There’s an old proverb about time moving slowly but passing quickly. And when it comes to implementing the Financial Accounting Standards Board’s lease accounting standard, time is passing very quickly.
The Financial Accounting Standards Board (FASB) issued its revised lease accounting standard — ASU 2016-02, Leases (ASC Topic 842) — in February of 2016.
For a detailed discussion of the provisions of ASU 2016-02, Leases, refer to our previous blog post Lease Real Estate, Manufacturing or Office Equipment or Vehicles? What to Know About the Updated Leasing Standard.
As a private company and a lessee, you’re required to implement this lease accounting standard for fiscal years beginning after December 15, 2019. If your fiscal year ends on December 31, 2019, you must implement the standard in your 2020 financial statements.
And that means it’s getting late.
Major Implications of the Revised Lease Accounting Standard
As a result of the revised lease accounting standard, ASU 2016-02, lessees will record most leases on the balance sheet as both a right of use (leased) asset and a liability. For example:
|Right of use asset||$105,000|
There are three key components of the calculation required to establish the lease amount that is recorded on the balance sheet, as follows:
lease consideration and related timing
incremental borrowing rate or the discount rate implicit in the lease
initial lease incentives or direct costs
Leases that fall outside of the scope of the lease accounting standard include the following:
leases of inventory or of construction in progress
leases of intangible assets, including licenses of internal use software
leases to explore for or use natural resources
leases of biological assets
service concession arrangements that fall within the scope of ASC 853
Transition Approach, Practical Expedients and Elections
The revised lease accounting standard was updated in both 2017 and 2018 by new Accounting Standard Updates. These updates are published in Accounting Standard Update 2017-14 and Accounting Standard Updates 2018-01 and 2018-11.
One of the most significant results of the updates was to provide a choice for how to implement the lease accounting standard in the financial statements.
Companies are now allowed to elect to apply the transition approach as of the beginning of the earliest period presented in the financial statements, or as of the beginning of the period of adoption, and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. (ASU 2018-11)
Of these options, electing the latter is likely to ease the burden of implementing the standard.
In making the choice, you should also consider the impacts on the comparability of the financial statements (if more than one period is presented) and the anticipated needs or understanding of the financial statement users.
The transition guidance in ASU 2018-11 also provides a package of practical expedients (essentially time-saving options) to simplify the implementation. By adopting them, you can reduce the effort required to implement the standard. The only catch is you must elect all of these practical expedients or none of them. They include the following:
You do not need to reassess whether any existing or expired contracts are, or contain, leases.
The classification of existing leases doesn’t need to be reassessed. Operating leases remain operating leases. Capital leases change only in name; they become finance leases.
You do not need to reassess initial direct costs for any existing leases.
In addition, two other practical expedients were added by the recent accounting standard updates. They may be elected separately or in conjunction with the practical expedients noted above. If elected, they must be applied to all of your leases (both as lessee and lessor).
You may use hindsight in determining the lease term and in assessing impairment of the entity’s right-of-use assets.
You do not need to evaluate existing or expired land easements that were not previously accounted for as leases under current guidance.
Other changes in the updates include clarifying language, technical corrections and additional practical expedients.
Finally, the original Accounting Standards Update 2016-02 also contains practical expedients. One establishes that you may elect not to apply the lease accounting standard to leases with a term of twelve months or less. Typically, this election is useful in minimizing the work required to implement the standard.
Another states that if separating the lease components from the non-lease components is too difficult, you may elect to apply the standard to total lease consideration. Determining whether or not to make this election should be made based on the facts and circumstances of a specific lease.
Implementation Process for the Revised Lease Accounting Standard
To start the implementation, organize all of your contracts that might contain a lease. Then implement the process by determining the following for each contract:
1. Does the contract contain a lease?
Review the contract to answer the following questions:
Is there an identified asset?
Do you have the right to control the use of the identified asset for a period of time in exchange for consideration:
Do you obtain substantially all of the economic benefits from use of the asset throughout the period of use?
Do you have the right to direct how and for what purpose the identified asset is used throughout the period of use?
Do you have the right to operate the asset throughout the period of use without the supplier having the right to change those operating instructions?
If all of the answers to these two questions are YES, your contract contains a lease.
2. Should a contract that contains a lease be combined with other contracts for lease accounting purposes?
The contracts should be combined and treated as a single lease if any one or more of the following criteria are met:
The contracts are negotiated as a package with the same commercial objectives.
The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
The rights to use the underlying assets conveyed in the contracts (or some of the rights of use conveyed in the contracts) are a single lease component.
3. For a contract that contains a lease, is it a finance lease?
Review contracts that contain a lease to answer the following questions:
Does the lease transfer ownership to you at the end of the term?
If the lease gives you the option to buy the asset at the end of the term, is it reasonably certain (i.e., at least 75 – 80 percent likely) that you will exercise that option?
Does the lease term cover a majority of the remaining economic life of the asset? According to the implementation guidance, 75 percent or more of the remaining life is a major part of the remaining economic life.
Is the present value of the lease payments plus the residual value guarantee equal to or greater than the fair value of the asset and 90 percent or more of the fair value amounts to substantially all of the asset’s fair value?
Did you specially design the asset such that it would have little alternative use to the lessor at the end of the lease term?
If the answer to any of these questions is Yes, the lease is classified as a finance lease. If the answers to all questions are No, the lease will be classified as an operating lease.
4. Is there a readily identifiable interest rate implicit in the lease?
To readily determine the implicit rate in a lease you need to know the present value of the unguaranteed residual value, plus the lessor’s deferred initial direct costs. As these are not typically known by a lessee, it would be unusual if you were able to determine this rate.
Even if you can reasonably estimate the rate, the standard requires that the rate must be readily determinable based on information contained in the lease.
5. What is the incremental borrowing rate (IBR) in effect at the time of implementation or lease commencement for newly acquired leases?
The guidance has changed the definition of IBR 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 determination likely starts with a verifiable rate, which you then adjust to reach the IBR to be used in the lease calculation.
The rate on existing secured debt could be used, however, the term would likely be different than that of the lease. Note that the IBR likely changes for different lease terms.
Virtually any form of collateral can be used as, in many cases, you won’t be able to pledge the leased asset as collateral.
Depending on your accounting policy, renewal options may or may not be considered in the term to determine the IBR.
6. What are the critical terms of the lease?
For contracts that contain a lease, you’ll need to gather detailed information for each contract.
To assist in recording the pertinent information for each lease, you can download our Lease Template.
Your auditors and other interested parties may review the template, so it’s wise to include a reference to the page of the related contract, indicating the source of the information.
Alternatively, if you have many leases and manual tracking would be burdensome, there are commercially available software programs to develop this documentation and perform the calculations.
The information you need for each contract is as follows:
Description of the contract and reference number, if applicable
What is the identified asset?
What is the stated lease term?
Does the contract provide for any free period of use?
Does the contract provide for any renewal options?
Is the total lease term (including free use and renewal options) less than or equal to 12 months?
If Yes and you elect the practical expedients to not apply the revised lease accounting standard, you may stop the analysis as the lease consideration can be expensed.
If No, you must adopt the revised lease accounting standard and continue this process.
Detail any consideration payments called for in the lease for the entire lease term, including renewal terms if they are considered reasonably certain of exercise.
In determining whether lease consideration should be included or not included in the lease calculation it’s helpful to determine if the cost is known and unavoidable. For example, a company enters into a lease that calls for monthly payments of $20,000 plus five percent of the prior month’s sales. The five percent factor tied to sales is not included as it is not known at the time of lease commencement.
Alternatively, a company enters into a lease that calls for monthly payments of $15,000. Rents increase by the greater of one percent of actual sales or four percent of the immediate prior rental rate on each anniversary of the commencement date. In this case, the four percent factor is considered in addition to the $15,000 monthly payment because it is the minimum increase and therefore unavoidable.
Identify any variable lease payments that depend on an index or rate. Note, the rate or index at the time of lease commencement is what is used in the calculation. Do not include estimates of any future undisclosed changes in the rate or index.
Identify any exercise price to purchase the identified asset if the entity is reasonably certain to exercise that option.
Identify any penalties for terminating the lease and consider whether that is probable of occurrence.
Identify any payments that are probable of being owed under residual value guarantees.
Identify any lease incentives that you will collect.
Identify any direct costs that you will pay.
Does the contract contain lease and nonlease components?
If Yes, are you electing the practical expedient to treat all nonlease components as subject to ASC Topic 842?
If No, allocate the consideration, lease incentives and direct costs between the lease and non-lease components. Use the relative standalone selling price basis if the lease does not stipulate.
Detail consideration payments for lease components by your accounting period (calendar year or fiscal year).
Determine the rate implicit in the lease or the applicable incremental borrowing rate (IBR).
7. Prepare present value computations for each lease contract.
To streamline this task, there is commercially available software (for example, TValue) to run the amortizations, then print and attach them to your contract documentation to perform the present value computations.
8. Complete the lease calculation and prepare the journal entry to record the lease as of the date of adoption or initiation of a new lease.
(See examples below.)
The calculations for a lease will not change prospectively unless the lease is modified, the lessee determines that the reasonably certain events accounted for at lease commencement have now changed, or contingency factors are removed where previous unknown lease payments are now fixed.
9. Prepare the required financial statement disclosures, including accounting policies for practical expedient elections.
See ASC Topic 842.50.
Lease Accounting Examples:
Accounting for an Existing Operating Lease (with practical expedients elected)
DCS, Inc. has an existing office space lease, as follows:
|Commencement date||January 1, 2018|
|Lease term||5 years|
|Annual rental payments (paid in arrears)||$31,000 for first two years
|Lease classification at inception under FASB ASC 840 (legacy GAAP)||Operating lease|
|Initial direct costs, amortized on a straight-line basis over the lease term||$500|
|DCS’s incremental borrowing rate at January 1, 2019||6 percent|
|Earliest period presented (comparative financial statements)||December 31, 2019|
|Current year financial statements||December 31, 2020|
|Accrued rent liability at 12/31/2018||$1,200|
|Unamortized initial direct costs at 12/31/2018||$400|
DCS, Inc. intends to adopt the lease accounting standard at the beginning of the earliest period presented.
DCS, Inc. Timeline for Adoption
The accrued rent liability results from the prior GAAP requirement that the lease expense be recognized on the straight-line basis as opposed to rates stipulated in the lease. The aggregate lease expense is $161,000 (two times $31,000 plus three times $33,000). Thus, the annual straight-line rent is $32,200 ($161,000 divided by the five year lease term). The $1,200 liability results from the 2018 recording of rent as follows:
|Accrued rent liability||$1,200|
The unamortized amount of initial direct costs ($400) represents the original cost of $500 amortized over five years ($100 per year). One year has already elapsed under the lease, so there remains $400 to amortize.
Because DCS, Inc. elected the package of practical expedients, it does not need to reassess whether the contract is or contains a lease, whether classification of the lease would be different under the lease accounting standard, or whether the unamortized initial direct costs at January 1, 2019 meet the definition of initial direct costs.
The following illustrates the calculations, with explanations on how the numbers are derived:
|Lease liability||$112,462||Remaining minimum rental payments ($31,000 for 2019 and $33,000 for each year 2020-2022) discounted at six percent|
|ROU asset||$111,662||Sum of the lease liability recognized and $400 of unamortized initial direct costs less $1,200 of accrued rent liability|
|Accrued rent liability||$1,200||Balance at transition due to straight-line expense recognition under the lease accounting standard|
|Unamortized initial direct costs||$400||Balance at transition under the lease accounting standard|
|Annual lease expense||$32,300||Straight-line expensing of the lease and $100 per year for initial direct costs|
The debits and credits to implement the existing lease under the lease accounting standards are as follows:
Lines two and four ($111,662) essentially remove the existing balances from the general ledger as they are now part of the right of use asset.
|Right of use asset||$111,662|
|Unamortized initial indirect costs||$400|
It’s likely that the lease liability could have a current and long-term portion. Assuming the lease is not modified and there is no re-measurement of the lease liability, the balance of the lease will be amortized as follows:
(B) – (C)
(A) – (C)
Interest is not recorded on the income statement as it is already a part of the lease expense. However, it is used to determine the amount of principal that reduces the lease liability each year.
On the statement of cash flows the lease expense would be shown as an operating outflow.To record the effects of the lease as of December 31, 2019, with similar entries for the balance of the lease term using the above numbers:
|Right of use asset||$25,552|
Accounting for a Finance Lease
On January 1, 2020, DCS, Inc. enters into a lease with BNP Equipment Company for a piece of equipment. The right to use the equipment is a 10-year term lease and there are no other components of the contract.
The following facts are relevant at the lease commencement date:
|Commencement date of the lease||January 1, 2020|
|Lease payments||Fixed payments of $14,527 per year in arrears, with a 3% increase every year|
|Transfer of ownership||No|
|Residual value guarantee||None|
|Remaining economic life of equipment||12 years|
|DCS’s incremental borrowing rate (implicit rate cannot be readily determined)||10%|
|Initial direct costs||$5,000|
Assuming the lease is not modified and there is no re-measurement of the lease liability, the contractual payments for the lease will be amortized as follows:
|Right of Use
The following entry records the right of use asset and lease liability as of January 1, 2020:
|Right of use asset||$105,000|
The $100,000 is the present value of the payment stream discounted at the 10 percent IBR. The indirect costs are added to the lease liability amount to obtain the value for the right of use asset.
DCS, Inc. expects to consume the asset’s future economic benefits evenly over the lease term. Accordingly, DSC, Inc. elects to amortize the right of use asset on a straight-line basis over 10 years.
DCS, Inc. will record the following journal entry at December 31, 2020, with similar entries for the balance of the lease period based on the above table:
|Right of use asset||$10,500|
Note that, unlike an operating lease, the interest expense and amortization expense are shown on the income statement rather than combined as a lease expense. On the statement of cash flows, the interest expense is shown as an operating outflow and the amortization as a financing outflow.
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