Lease Accounting Standards
Lease accounting standards are changing, aiming to improve transparency and make it easier to compare statements. Here’s what you need to know.
What is ASC 842?
ASC 842 stands for Accounting Standards Codification 842, also known as the updated lease accounting standards being implemented by the Financial Accounting Standards Board. ASC 842 affects the way leases are reported under GAAP and introduces the right-of-use model that shifts from the risk and rewards approach to a control-based approach.
Why is the FASB updating lease accounting standards?
Overall, the FASB is updating lease accounting standards to improve clarity in accounting. The new standards will move off balance sheet leasing arrangements, like operating leases, on to the balance sheet which will allow investors and other uses of financial statements to more readily and accurately understand the rights and obligations associated with the leases a company is beholden to. Additionally, the new lease standard will increase transparency and comparability among organizations that lease buildings, equipment, and other assets by recognizing the assets and liabilities that arise from lease transactions.
What are the new lease accounting standards?
This change in compliance isn’t quite as simple as transferring where you’re reporting your leased assets.
Previously, there were two ways to classify a lease:
- As a “capital” lease, where ownership of the asset transferred to the lessee. Capital leases were recorded on the balance sheet.
- As an “operating” lease, where only the right to use the asset transferred. Operating leases were not included on the balance sheet, but were disclosed in the footnotes of the financial statements.
With the new lease accounting standards, you’ll want to take each lease individually and assess how you will account for the leased asset:
- Month-to-month leases: Review any current leases you have listed as month-to-month. If the asset is solely used by the lessee and the lessee is guaranteeing the debt by providing the cash flow necessary to service the debt, then a longer lease may be appropriate.
- Related-party leases: Although these leases may be a month-to-month or under 12 month arrangement, depending on the situation, if the arrangement functions more like a longer-term lease, it must be recorded on the balance sheet.
- Job costing: The new lease standards directly affect how you report leases that are alleviating a debt. Accurately capturing your job costs will likely change, depending on what the cash flow of paid leases provide to your business.
While the new reporting standards do not change the core economics of your business, certain important finance ratios may shift. If your company currently has a number of off-balance sheet leases that, going forward, will be recorded on the balance sheet, it is a good idea to meet with your lenders and sureties about the potential changes in your reporting. A sudden increase in liabilities on a balance without prior warning or explanation may trigger cause concern with lenders, so it’s best to make sure everyone is on the same page. Depending on your situation, you may want to discuss updating the terms of any covenant to build in needed flexibility to prevent violations brought on by any potential future changes to accounting standards.
The new leases standard also will require lessees and lessors to provide additional qualitative and quantitative disclosures to help financial statement users assess the amount, timing, and uncertainty of cash flows arising from leases. These disclosures are intended to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an organization’s leasing activities
Do I have to reassess all of my existing leases when I adopt ASC 842?
No, there is an election available to treat existing operating leases as operating leases and existing capital leases as finance leases at the ASC 842 adoptions date.
As a lessee, does my accounting for a finance lease remain the same as it was for a capital lease under ASC 842?
Yes. Only the terminology changes.
What qualifies as a lease?
Overall, to be considered a or containing a lease, a contract must convey the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration or a period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).
There are specific kinds of leases, however, that meet more exact standards:
- Must meet the following criteria at the commencement date
- The lease transfers ownership of the leased asset to the lessee on or before the end of the lease term
- The lease gives the lessee an option to purchase the asset and the lessee is reasonably certain to exercise that option.
- The lease term represents the major part of the remaining economic life of the leased asset. (However, if the leased asset is at or near the end of its economic life as of the beginning of the lease, this criterion is not applicable.)
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the leased asset.
- The leased asset is so specialized for a particular purpose that it is not expected to have an alternative use to the lessor when the lease is over.
- Any lease that does not meet the criteria of a finance lease, as previously discussed
Short term lease
- A lease that has a term of 12 months or less as of the commencement date and does not have a purchase option that the lessee is reasonable certain to exercise.
- A lessee may elect as an accounting policy, by class of underlying asset, to not recognize a right-of-use asset and lease liability for a short-term lease.
Right-of-use (ROU) asset
- The asset is the lease
- Lessee has control of asset and right to direct the assets uses measured as the sum of:
- the lease liability as measured at the beginning of the lease
- lease payments made to the lessor on or before the commencement date (less any incentives received)
- any initial direct costs that the lessee incurred
- In some instances, the right-of-use asset and the lease liability may be the same amount
- Amortized over the life of the lease
EXAMPLE 1: Is This a Lease?
A customer enters into a contract with a vehicle owner (the supplier) for the transport of cargo from the Port of Cleveland to Huntsville, Alabama on a specified vehicle. The vehicle is explicitly specified in the contract and the supplier has no substitution rights. The cargo will occupy substantially all of the capacity of the vehicle. The contract specifies that the cargo is to be transported on the specified vehicle and the dates of pickup and delivery. The supplier must operate and maintain the vehicle and is responsible for the safe passage of the cargo onboard the vehicle.
In this case, there is no lease because the customer does not have the right to control the use of the vehicle because it does not have the right to direct the vehicle’s use. For example, the route is not specified.
EXAMPLE 2: Is This a Lease?
The customer enters into a different contract with a different vehicle owner (another supplier) for the use of a specified vehicle for a five-year period. The vehicle is explicitly specified and the Supplier has no substitution rights. The customer decides what cargo will be transported and whether, when and to which destinations the vehicle will travel, throughout the period of use subject to restrictions in the contract. These restrictions prevent the customer from carrying hazardous materials. The supplier must operate and maintain the vehicle and is responsible for safe passage.
In this case, the contract does contain a lease because all elements of lease identification are present. The customer has the right to use the vehicle for five years. There is an identified asset. The vehicle is explicitly specified in the contract, and the supplier does not have the right to substitute the specified vehicle. The customer has the right to control the use of the vehicle throughout the five-year period of use because it has exclusive use of the vehicle throughout the period and has the right to direct the use of the vehicle, thereby enabling it to obtain substantially all economic benefits.
The contractual restrictions regarding the prohibition of carrying hazardous materials do not prevent a customer from the right to direct the use of the asset in question, as these are called protective rights which are designed to protect a supplier’s asset or comply with laws and regulations.
How do I know if I have control of a leased asset?
You must have both of the following:
- The right to obtain substantially all of the economic benefits from use of the identified asset
- The right to direct the use of the identified asset
What does lease liability include?
Lease liability is associated with ROU assets, where the asset is the lease. Liability is measured at the present value of the remaining lease payment, using a discount rate based on the rate implicit in the lease, if readily determinable.
Implicit rate is the discounted rate used by the lessor to determine the total value of the least. Essentially, the rate implied is what the loan would be if a lessee decided to purchase the ROU asset instead of utilize a lease.
Lease payments include:
- Fixed payments (less incentives paid or payable to the lessee)
- Variable lease payments that are dependent on an index or a specified rate
- Exercise price of a purchase option for the leased asset that is reasonably certain to be exercised
- Penalties for terminating the lease if the lessee is reasonably certain to exercise the termination option
- Certain fees paid by the lessee for structuring the transaction
- For lessees only, amounts probable of payment under residual value guarantees
Lease payment are made during the lease term which represents the non-cancellable period in which the lessee has the right to use the leased asset plus the periods covered by (a) an option to extend the lease if the lessee is reasonably certain to exercise the option; (b) a lease termination option if the lessee is reasonably certain to not exercise the option; and (c) an option to extend (or not to terminate) the lease that is controlled by the lessor.
Lease term is dictated by intent and if an event is reasonably possible.
What types of leases are covered under the new accounting standards?
Every type of lease your company is contracted under should be examined. Below are the most common leases that will need to be adjusted under the new standards:
- IT Equipment
- Office Equipment
- Fleet Vehicles
- Manufacturing Equipment Leases
- Construction Equipment Leases
- Building Leases
- Medical Equipment Leases
- Trucking and Transportation Leases
Are there special considerations for different industries?
In short, yes. There are special considerations for every industry, but especially for the manufacturing, construction and not-for-profit Corrigan Krause has a dedicated team for each industry, manufacturing, construction and not-for-profit, as well as a team for healthcare and dental, real estate and financial/professional services.
Who needs to comply?
Private companies and most not-for-profit organizations must start using the new lease accounting standards in annual reporting periods beginning after 12/15/2021.
When do businesses need to comply?
The effective date for the new lease standards has changed a few times. As it stands now, private companies and most not-for-profit organizations must start using the new lease accounting standards in annual reporting periods beginning after 12/15/2021. For example, if your year end is 12/31, you must adopt the new standards for your year beginning 1/1/2022 and ending 12/31/2022. For an entity with a 3/31 year end, the new lease standards are required for the fiscal year beginning 4/1/2022 and ending 3/31/2023. Leases that have terms of 12 months or less generally do not need to be included on the balance sheet, however. Additionally, capital leases are now referred to as finance leases.
What can I do to prepare for the new lease accounting standards?
The Corrigan Krause Lease Accounting Team created a helpful checklist to walk you through preparing for the new lease accounting standards. Click here to download the new lease accounting checklist.
What discount rate should I use?
ASC 842 requires that lease liabilities be measured that the present value of the remaining lease payments using the interest rate implicit in the lease. How do you know what interest rate to use?
Some leases, such as vehicle or equipment leases, will directly state the lease’s interest rate. This would be the rate to use when measuring the lease liability at adoption or lease commencement. Many other leases do not specify an interest rate. In these cases, the rate to use is the rate that you would expect to pay if purchasing the asset in question using a collateralized debt instrument. For example, if you are analyzing a building lease, what interest rate would you expect to be employed in a mortgage on this same building with the same payment terms (also known as the incremental borrowing rate or IBR)? Collateralized debt financing is the operative phrase here, as simply defaulting to the rate associated with your business’s line of credit or other credit facility interest rate would not reflect the same lending risks as the mortgage rate referred to. In determining this rate, discussions with your lender may be helpful, however, this may not be practical. If a lessee has a portfolio of similar leases (i.e., leases of buildings housing separate restaurant operations), this lessee may use a single discount rate to apply to the entire portfolio, assuming the result would not be significantly different that applying individual interest discount rates to each building lease separately.
Determining a lessee’s IBR when it is not explicitly stated in the lease can be very challenging and costly, requiring the lessee to apply advanced treasury analyses. So what is the typical privately-held business to do when practical tactics to determine the incremental borrowing rate are fruitless? The Financial Accounting Standards Board (FASB) has permitted a private company policy election to use a risk-free discount rate, normally the federal funds rate or the interest rate applicable to a zero-coupon US Treasury bond with a similar maturity. Although this private company alternative offers a simplified solution, there are caveats that lessees should be aware of before electing this alternative.
What are the implications of using a risk-free interest rate to discount a privately-held lessee’s leases?
Although offering a simpler option to calculating an incremental borrowing rate to privately-held lessees, risk-free rates pose several challenges as well. First, the election is irrevocable, meaning that the lessee is bound to use the risk-free rate for all of its leases going forward. Second, the risk-free rate (i.e., the fed funds rate or zero-coupon US Treasury rate) will almost always be lower than the lessee’s IBR, resulting in higher calculated lease liabilities and right-of-use assets, which will negatively impact working capital calculations since there is no current portion of property and equipment and the mere adoption on ASC 842 puts additional liabilities on the balance sheet. Third, the use of a relatively lower risk-free rate will make it more likely that a new lease is classified as a finance lease, rather than an operating lease because the fair value of the future lease payments is more likely to equal or exceed substantially all of the underlying asset. Fourth, lessees are required to reassess the risk-free discount rate when there is a subsequent change to the initial lease.
What happens when the risk-free rate changes due to a subsequent change in the initial lease?
Subsequent changes in a lease can be related to the lease term or whether a lease originally assessed as an operating lease now meets the criteria of a finance lease (for example, if a purchase option that was previously assumed to be ignored is now “reasonably certain” to be exercised). Subsequent changes in lease terms necessitate the reassessment of the risk-free rate. When the risk-free rate changes, the lessee is required to remeasure the lease liability using the new risk-free rate (for example if the lease term jumps from 10 years to 20, the US Treasury zero-coupon rate for a 20-year bond will now be employed). The lease liability remeasurement causes the related lease asset to be remeasured. In certain cases, these remeasurements will result in a profit or loss.
What do I do about various options presented in my initial lease?
Many leases have purchase options, renewal options or on the other end, options to terminate a lease. The critical part of assessing lease options is whether the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For example, if it is reasonably certain that the lessee will exercise a 5-year renewal option on a 5-year lease, then the lease term is 10 years. If it is reasonably certain that a lessee will exercise an option to terminate a 10-year lease 8 years into the lease, the lease term is 8 years. If it is reasonable certain that a lessee will exercise an option to purchase the underlying lease asset, the optional payments to exercise that purchase will be included in the measurement of the lease asset.
What is “reasonably certain”? Reasonable certainty means a high degree of confidence that a future event will take place. In other words, it is much more likely that the event in question will be achieved than it will not be. It’s important to note that an expectation of exercise alone (for example, based on management’s estimates, intent, or on past practices with similar arrangements), and without a significant economic incentive to do so, would not be sufficient to conclude that the option is reasonably expected to be exercised (or not exercised).
Here’s an example. A lessee has entered into a contract to lease excavating equipment that has an initial non-cancelable term of seven years. During the fourth year of the lease, the lessor has the unilateral ability to extend the lease for another 3 years at the conclusion of the initial 7-year term. Additionally, the lessee is provided with two 3-year options to extend the lease. However, at the commencement date, the lessee is not sure whether it will extend the lease. In the case of lessor-controlled extension options, the new standard assumes that they will be exercised, so the lessor’s unilateral ability to extend the lease for another 3 years is assumed, making the initial lease term 10 years. Since the lessee is not reasonably certain to exercise the two 3-year extension options, they are not considered part of the initial lease term.
What do I need to know about month-to-month leases?
Since lease terms are ambiguous with month-to-month, evergreen or rolling leases, a consideration of “reasonable certainty” becomes critical. There must be an economic benefit present for reasonable certainty. In many month-to-month agreements, “mutual renewal options” are stipulated. These mutual renewal options would require both the lessee and the lessor to agree to exercise a renewal option, otherwise the lease term ends. If any non-cancellable period is over, such mutual renewal options effectively render the lease an at-will arrangement where both parties have the right to terminate the lease without permission and with no penalty. Such agreements no longer meet the definition of a lease per ASC 842 and, as such, would not be subject to it.
How do I record an operating lease under ASC 842?
At the commencement date, our lessee client will measure and record (a) the initial payment; (b) the lease liability at the present value of the remaining lease payments, discounted at its discount rate, using the identified lease term including any applicable renewal periods; and (c) will also measure and record a right-of-use asset which equals the initial measurement of the lease liability plus any initial direct costs plus the initial lease payment.
Here’s an example of a lessee recording the operating lease for its main office building. Facts pertinent to accounting for this lease at the ASC 842 adoption date (12/31/2022) are:
- The lease commenced 8/1/2020.
- Initial lease term is 15 years. Although there are options to renew for 3 additional 5-year terms, the lessee is not reasonably certain to renew.
- The monthly lease payments are $17,500 through 7/31/2024 and $19,250 from 8/1/2024 to the end of the 15-year lease on 7/31/2035.
- The lessee has determined that its IBR is 3.71425%.
- There was deferred rent at 1/1/2022 of $19,007.
- Straight-line monthly lease payments are $18,788.
|(B )||( A )||( C )||( B ) – ( C )||( A ) – ( C )|
|Cash payments||Number of payments||Annual lease expense||Interest||Principal||ROU Amort||Lease liability|
At the ASC 842 adoption date, 1/1/2022, the lessee will record the following to recognize the ROU asset and lease liability and remove the deferred rent balance that pertained to ASC 840:
At 12/31/2022, the end of the year of adoption, the lessee will record the following to recognize the lease expense and payments that occurred during the year:
Corrigan Krause Can Help
Corrigan Krause has a Lease Accounting Team ready to walk our current and new clients through the transition to the new lease accounting standards. If you’re a current Corrigan Krause client, reach out to your team any time to get started.