Lease Accounting is No Cake-Walk
I remember when the Financial Accounting Standards Board issued FAS No. 13, Accounting for Leases, in November 1976. I was tasked with outlining the standard for the firm where I worked. Now, here it is in November, some 46 years later, and I’m looking at the latest rendition of the lease standard—ASC 842. When comparing the two, FAS 13 was much kinder and gentler than ASC 842, even though FAS 13 did not seem that way at the time. Under FAS 13, there were bright lines, and the accounting was more straightforward. For example, operating leases were not capitalized nor depreciated. On the other hand, capital leases, as the name implies, were capitalized and depreciated; thus, you could account for them in much the same way as you did with property, plant, and equipment.
However, ASC 842 requires capitalization of all leases on the balance sheet, both operating and finance leases. That is, unless you choose to make the short-term lease election not to capitalize a lease with a term of twelve months or less. Additionally, after the initial recording of the right-to-use asset and lease liability, ASC 842 requires different accounting for operating and finance leases on the income statement. This is because the FASB conceptually views finance leases more akin to property, plant, and equipment. But it considers operating leases conceptually more like the old FAS 13 operating leases and, therefore, affords them treatment on the income statement similar to that found in FAS 13.
This article will describe a few complex areas of ASC 842 for the lessee as a heads-up to those who have not yet made the deep dive into the (semi) new accounting standard. And by the way, if you are not up to speed on ASC 842 yet, it might be wise to set aside some time over the holidays to become more familiar with its oddities. It isn’t easy to wrap your head around it because leases are structured in countless ways. While the standard is principle-based to accommodate the many variations in lease agreements, it is also very specific in numerous areas to facilitate consistency in practice. And some of it may seem counter-intuitive.
The Components of a Lease Contract. A lease contract may specify payments for more types of components than just a lease component. Identifying each component of a lease contract is essential because each component type is to receive an allocation of the contract consideration, which is accounted for under different sections of the ASC.
A lease contract can have three broad components:
- Lease component
- Non-lease component
A good or service must be transferred to the lessee or customer to be considered a contract component. This is important because consideration in the contract is only allocated to components that transfer a good or service. Contract components are the first two identified above (i.e., lease component and non-lease component).
If the transfer of goods or services relates to an asset used in a leasing arrangement, it is considered a lease component subject to the rules of ASC 842. This includes leases for:
- Real property (building and land)
- Construction equipment
- Copiers, etc.
All other payments for goods and services transferred in the contract are non-lease components accounted for under other GAAP (e.g., ASC 606 Revenue Recognition). This would include payments for:
- Common area maintenance services
- Management fees
- Security services
- Repairs and maintenance of the leased asset
Payments in the contract that are not for the transfer of goods and services are considered non-components. This would include the following:
- Reimbursements of insurance and property taxes to the lessor or third party for the benefit of the lessor.
- Administrative tasks to initiate the lease.
As stated above, contract consideration (see ASC 842-10-30-5 and ASC 842-10-15-35) is only allocated to lease and non-lease components. Notice that contract consideration is not assigned to non-components of the contract. This allocation can be a difficult and time-consuming process. However, the standard provides a way to simplify the accounting via an election to combine lease and non-lease components and treat all payments as lease payments.
The Consideration in a Contract. So what is consideration in a lease contract? Under ASC 842-10-30-5 – Consideration in the contract at the commencement date includes:
- Fixed payments, including in substance fixed payments, less any lease incentives paid or payable
- Variable lease payments that depend on an index or rate, initially measured using the index or rate at the commencement date
- The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise the option
- Payments for penalties for terminating the lease
- Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction
- Amounts probable of being owed by the lessee under residual value guarantees
Additionally, ASC 842-10-15-35 specifies that consideration in a contract includes all payments described above in paragraph 842-10-30-5 as well as the following payments made during the lease term:
- Any fixed payments or in substance fixed payments, less any incentives paid or payable
- Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.
Notice that consideration in a contract can include payments for lease components, non-lease components, and non-components if it meets the criteria stated above. For example, fixed payments for lease components, non-lease components, and non-components would all be included as consideration in a contract. However, the contract consideration would only be allocated to the lease and non-lease components unless the election not to allocate is made. In such a case, all the fixed payments mentioned would be considered lease component payments.
The Underlying Land in a Building Lease. Building leases are somewhat problematic. Should the underlying land be considered a separate lease? The answer is “maybe yes and maybe no—it ain’t necessarily so.”
The initial question is whether the underlying land can even be considered a lease. ASC 842-10-15-3 defines a lease as follows:
A contract is or contains a lease if the contract 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.
So the overriding question is whether the lessee has the right to control the use of the underlying land. A follow-up question is, does the lessee have the right to control all or a substantial portion of the use of the building? If so, it would seem that the lessee also has the right to control the use of the underlying land. This right to control the use of identified property (land) determines that the contract contains a land lease. So how much control is “substantial”? It’s a matter of judgment, but many commentators think the ability to control 90% or more of the economic benefits of the building is substantial control that enables the lessee to control 100% of the underlying land.
Once control of the underlying land is established and considered a separate lease component, should part of the consideration in the contract be allocated to the land lease? ASC 842-10-15-29 states that:
…an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land component would be insignificant.)
Therefore, land should be considered a separate component and be allocated a portion of the consideration in the contract unless doing so would be insignificant.