The new leasing standard under ASC Topic 842, Leases, brings changes to key terminology and accounting for leases for both lessees and lessors. Under the core principle of ASC Topic 842, a lessee will recognize right-of-use assets and related lease liabilities on the balance sheet for all leases, except for short-term leases for which the recognition exemption is elected. Public companies must adopt for fiscal years beginning after Dec. 15, 2018 (generally the 2019 calendar year). All other entities will adopt for fiscal years beginning after Dec. 15, 2019 (generally the 2020 calendar year).
As the effective date nears, entities should be prepared for the changes to lease accounting. The following are some elements to consider when preparing for the transition to ASC Topic 842.
Consideration 1: Does the Contract Contain a Lease?
A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Right to control includes the right to obtain substantially all of an asset's economic benefits and the right to direct the use of the underlying asset.
An identified asset can be implicit in the contract or explicitly stated without a substantive right of substitution. Entities will also want to be cognizant of embedded leases- just because an agreement doesn’t use the word lease doesn’t mean it isn’t a lease under ASC Topic 842. If an entity identifies assets in an arrangement (either explicitly or implicitly), who controls the use of the assets throughout the period of use must be determined.
Consideration 2: What Are the Components of the Contract?
A key to recognizing revenue from a leasing contract is splitting the contract into lease and nonlease components. Lease components transfer a good or a service and should be separated if the lessee can benefit from using the underlying assets on their own or with other readily available resources. Controls will need to be in place around the identification of lease and nonlease components.
Entities will need to consider whether to elect an accounting policy not to separate nonlease components from their related lease components. They will also need to consider how to allocate consideration to the components of the contract, including how they determined the relative standalone price of the components.
Consideration 3: What Is the Lease Classification?
Under ASC Topic 842, five classification criteria are used for determining whether a lease is an operating lease or a finance lease. Each step has its own considerations that should be evaluated, including the following:
· The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
Entities will need a process to identify transfers.
· The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
Entities should evaluate and document what constitutes “reasonably certain.”
· The lease term is for the major part of the remaining economic life of the underlying asset
Entities will want to determine the threshold for “major part,” as well as processes to establish the lease term, including an assessment whether a renewal or termination option is reasonably certain to be exercised.
· 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
Entities will need to evaluate and document what constitutes “no alternative use.”
· The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset
Entities will also want to determine their process for identifying lessee residual value guarantees, lease payments, fair value, discount rates, initial direct costs, and threshold for “substantially all.” Private companies may want to consider the accounting policy election to use the risk-free discount rate.
Lessors also have considerations with lease classifications, including whether all residual value guarantees (not just guarantees by the lessee) meet the “substantially all” criterion and that collectability is probable. To transition to the new standard, lessors will want processes to identify all residual value guarantees and evaluate collectability. They should also set a threshold for what constitutes “probable.”
Consideration 4: What Is the Accounting Treatment of My Leases?
Lessees record a right-of-use asset and lease liability for both operating and finance leases, with a different pattern of recognition for subsequent measurement. They will need to determine if they will elect the accounting policy for the recognition requirement of short-term leases. Lessees will also need to consider their capitalization policy, the amortization period for right-of-use assets, the potential impairment of the right-of-use assets, and any variable lease payments not included in the lease liability.
For financial statement presentation, they will need to determine the presentation of the right-of-use assets and lease liabilities (which much be presented on separate line items for operating and finance leases) and the disclosure requirements. Subleases will need to evaluate whether the original lessee is relieved of the primary obligation. For sale and leaseback transactions, an evaluation will be needed to determine if a sale has occurred. Lessees involved in construction should determine who controls the asset during the construction process.
Consideration 5: Reassessments and Modifications
When terms and conditions of a lease change, the reporting entity will need to reassess the contract under ASC Topic 842. Entities should have processes around when to reassess contracts and evaluate potential impairment triggers. Modifications should be accounted for based on the new requirements.
Consideration 6: Am I Using Any Practical Expedients?
The new leasing standard is applied using a modified retrospective approach, which requires entities to apply the leasing standard to all leases presented in the financial statement and make adjustments to beginning equity as if the new leasing standard had always been applied. Entities can choose to apply the new standard as of either the beginning of the period of adoption or the beginning of the earliest period presented in the financial statements. To simplify the evaluation of existing and expired leases presented in the financial statement, entities can elect a package of practical expedients to:
- Not reassess whether contracts contain a lease
- Not reassess lease classification
- Not reassess initial direct costs
They can also elect to use hindsight of lease term and impairment of the right-of-use asset and not reassess existing or expired land easements not accounted for under previous lease guidance.
Consideration 7: What Other Transitions Are Involved in My Adoption?
In addition to current leases, companies will need to consider any other situations that may involve transitions to ASC Topic 842. For example, business combinations must derecognize favorable or unfavorable leases and adjust the right-of-use-asset or beginning equity.
Lessees involved in construction must derecognize assets as a result of a build-to-suit arrangement. Leveraged leases are grandfathered in and can still use ASC Topic 840 guidance until the arrangements are modified.
With sale and capital leaseback arrangements, lessees will continue to recognize deferred gain or loss. Sale and operating leasebacks, however, will require companies to recognize the gain or loss at the date of application. Any failed sale and leaseback transactions should be reassessed under ASC Topic 842 guidance.
Consideration 8: Am I Early Adopting?
Entities are permitted to early adopt. Private companies can adopt at the same time as public companies for 2019, but they'll need to be relatively far into their evaluation process in order to be successful. They should have already evaluated the impact of adopting the new standard and considered how recording more leases on the balance sheet affects financial metrics and loan covenants.
Expediting the Transition
As you can see, ASC Topic 842 is far more complex than at first glance. A third party provider may be able to help with the transition to the new leasing standard. For comments, questions or concerns about the leasing standard, please contact us.
Thomas McGauley, CPA, is a Director and member of the Accounting Advisory Services Practice in New England. He can be reached at 617.761. 0719 or at firstname.lastname@example.org.
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