United States: FASB Issues New Lease Accounting Standard

Long-awaited guidance brings most leases on balance sheet for lessees.

Overview

On February 25, the FASB released ASU 2016-02, Leases, completing its project to overhaul lease accounting. The ASU codifies ASC 842, Leases, which will replace the guidance in ASC 840. The new guidance is effective for public business entities in fiscal years beginning after December 15, 2018. The effective date for most other entities is deferred for one year, meaning that most calendar-year private companies will be required to adopt the new standard in 2020. Early adoption is permitted for all entities.

Entities should be aware of the following key points about the new FASB standard:

  • Lessees will be required to recognize most leases "on balance sheet."
  • The new guidance retains a dual lease accounting model for purposes of income statement recognition, continuing the distinction between what are currently known as "capital" and "operating" leases for lessees.
  • Lessors will focus on whether control of the underlying asset has transferred to the lessee to assess lease classification.
  • A new definition of a "lease" could cause some contracts formerly accounted for under ASC 840 to fall outside the scope of ASC 842, and vice versa.
  • A modified retrospective transition will be required, although there are significant elective transition reliefs available for both lessors and lessees.

The IASB also recently issued a new lease accounting standard that differs from the FASB model primarily with respect to classification (the IASB model does not distinguish between different types of leases) and practical expedients (the IASB model provides a practical expedient for low-value leases).

This bulletin provides a high-level summary of the new standard, including transition guidance. Given its pervasive impact, both lessors and lessees should begin planning their transition to ASC 842 as soon as possible.

Definition of a 'lease'

The new standard defines a "lease" as a contract or part of a contract that conveys the right to control the use of identified property, plant, and equipment for a period of time in exchange for consideration. Under the new guidance, an entity will determine whether a contract is or contains a lease by assessing whether the customer has both (a) the right to obtain substantially all of the economic benefits from using the asset, and (b) the right to direct the use of the asset. If both these criteria are met, then a contract is or contains a lease.

ASC 842 includes additional guidance, including examples, to assist preparers with evaluating whether a contract meets the definition of a lease.

In addition to amending the definition of a lease, the new standard will narrow the definition of "initial direct costs" so that they include only incremental costs that an entity would not have incurred had the lease not been executed.

Lease classification model

The new lease accounting standard requires lessees to recognize most leases on the balance sheet. While it will still be necessary for lessees to distinguish between "operating" and "financing" (formerly known as "capital") leases, and for lessors to distinguish between sales-type, direct financing, and operating leases, these distinctions will primarily affect how a lessee or lessor must recognize expense or income, respectively, in its income statement.

Under the new guidance, a lease is a financing lease for a lessee, and a sales-type lease for a lessor, if the lessee effectively obtains control of the underlying asset. A lessee has effectively obtained control of the underlying asset if the lease meets any one of the following criteria at lease commencement:

  • The lease transfers ownership of the asset to the lessee by the end of the lease term.
  • The lessee has a bargain purchase option.
  • The lease term is for the major part of the remaining economic life of the asset. Entities will disregard this criterion if the lease commences at or near the end of the asset's useful life.
  • The present value of the lease payments, plus the residual value guaranteed by the lessee that is not already included in the lease payments, amounts to at least substantially all of the fair value of the leased asset.
  • The underlying asset is specialized such that it is expected to have no alternative use to the lessor at the end of the lease term.

While these criteria are similar to the classification criteria in ASC 840, they are not necessarily intended to be applied by referencing the quantitative thresholds in ASC 840. Nevertheless, to ease implementation of the new guidance, the FASB states in ASC 842-10-55-2 that applying the following thresholds is a reasonable approach to assess certain of these criteria:

  • 75 percent or more is a major part of an asset's remaining economic life.
  • 90 percent or more is substantially all of an asset's fair value.
  • An asset is at or near the end of its economic life when 25 percent or less of its economic life remains.

"Lease term" is defined similarly under ASC 842 as under ASC 840. Likewise, "lease payments" is defined similarly under ASC 842 as "minimum lease payments" is defined under ASC 840.

Also similar to ASC 840, the discount rate used to present value the lease payments under ASC 842 is equal to the rate implicit in the lease. However, unlike previous guidance, ASC 842 requires an entity to add deferred initial direct costs to the asset's fair value for purposes of computing the rate implicit in the lease.

If the lessee cannot readily determine the rate implicit in the lease, it is permitted to use its incremental borrowing rate as the discount rate. ASC 842 provides a new practical expedient for lessees that are not public business entities: As an accounting policy election for all leases, a lessee is permitted to use a risk free discount rate, determined using a period comparable to the lease term.

Lessee accounting

For most leases, a lessee will recognize a right-of-use (ROU) asset and a lease liability, unless it elects the new practical expedient for short-term leases. If the original lease term is 12 months or less, and the lease does not contain a purchase option that the lessee is reasonably certain to exercise, a lessee is permitted to forego recognizing an ROU asset and lease liability on its balance sheet, effectively applying the operating lease model in ASC 840. Leases with renewal options that would extend the lease term beyond 12 months will qualify for the practical expedient as long as renewal is not reasonably certain at the beginning of the lease term.

Under the new guidance, a lessee will generally be required to initially measure both the ROU asset and the lease liability at the present value of the remaining lease payments. Lessees will also capitalize initial direct costs as part of the ROU asset. Subsequent measurement will depend on the type of lease. A lessee will also assess the ROU asset for impairment under ASC 360, Property, Plant, and Equipment.

If a lease does not meet any of the criteria in ASC 842-10-25-2 (see "Updated lease classification model" section, above), then it is an operating lease for the lessee.

For most operating leases, a lessee will recognize rental expense in a similar pattern to that prescribed under ASC 840. In other words, rental expense will be recognized on a straight-line basis over the lease term, unless another systematic and rational approach better represents the pattern in which the lessee expects to derive benefits from its right to use the leased asset.

For finance leases, a lessee will recognize rental expense in a similar manner to capital leases under ASC 840. Therefore, a lessee will recognize interest expense based on either the interest rate implicit in the lease, its incremental borrowing rate, or the risk free rate if applicable, and amortize the ROU asset over the shorter of its useful life or the lease term.

Much of the guidance related to build-to-suit and sale-leaseback arrangements, two particularly complex areas of lease accounting, has been eliminated. The new standard contains guidance for sale-leaseback arrangements, but it is much less prescriptive than the guidance in ASC 840-40, Sale-Leaseback Transactions, especially for real estate transactions.

Lessor accounting

Under ASC 842, a lessor will account for a lease as a sales-type, direct financing, or operating lease. To determine the appropriate classification, a lessor will first assess whether a lease meets any of the sales-type lease criteria mentioned earlier in the "Updated lease classification model" section. If any one of those criteria is met, then control of the asset is deemed to have transferred to the lessee, and the lessor will derecognize the asset and recognize both its net investment in the lease and any resulting profit or loss, provided that collectibility of the lease payments and any amount necessary to satisfy a residual value guarantee from the lessee is probable at the commencement date. If collectibility is not probable, then the lessor will not derecognize the asset, and will account for any lease payments received as a deposit liability.

For sales-type leases, if the asset's fair value is different than its carrying amount at the lease commencement date, then the lessor is required to expense any initial direct costs at the commencement date. Otherwise, the lessor must defer any initial direct costs by including them in the net investment in the lease. After commencement, a lessor in a sales-type lease will recognize interest income using the interest method.

If none of the sales-type lease criteria are met, then control did not transfer to the lessee, and the lessor will classify the lease as either a direct financing or an operating lease. The new standard identifies a lease as a direct financing lease when both (a) the present value of the lease payments, plus any residual value guaranteed by the lessee (not already included in the lease payments) or another party unrelated to the lessor, equals at least substantially all of the asset's fair value, and (b) it is probable that the lessor will collect all of the lease payments and any amount necessary to satisfy a residual value guarantee. If either of these criteria is not met, then the lessor is required to account for the lease as an operating lease.

For a direct financing lease, a lessor will derecognize the leased asset and recognize both an investment in the lease and any loss incurred. If the lessor computes a gain upon derecognizing the leased asset, the profit will be deferred and recognized over the lease term. A lessor is required to defer any initial direct costs associated with a direct financing lease by including them in the net investment in the lease.

After commencement, a lessor in a direct financing lease will recognize interest income using the interest method.

Lessors will account for operating leases in the same manner as under ASC 840. That is, operating lease income will be recognized on a straight-line basis over the lease term, unless another systematic and rational basis better represents the pattern in which the lessee derives benefits from the leased asset. A lessor is required to defer any initial direct costs associated with an operating lease, and recognize them as an expense over the lease term on the same basis as lease income.

Separating lease and nonlease components

Both lessees and lessors are required to allocate arrangement consideration among lease and nonlease components of a contract. Lessors will follow the allocation guidance in ASC 606, Revenue from Contracts with Customers. Lessees will allocate consideration based on relative stand-alone selling prices, unless they elect to apply a practical expedient whereby they will account for lease and nonlease components together as a single lease component. Lessees are permitted to elect this practical expedient by class of underlying asset.

Separation anxiety

Although ASC 840 requires entities to evaluate multiple-element arrangements to identify lease and nonlease components, as a practical matter, some lessees might not currently separate the lease and nonlease elements for accounting purposes because both operating leases and the related service elements are accounted for similarly.

Under ASC 842, lessees will be required to recognize an ROU asset and a lease liability for the lease element, but not for service elements, within a full-service lease contract. Therefore, lessees with leases that contain both lease and nonlease elements might need to account separately for those elements. To the extent that a lessee currently lacks sufficient information to separately account for lease and nonlease components of arrangements involving an operating lease, it might need to ask the lessor(s) whether that information can be provided.

The practical expedient to account for a single lease component could significantly reduce the cost for a lessee transitioning to the new standard in this regard, but will likely increase the amounts recognized on the balance sheet if significant nonlease components are reflected in the ROU asset and lease liability.

Transition

Lessors and lessees are required to apply a modified retrospective transition approach, which requires adjusting the accounting for any leases existing at the beginning of the earliest comparative period presented in the adoption-period financial statements ("initial application date"). Any leases that expire before the initial application date will not require any accounting adjustment.

Smooth transition

The Board recognized that lessors and lessees might struggle with the modified retrospective transition approach due to the magnitude and scope of many entities' leasing activities, so there are several transition reliefs in the final standard (described below). As entities begin to plan their transition to ASC 842, they should consider early on whether they intend to utilize any of the transition reliefs and plan their transition activities accordingly.

Lessees are required to apply the transition guidance to leases existing at the initial application date as follows:

  • For former capital leases classified as finance leases:

    • Recognize an ROU asset and a lease liability based on the carrying amount of the capital lease asset and capital lease obligation, respectively, as measured under ASC 840
    • Recognize any unamortized initial direct costs that qualify for capitalization under ASC 842 as a component of the ROU asset
    • Recognize any unamortized initial direct costs that do not qualify for capitalization under ASC 842 as an adjustment to equity
    • For the period between the initial application date and the effective date, subsequently measure the ROU asset and the lease liability based on the guidance in ASC 840
    • Beginning on the effective date, measure the ROU asset and lease liability based on the guidance in ASC 842, except for adjustments based on changes in the amount a lessee expects to pay under a residual value guarantee
  • For former capital leases classified as operating leases:

    • Derecognize the capital lease asset and obligation and account for any difference in their carrying amounts in the same manner as prepaid or accrued rent
    • Recognize an ROU asset and a lease liability based on the subsequent measurement guidance in ASC 842 for operating leases if the lease commenced before the beginning of the earliest period presented
    • Recognize an ROU asset and a lease liability based on the initial measurement guidance in ASC 842 if the lease commenced after the beginning of the earliest period presented
    • Subsequently account for the lease in accordance with ASC 842
    • Recognize any unamortized initial direct costs that do not qualify for capitalization under ASC 842 as an adjustment to equity
  • For former operating leases:

    • Recognize a lease liability based on the present value of the remaining "minimum lease payments" as defined in ASC 840, adjusted for the present value of any amounts that are probable of being owed by the lessee under a residual value guarantee using a discount rate established under ASC 842
    • For operating leases under ASC 842:

      • Recognize an ROU asset based on the carrying amount of the lease liability, adjusted for prepaid or accrued rent, lease incentives, unamortized initial direct costs that qualify for capitalization under ASC 842, and impairment of the ROU asset
      • Subsequently measure the ROU asset throughout the remaining lease term based on the subsequent measurement guidance in ASC 842
    • For finance leases under ASC 842, measure the ROU asset as the applicable proportion of the lease liability at the commencement date, calculated using the ratio of the remaining lease term at the beginning of the earliest period presented to the total lease term, and adjusted by the carrying amount of any prepaid or accrued lease payments
    • Recognize any unamortized initial direct costs that do not qualify for capitalization under ASC 842 as an adjustment to equity

The transition guidance for lessors is similar to that for lessees. Refer to ASC 842-10-65-1 for details regarding lessor transition

Lessors and lessees can elect, but only as a package for all leases, not to reassess the following circumstances upon transition:

  • Whether any expired or existing contracts are or contain leases
  • Classification for any expired or existing leases
  • Whether initial direct costs for any existing leases qualify for capitalization under ASC 842

As a separate transition relief, both lessors and lessees are also permitted, as a policy election applicable to all existing leases, to use hindsight in determining the lease term with respect to lease renewals and purchase options, and in evaluating the ROU asset for impairment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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