Other Things That Make You Go Hmmm
Well, it’s here for private companies. Welcome to the universe of ASC 842. The lease standard is massive and, being a principle-based standard, leaves a lot of GAAP in gray areas. Yet, the standard is also specific, especially regarding disclosure. This blog, directed at the lessee’s accounting, is a follow-up to our May 2021 blog on leases and will focus on a few of the areas of ASC 842 that have given us some — shall we say, pause.
First Things First. Before we dive into the deep gray, let’s briefly review some of the core tenants of ASC 842 as it applies to the lessee.
- To be a lease contract, it must have two elements:
- There must be an identified asset, and
- The lessee must have a right to control the use of the asset for a period of time.
- Finance lease and
- Operating lease.
Materiality. Of course, the professional decision of what is not material to financial statement presentation is not a new concept under ASC 842. However, materiality is of utmost importance under the lease standard because the standard places a heavy burden on companies performing calculations to capitalize the leases, in addition to the future effort required to account for leases to completion. Because of this burden, care must be taken not to spend precious time capitalizing immaterial leases.
So what is immaterial? Initially, the company should have a reasonable lease capitalization policy stating a threshold under which all leases will automatically be considered immaterial and, therefore, not capitalize.
Beyond the company’s capitalization policy, the overall materiality of the potential ROU assets and lease liabilities to the financial statements should be considered. While materiality is both a quantitative and qualitative assessment, in the end, the qualitative evaluation carries the most weight. For example, if capitalizing a lease liability causes the company to violate a financial loan covenant, then that lease is material to the financial statements, notwithstanding the quantitative analysis.
Reasonably Certain. The term “reasonably certain” is not defined in ASC 842. However, even though not defined, it is a critical term. The reasonably certain threshold plays a sizable part in determining the:
- Lease term;.
- Lease classification (finance or operating lease);
- Amount of lease payments;
- Amount of ROU assets; and
- Amount of lease liabilities.
Even though the concept of reasonably certain is important, there are no bright lines. Some commentators have suggested that reasonably certain is 75% or better certainty. Others have suggested that it is “almost certain.” One thing is certain, though. The certainty rests in the minds of the company’s decision-makers. It will take sound professional judgment to ascertain the degree of reasonableness.
Related Party Transactions. Under prior GAAP (ASC 840), the economic substance of the lease agreement determined how related party leases were classified. This, in turn, determined lease accounting. New GAAP changed things. Under ASC 842, leases between related parties are classified and accounted for based on legally enforceable terms. In short, lease accounting for leases between related parties is the same as accounting for leases between unrelated parties.
It sounds straightforward. But it’s not. Consider the following example:
The company(lessee) has three unrelated stockholders. One stockholder holds 60% of the stock. The minority stockholders each hold 20%. The company leases its operating facilities from an LLC lessor that is owned 100% by the majority stockholder of the lessee company. The company made substantial leasehold improvements with a fifteen-year useful life. The lease is month-to-month (unwritten). Questions: What is the lease term? What would be legally enforceable?
This type of lease arrangement, or similar, may put accountants in a dilemma. The majority owner of the lessee company, because he understandably wants to keep the lease obligation off the company’s separate(unconsolidated) financial statements, tells you that it’s a month-to-month lease. No doubt about it. It is not a long-term lease. The unwritten monthly options to renew will not extend longer than one year. After all, “reasonably certain” is in the mind of management — right?. However, the short-term lease status doesn’t make sense for several reasons. But primarily, it does not make sense because the substantial leasehold improvements, with a fifteen-year life, reflect an obvious intent to lease the operating facilities long-term.
It may be necessary to remind the majority owner, in very carefully chosen non-technical words, of course, that GAAP generally requires the leasehold improvements to be amortized over the lease term. So in this example, the improvements would be written off over twelve months. Ouch!
ASC 842-20-35-12 states the following:
Leasehold improvements shall be amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which case the lessee shall amortize the leasehold improvements to the end of their useful life.
In the above example, the underlying asset (building) will not be transferred to or purchased by the company. This would not be to the advantage of the majority stockholder. Accordingly, the leasehold improvements must be amortized over the shorter of the lease term (twelve months or less) or the useful life of the building. The lease term is obviously shorter. This may cause the majority owner of the company to reconsider the lease term.