This RubinBrown Focus on Lease Accounting is the second 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 first article described the scope of the standard and the definition of a lease. Once it is determined that a contract contains a lease, the next step is to identify the components of the contract. The standard indicates that contracts should be separated into lease components, non-lease components and executory costs. Lease components represent the right to use the identified asset. Non-lease components represent the purchase of other goods or services, like common area maintenance, parking and security. Executory costs, like taxes and insurance, are not considered components because they don’t involve the delivery of a good or service to the lessee. Once the components are identified, consideration in the contract is allocated on the basis of “observable or estimable standalone prices."  The stated pricing breakdown in the contract may or may not be the same as standalone prices.  

The standard provides an accounting policy election to choose not to separate non-lease components and instead account for the arrangement as a single lease component. The election must be applied consistently by class of underlying asset. The election is available to both lessees and lessors. Lessees can apply it to all contracts, provided that the lease and non-lease components are associated with one another.  Lessors can adopt the policy for operating leases when the timing and pattern of transfer of the lease and non-lease components are the same. In order to reduce the burden of having to account for lease components under the new guidance and nonlease components under other guidance, we expect many entities to elect this practical expedient.

Once the components of the contract are identified, the next step is to calculate the lease payments. Lease payments are the basis for calculating the lease liability and the related right-of-use asset. The standard states that lease payments include fixed payments and any in-substance fixed payments. In-substance fixed lease payments appear to contain variability, but are unavoidable. For example:

• Variable payments depending on an index or rate (such as CPI or market interest rate)
• Variable payments subject to a minimum. In this case, the minimum is included in fixed payments and any incremental payments are variable
• The lower of the payments to be made when a lessee has a choice about which set of payments to make
• For lessees, any residual value guarantees that are probable of being paid 

By definition, lease payments do not include amounts allocated to non-lease components (unless the policy election has been made) or variable payments that are for executory costs or that are based on usage or performance.  Variable lease costs, such as rent calculated as a percent of retail store sales or machine hours used, are recognized when probable, which will usually be in the period of use. Accordingly, entities do not have to project sales or usage at the lease commencement date to estimate future variable payments.

Remember that taxes, insurance, and other executory costs are not components of the contract as no goods or services are received. The accounting treatment for these costs depends on whether they are fixed or variable.  When executory costs are variable, they are included in rent expense as they are incurred; when fixed, they are included as a part of the lease component and the entire payment is included in the lease liability.

The lease liability is measured as the present value of:

• Fixed payments for lease components, less lease incentives payable after commencement date
• Variable payments that depend on an index or rate
• Exercise price of reasonably certain purchase options
• Termination penalties if planning to exercise
• Amounts probable of being owed under residual value guarantees
• Structuring fees paid by lessee

The calculation of the initial right of use (ROU) asset starts with the amount of the lease liability, adjusted as follows:

• Plus: any lease payments made at or before commencement date
• Less: any lease incentives received at or prior to commencement date
• Plus: any initial direct costs

You will notice lease incentives as a component of both the lease liability and the ROU formula. The treatment depends on the timing of the payments. If the lessee expects to receive the payment after the commencement date, the payments are added in to the present value calculation as net inflows on the anticipated date. This will reduce both the liability and the ROU asset. If they are received at or prior to commencement, you will have another asset, usually cash or leasehold improvements in addition to the ROU asset. In this case, the sum of the ROU and the other asset will equal the lease liability.

The present value calculation of the lease liability has two additional components that may require some judgement: lease term and the discount rate. Lease term includes:

• Non-cancellable term, beginning with commencement date
• Renewal periods if lessee has significant economic incentive to exercise option
• Periods covered by an early termination option if lessee has a significant economic incentive not to exercise the termination option
• Periods where the exercise of those options is controlled by the lessor

The significant economic incentive is meant to be a high threshold. The default position is that the exercise of an option is not probable, unless there is specific evidence to the contrary.  Another consideration is whether any investment in leasehold improvements indicates that it is probable that a renewal option will be exercised.  If the investment is significant, it may meet the threshold for a significant economic incentive. Lessees should pay close attention to these factors, especially in related-party leases. In the event it is determined that the payment of a termination penalty is probable, the payment should be included in lease payments for purposes of determining the lease liability.

The present value calculation also requires a discount rate. The standard indicates that the rate used to calculate the lease liability should be the lessor’s implicit rate in the lease agreement. If the implicit rate is not readily known, the lessee should use its incremental borrowing rate as of the lease commencement date. Since the lessor’s rate will not usually be known, most entities will have to determine their incremental borrowing rate, which the standard defines, as the rate the lessee would have to pay to borrow on a collateralized basis over a similar term for a similar amount in a similar economic environment. This is not as simple as using the rate on an existing line of credit and will require significant management judgement. To reduce some of the complexities in measuring lease liabilities and ROU assets, the FASB allowed private companies the option to make an accounting policy election to use the risk-free rate for a period comparable to lease term. Utilizing the risk-free rate rather than the entity’s incremental borrowing rate will result in a larger lease liability and ROU asset.

In the next installment, we will address lease classification and summarize both the initial and subsequent accounting under the new standard.

 

^{Readers should not act upon information presented without individual professional consultation.}