The new lease accounting standard issued by the Financial Accounting Standards Board (FASB) in 2016 was one of two major overhauls to accounting standards. The new standard, ASC 842, requires companies to recognize lease assets, or right-of-use assets, and lease liabilities for all leases with a term in excess of twelve months. Here are a few major areas your company should consider regarding the new lease standard:
For a contract to be, or contain, a lease, there must be an identified asset and the contract must convey the right to use the asset to the customer. The customer must also have the right to obtain substantially all of the economic benefits from the use of the asset and the right to direct the use of the asset over the lease term. While there are a number of factors that need to be contemplated to reach the conclusion that a lease exists, these are the fundamental criteria that require consideration.
Classification of Lease
Once a contract is determined to be a lease, the entity must determine whether it is an operating lease or a finance lease.
A lease is considered a finance lease when it meets any one of the following criteria:
- 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 a 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 included 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.
If none of this criteria is met, then the lease is an operating lease. The FASB decided to retain the term “operating” in the new standard, which can cause a bit of confusion. Under the old standard, an operating lease was an off-balance sheet transaction, ignoring deferred rent assets or liabilities. However, under the new standard, an operating lease requires the entity to record a right-of-use (ROU) asset and a lease liability. So what makes this any different than a capital lease under the old standard? The key difference is the method in which the asset and liability are amortized and relieved, respectively.
Initial and Subsequent Measurement
Under the new standard, operating leases and finance leases record the same entry for initial measurement. In the simplest form of lease terms, a lease liability is credited by using a discount rate on the future payments, with a corresponding debit to the ROU asset. Under both operating and finance leases, the lease liability is reduced similar to how principal on a note payable is amortized. However, the offsetting entries to reduce the lease liability depend on the lease classification:
- Under an operating lease, the offsetting entries are made to “lease expense” and to the ROU asset. The lease expense is generally recorded on a straight-line basis. The ROU asset is reduced by an amount to balance the entry, after considering cash, incentives, initial direct costs, etc.
- Under a finance lease, the accounting is similar to the current capital lease approach under ASC 840, with offsetting entries made to interest expense and amortization expense. Expenses are front-end loaded as a result of compounding interest and amortization expense on the ROU asset.
Other Measurement Considerations
In order to perform the above measurements, entities need to consider a variety of other factors that affect the ROU asset and lease liability balances. They include:
- Lease term: The term consists of the noncancelable period plus renewal option periods for which the lessee is reasonably certain to exercise. Lessees are also required to reassess the lease term upon modifications in terms.
- Lease payments: Payments can occur in a variety of ways including fixed payments, variable payments based on index or rate, residual value guarantees, and purchase or termination options.
- Discount rate: If available, the rate to be used is the one implicit in the lease. If the implicit rate is not available, the incremental borrowing rate should be used.
The new lease standard has a number of factors to consider and has numerous other complexities. Companies should plan accordingly by implementing effective processes and lease management systems to determine the population of contracts, extract relevant data, analyze and maintain data, communicate the lease process across business units, and maintain the lease portfolio. Once these processes and procedures are implemented, an entity will be well positioned to navigate and maintain the information required under the new standard.
For more information or questions regarding ASC 842, please contact our construction and real estate specialists at 301.231.6200.