This RubinBrown Focus on Lease Accounting is the fourth in a series of articles on the new accounting guidance for leases, Accounting Standards Codification Topic 842, Leases
(ASC 842). In this series, we will explore different aspects of the new standard. Please contact a member of your RubinBrown team for more information and ways that we may be able to help you.
The previous articles described the scope of the standard, the definition of a lease, identifying components, determining the lease liability and right-of-use (ROU) assets and both the initial and subsequent accounting. As the standard creates a new category of long-lived assets, it also provides considerations for the impairment of those assets. ASC 842 also provides guidance on lease modifications and several other specific areas of lease accounting, along with presentation and disclosures requirements.
Impairment - Regardless of classification, the ROU asset is to be tested for impairment consistently with other long-lived assets. If an operating lease was determined to be impaired, the lessee would amortize any remaining ROU asset straight-line over the remaining lease term, continuing to present the ROU asset amortization and interest components as a single lease expense item. This will effectively end the overall straight-line expense pattern for the operating lease.
Remeasurements and modifications – The new standard provides specific guidance on modifications and for remeasuring the lease liability and ROU asset. Modifications granting a new ROU asset at market rates are treated as a new lease while modifications that change the scope or the total consideration will trigger a remeasurement of the existing lease. Accounting will differ based on the type of change.
Lessee remeasurements are required when a lease is modified, and the modification is not accounted for as a separate contract; when a contingency is resolved, fixing previously variable payments; when there is a change in lease term or in the assessment of whether the lessee is reasonably certain to exercise a purchase option. Remeasurement will take two forms. The first is applicable when a change in term or the likelihood of exercise of a purchase option trigger the remeasurement. In this case, entities will revalue ROU asset and lease liability updating all key inputs:
When a facts and circumstances change concerning the resolution of a contingency or the amount owed on a residual value guarantee trigger the remeasurement, entities will revalue ROU asset and lease liability updating only total consideration/ lease payments and the allocation of consideration.
Leasehold improvements - Similar to current U.S. GAAP, a lessee would capitalize a leasehold improvement as a separate asset and amortize it over the shorter of its useful life and the remaining lease term. However, a lessee would amortize a leasehold improvement over its useful life (even if such life is longer than the lease term) if the lease transfers ownership to the lessee at the end of the lease term or it is reasonably certain that lessee will exercise an option to purchase the asset.
Related-party leases - The recognition and measurement of related – party leases are based on their legally enforceable terms and conditions. This is the case even when related-party transactions are not documented and/or the terms and conditions are not at arm’s length. Related-party disclosures required under ASC 850 are unchanged.
Sale-leaseback transactions - ASC 842 also establishes a new model for sale-leaseback transactions that applies to both lessees and lessors. Essentially, the determination rests in who controls the asset as defined. If the transaction is a sale, the seller-lessee recognizes the gain or loss immediately under ASC 606. If the transaction is not a sale, the seller-lessee accounts for the transaction as a borrowing. The considerations have changed enough that you may get a different answer than under legacy GAAP.
Assets under construction - One of the scope exceptions to ASC 842 is assets under construction. When considering a build-to-suit transaction, the accounting depends on who controls the asset during construction using the ASC 606 model of control. If lessee has control over the asset being constructed, the asset is capitalized as construction in progress as costs are incurred and sale and leaseback accounting applies at the commencement date. If lessee does not have control, any right of use payments made prior to lease commencement are prepaid assets and will be added to the liability to calculate the ROU at lease commencement.
Initial direct costs - ASC 842 also provides a more narrow definition of initial direct costs that more closely aligns with the provisions for contract assets in ASC 340-40. Going forward, only commissions, and payments made to an existing tenant to incentivize that tenant to terminate its lease are included in the calculation of lease payments. All other costs are expensed as incurred.
Transition - The ASU provides for the use of either the modified retrospective approach with application in all periods presented or with application at the adoption date, without adjusting the comparative periods. A package of three practical expedients that must be elected together is available to facilitate transition. If elected an entity need not reassess:
Separately, entities can also elect to use hindsight in determining lease term for all leases.
The accounting at the transition date differs by lease classification. For existing operating leases, recognize a ROU asset and lease liability at the later of transition date or the lease commencement date. The lease liability is calculated as the present value of the sum of the remaining minimum rental payments and any probable amounts owed under a residual value guarantee. The ROU asset should equal the lease liability, adjusted for prepaid rent, lease incentives, unamortized initial direct costs and any impairment. For existing capital leases, simply reclassify existing capital lease assets to an ROU asset and the debt to a lease liability beginning with the transition date and continue amortizing.
Financial statement presentation - Finance and operating lease liabilities and ROU assets are to be presented separately from each other and from other liabilities and assets either on the face of the balance sheet or in the notes. Lease liabilities are classified as current/noncurrent. On the income statement, operating lease expense is reported as a single item included in income from continuing operations. Finance lease expenses are split with interest expense included with finance costs and ROU asset amortization reported similarly to depreciation and amortization of similar assets. Variable lease payments are reported as lease expense.
On the statement of cash flows, principal payments for finance leases are classified as financing, while payments representing the interest component are classified as operating activities. All operating lease payments are cash flows from operating activities. Irrespective of classification, both variable lease payments that are not included in the lease liability and payments on short-term leases are presented as cash outflows from operating activities.
Disclosure - Substantial new disclosure requirements include qualitative and detailed quantitative information regarding an entity’s leases, the significant judgements applied, and the related amounts recognized in the financial statements. Some of the new qualitative disclosures include significant judgements made, such as determining whether a contract contains a lease, determining the discount rate, and allocating the consideration to lease and non-lease components and information about leases that have not yet commenced at the reporting date. Examples of new quantitative disclosures include supplemental non-cash information on lease liabilities arising from obtaining ROU assets for operating leases, weighted-average remaining lease terms, and weighted-average discount rate information.
Lease Tracking Solutions - There has been a lot of discussion on whether entities will need to implement new IT systems (or upgrade existing ones) to support accounting for leases under the new standard. Entities that implement new IT systems or upgrade their existing systems will need to factor sufficient time into their project plan to perform testing to make sure their systems comply with the requirements of ASC 842. We expect it to be difficult for entities with a sizable portfolio of leases to maintain spreadsheets to track the data, make the necessary computations, and compile the data needed for disclosures without a significant time investment. Thus, performing manual calculations (e.g., using a spreadsheet to perform complex calculations) may create a higher risk of error. We recommend entities take the time to evaluate whether a spreadsheet or a lease accounting software system is the right solution. Spreadsheets maybe a viable solution for entities with a small number of straightforward leases. However, any recurring complexities or a large volume of leases would warrant a strong consideration of lease accounting software.
Readers should not act upon information presented without individual professional consultation.