Lease Accounting: Key Concepts

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Private companies and organizations that have not yet adopted the provisions of ASC 842, Leases, will soon see changes in the lease accounting rules. As privately held entities and organizations prepare to implement the new rules, it is helpful to understand overarching implications of the new lease accounting model. Below, we explore that:

Key concept: Lease accounting rules will apply to most leases.

vintage key laying next to closed bookMost leases will require application of the new accounting rules. Leases excluded from the scope of ASC 842 are somewhat limited, summarized as:

  • Leases of intangible assets,
  • Leases for exploration or use of certain natural nonregenerative resources,
  • Leases of biological assets, such as certain plants and animals,
  • Leases of inventory,
  • Leases of assets under construction.

Many private companies and organizations will find that very few, if any, of their leases meet the scope exceptions listed above; and hence, ASC 842 will be applicable.

Companies and organizations may elect to not apply lease accounting to leases with initial durations of 12 months or less, which do not include an option to purchase the asset. In assessing the term of the lease, entities should also consider renewal periods as part of the lease term if they are reasonably certain of being exercised.

Key concept: Certain arrangements not historically considered to be leases may require lease accounting treatment.

ASC 842 introduces new criteria to determine whether an arrangement is subject to lease accounting. An arrangement is (or contains) a lease under ASC 842 if it “conveys the right to control” an asset “for a period of time, in exchange for consideration,” according to the provisions. There will be a new emphasis on control in assessing whether an arrangement is (or contains) a lease. Assessments about control will focus on evaluating the extent that economic benefits of an asset are transferred and which party of the contract has the right to direct use of the asset. As a result of this new definition and applying the new criteria, certain contracts that were not accounted for as leases in the past will begin requiring lease accounting treatment in the future. Examples of such contracts include data center, contract manufacturing, supply and warehousing agreements that meet certain criteria.

Key concept: Lease arrangements fundamentally contain assets and liabilities.

One of the FASB’s primary objectives for the development of ASC 842 was to provide transparency and comparability of lease accounting across organizations. As part of developing the ASC 842 accounting model, the FASB considered whether lessees’ rights to use and control leased property constitute “assets,” and whether lessees’ obligations to make payments for leased property constitute “liabilities.” According to the FASB’s Concepts Statement No. 6, Elements of Financial Statements, assets are defined as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events,” and liabilities are defined as “probable future sacrifices of economic benefits arising from present obligations.” The FASB concluded that rights and obligations contained in lease arrangements meet the spirit of the conceptual framework defining assets and liabilities and should be recorded as such on lessees’ balance sheets.   

Key concept: Lessees will generally record assets and liabilities on their balance sheets.

Under ASC 842, virtually all leases will be reflected on the balance sheet. Lessees will begin recording asset and liability line items called right-of-use (ROU) assets and lease liabilities.  

  • ROU assets will be recorded, representing amounts from the following components:
    • The present value of remaining lease payments,
    • Lease payments made at or before lease commencement date and
    • Capitalizable initial direct costs incurred by lessee.
  • Lease liabilities will be recorded to reflect:
    • The present value of remaining lease payments (which is the first component of ROU assets noted above).

Key concept: Terminology change for lessees from “capital leases” to “finance leases.”

The familiar label capital lease currently used under ASC 840, which recorded an asset and liability for leased property, is no longer referenced under ASC 842. The term finance lease is its replacement in ASC 842. Going forward, lessee classifications will include operating and/or finance leases. Lessor classifications do not change and include operating, direct financing and/or sales-type leases.

Key concept: Income statement treatment will not change significantly for most lessees and lessors under the new classifications.

At a high level, the significant income statement impacts of lease accounting will remain unchanged. Lessees will generally recognize expenses as follows:

  • Operating lease: record lease expense straight-line over the lease term.
  • Finance lease: record amortization of the ROU asset and interest expense on the lease liability over the lease term.

Lessors will generally recognize income as follows:

  • Operating lease: record rental income straight-line over the lease term.
  • Direct financing and sales-type leases: recognize any selling profit/loss at commencement date (for direct financing, only recognize loss at commencement, defer profit) and recognize interest income over the lease term.

Key concept: Bright line tests will not be required to determine lease classification.

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. We 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. Hence, the new guidance will 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.

Key concept: Leases will be classified as of commencement date.

Assessments of lease classification are currently 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 as of lease commencement date (the date an asset is made available to the lessee for use). 

Key concept: Lessees will be required to reassess lease term (and thus, classification) upon occurrence of a triggering event.

Currently, lessees are not required to reevaluate 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 lease term and lease classification if a triggering event occurs. Examples of triggering events include 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 lessee will remeasure its ROU asset and lease liability associated with that lease.

Key concept: There will be new considerations to assess for lease and nonlease components.

ASC 842 will require entities to evaluate lease provisions to identify lease and nonlease components and allocate contract consideration to those components. Only lease components will be included in computations of the ROU asset and lease liability. Nonlease components will be accounted for in accordance with other applicable accounting principles.

Provisions of a lease that are integral to the use of an asset are considered lease components, while other provisions are generally nonlease components. An example of a lease component is the use of land that is integral to a building lease. Costs associated with this component are included in the computation of lease ROU assets and lease liabilities. An example of a nonlease component is a cleaning service provided as part of a building lease. Costs associated with nonlease components such as this are generally accounted for as period costs when the landlord provides the services.

Key concept: Certain initial direct costs to obtain a lease will be expensed.

Existing GAAP allows capitalization of incremental direct costs to obtain a lease, including certain costs incurred before the lease was obtained. Under ASC 842, initial costs that are capitalizable as part of the ROU asset do not include costs that would have been incurred regardless of whether a lease is obtained. Therefore, any costs incurred before a lease is obtained will not be capitalizable. An example of this would include legal costs to review the lease document. The review of the document would be necessary even if the lease is not signed. As a result, it is expensed as incurred.   

Key concept: There are administrative and operational implications of the new lease accounting framework.

Implications stemming from recording ROU assets and lease liabilities include administrative preparations, such as evaluating contracts for the existence of leases and extracting relevant details, adding new accounts to the chart of accounts and determining methods to maintain lease accounting records. There will also be strategic and analytical considerations of the impact that newly recognized assets and liabilities will have on financial ratios, bank covenants, borrowing base calculations and asset impairment analyses, to name a few.  

Key takeaways

An early step to take in preparation for adopting the new lease accounting rules and contemplating how they will impact your organization is to understand the key concepts and gather all the current lease contracts for analysis. Contact our team to learn more about how Sikich can help you assess these concepts and prepare to implement the new lease accounting model.

This publication contains general information only and Sikich is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or any other professional advice or services. This publication is not a substitute for such professional advice or services, nor should you use it as a basis for any decision, action or omission that may affect you or your business. Before making any decision, taking any action or omitting an action that may affect you or your business, you should consult a qualified professional advisor. You acknowledge that Sikich shall not be responsible for any loss sustained by you or any person who relies on this publication.

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