The Financial Accounting Standards Board (FASB)'s new leasing standard, released February 25, 2016, brought several changes to lease accounting. While not all of the changes will mean significant updates to existing U.S. generally accepted accounting principles (GAAP), they will require entities with leasing arrangements to adjust their current practices.
Throughout our leasing serial, we will explore the standard's key points and provide practical examples and other considerations for meeting your new reporting requirements. In part one, we will provide an overview of the major changes, a summary of lease classifications, definitions and recommendations for what your organization can do now to prepare for the new standard.
Highlight of the Major Changes
FASB issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) to bring greater transparency to leasing transactions and align leasing guidance with other recent accounting standards updates, such as the changes affecting Topic 606, Revenue from Contracts with Customers.
Among the more significant provisions, the new leasing standard requires all leases except short-term leases to be recorded on the balance sheet. Presentation and disclosure requirements have been expanded and will include information about significant assumptions and judgments, such as the determination about whether a contract contains a lease and how consideration is allocated, as well as additional quantitative disclosures, including total lease cost segregated by type, the weighted average remaining lease term, discount rate and a maturity analysis of lease liabilities.
Real estate-specific provisions related to lessor accounting were eliminated, so there is no different treatment of accounting for leases involving real estate versus other types of assets. Guidance related to leveraged leases was removed as well, although leveraged leases under the current leasing standard are grandfathered until they expire or are modified. For a complete overview of the changes, please see FASB Unveils New Leasing Standard.
Definition of a Lease
Determining whether a contract contains a lease is the fundamental question under the new guidance since most leases will be recorded on the balance sheet. Under current GAAP, the fundamental question is the lease classification because operating leases are not recorded on the balance sheet.
Two parties enter into a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. A party has control over an asset when it obtains substantially all of its economic benefits and can direct the use of the asset. Directing the use of the asset can mean the entity has the right to direct how and when the asset is used. In some cases, relevant decisions for use of the asset are predetermined. In these cases, a party has the right to direct the use of the asset if it was involved in the design of the asset (including how and when used) or if it has the right to use the asset without the other party changing the operating instructions.
In order to contain a lease, the contract must have an identified asset, which can be explicitly or implicitly stated in the contract. The asset can be a portion of a larger asset if it is physically distinct, such as a floor of a building or an identifiable cable line within a group of cables. If the supplier has the practical ability to substitute an alternative asset, and would benefit economically from the situation, then the supplier has a substantive right of substitution. Contracts with a substantive right to substitute another asset are not considered to have an identified asset and would not meet the definition of a lease. An organization's evaluation of whether a supplier's substitution right is substantive is based on facts and circumstances at the inception of the contract and should only include consideration of future events that, at inception, are considered likely to occur. Factors to consider when determining whether the right is substantive include the cost of substitution and the location of the asset. Repairs and maintenance requirements, protective rights and any restrictions on the substitution do not cause a right to be substantive. If a customer cannot readily determine whether a supplier's right is substantive, then the customer should presume that it is not substantive.
Excluded from the scope of the leasing guidance are:
- Intangible assets;
- The exploration for or use of natural resources;
- Biological assets;
- Inventory; and
- Assets under construction.
In addition, lessees can make a policy election by class of asset for short-term leases to not recognize a lease asset and liability. Instead, the short-term leases would be recognized like operating leases under current GAAP, recognizing rent on a straight-line basis over the lease term and variable lease payments as incurred. Short-term leases have lease terms (as defined below) of 12 months or less and do not contain an option to purchase the underlying assets that the lessee is reasonably certain to exercise.
The following are examples regarding the determination of whether a contract contains a lease, which is included within the implementation guidance of the new leasing standard.
842-10-55-42 A contract between Customer and a freight carrier (Supplier) provides Customer with the use of 10 rail cars of a particular type for five years. The contract specifies the rail cars; the cars are owned by Supplier. Customer determines when, where, and which goods are to be transported using the cars. When the cars are not in use, they are kept at Customer's premises. Customer can use the cars for another purpose (for example, storage) if it so chooses. However, the contract specifies that Customer cannot transport particular types of cargo (for example, explosives). If a particular car needs to be serviced or repaired, Supplier is required to substitute a car of the same type. Otherwise, and other than on default by Customer, Supplier cannot retrieve the cars during the five-year period.
842-10-55-43 The contract also requires Supplier to provide an engine and a driver when requested by Customer. Supplier keeps the engines at its premises and provides instructions to the driver detailing Customer's requests to transport goods. Supplier can choose to use any one of a number of engines to fulfill each of Customer's requests, and one engine could be used to transport not only Customer's goods, but also the goods of other customers (for example, if other customers require the transport of goods to destinations close to the destination requested by Customer and within a similar timeframe, Supplier can choose to attach up to 100 rail cars to the engine).
842-10-55-44 The contract contains leases of rail cars. Customer has the right to use 10 rail cars for five years.
842-10-55-45 There are 10 identified cars. The cars are explicitly specified in the contract. Once delivered to Customer, the cars can be substituted only when they need to be serviced or repaired. The engine used to transport the rail cars is not an identified asset because it is neither explicitly specified nor implicitly specified in the contract.
842-10-55-46 Customer has the right to control the use of the 10 rail cars throughout the five-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of the cars over the five-year period of use. Customer has exclusive use of the cars throughout the period of use, including when they are not being used to transport Customer's goods.
- Customer has the right to direct the use of the cars. The contractual restrictions on the cargo that can be transported by the cars are protective rights of Supplier and define the scope of Customer's right to use the cars. Within the scope of its right of use defined in the contract, Customer makes the relevant decisions about how and for what purpose the cars are used by being able to decide when and where the rail cars will be used and which goods are transported using the cars. Customer also determines whether and how the cars will be used when not being used to transport its goods (for example, whether and when they will be used for storage). Customer has the right to change these decisions during the five-year period of use.
842-10-55-47 Although having an engine and driver (controlled by Supplier) to transport the rail cars is essential to the efficient use of the cars, Supplier's decisions in this regard do not give it the right to direct how and for what purpose the rail cars are used. Consequently, Supplier does not control the use of the cars during the period of use.
At the commencement of the lease, organizations will have to evaluate the lease using five classification criteria:
- 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. If the lease commencement date falls at or near the end of the economic life of the underlying asset, 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.
Lessees will determine the type of lease based on whether the lease meets any of the criteria. If the lease meets at least one criterion, the lease should be accounted for as a finance lease. Otherwise, the lease should be accounted for as an operating lease.
Lessors will use a similar evaluation process to determine the type of lease. The lease is considered a sales-type if at least one of the five criteria is met. It is a direct financing lease if none of the criteria is met and:
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee and/or any other third party 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.
Lessors will classify all leases that do not meet the definition of sales-type or direct financing as operating leases.
The first four lease classification criteria are similar to current GAAP except that the bright lines of 75 percent and 90 percent were replaced with more principles-based terms of "major part" and "substantially all." However, the new standard does cite those old bright lines as one reasonable approach to applying the new standard. The lessor classification test was changed a bit, removing the requirement for a sales-type lease to have selling profit or loss. In addition, a lessor can only have a direct-financing lease if there is a residual value guarantee by an unrelated third party that is sufficient to satisfy the criteria above (i.e. causes the lease payments and residual value guaranteed to equal or exceed substantially all of the fair value of the underlying asset).
Other Key Concepts
The guidance contains several other terms and concepts with which entities should be familiar. They include the following.
Components of a Leasing Contract – Items or activities that transfer goods or services between the lessor and the lessee should be evaluated in a leasing contract. The right to use an underlying asset should be considered a separate lease component if the lessee can benefit from the right of use on its own or together with other resources readily available and the right of use is neither highly dependent nor highly interrelated with other right(s) to use underlying assets in the contract. However, organizations should separate the land and building components of a contract, without regard to the two criteria previously mentioned, unless the accounting effect is insignificant.
Lessees will allocate consideration for components of contracts based on relative standalone prices. Lessors will use the revenue recognition guidance outlined in Topic 606 even if the organization has not yet adopted Topic 606.
Nonlease components should be separated and recognized apart from the lease components of the contract. An example of a nonlease component is the maintenance agreement for an office space. Payments for taxes and insurance are not considered to be separate components as they do not transfer a good or service. Lessees may elect to make an accounting policy election by class of underlying asset to account for each lease component and related nonlease components as a single lease component. However, doing so will result in a larger lease liability and right-of-use asset to be recorded on the balance sheet.
Lease Term – The noncancellable period plus optional periods in which it is reasonably certain that the lessee will exercise the option or the lessor controls whether the option will be exercised. The optional periods include both options to renew as well as terminate the lease.
Lease Payments – Fixed payments and in-substance fixed payments less any incentives paid. Variable lease payments are included if they are dependent on a rate or index, such as the consumer price index. If the lease term includes the lessee exercising options, then the lease payments include the exercise price related to those options included in the lease term (the option to purchase the underlying asset, payments to extend the lease, and payments for penalties to terminate the lease). Payments also include fees paid by the lessee to owners of a special purpose entity for structuring the transactions and, for lessees, the amounts that are probable to be owed under residual value guarantees. Lease payments exclude guarantees of the lessor's debt and amounts allocated to nonlease components.
Variable Lease Payments – Payments that are determined by an index or rate are included in the lease payments defined above, which are used to calculate the lease liability and right-of-use asset. Variable lease payments not dependent on a rate or index, such as rent that is a percentage of sales, are recognized in the period in which they occur.
Initial Direct Costs – Incremental costs that would not have been incurred if the lease was not executed. For example, a lease commission that is paid only if the lease is signed is an initial direct cost. However, legal fees incurred reviewing a lease draft or staff time spent negotiating a lease are not initial direct costs as an organization will have to pay those amounts regardless if the lease is signed. This definition of initial direct costs has a much narrower scope than current GAAP.
Discount Rates – The discount rate to be used should be the rate implicit in the lease that causes the aggregate present value of lease payments and the amount the lessor expects to derive from the underlying asset at the end of the lease term to equal the fair value of the underlying asset at the start of the lease (less any tax credit realized by the lessor) and any deferred initial direct costs (except for sales-type leases with selling profit or loss).
If the rate implicit in the lease cannot be determined, then lessees can use the incremental borrowing rate, which is a fixed rate to borrow a similar amount for a similar term with similar collateral as the lease. Nonpublic lessees can make an accounting policy election for all leases to use a risk-free discount rate. However, this will result in the amounts recorded on the balance sheet to be larger and could change an operating lease classification to a finance lease, which has an accelerated expense recognition pattern.
Public companies (as defined in GAAP) must adopt the new standard for fiscal years and interim periods that begin after December 15, 2018. Nonpublic business entities must enact the standard for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020.
Though the guidance is still several years away from taking effect, your organization should begin preparing for changes now.
It is recommend that you first take inventory of your lease agreements and create processes for how you gather and assess that information. Design and implement controls that evaluate contracts, modifications to leases and potential impairment. Consider whether your information systems need to be modified to help facilitate the processes, controls and accounting for leases under the new standard.
Next, evaluate the standard's expected impact to your organization. Determine which of the standard's practical expedients you should elect to your organization. Educate the users of your financial statements about the upcoming changes under the standard and their expected impact on your organization. Review contracts with covenants, like debt and leasing contracts, to see if the recognition of the lease liability or income statement presentation of the expense cause any covenants to be violated.
Lastly, when you adopt the standard, all comparative periods presented will need to be restated, which will require a significant amount of information to be gathered. Decide what process you will be using and how you will ensure the adequate information is covered. Gather the information for the years before your adoption date so there is less time spent at adoption trying to gather the needed information.
For More Information
If you have specific comments, questions or concerns about the changes to lessee accounting, please contact Hal Hunt or Heather Winiarski of MHM's Professional Standards Group. Hal can be reached at firstname.lastname@example.org or 816.945.5610. Heather can be reached at email@example.com or 816.945.5168.
MHM's Understanding the Leasing Standard Serial
Published on April 26, 2016