Hot Topic: Leases ASC 842 – Technical Summary and Key Decision Points

Client Advisor – Shannon & Associates LLP - Kent, WA

As you may know, as the result of a joint project with the International Accounting Standards Board (IASB), the Financial Accounting Standard Board (FASB) issued Accounting Standards Updates (“ASU” or “Update”) 2016-02, Topic 842, Leases. This is one of the most significant GAAP changes in many years, potentially more impactful than Revenue Recognition.

For non-public entities, this new standard applies to all GAAP basis financial statements and is effective for fiscal years beginning after December 15, 2021 – which translates to January 1, 2022, for calendar year-end entities.

This new leasing guidance significantly changes lessee accounting for leases and impacts financial statement presentation as well as financial metrics, including many that relate directly to debt covenants and key performance indicators. One of the goals of the new standard is to increase comparability and transparency through recognizing leases on the balance sheet and providing more detailed disclosures. This standard is also included in the larger set of convergence goals to align US GAAP with other international standards.

Because of this, we wanted to send this alert to summarize key information you need to know and get you ready for key decisions you need to make.  

First, let us give you the basics:

There are several key steps in  ASC 842 that should generally be applied as follows:

1. Determine whether a contract is or contains a lease:

The new standard redefines a “lease” as a contract, or part of a contract, that conveys the right to control the use of identified tangible property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.

  • An identified asset is an asset that is specifically identifiable in the contract either explicitly (for example, by serial number) or implicitly (for example, the only asset available to satisfy the lease contract).
  • A contract has the right to control an identified asset’s use, if, throughout the lease period, you obtain substantially all the economic use and have the right to direct the use of the asset.

The new standard requires both the ability to obtain the benefit from the use and the power to direct the asset’s use, whereas the old standard only included the benefit component.

The following are excluded from the new standard: leases of intangible assets, leases to explore for or use mineral, oil, natural gas, and similar nonregenerative resources, leases of biological assets (including timber), leases of inventory, and leases of assets under construction. As a note, most software arrangements will not be included.

Other items to consider in this determination:

A substantive right of substitution in the contract can impact the determination if a lease exists.

Also, consider that you may have contracts that contain embedded leases. Things not considered leases before may be a lease. Assets such as servers in “cloud” contracts, storage units, parking spaces, railcars, billboards, cranes, and scaffolding, etc. may be considered a lease.

2. Identify the lease and non-lease components and non-components in the contract, and allocate consideration to them:

A contract may include the following three elements:

  • A lease component represents your right to control the use of an identified asset (for example, leasing an office space or a piece of equipment) including fixed and variable lease payments, non-refundable deposits, early termination fees, and non-refundable deposits,
  • A non-lease component represents other goods or services transferred to the lessee, such as the following:  common area maintenance (CAM), maintenance service included with an equipment lease, or parking spaces where parking is at a premium.
  • Non-components are charges included in the lease that are not directly related to the use of the leased asset and are not considered lease or non-lease components (for example, reimbursement for insurance and property taxes, or shipping, delivery, and installation of the underlying asset). Non-components do not provide additional goods or services to the lessee.

Lease components are accounted for under ASC 842 and treated as a finance lease or operating lease. Non-lease components and non-components are accounted for under other relevant GAAP, with recognition in the period of expense or as incurred. If you make the non-lease component policy election (see “Policy Election” section below), the non-lease components are combined with the lease components. If the election is not made, the contract costs are allocated among the separate lease and non-lease components and non-components, using relative standalone prices (generally the rates defined in the lease agreement or estimated if not readily available).

3. Classify the lease:

At the contract commencement, you will need to determine the classification of the lease. You are not required to reassess the classification throughout the term unless the contract is modified, and the modification is not accounted for as a separate contract. For existing leases, there is a package of practical expedients that allow entities to retain determinations made on those leases prior to implementing ASC 842 (See “Package of Expedients” under “Practical Expedients” below).

The FASB uses a dual model approach that includes financing leases, which are similar to today’s capital leases, and retains the operating lease classification. The classification criteria are mostly consistent with the old standard. There are now five criteria to determine lease classification incorporating the original four criteria (if any one criterion is “yes”, the lease is considered a finance lease):

  1. Will ownership transfer to you at the end of the term?
  2. Are you reasonably certain to exercise a purchase option?
  3. Will lease asset have no alternative use at the end of the lease?
  4. Is the lease term a major part of the economic left of the underlying asset?
    1. Note – this used to be 75% of the asset’s economic/useful life. While the FASB did not include an actual percentage in the new standard, it has indicated that the 75% from the old standard is a reasonable approach – See “Classification Criteria” under “Policy Elections” below.
  5. Does the present value of lease payments equal “substantially all” of the fair value of the leased asset?
    1. Note – this used to be 90% of the FMV. While the FASB did not include an actual percentage in the new standard, it has indicated that the 90% from the old standard is a reasonable approach– See “Classification Criteria” under “Policy Elections” below.
      1. Be advised, that by electing the practical expedient to include non-lease components with lease components, results in including those charges in total lease payments for this analysis making it more likely for the lease to be a finance lease. See our recommendation regarding this election with the “Policy Elections” below.

4. Measure and recognize the lease component(s):

The new lease standard requires you to reflect virtually all leases on your balance sheet as lease liabilities for the present value of committed future lease payments with a corresponding right-of-use (ROU) asset which will significantly increase reported assets and liabilities for some entities.

  • Future lease payments include fixed payments, purchases costs at the end of the term, termination fees, residual value guarantees and non-lease components (if elected to combine – see “Non-lease Components” under “Policy Elections” below).

To calculate the present value, you will have to determine the discount rate which can be one of three rates:

  • The implied rate in the lease (only applicable to equipment leases if you have the FMV of the equipment being leased)
  • The incremental borrowing rate (effectively your rate if you went to a bank to obtain financing requiring similar repayment terms to that of the underlying lease)
  • The risk-free rate, elected alternative to the incremental borrowing rate, which is the zero coupon treasury rate chosen for the period that represents the remaining term of the lease as of the adoption date or the lease commencement date (See “Discount Rate” under “Policy Elections” below).

There are several options for presenting the ROU asset and liability on the balance sheet (See “Presentation of Right-of-Use Assets and Lease Liabilities” under “Policy Elections” below). Finance lease ROU assets or liabilities and operating lease ROU assets or liabilities are shown separately on the balance sheet. Short term and long term of each classification will also be shown separately.

5. Recognize lease expenses over the lease term:

Total lease expense and reported cash flows will usually not be substantially changed from the old standard. You will generally recognize expenses for operating leases on a straight-line basis over the lease term. For finance leases, you will recognize interest expense based on the effective interest method and amortization expense generally on a straight-line basis (the same way that capital leases are accounted for under legacy GAAP) over the lease term. Consistent with capital leases under old GAAP, the now finance leases do end up with front-loaded expense recognition in some cases due to higher amounts recognized as interest expense under the effective interest method in earlier years of the lease.

A lease term is the noncancellable lease period plus any option periods if it is “reasonably certain” you will exercise the renewal option. The lease term also includes optional periods if you control the option to extend.

Lastly, lease reassessments after initial measurement, lease modifications and lease remeasurements all have accounting requirements as well.

Now that you have the basics, let’s understand what you do when you first adopt the standard and some key decisions that need to be made.

Transition options:

You have two choices for transition – both classified as a modified retrospective method. The first requires application of ASC 842 as of the beginning of the earliest period presented so assuming comparative statements are presented, this would be January 1, 2021 for calendar year reporting, while the alternative allows the election to apply to the standard as of the beginning of the current period/adoption period. For calendar year-end entities, this is January 1, 2022. Under the modified retrospective method applied at the beginning of the first period presented, a cumulative-effect adjustment is recorded to the retained earnings as of the beginning of the earliest period resulting in restatement of the prior year financial statements. In applying the alternative with application in the current period, the cumulative-effect adjustment is recorded to retained earnings as of the beginning of the period in which ASC 842 is adopted without restating the prior period. See “Initial Application Date of Standard” under “Policy Elections” below.

Practical Expedients:

The ASB has made the following practical expedients available to help you transition from the old guidance to ASC 842.

1. Package of Three – These three practical expedients allow you to continue accounting for existing leases based on determinations reached under the old standards and only apply the new standard to new leases entered into after January 1, 2022. All expedients in this package must be applied together and cannot be applied on a lease-by-lease basis. You may elect not to reassess: 1) whether an expiring or existing contract contains a lease, 2) lease classification as a finance or operating lease for existing leases, and 3) classification of previously capitalized initial direct costs.

  • We recommend that you do elect this package of three as this will help simplify the transition to the new standard and save costs.

2. Use of Hindsight – You can use hindsight when determining the lease term and assessing impairment of the right-of-use assets. This allows you to use knowledge or current expectations as of the effective date, instead of knowledge and experience at inception of the lease when determining the likelihood of exercising the option to extend or terminate a lease or to purchase the underlying asset. You may also use the most recent information as of the effective date to evaluate impairment of the right-of-use assets. If this is elected, this applies to all preexisting leases.

  • We can discuss if it applies to you. Most entities are not electing this expedient.

3. Land Easements – Entities with existing or expired land easements not previously accounted for under the old guidance may elect not to reassess whether those contracts contain leases under the new standard. In general, land easements are not expected to qualify as a lease.

  • This is not widely applicable. We can discuss if it applies to you.

Policy Elections:

The new lease accounting guidelines require significant judgement and assessments at adoption of the new standard, which will most likely require you to make changes in your processes and internal controls. Policy elections you must consider are as follows:

  • Short-Term Leases: A short-term lease is defined as a lease with a term of 12 months or less. You can elect to adopt a policy by asset class of not applying ASC 842 to any short term leases. This would cause you to not recognize a lease liability or right-of-use asset on your balance sheet and you would recognize lease payments on a straight-line basis over the lease term. The short term definition is based on the original lease term and not the remaining lease term at implementation.
    • We recommend that you elect this as this will save time on accounting for short term leases.
  • Non-lease Components:  As a practical expedient, you can, as an accounting policy election by class of underlying asset, elect to combine lease and non-lease components into a single lease component instead of accounting for each separately.
    • We recommend that you elect this for equipment leases as this will save time as you will not have to allocate between lease and non-lease payments. One thing to consider is that making this election for equipment leases results in greater likelihood for a finance lease classification and also results in a larger liability and ROU asset.
    • We recommend that you do not elect this for facility type leases.
  • Discount Rate: Discount rates are used to determine the present value of the lease payments. The discount rate for a lease is the rate implicit in the leases unless that rate cannot be readily determinable. In that case, you are required to use the incremental borrowing rate. You can make a policy election to use the risk-free discount rate, by asset class, instead of the incremental borrowing rate, determined by using a period comparable with the lease term. The transition discount rate is measured as of the adoption date, but you must elect by policy if it is based on the full term of the lease or the remaining term of the lease.
    • We recommend that you elect this as this will save time as determining the incremental borrowing rate will take research, judgement, and documentation of conclusions. You must disclose to what asset classes the risk-free rate applies.
  • Classification Criteria: As discussed under the “Classify the lease component(s)” section above, the standards no longer include the percentages to define major part of the economic life and substantially all of the fair value for finance lease classification. This policy election allows you to specify the percentages to use in making these determinations.
    • We recommend that you use the widely accepted standards of 75% of the useful life and 90% of the FMV to ensure leases are treated consistently.
  • Presentation of Right-of-Use Assets and Lease Liabilities: The standard allows you to present the ROU assets and lease liabilities as seperately stated items on the balance sheet or combine them with other assets and liabilities and disclose the presentation in footnotes.
    • We recommend that you elect to include the amounts as separately stated items on the balance sheet for increased transparency.
  • Initial Application Date of Standard: As discussed under “Transition” above, there are two choices for transition, implementation in the earliest year presented or just in the year of adoption.
    • We recommend applying the standard to the current year financial statements only when two years are presented to avoid restating the prior year financial statements.
  • Transition Reliefs: As discussed under “Practical Expedients” above, there are several practical expedients (such as the “Package of Expedients” that should help simplify the transition to the new standard. See recommendations above for the practical expedients to elect.

An important topic that is impactful to most of you is the treatment related party leases. This is an ever-evolving area of discussion at the FASB.

Related Party Leases

The guidance specifies that related-party leases should be evaluated using the same criteria used for nonrelated party leases and be based on the legally enforceable terms and conditions of the lease. Under the prior guidance, the entity could recognize based on economic substance rather than legal form. If not formally documented, legal counsel would be required to identify the legally enforceable terms and conditions.

During the feedback window of the new guidance, some private company stakeholders expressed concerns about the new criteria as can be difficult in certain circumstances to determine the legally enforceable terms and conditions between entities under common control and about accounting for leasehold improvements with leases between related parties. In response to these concerns, the FASB has issued a proposal for an update that provides non-public entities a practical expedient to allow you to use the written terms and conditions in the lease to determine if a lease exists and if so, the classification of and accounting for the lease. Under the proposed changes, if you elect the practical expedient, you would not be required to determine whether terms and conditions are legally enforceable if there is a written lease in place. If there are no written terms and conditions, you would be required to apply the new standard on the basis of the legally enforceable terms of the lease. In general, we recommend all related party leases be in writing, in anticipation of this proposed change.

Also included in the proposed update was amortizing leasehold improvements associated with a related party leases over the life of the asset instead of just the lease term. You would amortize the leasehold improvements over the asset’s economic life as long as you continue to use the asset. If you cease use of the asset, you will write off the asset. This proposal was put out for comment period on November 30, 2022 and the FASB asked for comments through January 16, 2023. Our technical advisor has indicated that it be at least mid-March before a decision is made.

If your entity has related party leases, you may want to look at delaying issuance of your financial statements for issuance of these very important proposed changes.

Other considerations

Finance and operating leases have different income statement account impacts and cash flow presentation differences to be aware of. Footnote disclosures are significantly expanded as well.

This will result in changes to your financial statement presentation. Remember this will likely impact certain bank covenants. Talk with your banker early.

Your Lease Team – Shannon & Associates and LeaseCrunch

In summary, there is a lot to know and do!

To assist you in your implementation process including accounting and disclosure for this new standard, we have partnered with LeaseCrunch for a software platform.  Also, as requested, we will work with you on establishing your plan, and offering GAAP assistance, training, and other resources. 

We have already helped many of you get started.

Though the financial statements are management’s responsibility, Shannon & Associates is here to help! Get in touch!

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