Every lease will need to be evaluated under the new leasing standard, which takes effect for public business entities beginning in the 2019 calendar year and nonpublic business entities beginning in the 2020 calendar year. ASC Topic 842 makes several changes. Most operating and finance leases will be recorded on the balance sheet and disclosure and presentation requirements will be expanded. The definition of a lease was also updated to reflect the principle of control, which brings lease accounting more in line with the recent changes made to revenue recognition.
As entities work through their transition to the new guidance, a number of questions may come up. The following may assist with implementation.
Can I Use a Portfolio Approach to Transition Leases?
The short answer is yes. Leases can be evaluated and recorded together if they are similar in nature. As an entity works through groups of leases, consider the size and composition of the portfolio. The application of the guidance to the portfolio should not differ materially from the application to the individual leases within the portfolio.
There is an asterisk here, though. Sometimes residual value guarantees are not solely based on the residual value of the individual underlying asset. Rather, when an asset has a residual value in excess of the "guaranteed" amount, entities offset that excess against shortfalls in residual value that exist in other assets in the portfolio. In those situations, residual value guarantees for a portfolio of underlying assets cannot be considered when evaluating the lease classification.
Can a Materiality Threshold Help Determine Which Leases to Recognize on the Balance Sheet?
Entities will be able to create reasonable capitalization thresholds, and items that fall underneath the threshold would not need to be recognized on the balance sheet. Capitalization thresholds for leases should be similar to thresholds used in capitalization of property, plant and equipment. Existing capitalization policies should also be revisited because the leasing standard creates "right-of-use" (ROU) assets, which could affect the evaluation of whether aggregated amounts are material enough to be capitalized.
Several approaches can help with setting the materiality threshold. One would be to take the lesser of a threshold for property, plant and equipment that includes ROU assets and a recognition threshold that takes into account the effect of lease liabilities determined under the new leasing standard.
Another way entities can set their capitalization threshold would be to record all lease liabilities but create a capitalization threshold for ROU assets. ROU assets that exceed the threshold would be recognized as an expense, and in subsequent periods, the lease liability would be amortized using the effective interest method.
Consider as well how omitted disclosures related to leases that were not recognized will affect the balance sheet and the related internal controls over financial reporting implications. For further assistance on considering the impact of materiality on policies, refer to SEC Staff Accounting Bulletin Topic 1.M (SAB 99).
Can I Still Use the Bright Lines from ASC Topic 840 to Determine Lease Classification?
Using the bright lines tests under ASC Topic 842 is considered one reasonable approach to lease classification. The bright lines include:
- 75 percent or more of the remaining economic life of an underlying asset is considered a major part of the remaining economic life of that underlying asset.
- A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset and
- 90 percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.
Recording the Lease
Should Noncash Considerations Be Included in the Determination of Lease Payments?
Entities will normally treat noncash considerations similar to variable lease payments that depend on an index or rate. Changes to the fair value of the noncash considerations between the lease liability's initial measurement and the ROU asset should be recognized as variable lease payments. For example, if an entity agrees to transfer a certain number of its shares at the end of each year in lieu of lease payments, the fair value of the stock would be determined at lease commencement and included in lease payments. Then, as the actual fair value is determined each year as the stock is transferred, any differences between the actual fair value and estimated fair value would be recognized into the income statement.
Guarantees, with the exception of guarantees of a lessor's debt because they are explicitly excluded from the definition of lease payments in the new standard, should be treated as final lease payments because the lessee has delivered its obligation under the guarantee at the end of the lease.
Is a Security Deposit Considered a Lease Payment?
It depends on whether the security deposit is refundable. If the security deposit is used to secure the terms of the lease and is nonrefundable, the deposit would be considered part of the paid contract consideration, and therefore treated as a fixed lease payment.
Security deposits that are refundable would not be considered lease payments. In the event that a refundable security deposit is not returned because of a missed lease payment, the security deposit should be applied against the unpaid lease liability. If the lessor keeps the refundable deposit for other reasons, the lessor should treat it as a variable lease payment. Interest earned on the security deposit would also be treated as a variable lease payment by the lessor.
How Does a Lessee Account for Other Costs in the Lease, Such as Reimbursement of Lessor's Cost?
The guidance specifies that components are only related to items or activities that transfer a good or service to the lessee. Maintenance services would fall under that definition. Taxes and insurance would not. Consideration of the contract, which includes other costs in the lease, is allocated to the lease and nonlease components based on the relative standalone selling price of those items or activities.
How Should Variable Lease Payments Based on an Index or Rate Be Calculated?
If variable lease payments are based on specific indices or rates at the lease commencement, the index or rate would be included in the initial lease liability calculation. If the variable lease payment is based on the change in the rate or index, the index or rate would not be included in the initial lease liability calculation. When a lessee remeasures the lease liability in accordance with the new leasing standard guidance, the variable lease payments that depend on an index or rate should be remeasured using the index or rate at the remeasurement date.
If a Variable Lease Payment is Based on Performance or Usage, Does a Lessee Need to Estimate the Probable Lease Payment?
First, an entity should also consider whether the variable lease payments are in-substance fixed payments. If they are not, then the variable lease payments based on performance or usage will be recognized in the period the obligation is incurred and should consider the probability and duration of the obligation. Variable lease payments based on usage or performance are likely discrete performance targets (for example, lessee pays $1,000 per year plus 2 percent of store sales each year) or cumulative performance targets (for example, lessee pays $1,000 per year plus $300 per year when cumulative sales exceed $500,000). Discrete targets will likely be recorded in the period they are met while the cumulative targets will need to take into consideration the probable amount to be paid over the duration of the contract and then recognize a portion of that obligation each period, even if the target is not yet met.
How Should a Lessee Present the ROU Assets and Lease Liabilities for Operating and Finance Leases in the Balance Sheet?
The balance sheet items for operating and finance leases are prohibited from being presented on the same line items as each other. Furthermore, the ROU assets are amortizable assets, so they should not be separated between current and noncurrent portions. Conversely, the lease liabilities represent future commitments and the portion of lease liabilities expected to be paid within the year should be presented as current liabilities.
Sale and Leaseback and Build-to-Suit Leases
If the Seller-Lessee Has a Repurchase Option in a Sale and Leaseback of Real Estate, Can It Qualify as a Sale Under ASC Topic 606, Revenue from Contracts with Customers?
To qualify as a sale, the leaseback cannot be a finance lease, the option must be priced at fair value, and there must be other alternative assets that are substantially the same and readily available. Real estate is unique by its nature. As such, a repurchase option of real estate would not qualify as a sale.
How Should Build-to-Suit Transactions be Transitioned?
The assessment of build-to-suit transactions has been changed from a risk-based approach (risk of loss during the construction period) to a control-based approach (who controls the assets during the construction period). If the lessee controls the asset, the lessee recognizes the entire construction project on its books. In transitioning build-to-suit transactions, the first step is to derecognize the assets and liabilities at the later of the beginning of the earliest period presented in the financial statements or the date the construction of the asset began. The second step depends on whether the construction is completed before the effective date. If it was, the lease does not need to be re-evaluated under the new standard. If construction is ongoing at the effective date, it must be re-evaluated under the new standard's lessee involvement in asset construction guidance.
For More Information
If you have specific comments, questions or concerns about leasing, please contact Heather Winiarski or Hal Hunt of MHM's Professional Standards Group. Heather can be reached at firstname.lastname@example.org or 816.945.5168. Hal can be reached at email@example.com or 816.945.5610.
Published on August 08, 2017