Changes in Leases and the Leasing Industry

The Leasing Industry will Change

In my last lease post, we saw that bright-line criteria (e.g., lease terms of 75% or more of economic life and minimum lease payments of 90% or more of fair market value) are eliminated with ASU 2016-02. Consequently, almost all leases—including operating leases—will create lease liabilities. This accounting change will alter the leasing industry.

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Lessees have historically paid high lease interest rates to obtain operating lease treatment (no lease debt is recorded). Now—with the new lease standard—those same operating leases will generate lease liabilities. So why would the lessee pay the higher interest rate? There is nothing to be gained. I think Lessees will begin to borrow money from banks (at a lower rate). And they will buy the formerly leased asset, or they will demand lower interest rates from the lessor. Lessees, I think, will obtain better interest rates.

The Scope of the Lease Standard

To what does the lease standard apply? It applies to leases of property, plant, and equipment (identified asset) based on a contract that conveys control to the lessee for a period of time in exchange for consideration. The period may be described in relation to the amount of usage (e.g., units produced). Also, the identified asset must be physically distinct (e.g., a floor of a building).

Control over the use of the leased asset means the customer has both:

1. The right to obtain substantially all of the economic benefits from the use of the identified asset
2. The right to direct the use of the asset

To what does the standard not apply?

The lease standard does not apply to the following:

1. Leases of intangible assets, including licenses of internal-use software
2. Leases to explore for or use minerals, oil, natural gas, and similar resources
3. Leases of biological assets
4. Leases of inventory
5. Leases of assets under construction

Operating or Finance Lease

Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. Under present lease standards, a finance lease is referred to as a capital lease.

So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:

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 (today we use the 75% rule)
4. The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
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

And what is an operating lease? It’s any lease that is not a financing lease.

Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases will be different (a topic we’ll cover in my next lease post).

Are there any leases that will not result in a right-of-use asset and a lease liability? Yes, those with terms of twelve months or less.

Lease Terms of Less Than 12 Months

Companies do have the option to not capitalize a lease of 12 months or less. To do so, the company must make an accounting policy election (by class of the underlying leased asset). Companies that use the election will recognize lease expenses on a straight-line basis, and no right of use asset or lease liability will be recorded. If, however, the terms of the short-term lease change, the agreement could become one in which the lease is capitalized–for example, if the lease term changes to greater than twelve months. (Expect to see plenty of leases terms of twelve months or less.)

ASC 842-10-30-1 defines the lease term as the noncancelable period of the lease together with all of the following:

• Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
• Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
• Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor

Getting Ready for the New Lease Standard

Companies can ready themselves for implementation of the new lease standard by doing the following:

1. Take an educational class that explains the particulars of the lease standard
2. Create an inventory of all leases (I would use an Excel spreadsheet and create a worksheet summarizing financing leases and another worksheet for operating leases)
3. Obtain copies of all lease agreements to support the inventory of leases (note–some verbal lease contracts are enforceable)
4. Determine the terms of the leases (see ASC 842-10-30-1 above)
5. Segregate the lease and non-lease (e.g., maintenance, cleaning) components in the lease contracts (companies can capitalize just the lease portion, though ASC 842-10-15-37 allows a lessee to make an election to not separate the non-lease component)
6. Document judgments made such as whether the lessee is reasonably certain to exercise a renewal extension 
7. Compute all lease liabilities and right-of-use asset amounts 
8. Determine whether the implementation of the standard might adversely affect the company’s compliance with debt covenants (you may want to discuss the impact with your lenders)

While this list is not comprehensive, performing these actions will assist you in preparing for implementation of the lease standard.

Effective Dates for New Lease Standard

ASC 842 (ASU 2016-02), Leases, replaces ASC 840, Leases.

The effective dates for 842 are as follows:

For public entities, the standard is effective for fiscal years beginning after December 15, 2018.

ASC 842 is effective for the annual reporting periods of private companies and nonprofit organizations beginning after December 15, 2021.

Early implementation is permissible for all entities.

More Lease Information Coming

See How to Account for Finance and Operating Leases.