease).
If a transaction is determined not to meet the criteria of a direct financing lease, it will then be recognized as an operating lease. As such, the lease payments are recognized in income over the straight line method (unless there is another systematic and rational basis that better represents the underlying transaction), variable lease payments are recognized as income in the period in which changes in facts and circumstances giving rise to the payments occur, and initial direct costs are reflected as an expense over the lease term on the same basis as lease income. The leased asset continues to be shown on the balance sheet of the lessor, with periodic charges to reflect the depreciation of the asset. Fundamentally, the accounting for an operating lease for a lessor remains consistent with the guidance found in the previous standard (ASC 840).
If a lease agreement is replaced by a new agreement with a new lessee, the lessor shall account for the termination of the original lease and shall account for the new lease as a separate transaction.
Also, under ASC 842 and consistent with the treatment required of lessees, lessors are required to allocate consideration in a contract into separate lease and non-lease components. Using the guidance on variable consideration under ASC 606 Revenue Recognition, this would relate to the transfer of one or more goods or services that are not leases or an outcome from transferring one or more goods or services that are not leases. An example of a non-lease component would be payment by the lessee to the lessor for common area maintenance, utilities or cleaning services. There is a practical expedient that a lessor can elect and that is, by class of underlying asset, not to separate non-lease components from the associated lease component and instead, to account for those components as a single component if the non-lease components would otherwise be accounted for under the new revenue guidance under ASC 606 and both the following are true:
1) The timing an pattern of transfer of the non-lease components and lease components are the same, and;
2) The lease component, if accounted for separately, would be accounted for as an operating lease.
If the non-lease component or components associated with the lease components are the predominant component of the combined components, then the entity is required to account for the combined component in accordance with ASC 606, Revenue Recognition. Otherwise, the entity must account for the combined component as an operating lease in accordance with ASC 842.
There can be complex transactions involving sales and leaseback arrangements and the accounting for deferred taxes which are beyond the scope of this newsletter. This newsletter is intended to provide a very high level summary of the more pertinent areas of the new standard.
In the financial statements in which an entity first applies the standard, the entity will apply the standard to all leases that exist at the beginning of the earliest comparative period presented. An entity shall adjust the equity at the beginning of the earliest comparative period presented and other comparative amounts disclosed for each prior period presented.
A lessee may elect not to apply the standards to short-term leases, i.e. leases with a term less than twelve months.
Practical expedients were provided in the initial ASC 842 standards. They must be elected as a package and applied consistently to all leases that commenced before the effective date of the standard:
1) An entity need not reassess whether any expired or existing contracts are or contain leases;
2) An entity need not reassess the lease classification (i.e., operating or finance lease) for any expired or expiring leases, and;
3) An entity need not reassess initial direct costs for any existing leases.
Another practical expedient that is available is the entity may elect to use hindsight in determining the lease term (including purchase options) and in assessing impairment of the entity’s right-of-use asset. This practical expedient may be elected separately or in conjunction with practical expedients mentioned in the aforementioned paragraph.
Accounting Standards Update 2018-11 provides entities (both lessees and lessors) with an additional optional transition method upon adoption. An entity may elect, in lieu of restating prior years financial statements for the implementation of ASC 842, to recognize a cumulative effect adjustment to the opening balance of retained earnings in the period of adoption. For an entity providing comparative financial statements, the statements for the periods prior to adoption would continue to reflect the standards under ASC 840, along with the footnote requirements under ASC 840 for such periods.
Public firms will need to disclose the effect on the pronouncement in the footnotes for 2018 financial statements, assuming they do not elect early adoption.
This summary, along with our newsletter of January 2018, is intended to provide an overview of the new pronouncement for lease accounting. This implementation is expected to have a deep impact on most entities and with the implementation date rapidly approaching, it is imperative that firms begin to understand the standard and assess the effect this pronouncement will have on their financial statements. For public firms, they will need to begin to reflect this new standard in their first quarterly financial statements for 2019.
CFO Consulting Partners has an extensive understanding of the new standard, and assist companies in the evaluation and implementation of this standard.