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.
Lessees are presently paying 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. 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.
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:
To what does the standard not apply?
The lease standard does not apply to the following:
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:
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).
Leases between related parties will be classified just as any other lease will be. Companies will look to the legally enforceable terms and conditions of the lease to determine whether a lease contract exists. If a lease contract exists, the agreement will be treated as a lease with the lessor reflecting a sale and the lessee capitalizing the related lease liability and right-of-use asset.
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.
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.)
Month-to-month leases will usually not be capitalized if the accounting policy election is taken. Consider, however, any options to renew or if the leases contain “mutual” renewal options. Once the noncancelable period is over and the contract is no longer enforceable, the lease becomes an “at-will” arrangement.
ASC 842-10-30-1 defines the lease term as the noncancelable period of the lease together with all of the following:
Companies can ready themselves for implementation of the new lease standard by doing the following:
While this list is not comprehensive, performing these actions will assist you in preparing for implementation of the 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, including interim periods within those years.
For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
Early implementation is permissible for all entities.
We’ll continue this series of lease posts next week. So stay tuned.
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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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