Leases – 10 Takeaways

It’s Almost Time To Implement ASC 842

The implementation date for the new lease standard for private companies is just around the corner. As amended by ASU 2020-5, the extended effective date is fiscal years beginning after December 15, 2021 (i.e., January 1, 2022, for calendar year companies). It doesn’t apply to interim periods until 2023. That gives private companies a bit more breathing room, but not much. The new lease standards are codified in ASC 842.

I suspect that many are not quite up to speed yet on the tenants of ASC 842. That’s understandable, given the pandemic, PPP loans, stimulus payments, and the many other rapid-fire legislation that have monopolized our time. Everyone has had their hands full. This standard is enormous, both in terms of print and the impact of its changes. This piece will highlight a few of the many primary provisions.

Our focus in this article is on lessee accounting. This is because most of the significant changes under ASC 842 are directed at the lessee instead of the lessor.

Brief History. Over forty years ago, the Financial Standards Accounting Board (“FASB”) issued the original standard, FAS 13 – Accounting for Leases. It’s been amended several times through the years. FAS 13 was later codified as ASC 840. For lessee accounting, ASC 840 categorized leases as either capital leases or operating leases. Capital leases were capitalized as assets and liabilities on the balance sheet, and operating leases were not. Instead, operating leases were expensed in the period incurred. Footnote disclosure provided information about long-term commitments for operating leases.

The prior standards under ASC 840 provided four criteria for classifying a lease as a capital lease. If none of the following criteria were met, the lease would be classified and accounted for as an operating lease:

  1. The lease transferred ownership of the property to the lessee by the end of the lease term.
  2. The lease contained a bargain purchase option.
  3. The lease term was equal to 75 percent or more of the estimated economic life of the leased property.
  4. At the beginning of the lease term, the present value of the minimum lease payments equaled or exceeded 90 percent of the fair value of the leased property.

Under the bright-line tests in nos. 3 and 4 above, many, if not most, leases were classified as operating leases and therefore not presented on the balance sheet under (soon to be) legacy ASC 840. Furthermore, numerous leases were strategically structured to avoid classification as a capital lease and balance sheet presentation. This prompted many end users of the financial statements, such as bonding sureties, to make proforma adjustments to the balance sheet for the unrecorded operating leases.

Ten Key Takeaways. So ASC 842 steps in to address some of the gaps caused by the application of ASC 840. Here are ten essential takeaways from ASC 842.

  1. Identifying Leases. Agreements must be carefully reviewed to identify clauses that contain leases.
    • To be considered a lease under ASC 842, the lessee must have control of or direct how the asset is used
    • This identification can be tricky because some contracts, not described as lease agreements, may, nevertheless, contain lease clauses. For example, a service agreement for a copier may have an equipment lease embedded in the contract.
    • For larger companies, the process of locating agreements, identifying the lease clauses, and extracting the data points should begin as soon as possible. It could be a big undertaking.

  2. Capitalization of All Leases. All leases will now be included on the balance sheet.
    • That is, all leases, except those with a lease term of 12 months or less (if you choose to elect that practical expediency), will be capitalized on the balance sheet. In addition, such short-term leases must not include a purchase option reasonably certain to be exercised.
    • ASC 842 does not provide a low-dollar amount to exclude a lease from balance sheet capitalization. However, the general principle of materiality is still applicable.

  3. Right-of-Use Asset and Liability. The new standard requires recognition of a right-of-use asset and a lease liability at the inception of the lease.

  4. Lease Classifications. Under ASC 842, there are still only two types of leases for lessee accounting:
    • Finance lease – This is the new name for the legacy ASC 840 capital lease. And the accounting is pretty much the same for a finance lease as it was for a capital lease.
    • Operating lease – The name is the same. However, even though the FASB retained the name, accounting for operating leases under ASC 842 is profoundly different from ASC 840. This is because, under ASC 842, operating leases are also capitalized on the balance sheet.

  5. Finance Lease Criteria. Per ASC 842, the lessee will classify a lease as a finance lease when any of the following criteria are met at lease commencement. (The first four will sound familiar).
    • 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.
    • 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.

    Notice that the first four criteria above for classification as a finance lease closely track the requirements for classification as a capital lease under legacy ASC 840. However, the bright-line 75% and 90% tests are removed from c and d above. Accordingly, ASC 842’s approach is more principle-based than the approach under ASC 840. Companies will need to develop policies on what constitutes a “major part of the remaining economic life” and “substantially all of the fair value of the underlying asset.”

    Also, notice that ASC 842 added one new criterion, i.e., the underlying asset has no alternative use to the lessor at the end of the lease term.

  6. Operating Lease Criteria. If the above criteria are not met, then the lease is classified as an operating lease.

  7. Purpose of Two Lease Classifications. If both finance and operating leases are capitalized on the balance sheet under ASC 842, what is the purpose of the two classifications? The reason is that the subsequent accounting and disclosure for each category differs.

  8. Discount Rate. Leases are capitalized using one of the following rates:
    • The rate implicit in the agreement (challenging to obtain)
    • Lessee’s incremental borrowing rate (the rate the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset)
    • Or use the risk-free interest rate as an accounting policy election for all leases (i. e., U.S. Treasury bond rate over the loan term).

  9. Embedded Leases. Leases included in broader agreements are important under ASC 842 because such embedded leases must be identified and capitalized on the balance sheet. These leases are often concealed in other contracts that are not explicitly considered lease agreements.

  10. Related Party Leases. ASC 842-10-55-12 states that “Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the 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.”
    • ASC 842-10-55-12 appears to represents a change in GAAP from that under ASC 840. Legacy GAAP required entities to account for the economic substance over the legal form of related party leases.
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