On Wednesday, October 30, 2019, GAAP Dynamics partnered with Accounting Principals and Parker + Lynch to bring together over 500 of our closest friends for 1.0 free CPE by attending our live webinar, ASC 842: An Introduction to Lessee Accounting. We had a blast, and we hope our participants did too! If you missed the live webinar, you can always catch the play-back version of it here. Want to be in-the-know for future free CPE events? Make sure you subscribe to our blog, GAAPology, today!
In our jam-packed, 60-minute session, we covered so much content, we barely had time to answer participants’ questions. So, we’re taking the opportunity to do that now, via this blog post. Let’s take a look at the questions that other preparers, like yourself, are asking when it comes to implementing the new leasing standard.
Introducing ASC 842
Our course began by introducing ASC 842, Leases, particularly talking about why the FASB decided to issue the new standard and how it is expected to impact various industries. The bottom line: this standard will result in ALL contracts meeting the definition of a lease being recognized on the balance sheet (unless it meets the definition of short-term lease). Lessees recognize both a right-of-use (ROU) asset and a lease liability. You can learn more about this in this blog post. Here’s a slide from our webinar visually depicting the amount of lease obligations expected to be recorded, by industry, for operating leases that are currently off-balance sheet:
There are only two ways under U.S. GAAP to get out of having to record the ROU asset and lease liability on your balance sheet:
- An entity has a lease that is one-year or less and elects to apply the accounting policy election to not recognize short-term leases
- An entity has a contract that does NOT meet the definition of a lease under ASC 842.
So, let’s look at how ASC 842 defines a lease.
In order for a contract to contain a lease, it must meet two critical criteria:
- The lease is for an identified asset; and
- The lessee must control the use of that identified asset
You can see the various characteristics that must be met in order to meet these two criteria on this slide:
Need more information? Check out this blog post.
Not too hard to apply, right? But what about embedded leases? Can those exist? YES! As preparers have begun to implement ASC 842, identifying leases in other types of service contracts has been one of the roadblocks they’ve encountered. We discuss embedded leases, including some great examples, in this blog post.
Determining the Lease Liability
Now that we’ve determined we do have a lease, it’s time to figure out those day one entries to record the ROU asset and the lease liability. In order to figure out the lease liability, we need a few key inputs:
The lease liability is a discounted amount. This means we need to figure out the term over which we will determine the present value of the liability. The lease term begins on the lease commencement date and will include any noncancelable periods. It also should consider:
- Optional renewal periods (if lessee is reasonably certain to renew)
- Periods after a termination date (if lessee is reasonably certain not to terminate)
- Optional periods to extend (if exercise is controlled by lessor)
Want more on the lease term? Check out Christine’s blog post that includes an informative video!
Questions from the audience
Q: What is the non-cancellable period? To meet the definition of cancellable leases it should be cancellable by both the lessee and lessor, correct?
A: That is correct! According to ASC 842, a lease is no longer enforceable when both the lessee and the lessor each have the right to terminate the lease without permission from the other party with no more than an insignificant penalty.
If only a lessee has the right to terminate a lease, that right is considered to be an option to terminate the lease available to the lessee that an entity considers when determining the lease term. If only a lessor has the right to terminate a lease, the lease term includes the period covered by the option to terminate the lease.
Q: How often do you review and adjust the reasonably certain lease term? For instance, what if it is reasonably certain you will renew on Day 1 when you determine the lease term? But by Year 3 that changes so you are no longer reasonably certain to renew?
A: During the life of the lease, there may be events that occur that, if considered, would change the measurement of the lease liability and ROU asset. ASC 842 provides guidance on when these events require a remeasurement of the lease liability and the ROU asset during the term of the lease. The guidance (discussed below) is only applicable to lessees. For a lessee, the lease liability and right-of-use asset must be remeasured when there is a:
- Change in the lease term
- Change in the assessment of the lessee exercising a purchase option
- Change in the amount probable of being owed by a lessee under a residual value guarantee
- Variable lease payments becoming lease payments following the resolution of a contingency.
However, there would only be a reassessment event when there is a change in the lease term or a change in the likelihood of a purchase option being exercised, if any of the following occurs:
- An event is written into the contract that requires the lessee to exercise (or not to exercise) an option;
- The lessee elects to exercise an option that it had previously determined that it was not reasonably certain to exercise;
- The lessee elects not to exercise an option that it had previously determined that it was reasonably certain to exercise; or
- There is a triggering event.
A triggering event is a significant event or significant change in circumstances that are within the lessee’s control and directly affect the assessment of whether the lessee is reasonably certain to exercise the option.
Q: Which term do you use to discount the lease payments when you have an agreement without termination date? For example, a sub-lease of an office with a related party with no ending date.
A: These types of leases are often referred to as “evergreen leases” and determining the lease term is quite subjective! The noncancelable lease term will depend on the facts and circumstances within the contract. Refer to the question above for more information on the noncancelable lease term. Beyond the noncancelable lease term, the lessee will have to determine whether it is reasonably certain to continue to use the asset beyond the noncancelable lease term. In other words, the lease term for an evergreen lease is determined the same way as it is for all other leases! Check out KPMG’s Leases Handbook (or any of the Big 4 guides) for more information!
The lease payments, for purposes of determining the lease liability to be recorded at lease commencement, generally include the following:
Any other lease payments that are not included in the lease liability will simply be expensed by the lessee as paid. You can read more about the specifics in this blog post.
Questions from the audience
Q: How would performance rent (in addition to base rent) be treated for measuring the lease ROU asset and liability?
A: Variable lease payments should ONLY be included in measuring the lease liability (and ROU asset) to the extent that the payments are based on an index or rate, like the consumer price index (CPI). The prevailing index or rate at the commencement date would be used to determine these payments. Forward rates and forecasting techniques would not be considered. Variable lease payments that do not depend on a rate or index are not lease payments when determining the lease liability, even if the variability is based on something that is virtually certain of being achieved.
This is an important point and can result in unusual accounting answers. For example, in situations where all or nearly all of a leases payments are variable, such as retail space where all monthly payments are a percentage of sales, there may be no payments included in ‘lease payments’ to be discounted and no lease liability or ROU asset for a lessee.
Finally, the last key input in determining the lease liability to record is the discount rate. Lessees have a few choices when determining the rate to use:
- The rate implicit in the lease – Many times, this will not be known by the lessee, only the lessor, so this is not likely to be an option widely used by lessees in practice.
- The lessee’s incremental borrowing rate – The codification defines the incremental borrowing rate as the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.
- The risk-free rate – This option is ONLY available to private entities. And while it will be easier than determining the incremental borrowing rate for each loan, it may also cause the entity to record a higher lease liability, so entities will need to weigh the pros and cons of the options available.
You can read more about those rates here.
Questions from the audience
Q: What sources are available for the risk-free rate?
A: In the U.S. we often base the risk-free rate on U.S. Treasury Yield Curves, which can be obtained from the U.S. Department of the Treasury. You can look on this site for the yield curve at the date of lease commencement that corresponds to the lease term of your lease.
Q: How do you determine the lessee’s incremental borrowing rate?
A: ASC 842 is silent on how to determine the incremental borrowing rate, but it should consider the following factors at a minimum:
- Similar term as the lease term
- Collateralized basis
- Similar economic environment
- Amount equal to the lease payments
An entity could consider the following when attempting to determine the incremental borrowing rate:
- Referencing the costs of borrowing for competing entities within the same industry with credit ratings similar to the entity (for a similar term and seniority).
- Obtaining borrowing costs from other credible sources such as lenders.
- Determining the incremental borrowing rate using the rate of this bond (and/or other borrowings) and adjusting them for differences for differences in payment terms and collateral (and possibly other things).
For more information on determining the incremental borrowing rate, make sure to check out the guides and handbooks published by the Big 4.
Initial Accounting, Classification, and Worked Examples
After calculating our lease liability, we’re ready to determine and record our ROU asset as well. The ROU asset is calculated as follows:
Our initial entries are the same regardless of lease classification. However, the subsequent recognition and measurement will vary depending on whether or not our lease is classified as a Finance Lease or an Operating Lease. You can see those lease classification criteria here:
And a summary of the accounting requirements here:
Finally, our course concluded with other issues to be on the lookout for, including subsequent remeasurement of the lease payments, lease modifications, sale-leaseback transactions, and more. We also included a discussion of the presentation in the financial statements and effective dates and transition.
And don’t forget! The FASB recently approved its deferral of the effective date for companies that are not SEC filers! The effective date for those entities is now periods beginning after December 15, 2010. But don’t delay! The time to act to prepare for implementation is now!
Questions from the audience:
Q: What if you are in the middle of a lease upon implementation. Do you ignore the implementation date of the lease?
A: If you are in the midst of a lease upon adoption of ASC 842, that lease must be recognized on the balance sheet via a ROU asset and lease liability! Depending on the transition approach your entity elects, the prior periods may be prepared in accordance with ASC 840 and not reflect such ROU assets and liabilities, but the lease must be recognized in the balance sheet on year of adoption. For more information about adopting ASC 842, including transition approaches and available practical expedients, please refer to the guides and handbooks of the Big 4 firms.
Q: What is the deduction for tax purposes? Is the tax for lease expense the amount that is actually paid in case?
A: For tax purposes, leases are either treated as a true tax lease or a non-tax lease. A true tax lease is simple – the lessor maintains ownership of the asset and the related deductions, while the lessee would deduct rental payments (this is like an operating lease under the old U.S. GAAP guidance). A non-tax lease assumes that the risks and rewards of ownership is with the lessee. Therefore, the tax benefits of ownership such as depreciation deductions and the deduction for the interest portion of the payments are booked by the lessee (This is like a capital lease under the old U.S. GAAP guidance). For more, check out this blog post.
Q: From what we understood, our University needed to implement starting with periods after Dec 15, 2019. Did the ASU change this for non-profits recently to 12/2020?
A: Not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed, or quoted on an exchange or an over-the-counter market had an effective date of fiscal years beginning after December 15, 2018. Assuming you did not fall into that category, yes, your new effective date is now periods beginning after December 15, 2020!
Does this blog post leave you thirsty for more information on lessee accounting under ASC 842? If so, make sure you check out our collection of eLearning courses on the new leasing standard on The Revolution, our online learning platform.
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.