Major changes in lease accounting lie ahead for private companies that have not yet adopted the guidance in Accounting Standards Codification (ASC) Section 842, Leases. New guidance under ASC 842 will replace lease accounting rules currently in effect under ASC 840. As privately held entities prepare to implement the new rules, it’s important to know the major differences between ASC 840 and ASC 842.
Changes in accounting introduced by ASC 842 will have the biggest impact on lessees with operating leases. Accounting by lessors, on the other hand, will generally not be significantly affected. Let’s address some of the more widely applicable differences that private companies can anticipate.
Most leases will be recorded on the balance sheet.
The broadest change introduced by ASC 842 is that virtually all leases will be reflected on the balance sheet. Lessees will record assets, representing their right to use assets, with corresponding liabilities representing their obligations to make lease payments for those assets.
Leases will continue to be classified into two categories for lessees: operating leases and finance leases (formerly capital leases).
For operating leases, the lessee’s balance sheets will contain new asset and liability line items the standard calls right-of-use assets and operating lease liabilities. Implications stemming from this presentation include administrative preparations. This can consist of adding new items to the chart of accounts and determining methods to maintain lease accounting records for the amortization of the new asset and the liability payments. Additionally, strategic and analytical considerations of the impact from the newly recognized assets and liabilities will influence financial ratios, bank covenants, borrowing base calculations and asset impairment analyses, to name a few.
A new definition of a lease will apply.
Another widely applicable change is that the standard includes new criteria for evaluating whether the ASC 842 lease accounting model applies to an arrangement. An arrangement is (or contains) a lease under ASC 842 if it “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,” according to the standard. There will be a new emphasis on control in assessing whether an arrangement is (or contains) a lease. Assessments about control will center on evaluating the extent that economic benefits of an asset are transferred and which party to the contract has the right to direct use of the asset. As a result of this definition and applying the new criteria, certain contracts that were not accounted for as leases in the past will begin receiving lease accounting treatment in the future.
Lease classification determination will be performed at commencement date.
Pursuant to ASC 840, assessments of lease classification are performed at the lease inception date (the date the arrangement was agreed or committed). Under the new guidance in ASC 842, lease classification assessments will be performed at the lease commencement date (the date an asset is made available to the lessee for use).
Bright line tests for lease classification will be eliminated, and a fifth criterion added.
Under ASC 840, leases are classified as capital or operating for accounting purposes on the basis of several criteria, including two that contain bright line measurements (simplified and abbreviated here):
1) Whether the lease term represents 75% or more of the economic life of the leased asset, and
2) Whether the present value of future minimum lease payments represents 90% or more of the fair value of the leased asset.
Under ASC 842, classification criteria for a financing lease removed specific percentage measurements for these criteria and were replaced with “major part” of the asset life and “substantially all” of the fair value of the leased asset. The new guidance will therefore require judgment in assessing lease classification criteria. However, ASC 842 also indicates that it is reasonable to use the 75% and 90% measurements, thus allowing (but not requiring) use of the existing bright line measurements.
ASC 842 also introduces a fifth classification criterion, which involves evaluating whether the leased asset is specialized in nature, such that it is expected to have no alternative future use. If this is the case, the lease would be classified as a finance lease for the lessee and a sales-type lease for the lessor.
Transfer of asset title will no longer be required for sales-type leases of real estate.
For lessors to achieve sales-type lease classification and treatment for real estate, ASC 840 requires title of the leased asset to automatically transfer to the lessee by the end of the lease term. ASC 842 does not retain this requirement. The new sales-type lease accounting rules hinge on demonstrating that control passes from lessor to lessee and require a lessor to assess collectability of payments from the lessee.
Lessees will be required to reassess lease term (and thus, classification) upon occurrence of a triggering event.
Pursuant to the existing guidance of ASC 840, lessees are not required to reevaluate the lease term or lease classification unless a lease is modified or a lease option is exercised. However, under ASC 842, lessees will be required to reassess the lease term if a triggering event occurs that is under the control of the lessee or an option is exercised/not exercised as planned at the lease commencement. Examples of triggering events provided in ASC 842 include: an option to renew or terminate the lease or purchase the underlying asset; a change in the likelihood that a lessee will exercise a purchase option; or a change in the amount of residual value guarantee that is probable of being paid by a lessee. If a lessee determines that the lease term is changed as a result of a triggering event, the result will be reassessment of the classification and remeasurement of its right-of-use asset and liability associated with that lease.
There will be new distinctions of, and accounting for, lease and nonlease components.
ASC 842 requires entities to identify components contained in their lease agreements. Components are, according to the standard, activities that transfer a good or service. Specifically, entities will evaluate leases to separately identify “lease components” and “nonlease components” and allocate contract consideration to each. Lease components will be accounted for in accordance with ASC 842; nonlease components will be accounted for in accordance with other applicable accounting principles. Lease components are provisions of a lease that are integral to the use of an asset.
Examples of lease components are use of land, building and equipment. Examples of nonlease components are maintenance, security, training, repairs and service agreements. Under ASC 842, property taxes and insurance are not considered components; however, they are included in the total contract consideration that will be allocated to lease and nonlease components. Under ASC 840, property taxes and insurance were considered executory costs and were not included as part of the lease payments.
Another key difference is that, under ASC 840, land was separated from the building when the land represented 25% or more for the fair value of the assets being leased. Under 842, land is a separate lease component unless the effect of combining with other lease components is immaterial.
Several practical expedients are available to lessors and lessees to simplify the accounting relating to lease and nonlease components.
Certain initial direct costs previously eligible for capitalization will be expensed.
ASC 840 allows capitalization of incremental direct costs to obtain a lease, even if they were incurred before the lease was obtained. However, ASC 842 deems that initial costs that are capitalizable as part of the right-of-use asset do not include costs that would have been incurred regardless of whether a lease is obtained. Specifically, costs incurred before the lease is obtained will not be capitalizable (such as employee salaries, legal fees for services rendered prior to execution of the lease, negotiating lease terms, advertising and other origination efforts). Examples of initial direct costs that could be capitalized are commissions to selling agents, legal fees from the execution (closing) and lease document preparation costs incurred after the execution of the lease.
There will be changes to sale and leaseback accounting.
Currently, sale and leaseback accounting only applies to lessees. ASC 842 will provide sale and leaseback provisions for both lessees and lessors. A key element of applying sale and leaseback accounting under the new guidance will be meeting the provisions of ASC 606, Revenue from Contracts with Customers.
The new lease accounting standards, ASC 842, constitute a major shift from rules currently in place, especially for lessees with operating leases. Private companies should plan ahead for their upcoming implementations, including understanding the key differences between existing and new guidance. Contact our team to learn more about how Sikich can help you understand and implement the new lease accounting standards.