Q: Does ASC 842, Leases, apply to my organization?
A: If your organization issues financial statements in accordance with U.S. GAAP, then yes, the new requirements apply to your organization. There are no entities excluded from the scope of this topic. There had been some question as to whether the FASB’s Private Company Council (PCC) would provide a GAAP alternative for private companies (like they did with applying VIE guidance to common control leasing arrangements); however, the PPC seems to have made it clear that no such alternative will be coming.
Q: I don’t believe these new accounting standards provide any value to my financial statements. Do I have any alternatives to implementation?
A: Options will likely be dependent on the users of your financial statements and what they will accept. There are no other options that would be in accordance with U.S. GAAP, but there are a few alternatives which organizations might be able to consider:
- Issue financial statements prepared in accordance with a special purpose framework (e.g., tax- or cash-basis financial statements). If you have users who require U.S. GAAP basis financial statements (for example, as a debt covenant), you will need to discuss this soon and ensure agreements are modified prior to the end of the reporting period in which ASC 842 becomes effective.
- In a limited set of circumstances, you may be able to avoid accounting for related-party leases under ASC 842 by issuing combined financial statements (assuming consolidation is not required under ASC Topic 810). For example, this option may be acceptable for related parties with the same ownership structure and filing consolidated tax returns. However, electing to issue combined financial statements may not relieve you of the requirement to adopt ASC 842 for the separate entities. There are potentially complex matters that should be discussed with your accounting and tax professionals.
- Accept an adverse or qualified opinion on your financial statements. We do not recommend this option. The adverse or qualified opinion would be present each year as long as you are not in compliance with ASC 842. Whether the opinion is adverse or qualified would be a matter of materiality and pervasiveness (how impactful the noncompliance is to your financial statements and their users). Some users may be open to accepting an adverse or qualified opinion if it is limited to noncompliance with ASC 842. You would need to discuss this option with your financial statements users, and you may need to modify related agreements prior to year-end.
Q: Do the new requirements apply to all my leases?
A: The new requirements apply to all leases, including related party leases, except for a handful of specific scope exceptions, which are covered under other guidance. Those exceptions include leases of:
- intangible assets
- rights to explore or use minerals, oil, natural gas and similar non-regenerative resources
- biological assets (plants and animals), including timber
- assets under construction
It’s also important to remember that these requirements not only apply to contracts specifically called or identified as leases, but also to contracts which contain leases. For example, service contracts or supply arrangements may include the use of identified assets in providing services or goods that could qualify for lease accounting under ASC 842. These are referred to as embedded leases.
There are also two accounting policy elections organizations can make to scope out certain leases:
- Entities can elect to exclude short-term leases from the recognition and measurement requirements of ASC 842. Instead, they would apply accounting similar to prior operating lease accounting under ASC 840, by recognizing expense on a straight-line basis over the lease term, and disclosing the amount of expense recognized as short-term lease expense in the notes to financial statements. To qualify as a short-term lease, the lease must be for a term of 12 months or less at the lease commencement date and cannot have any renewal or purchase options that the lessee is reasonably certain to exercise.
- Entities can also adopt a “reasonable recognition threshold,” similar to a capitalization threshold for property, plant and equipment. If total lease payments are below this threshold, then you would not need to apply the recognition and measurement guidance in the new standards for those leases.
Q: With regards to a reasonable recognition threshold, how is that amount determined? Can you just use the same capitalization threshold you have for PP&E?
A: It’s likely not that easy. The capitalization threshold for PPE only considers the asset side of the balance sheet, and the timing of expense recognition. Additionally, this threshold was established without consideration of the increased asset base from adding ROU assets. The new lease accounting requirements are going to include both the lease liabilities and related ROU assets on the balance sheet; therefore, you also need to consider what amount excluded from liabilities would be material. You should also give consideration to the fact the amount of lease liabilities and ROU assets excluded from the balance sheet could accumulate from year-to-year as new leases are entered into and prior leases continue in effect. You may need to be a bit more conservative here. One reasonable approach might be to determine appropriate thresholds for the assets and the liabilities sides of the balance sheet separately, and then use the lesser of the two amounts.
Q: Do you apply the recognition threshold based on discounted or undiscounted lease payments?
A: We believe a two-step method would be appropriate, in which you first consider the undiscounted amount and then consider the discounted amount. If the undiscounted amount is below the recognition threshold, you can exclude the lease from accounting under ASC 842. If the undiscounted amount is greater than the recognition threshold, you should perform the present value calculation to determine if the present value is below the recognition threshold. If so, you would exclude the lease from accounting under ASC 842.
Q: Should the recognition threshold be applied to the entire contract or to each underlying asset?
A: In our opinion it would be appropriate to apply the recognition threshold to each separate lease component. In many cases, this will be each underlying asset, but you may need to determine in accordance with ASC 842-10-15-28, that each ROU asset is neither highly dependent nor highly interrelated with other ROU assets in the contract. In addition, if you elect not to account for lease components separate from nonlease components, you may need to allocate the consideration for the nonlease components to the lease components prior to applying the recognition threshold.
Q: When should I use the portfolio approach?
The portfolio approach is explicitly allowed by the new guidance to reduce the cost of accounting for a group of leases or leased assets with similar terms. Determination of the size and composition of a portfolio is a matter of judgment; however, it should not result in an accounting that would be materially different than if the accounting for the leases were done separately.
One benefit of the portfolio approach is the ability to determine a single discount rate to be applied to each lease component. The guidance illustrates this using an example of a lessee that entered into 400 individual leases at different dates throughout the year. The example assumes that the leases are of similar terms (4 to 5 years) and that the lessee’s credit rating and the interest rate environment are stable.
Another application of the portfolio approach might be to a group of lease components in order to account for them as a single lease component. In this application, each lease component would need to be similar and have the same lease term (beginning and ending dates). Accounting for multiple components as a single component would reduce efforts for classification, determining the discount rate, and performing related calculations. However, the resulting accounting (including classification) cannot be materially different than had each lease component been accounted for separately. When considering this application of the portfolio approach, you should also consider whether various options (such as, renewal, termination, or purchase) are the same and have the same level of certainty of being exercised. If options are exercised differently for the underlying assets, subsequent accounting may be complicated due to the need to bifurcate the underlying assets based on the exercise of those options.
Q: How can I minimize the balance sheet impact?
A: There are a few strategies that may help minimize the balance sheet impact, if that is your goal.
- Structure lease agreements so as to reduce the lease term. Accounting under ASC 842 is based on “legally enforceable terms and conditions;” therefore, you should only recognize a liability and the corresponding asset for the lease term that is legally enforceable. Keep in mind this could expose you to possibly higher lease payments for the shorter term, potential risk in the ability to renew the lease upon termination, or higher lease payments upon renewal. However, it may be too late for this option for entities that have already reached their effective date. Remember that the new requirements are effective at the beginning of the year, not the end. So, any changes to existing leases would technically be contract/lease modifications, which require separate considerations.
- Negotiate to have lease payments that are variable based on performance or usage. These types of variable lease payments are excluded from the initial measurement of the lease liability.
- Certain policy elections will also have an impact on measurement of lease liabilities:
- Lessees can elect not to separate lease and nonlease components. Think of lease components as the asset being leased, and nonlease components as other goods or services related to the use of the leased asset. Electing not to separate lease and nonlease components can simplify the accounting but will result in higher lease liabilities and related ROU assets.
- Lessees can also elect to use a risk-free discount rate. While this again will simplify the accounting, the risk-free rate will likely be lower than the implicit or incremental borrowing rates, which will result in a higher lease liability (the payments are discounted by a lower amount) and related ROU assets.
Click here for additional insights on practice expedients under ASC 842.
Q: There is a policy election available to not separate lease and nonlease components. I am a bit confused by the concept of components. Can you explain lease components, nonlease components and other costs (or “non-components”)?
A: When looking at the costs or payments in the contract, it’s important to think about putting them into one of three buckets: lease components, nonlease components or other costs (or “non-components”).
Lease components are the portion(s) of the contract directly related to the use of underlying assets. For example, you pay $500/month to lease a vehicle. That is the lease component of the contract. Nonlease components are those portions of the contract which transfer a good or service related to use of the underlying asset. Using a vehicle lease example, paying a monthly maintenance fee of $25 to cover oil changes, tire rotations, etc. would be a nonlease component. Another example might be if the contract included a cost for a lessor-supplied driver or operator.
Finally, other costs (which are not components) are costs that do not transfer a good or service but are required to secure the asset. Examples of other costs include property taxes and insurance. A contract may have more than one of any of these three categories. The accounting for these costs will depend on whether the lessee elects not to separate lease and nonlease components. Absent this election, all costs in the contract will be allocated to each of the lease and nonlease components based on their relative standalone prices.
This results in lower lease liability and related ROU asset balances because only a portion of the total costs are allocated to the lease component(s). However, to simplify accounting, lessees can elect not to separate lease and nonlease components, meaning they would not have to allocate the contract consideration to nonlease components based on relative standalone prices. However, when all payments are allocated to the lease component(s), the resulting lease liabilities and ROU assets will be higher. For additional insights on the practical expedient of not separating lease and nonlease components, click here.
Q: When do I have to implement and reflect in my financial statements?
A: The new requirements are already effective for entities with a calendar year-end, and will become effective as others begin their next fiscal year during 2022. While we noted that ASC 842 needs to be adopted at the beginning of the year, you’re not actually required to issue financial statements in accordance with the new requirements until you issue annual financial statements for the first year. Interim statements are not required to reflect the new lease accounting standards until the second year following adoption. However, that doesn’t mean you have time to wait. You should already be working on implementation. The longer you wait, the more difficult implementation could become. If you implement at a later date, you may have to unwind the accounting already done for the year in order to correctly record accounting under ASC 842. If you have a requirement to provide financial statements within a certain number of days following the year-end, don’t let this be the reason you miss that deadline.
Q: What are my options for transition?
A: ASC 842 allows for two transition methods: one is applied retrospectively to each prior period presented (“comparative method”), and the other is applied at the beginning of the period of adoption (“effective date method”). The second option forgoes comparative reporting and is a simpler approach. We expect most entities will elect the non-comparative transition approach (effective date method) unless required to present comparative reporting by their users. In the effective date method, you would apply the new guidance as of the beginning of the period of adoption; any prior periods will continue to be presented in accordance with ASC 840. This includes the financial statement presentation and the disclosures in the notes to financial statements.
The transition guidance also provides several practical expedients.
1. The first is referred to as the “package of three” and must be adopted as a package. It’s all or none. By electing this practical expedient, lessees are not required to reassess:
- whether contracts are or contain leases,
- lease classification, and
- initial direct costs
We expect most entities will elect this practical expedient. However, it should be noted that this does not grandfather incorrect assessments. For example, if an embedded lease was not previously identified under ASC 840, that does not mean it can be excluded from ASC 842 accounting.
2. The second is the use of “hindsight” in determining the lease term and assessing impairment. This practical expedient is primarily beneficial when an entity is presenting comparative reporting in the year of transition and must restate the prior year. As this practical expedient must be applied to all leases, and we believe it generally provides little benefit for non-comparative reporting, we do not expect this expedient to be used by most.
3. The third relates to easements. Using this practical expedient, an entity can choose to continue to treat expired or existing land easements in other accounting standards, such as ASC 350, Intangibles – Goodwill and Other or ASC 360 Property, Plant and Equipment, by not applying the new lease standard at transition. However, this practical expedient cannot be used if the land easement was previously accounted for as a lease under ASC 840, or the easement is ongoing on a perpetual basis.
Click here for additional insights on practice expedients under ASC 842.
Q: I’ve heard I may need to report a cumulative effect adjustment as of the adoption date, but I am not sure when this would occur. What causes a cumulative effect adjustment if I’m just putting new assets and liabilities on the balance sheet?
A: Given the “package of three” practical expedient, we expect cumulative effect adjustments will be rare. If the package of three is not elected, the chance of a cumulative effect adjustment would be higher due to reassessment of the three items noted above.
Another example relates to sale-and-leaseback transactions. If a sale and leaseback transaction was accounted for as a sale and operating lease transaction under ASC 840, the transferor would recognize any deferred gain or loss resulting from an arm’s-length transaction as a cumulative-effect adjustment to equity at transition (assuming the sale occurred prior to the application date of ASC 842 if using the comparative transition method).
Q: What if we discover errors in prior accounting under ASC 840? For example, what if we didn’t recognize straight-line rent expense recognition, failed to defer lease incentives or miscalculated capital lease related balances? Are those a cause of a cumulative effect adjustment?
A: No, these types of errors need to be considered for a prior period adjustment as a correction of an error, if material. These types of corrections should not be included in the cumulative effect adjustment in adopting ASC 842. The adoption of the new standard does not grandfather in incorrect accounting under the prior standard.
Q: For the short-term lease exception, I understand that the lease term must be 12 months or less at commencement. What about leases that were originally longer than 12 months but have 12 months or less remaining at the date of application of the new standards?
A: The consideration of the short-term lease exceptions is based on the original commencement date of the lease, not at the application date of the standard. For example, if you have a lease with an original term of three years but only six months remaining at 1/1/22 (assumed application date), you will still need to account for the remaining six-month term in accordance with the new standards, as it would not qualify for the short-term lease exception.
Q: When selecting the discount rate for operating leases at transition, do you use the original lease term or the remaining lease term?
A: The transition guidance provided in ASC 842-10-65-1l states that the lease liability shall be measured at the present value of the remaining lease payments using a discount rate for the lease established at the application date. The application date is the date at which an entity first applies the requirements of ASC 842. The benefit of this guidance is that entities only need to consider discount rates as of the application date for all leases, rather than as of the commencement date for each lease.
Q: What are embedded leases? How do you identify them?
A: Embedded leases is an area where there could be some surprises in the implementation of ASC 842, and one of the reasons why the implementation of the new standards could take more effort and time than expected. These leases may not have been identified as leases for accounting under the prior standard.
Under ASC 840, there was little difference in accounting for these contracts as either period costs (e.g., expensing as incurred) or as operating leases. However, identification of embedded leases matters more under ASC 842 because they may have to be presented as liabilities and assets in the balance sheet. Contracts may contain a lease if the contract includes the right to control an identified asset for a period of time, even if it doesn’t use the word ‘lease.’ Contracts more likely to include embedded leases are service or supply arrangement type contracts, such as:
- Contract manufacturing
- Information technology related
- Inventory management and warehousing
- Cable and satellite
- Advertising (billboards)
- Sale of consumables with “free” equipment
- Arrangements that bundle a service with a device
Identification of embedded leases may require a complete inventory and review of all vendor contracts.
Q: To be considered a lease, the asset must be physically distinct. What does that mean?
A: Physically distinct is a consideration when you’re using a portion of a larger asset and, essentially, means that it can be used and benefited from separate from the larger asset. One floor of a building is clearly separate from the other floors of the building and can be used independently. Or, retail space within a shopping center/mall. However, something like use of a fiber optic cable may or may not be physically distinct. If you have sole rights to use a segment of the network, that would be physically distinct. If you just have rights to use a certain amount of capacity over the network, but not all the capacity, your portion of the capacity is not physically distinct from the rest of the capacity.
Q: If I use a portion of a larger asset, it may be physically distinct – but what about the concept of substitution rights? I rent retail space in a strip mall, but the vendor has the right to relocate me to another space in that strip mall. Is that not a lease under ASC 842?
A: For substitution rights to preclude lease accounting, they must be substantive – meaning, it’s practical for the lessor to substitute the underlying asset, and the lessor would benefit economically from doing so. This will be more common in service and supply contracts as opposed to real estate contracts. Determination of “substantive” is intended to be a relatively high threshold and should be established with a reasonably high degree of certainty. If the lessor’s rights are not clearly substantive, then they should be assumed not to be substantive. Let’s look at two examples:
First, a company contracts for air transportation services. The contracts specify the type and condition of aircraft, possibly with specific aircraft identified as an example. If the supplier could substitute any comparable aircraft that is available at flight time, then the lessors substitution rights are likely substantive. It could reasonably be assumed that the supplier would benefit economically by utilizing any available comparable aircraft, rather than having to prepare and relocate a specified aircraft for service.
Second, let’s consider the question of retail space in a strip mall. A lessor might reserve the right to relocate the tenant to a comparable space if/when they find a new tenant willing to pay a higher rent for that space. In this case, we’d conclude the substitution right is not substantive because (1) the future event of locating a higher paying tenant is not “likely” not occur as of the commencement date, and (2) it would be difficult to determine the lessor would economically benefit after considering the costs of relocating the current tenant and placing the new tenant.
Q: The right to direct use is another aspect of determining control. The contract specifies certain things about use. Do I have the right to direct use if the contract tells me how or when I can use the asset?
A: It’s not uncommon for a lease contract to include conditions of use, or to identify how and for what purpose the underlying asset will be used. It’s important to consider which party directs the use of the underlying asset within the terms of the contract.
Conditions of use for a retail space might include factors like hours of operation, maintaining attractive signage, etc. However, these conditions do not dictate how and for what purpose that retail space is used. The lessee still dictates how the space is operated during those hours, or if it’s operated during those hours.
Consider a lease of a truck to transport cargo between two locations. The contract may specify the cargo allowed to be transported and a mileage limit. The customer still specifies the details of each trip (route, speed, stops, driver, etc.). While the how and for what purpose are predetermined in the contract (origination, destination, type of cargo), the lessee still directs the use and operation within those terms.
Finally, consider a contract to use a specified aircraft. There are contractual and legal restrictions on where the aircraft can fly. There are also restrictions related to whether conditions and cargo. The supplier is responsible for operating the aircraft and providing the crew – the lessee is not allowed to use a different operator. While the contract provides the supplier with protective rights, the customer still directs use of the aircraft by determining when and where the aircraft flies, passengers and cargo.
Q: How do you determine the lease term when it’s not clearly specified in the contract? For example, month-to-month leases? Or “evergreen” leases?
A: Lease accounting should be based on legally enforceable terms and conditions. A lease would not be enforceable if both the lessee and lessor have the right to terminate the lease without permission from the other party and with no more than an insignificant termination penalty. This question is easier to deal with in leases between unrelated parties because the terms are often clearer. It could be a more complicated question for leases between related parties where the written terms are not the true intention or complete agreement between the parties. Related party leases should also be accounted for based on legally enforceable terms and conditions, the same as leases between unrelated parties – but what is legally enforceable is often less clear. Related parties should also consider various other factors including:
- Significance of leasehold improvements and whether the lease term is consistent with the useful lives of those improvements. It may not be reasonable to have a leasehold improvement with an estimated seven-year life, and amortized accordingly, on a month-to-month short-term lease. Additionally, an assertion that the lessor would reimburse the lessee for any unamortized costs if the lease were terminated would, in essence, be a termination penalty.
- Whether the underlying asset is directly or indirectly financed through debt provided by the lessee or debt guaranteed by the lessee, and that the debt will be outstanding longer than the stated lease term. They may include cross-corporate security or collateral agreements.
- Whether cash flow from the lessee is critical to the lessor’s ability to meet debt obligations.
- Whether it would be commercially disruptive and economically unrealistic for the lessee to relocate in the short term.
- Other agreements, such as management/operating/shareholder agreements, that could impose restrictions on either party’s ability to terminate or modify the lease.
Q: I lease an asset for only a few months each year. How does this affect lease accounting?
A: The period of time for lease accounting does not have to be consecutive periods of time. You need to add up the nonconsecutive periods you are contracted for, including renewal periods reasonably certain of exercise, to determine the lease term. A three-year lease, which includes use of the asset for six months each year, would be an 18-month lease. You need to consider the total term in applying the short-term lease exclusion. However, in determining whether you have control of the underlying asset, you only consider the periods of use. In the above example, you would only consider the six months you are using the asset and would disregard the six months you do not use it each year.
Q: How do I determine the right discount rate to use?
A: Selecting the correct discount rate is a significant piece of lease accounting. ASC 842 includes three possibilities for the discount rate: the rate implicit in the lease, the lessee’s incremental borrowing rate, and, for nonpublic businesses that make the policy election, a risk-free rate. Lessees are required to use the implicit rate if readily determinable, regardless of whether they’ve made a policy election to use a risk-free rate. If the implicit rate is not readily determinable and the lessee has not made or is not eligible for the risk-free rate election, they would need to use their incremental borrowing rate. The risk-free rate policy election is available to nonpublic businesses and is made by class of underlying assets. Click here for additional information on discount rates.
Q: Lessees are required to use the implicit rate when readily determinable. What does that mean, and how do you determine it?
A: The implicit rate is the rate that results in:
(1) the sum of the present value of lease payments; plus
+ (2) the present value of the amount that the lessor expects to derive from the underlying asset following the end of the lease term
(3) the fair value of the underlying asset; plus
+ (4) any initial direct costs of the lessor
From a mathematical standpoint, it’s not difficult to calculate. Sikich has created an Excel spreadsheet template, which can be used perform the calculation. The challenge is having the inputs for the calculation. This is where “readily determinable” comes in. Readily determinable means that the lessee has access to or knowledge of the inputs – that they can be determined without delay or difficulty. In many cases, the lessee won’t have this information, as it may only be known to the lessor. The lessee is not required to seek out the input from the lessor. However, lessees should be aware that the implicit rate may often be considered readily determinable in related party leases, especially where the parties are under the same ownership/management.
Q: How do you determine the incremental borrowing rate? Can lessees use the rate from their line of credit or some other existing borrowing rate?
A: The incremental borrowing rate is defined as the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term and amount equal to the lease payments in a similar economic environment. Because the circumstances for each lease will vary, it’s not likely the lessee can simply assume a rate equal to a rate on other outstanding borrowings. Rather, they might be able to use an existing rate and adjust based on the several factors – general economic conditions at commencement, lease term, changes in entity specific characteristics, etc. Estimating incremental borrowing rates can be a complex task and may require consultation with a third-party.
Q: What is involved in using a risk-free rate?
A: First, a nonpublic business needs to make a policy election to use a risk-free rate by class of underlying asset. That means you can choose which asset types you want to use a risk-free rate for, and you must use it for all leases of that asset class. After having made the election, lessees can obtain a risk-free rate from the U.S. Treasury website (“Daily Treasury Yield Curve Rates”), making sure to select a rate with a comparable term (e.g., a three-year lease should use a three-year rate). Because the risk-free rate will be lower than the other discount rates, the resulting liability and asset balances will be higher. Some entities might choose to use a risk-free rate for high-volume, low dollar leases (like office equipment, vehicles, etc.) and use an incremental borrowing rate for low-volume, high dollar leases (real estate).
If lease classification is an important factor, lessees should be aware that use of the risk-free rate would increase the possibility that a lease is classified as a finance lease (due to “a substantial portion of fair value” criterion).
Q: If I am in a situation where I lease only a portion of an asset, how do I determine the fair value for just that portion? Do I have to consider that for classification?
A: It is correct that the fair value of the underlying asset is part of one of the classification criteria. However, the good news is that the FASB recognized that there could be significant difficulty in determining this amount for certain underlying assets. If the fair value cannot be determined without undue effort, you would simply disregard that criterion and only consider the other four criteria.
Q: My related party leases are structured to recover the cost of the asset in a relatively short period of time. Could that result in an abnormally high implicit rate of interest?
A: Yes, it very well could. And this makes sense, since higher interest rates would be more tolerable between related parties. Think about a related party vehicle lease where scheduled rent payments total two or three times the original cost of the vehicle. Or, where schedule payments over three years equal the original cost of the vehicle, and the lessor retains the fair value of the vehicle at the end of the term. These types or arrangements are likely to result in abnormally high implicit rates.
Q: Abnormally high interest rates in related party leases might affect classification when looking at whether the present value of lease payments equals or exceeds substantially all the fair value of the underlying asset (the higher the rate, the lower the present value). What is the correct classification if lease payments reimburse the lessor for all or more of the fair value of the asset, but the calculated present value is below your “substantially all” threshold?
A: ASC 842-10-55-12 states (emphasis added), “Leases between
related parties should be classified in accordance with the lease
classification criteria applicable to all other leases on the basis of
legally enforceable terms and conditions of the lease. In the separate
financial statements of the related parties, the classification and
accounting for the leases should be the same as for leases between unrelated
parties.” As required by this guidance, we would use the same
threshold to determine whether the “substantially all of the fair value”
criterion has been met for both unrelated and related party leases. As a
result, the recorded lease liabilities and ROU assets should be more comparable
between unrelated and related parties, even though classification may be
different. Additionally, the information about excessively high (or low)
discount rates would provide users information about the financial support
provided to (or received from) related parties.
As presented in the question, and based only on consideration of the “substantially all of the fair value” criterion, the correct classification would be operating since the “substantially all” threshold was not met.
Q: How do I know when to include variable payments in the measurement of the lease liability?
A: Payments that are based on a rate or index are included in lease payments for classification and measurement, while those that are not based on a rate or index are not. Payments that are not based on a rate or index are typically based on usage (e.g., units produced, machine hours operated, etc.) or performance (e.g., percentage of revenues). It can be helpful to distinguish based on whether the lease payment is completely avoidable (could be $0 for a period) or not. If a payment can be completely avoided as a result of no use of performance, it would be excluded.
However, if a payment cannot be completely avoided and the variability is simply tied to other economic factors, then it would be included. This is also true for payments where the lessee has a choice of the amount to pay but must pay one of them. These are referred to as “in substance fixed payments.” The lessee would use the most likely amount to be chosen for classification and measurement. Click here for more details on variable payment considerations.
Q: My lease payments increase each year based on the change in CPI. How do I determine the payment about to use for future periods in the initial recognition and measurement of the lease?
A: Because the future change in CPI is variable (could go up, down, or stay the same), this portion of future lease payments is variable. While the variability is based on a rate or index, the amount of that rate or index at commencement is 0 because there is no change in the CPI at that date. Therefore, you would not include any amount for the change in CPI in the future payments for recognition and measurement; you would use the stated amount for the initial period for future periods as well. In future periods, the change in lease payments due to the change in CPI would be reported as variable lease expense in that period.
However, if the contract stated that annual payments increased based on the change in CPI, but will increase by a minimum of 2% each year, that 2% increased would be considered a fixed lease payment and should be considered in the initial recognition and measurement.
Q: My lease contract contains renewal options with payment amounts established at future market rents. These amounts are variable, so do I include them in lease payments for measurement?
A: Yes, future payments dependent on future fair market rents are tied to economic factors. While the amount cannot be known until the renewal date, the payment is not avoidable (assuming the renewal option is exercised). While the payment amount could increase or decrease from the last scheduled payment, there will still be a required payment and it is reasonable to expect it will be consistent with scheduled payments. The amount for the last scheduled payment should be used for renewal periods reasonably certain to be exercised.
Q: We have asset improvement (construction) costs in many of our real estate leases. Sometimes we are reimbursed by the lessor and other times we are not. We also are not always reimbursed for 100% of the costs. How do we account for these improvements under the new standard?
A: First, you should determine who owns the asset. If the contract does not require improvements, it will generally be the lessee’s asset. If the contract does require improvement and it could be utilized by a subsequent tenant, it will generally be the lessor’s asset. Next you need to consider who ultimately pays for the improvement. If the improvement is an asset of the lessee and the lessor reimburses the lessee, the amount reimbursed is treated as a lease incentive which reduces lease payments/ROU asset. If the improvement is an asset of the lessor but the lessor does not reimburse the lessee, then the amounts would be included in lease payments for measurement/expense recognition. In other cases (lessee asset and not reimbursed by lessor; lessor asset and lessor reimburse lessee), the amounts do not factor into lease consideration.
Q: For lease incentives received or receivable at commencement, I know these are treated as a reduction of the ROU asset after calculating the lease liability. What about reimbursement of leasehold improvement costs that I won’t receive until several months after lease commencement?
A: If you are going to be entitled to an incentive that does not become receivable until the occurrence of an event after commencement, we believe there are two reasonable approaches. The selected approach might depend on the certainty of the amount to be received. If the amount is probable, you could include it as a reduction of lease payments at commencement. This is the simpler approach and is like accounting for residual value guarantees. If the amount is not probable, the amount should be excluded from accounting at commencement and treated as a remeasurement event at the time the variable consideration becomes fixed (incentive amount becomes known and receivable).
Upon becoming entitled to the incentive, the lessee should reduce the lease liability and ROU asset and either (1) recognize the effect of the incentive prospectively or (2) recognize a cumulative catch-up adjustment to lease expense so that periodic lease expense is recognized as if the incentive was receivable at commencement.
Q: ASC 842 says that ROU assets and lease liabilities are subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in the financial statements. Do I really need to report ROU assets in both current and noncurrent portions?
A: No, you will not report ROU assets as current assets. The guidance says ROU assets are subject to the same considerations as other nonfinancial assets in classifying them. ASC Topic 210, Balance Sheet, says that the concept of current assets excludes depreciable assets. As ROU assets are required to be amortized, they are like other amortizable assets and would meet this exclusion from current assets.
Q: Obviously my balance sheet is going to be impacted, but will my income statement change?
A: Generally, no. There may be small timing changes due to a change in the definition of initial direct costs – certain items previously capitalized will now be expensed – but overall, expense recognition is substantially similar. Operating leases will still have expense recognized on a straight-line basis. Finance lease expense recognition will also be essentially the same as prior capital lease expense recognition. There may, however, be changes in how/where certain expenses are reported – for example, due to the policy election to not separate lease and nonlease components (all costs are lease expense). The presentation of expenses related to property taxes and insurance could also change.
Q: What are the presentation and disclosure requirements for leases that fall below the recognition threshold?
A: As the leases have been deemed to be immaterial, there are no presentation and disclosure requirements. The expenses would be recognized as period expenses in the financial statements and no related lease disclosures are necessary. We recommend that the expenses related to these immaterial leases be included in other expense line items, separate from “lease” or “rent” expense type captions. Due to the extensive disclosure requirements under ASC 842, inclusion of lease expense on the face of the financial statements that is not included in the lease disclosures would be inconsistent and raise question as to what has been excluded from the note disclosures. If the leases are truly immaterial, the expense classification should be as well.
Q: I have entered into a lease contract but the lease does not commence until after my reporting date. Do I need to do anything with it?
A: If the contract creates significant rights and obligations for the lessee, the existence and terms of the lease contract should be disclosed in the notes to the financial statements. However, you do not recognize the lease liability and ROU asset until the commencement date.
Q: How are footnote disclosures changed?
A: ASC 842 has significantly expanded the required disclosures. More qualitative information is required related to variable payments, renewal and purchase options, residual value guarantees, subleases and other aspects related to accounting under ASC 842. There are even more significant changes to quantitative disclosures, which must present amounts for operating and finance leases separately.
Two measures that are new and will require new calculations to determine are the weighted-average remaining lease term and the weighted-average discount rate. The weighted-average remaining lease term is measured relative to lease liability balances (discounted) while the weighted-average discount rate is measured relative to remaining lease payments (undiscounted). The guidance in ASC 842-20-55 provides the following illustration of how lessees may present the quantitative disclosures.
Q: How is lessor accounting changed by ASC 842?
A: The good news for lessors is that lessor accounting is substantially unchanged and existing accounting processes should continue to be sufficient. There are a few changes to lease classification considerations, and potential for both accelerated expense recognition as well as delayed profit recognition, compared to ASC 840, but timing differences are not expected to be significant. Lessors are also provided a policy election to not separate lease and nonlease components under certain conditions.
If those conditions are met, the lessor would account for the combined component based on whether lease or nonlease components are the predominate component. If nonlease components are predominant, the lessor would account for the contract in accordance with ASC 606, Revenue from Contracts with Customers. If the lease components are predominant, the lessor would account for the contract in accordance with ASC 842, Leases. A more in-depth discussion of the impacts for lessors can be found here.
Q: Has the accounting for security deposits changed? Are security deposits considered lease payments?
A: The accounting treatment will depend on whether the deposits are refundable or nonrefundable. A nonrefundable deposit is included in lease payments as it is a payment made to the lessor that will not be returned. Refundable deposits, however, are not included in lease payments, at least not initially, and should be accounted for as a separate deposit asset. However, if at termination of the lease, the lessor keeps all or part of the deposit, that amount would be reported as lease expense.
Q: Has the accounting for property taxes and insurance changed?
A: First, we need to remember that taxes and insurance would not be a component as they do not transfer goods or services. So, these costs would be allocated to the lease and nonlease components in the contract, and the expense reported accordingly. Any portion allocated to lease components would be presented as lease expense and any portion allocated to nonlease components would be included with that expense classification, such as maintenance. Lessees will generally not present “property taxes” or “insurance” related to leases on the face of the financial statements.
Q: Does the adoption of ASC 842 impact income taxes?
A: Generally no, or not directly. This is a GAAP rule change and not a tax code change. But there are still implications for preparation of tax filings. For tax purposes, leases are treated as either true tax leases or non-tax leases. In a true tax lease, the lessor maintains ownership of the asset and related deductions while the lessee deducts rental payments. In a non-tax lease, the risks and rewards of ownership are with the lessee and thus the tax benefits of ownership are recognized by the lessee.
However, the increased assets and liabilities as a result of ASC 842 implementation may have tax implications. For one, balances related to deferred tax items will no longer be recorded in separate general ledger accounts as they become a part of the ROU asset accounting. Balances such as deferred rent or unamortized incentives no longer exist and must be obtained in new ways. Second, the increased asset base could impact apportionment factors for companies with activity in states that include property factors.
Sikich tax professionals provide an in-depth consideration of the tax implications of the new lease accounting standards in a two-part insight article. Click here for Part 1 and click here for Part 2.
Q: Do we really need new software to manage lease accounting?
A: Unless you only have a couple of leases, a software solution is highly recommended. Remember that this is not just a one-time implementation effort; this is on-going GAAP compliance. Software solutions will reduce time and effort in future periods to accumulate data for note disclosures, remeasure lease liabilities and ROU assets when required, and to account for new leases. There are several lease accounting software solutions available at varying costs with varying capabilities. It’s important to think about what you really want and need from a software solution and how much you’re willing to pay for it.
At Sikich, we recognize that many businesses want a more simplified accounting solution that won’t have high recurring annual costs. Because of that, we developed our own Excel based solution, Lessee Ledger, and are offering this tool for a one-time up-front cost. If you have not been introduced to Lessee Ledger, be sure to contact us for more information: