New Lease Accounting Standards

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Rödl & Partner Accounting Matters Vol 2017 – 1, published in August 2017

 

​Accounting Standard Update (“ASU”) 2016-02, Leases (Topic 842), was issued in February 2016. For nonpublic entities, it is effective for fiscal years beginning after December 15, 2019. Early adoption is allowed.

Summary​

The new standard aims to bring leases onto balance sheets to give investors, lenders, and other financial statement users a more comprehensive view of a company’s long-term financial obligations as well as the assets it actually owns versus leases. Until now, companies that report under US generally accepted accounting principles (GAAP) were required to recognize capital leases (finance leases under the new standard) with an asset and liability while operating leases were only disclosed in the notes to the financial statements and not recorded on the balance sheet. Under the new standard, all leases will be recognized on the balance sheet as a right-of-use asset with a corresponding lease liability. The new requirement to record operating leases on the balance sheet will have a material impact on certain key financial ratios for some companies, despite the fact that their net assets will remain the same. These effects could potentially impact certain agreements, such as debt covenants. Although most financial institutions are aware of the new standard it is recommended that companies begin taking inventory of all leases and calculating the impact on key ratios, then coordinate with any affected counterparties, such as lenders, to address concerns and revise agreements as appropriate. Also, do not forget to assess internal key metrics and performance measures to determine if and how they may be impacted by this change. Again, now’s the time to coordinate with these financial statement users to understand how they are already using your lease information and how the new standard may affect their view of your company.

 

Lessee Accounting

As mentioned above, the core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise from leases. All leases create an asset and a liability for the lessee in accordance with FASB Concepts Statement No. 6, Elements of Financial Statements, and, therefore, recognition of those lease assets and lease liabilities represents an improvement over previous GAAP, which did not require lease assets and lease liabilities to be recognized for most leases.

 

A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. When measuring assets and liabilities arising from a lease, a lessee (and a lessor) should include payments to be made in optional periods only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. Similarly, optional payments to purchase the underlying asset should be included in the measurement of lease assets and lease liabilities only if the lessee is reasonably certain to exercise that purchase option. Reasonably certain is a high threshold that is consistent with and intended to be applied in the same way as the reasonably assured threshold in the previous lease guidance. In addition, also consistent with the previous lease guidance, a lessee (and a lessor) should exclude most variable lease payments in measuring lease assets and lease liabilities, other than those that depend on an index or a rate or are in substance fixed payments.

 

For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.

 

The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from previous GAAP. There continues to be a differentiation between finance leases and operating leases. However, the principal difference from previous guidance is that the lease assets and lease liabilities arising from operating leases should be recognized in the balance sheet.

 

For finance leases, a lessee is required to do the following:

  1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  2. Recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income
  3. Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows.

 

For operating leases, a lessee is required to do the following:

  1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  2. Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis
  3. Classify all cash payments within operating activities in the statement of cash flows.

 

Note: there are two important dates from an accounting perspective—the lease inception date and the lease commencement date. Lease inception represents the date of the lease agreement or commitment. The lease commencement date represents the date that the lessee obtains the right to use the underlying asset. Said differently, lease commencement date is the date the lessor makes the underlying asset available for use by the lessee. It is at this date that the lessee recognizes and measures the right-of-use asset and the related lease liability.

Lessor Accounting

Lease accounting on the lessor side is largely unchanged from prior to the release of ASU 2016-02. There are only minor changes, the most significant being changes to the recognition requirements that will align it with the new revenue recognition standard. Lease classification criteria has also been amended to be consistent with the lessee’s classifications. A lessor must now use criteria to classify a lease as a sales-type lease, a direct financing lease, or an operating lease at its commencement.

 

Lease Classification

An entity is required to determine the classification of a lease at lease commencement. The classification criteria under the new standard applies to both lessees and lessors. The focus of the criteria is on whether control of the underlying asset is effectively transferred to the lessee. Therefore, a lease would be classified as a finance lease (from the standpoint of a lessee) or a sales-type lease (from the standpoint of a lessor) if any of the following criteria are met:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
  3. The lease term is for the major part of the remaining economic life of the underlying asset.
  4. 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 in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
  5. 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.

 

Definition of a Lease

At inception of a contract, an entity should determine whether the contract is or contains a lease. Topic 842 defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. Control over the use of the identified asset means that the customer has both (1) the right to obtain substantially all of the economic benefits from the use of the asset and (2) the right to direct the use of the asset.

 

Under the lessee accounting model in previous GAAP, the critical determination was whether a lease was a capital lease or an operating lease because lease assets and lease liabilities were recognized only for capital leases. Under Topic 842, the critical determination is whether a contract is or contains a lease because lessees are required to recognize lease assets and lease liabilities for all leases-finance and operating-other than short-term leases (that is, if the entity elects the short-term lease recognition and measurement exemption).

 

Components

Topic 842 requires an entity to separate the lease components from the nonlease components (for example, maintenance services or other activities that transfer a good or service to the customer) in a contract. Although this was a requirement in previous GAAP, Topic 842 provides more guidance on how to identify and separate components than previous GAAP. Only the lease components must be accounted for in accordance with Topic 842. The consideration in the contract is allocated to the lease and nonlease components on a relative standalone price basis (for lessees) or in accordance with the allocation guidance in Topic 606 (for lessors). Consideration attributable to nonlease components is not a lease payment and, therefore, is not included in the measurement of lease assets or lease liabilities. Entities should account for nonlease components in accordance with other applicable Topics. Activities that do not transfer a good or service to the lessee or amounts paid solely to reimburse costs of the lessor are not components in a contract and are not allocated any of the consideration in the contract.

 

The above notwithstanding, Topic 842 provides a practical expedient for lessees as it relates to separating lease components from nonlease components. Lessees may make an accounting policy election by class of underlying asset not to separate lease components from nonlease components. If an entity makes that accounting policy election, it is required to account for the nonlease components together with the related lease components as a single lease component.

 

Transition

Lessors and lessees are required to apply a modified retrospective approach when adopting ASU 2016-02. This approach requires the adjustment for any existing lease at the earliest comparative period presented in the financial statements. Any leases expiring before the adoption date will not require an adjustment.

 

Illustration: Lessee’s Accounting for an Operating Lease

This example compares a lessee’s accounting for a lease that qualifies as an operating lease under Topic 842 and Topic 840. In particular, this illustration highlights the different effects on the lessee‘s balance sheet for an operating lease.

 

Assumptions. A lessee enters into a 5-year contract for $100,000 per year for total consideration of $500,000. The contract packages two components:
  • A lease component—equipment lease; and
  • A nonlease component—equipment maintenance to be performed by the lessor.

 

The equipment is new and has an estimated life of 15 years. The equipment has an estimated residual value of $10,000. At the end of the lease term, the lessee must return the equipment with a guaranteed minimum resale value of $12,000.

 

The contract does not specify payment amounts for the individual components. The lessor frequently provides similar equipment without maintenance services for $90,000 per year. The lessee has access to the comparable standalone equipment price based on a price list that the lessor widely distributes at trade shows and on the lessor’s website. The lessee is able to compare the market values for new and refurbished equipment of the same model to published price lists of the lessor’s competitors.

 

The lessor rarely provides maintenance services separately, but other service providers frequently provide service for the same type of equipment. The lessee is able to determine $20,000 per year as the observable standalone price for the maintenance services based on price lists widely distributed by vendors at trade shows and on vendor websites.

 

The lessee uses the observable standalone prices for each component to allocate the $500,000 total consideration on a relative basis as follows:

 

The lessee is not able to determine the rate the lessor charges the lessee or the implicit rate in the lease. The lessee’s incremental borrowing rate is 6.5%.

 

The lease does not contain any purchase or renewal options.

 

There are no initial direct costs or prepayments.

 

Accounting At Commencement Date (Topic 842 only).

At lease commencement date, the lessee recognizes and measures both of the following balances:

  1. Lease Liability of $340,000 - Calculated as the present value of the allocated annual lease payments of $81,818 (81.8% of $100,000) for five years, discounted at the incremental borrowing rate of 6.5%. The lease liability does not include any amounts for the resale value guarantee. This is based on the lessee‘s conclusion that, after the end of five years, the lessee will return the equipment at the fair market value for similar refurbished equipment. In other words, the lessee does not believe that it is probable of owing any amount under the residual value guarantee.
  2. Right-of-Use Asset of $340,000 - The right-of-use asset balance equals the amount of the lease liability.

 

Ongoing (Subsequent) Accounting.

This example assumes that the lessee’s allocated lease payments for both components (the lease and the maintenance) are the same for Topic 842 and Topic 840. Under both standards, a lessee separates consideration between lease payments and other services: [842-10-15-30; 840-10-15-19]

 

Dr. Lease expenses                     xx

Dr. Maintenance expenses            xx

Cr. Cash                                      xx

 

Accounting under Topic 842 - End of Year 1. The total contractual annual payment is $100,000, of which $81,818 represents the lessee‘s total annual operating lease expense. This annual operating lease expense is calculated as $409,090 allocated total consideration for the lease component, divided by the lease term of five years.

 

The lessee accretes interest on the lease liability at 6.5% using the effective interest method.

 

Due to the mechanics of Topic 842, a portion of the total lease expense relates to interest expense and the remainder relates to right-of-use amortization. The lessee amortizes the right-of-use asset. The amortization expense is calculated as $81,818 total annual lease operating expense, less the calculated interest expense for the year.

 

Over the course of the lease, the interest component decreases and the amortization component increases:

 

Note: Since this is an operating lease, the amortization and interest expense would show as a single line item on the income statement “lease expense”.

 

Accounting under Topic 840 - End of Year 1. Operating leases are not recognized on the balance sheet. As a result, the lessee does not recognize or measure any amounts for a lease asset or liability.

 

The total operating lease expense is the same as the amount illustrated for Topic 842. In addition, the lessee also records an expense related to the nonlease component (maintenance) of the contract. The amounts allocated to the lease (equipment) and nonlease (maintenance) components are the same under both standards.

 

Operating leases are not recognized on the balance sheet. As a result, the lessee does not recognize or measure any amounts for a lease asset or liability on its balance sheet at the end of year 1.

 

Illustration: Concept of Control—Power and Benefits

The revised definition of a lease is one of the significant changes from prior GAAP (Topic 840). The definition of a lease in Topic 842 focuses on the concept of control, which requires both a “power” element and a “benefits” element. The definition of a lease in Topic 840, however, focused only on whether the customer benefits from substantially all of the leased asset’s output (thus, only the “benefits” element). The FASB decided to incorporate the concept of control to align the lease guidance with other recently issued significant financial reporting standards. That is, the customer also must have decision-making rights regarding the use of the leased asset during the lease term (the “power” element). As a consequence of the revised definition of a lease, some contracts that were leases under Topic 840 may no longer qualify as a lease under Topic 842.

 

Consider the following changes in assumptions, in the context of the basic illustration above:
  • The “equipment” at the subject of this contract is one network server;
  • The contract is for the customer’s right to use one of the supplier’s 20 available host servers (that is, a network services agreement); and
  • The supplier can determine, at any point during the contract, which of the 20 available servers will host the customer’s data.

 

Under Topic 840, this contract may qualify for a lease simply because the customer benefits from substantially all of the use of one server (the “benefits” element). Under Topic 842, however, the contract would not qualify as a lease. This is because, at any point during the contract, the supplier can determine which of the 20 available servers will host the customer’s data. In this case, the customer lacks the “power” element because the supplier can decide how the servers are used to produce the customer’s desired output. Specifically, the customer lacks the “power” element because the supplier can configure the servers to achieve the customer’s desired speed and quality of the network services.

 

If you have any questions, please contact your Rödl & Partner office.

 

 

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