Finance and Operating Leases: Lessees

By Charles Hall | Accounting

Most CPAs grapple with leases from the lessee’s point of view, so in this post, we’ll look at finance and operating leases from the lessee’s perspective. Under the new lease standard (ASC 842, Leases), what are the types of leases? Does the accounting vary based on the type of lease? Are lease expenses different?

First, let’s start by defining the types of leases and how to classify them.

The Types of Leases

Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease using ASC 842. (Under ASC 840, a finance lease was referred to as a capital lease.)

Finance 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

While the bright-line criteria (e.g., the lease term of 75% or more of economic life) have been removed, the basis for conclusions in the new lease standard acknowledges some old rules of thumb.  It says that one reasonable approach to determining whether the lease is for a significant portion of the asset’s life is the 75% threshold. The conclusion goes on to say that “90 percent or greater is ‘substantially all’ of the fair value of the underlying asset.” So, in effect, FASB removed the bright lines as a rule but not in principle–the conclusion says FASB “does not mandate those bright lines.”

Operating Lease

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

Accounting Similarities and Differences

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 is quite different.

Finance Lease Accounting

The accounting for a finance lease–using ASC 842–is similar to capital lease accounting under ASC 840.

When a company enters a finance lease, it records the right-of-use asset and the lease liability. The amortization of the right-of-use asset will be straight-line, and the amortization of the liability will be accounted for using the effective interest method. Consequently, lease expenses are front-loaded (i.e., expenses will decline throughout the lease term). The amortization and interest expenses will be presented separately on the income statement.

As we are about to see, operating lease accounting is significantly different, particularly with regard to accounting for the lease expense and the amortization of the right-of-use asset.

Operating Lease Accounting

The primary change in lease accounting lies in the operating lease area. Under ASC 842, a company will book a right-of-use asset and a lease liability for all operating leases greater than twelve months in length (an election has to be made to exclude leases of twelve months or less). Under ASC 840, no asset or liability was recorded.

Will the operating lease expense be any different than it has been? No. But the recording and amortization of the right-of-use asset and the lease liability are new.

The Initial Operating Lease Entries

Let’s say a company has a five-year operating lease for $1,000 per month and will pay $60,000 over the life of the lease. How do we account for this lease? First, the company records the right-of-use asset and the lease liability by discounting the present value of the payments using the effective interest method.  In this example, the present value might be $54,000. As the right-of-use asset and lease liability are amortized, the company will (each month) debit rent expense for $1,000—the amount the company is paying. So the expense amount is the same as it was under ASC 840.

Amortizing the Right-of-Use Asset and the Lease Liability

How does the company amortize the right-of-use asset and the lease liability? The lease liability is amortized using the effective interest method, and the interest expense is a component of the rent expense. What’s the remainder of the $1,000? The amortization of the right-of-use asset. The $1,000 rent expense comprises two parts: (1) the interest expense for the month and (2) the right-of-use amortization amount, which is a plug to make the entry balance. Even though the rent expense is made up of these two components, it appears on the income statement as one line: rent expense (unlike the finance lease, which reflects interest expense and amortization expense separately).

Potential Impairments

Due to the straight-line lease expense calculation mechanics, the right-of-use asset amortization expense is back-loaded (i.e., the amortization expense component is less in the early part of the lease). One potential consequence of this slower amortization is that the right-of-use asset is more likely be impaired (at least as compared to a financing lease). The impairment rules do apply to the right-of-use asset.

Here’s a video showing you the journal entries for financing and operating leases.

Your Thoughts

So, what do you think of the new lease accounting? Is it better? Worse?

You can see my first two lease posts here:

Post 1: How to Understand the New Lease Accounting Standard

Post 2: Get Ready for Changes in Leases and the Leasing Industry

How to Understand the New Lease Accounting Standard

By Charles Hall | Accounting

Do you need help in understanding the new lease accounting standard? This article provides you with a basic understanding of the new guidance.

The existing lease guidance (FAS 13; codified as ASC 840) came out in 1976. In that standard, FASB defines capital leases with criteria such as minimum lease payments of at least 90% of fair market value or lease periods of at least 75% of the economic life of the asset. Given the bright-line criteria, lessees have asked lessors to construct leases so that they are considered operating and not capital. Why?

Most lessees don’t desire to reflect capital lease liabilities on their balance sheets. So for forty years, lessees have controlled assets with a lease agreement and not recorded them on their balance sheets—sometimes called “off-balance-sheet financing.”

The Problem: Tailored Leases

As an example under present lease standards, a company leases a building with an economic life of 40 years and desires a lease term of 28 years. Why? Well, 75% of 40 years is 30. Since the lease is less than 30 years, it is an operating lease—one not capitalized, one not recorded on the balance sheet.

What happens if the lease term is 30 years? Then it is a capital lease, and the company records the building and the related debt on the balance sheet. The lessee is fine with the recording of the asset (the building) but wants to keep the debt off the books. However, if a capital lease criterion is triggered, the asset and the debt are recorded on the balance sheet.

The New Trigger: Is This a Contract?

Under existing lease accounting rules, bright-line criteria are used to make the capitalization decision, for example, lease terms of 75% or more of the economic life or lease payments of 90% or more of the fair market value.

But the bright-line criteria is being replaced with a question: Is it a contract? If the lease is a contract, it goes on the balance sheet. (I am speaking generally here. There are other requirements such as the lessee must control the asset and reap the benefits of the arrangement.) If it is not a contract, it does not go on the balance sheet.

Result: Most operating leases will now be recorded on the balance sheet at the inception of the lease.

Recording Leases Under the New Lease Accounting Standard

So what is the accounting entry to record leases under the new standard?

A right-of-use asset (ROU) is recorded on the balance sheet at the amount of the lease liability (there can be some adjustments to the ROU as it is initially recorded, so I am speaking generally here). Also, a lease liability is concurrently recorded.

What’s the amount of the lease liability? It is the present value of the lease payments (including options that are reasonably certain). So, what is a right-of-use asset? It is an intangible that represents the lessee’s right to use the underlying asset. (The right-of-use asset will be amortized over the life of the lease.)

Is there any theory that supports this type of accounting? Yes, in FASB’s conceptual statements.

Congruence with FASB Conceptual Statement

FASB Concept Statement 6 says that assets are probable future economic benefits obtained or controlled by an entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Under the new lease standard, the right-of-use asset and the lease liability are congruent with the definitions in Concept Statement 6. So, if a company leases a truck for three years and the economic life of the vehicle is seven years, it has obtained “probable future economic benefits…as a result of past transactions.” And the company has “probable future sacrifices of economic benefits” arising from the lease obligation. Therefore, the lease should be booked on the balance sheet.

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 Information

This post is the first in a series concerning the new lease standard. See my other posts here:

• Get Ready for Changes in Leases and the Leasing Industry
• How to Account for Finance and Operating Leases

If you’re an auditor, check out my post Auditing Debt: The Why and How Guide.

Changes in Leases and the Leasing Industry

By Charles Hall | Accounting

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.

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.

Thefts of Cash From Local Governments

By Charles Hall | Asset Misappropriation , Local Governments

Thefts of cash from local governments is common.

How many times have you seen a local newspaper article like the following?

Johnson County’s longtime court clerk admitted today to stealing $120,000 of court funds from 2019 through 2021. Becky Cook, 62, faces up to 10 years in federal prison after pleading guilty to federal tax evasion and theft.

Thefts of Cash from Local Governments

Usually, the causes of such cash thefts are (1) decentralized collection points and (2) a lack of accounting controls.

1. Decentralized Collection Points

First, consider that governments commonly have several collection points.

Examples include:

• Recreation department
• Police department
• Development authority
• Water and sewer department
• Airport authority
• Landfill
• Building and code enforcement
• Courts

Many governments have over a dozen receipting locations. With cash flowing in so many places, it’s no wonder that thefts of cash are common. Each cash receipt area may have different accounting procedures – some with physical receipt books, some with computerized receipting, and some with no receipting system at all. 

A more centralized receipting system reduces the possibility of theft, but many governments may not be able to centralize the receipting function. Why? Here are three reasons:

1. Elected officials, such as tax commissioners, often determine how monies are collected without input from the final receiving government (e.g., county commissioners or school). Consequently, each elected official may decide to use a different receipting system.
2. Customer convenience (e.g., recreation centers and senior citizen centers) may drive the receipting location decision.
3. Other locations, such as landfills, are purposely placed on the outer boundary of the government’s geographic area.

What’s the result? Widely differing receipting systems. Since these numerous receipting locations have varying controls, the risk of theft is higher. 

2. Lack of Accounting Controls

Second, consider that many governments lack sufficient accounting controls for cash.

It’s more likely cash will be stolen if cash collections are not receipted. If the transaction is recorded, then the receipt record must be altered, destroyed or hidden to cover up the theft. That’s why it’s critical to capture the transaction as early as possible. Doing so makes theft more difficult.

Additional steps that will enhance your cash controls include the following:

1. If possible, provide the government’s administrative office (e.g., county commissioners’ finance department) with electronic viewing rights for the decentralized receipting locations (e.g., landfill).
2. Require the transfer of money on a daily basis; the government’s administrative office (e.g., county commissioners’ finance department) should provide a receipt to each transferring location (e.g., landfill).
3. Limit the number of bank accounts.
4. Deposit funds daily.
5. Periodically perform surprise audits of outlying receipting areas.
6. Use a centralized receipting location (and eliminate the decentralized cash collection points).
7. Persons creating deposit slips and handling cash should not key those receipts into the accounting system.
8. The person reconciling the bank statements should not also handle cash collections.
9. Don’t allow the person billing customers to handle cash collections.

If segregation of duties is not possible (such as 7., 8. and 9. above), consider having a second person review the activity (either an employee of the government or maybe an outside consultant).

Final Thoughts About Fraud Prevention for Cash

When possible, use an experienced fraud prevention specialist to review your cash collection procedures. Can’t afford to? Think again. The average incidence of governmental fraud results in a loss of approximately $100,000.

Finally, make sure your government has sufficient fidelity bonding. If all else fails, you can recover your losses through insurance.

For more fraud prevention guidance, check out my book on Amazon: The Little Book of Local Government Fraud Prevention. Additionally, here’s a post telling you how to audit cash.

Segregation of Duties: How to Overcome

By Charles Hall | Auditing , Fraud

Segregation of duties is key to reducing fraud. But smaller entities may not be able to do so. Today, I tell you how overcome this problem, regardless of the entity’s size.

The Environment of Fraud

Darkness is the environment of wrongdoing.

Why?

No one sees us. Or so we think.

Fraud occurs in darkness.

In J.R.R. Tolkien’s Hobbit stories, Sméagol, a young man murders another to possess a golden ring, beautiful in appearance but destructive in nature. The possession of the ring transforms Sméagol into a hideous creature–Gollum.

And what does this teach us? That which is alluring in the beginning can be destructive in the end.

Fraud opportunities have those same properties: they are alluring and harmful. And, yes, darkness is the environment where fraud happens.

What’s the solution? Transparency. It protects businesses, governments, and nonprofits.

But while we desire open and understandable processes, our businesses often have just a few employees that perform the accounting duties. And, many times, no one else understands how the system works.

It is desirable to divide accounting duties among various employees, so no one person controls the whole process. This division of responsibility creates transparency. How? By providing multiple eyes to see what’s going on.

But this segregation of duties is not always possible.

Lacking Segregation of Duties

Some people says here are three key duties that must always be separated under a good system of internal controls: (1) custody of assets, (2) record keeping or bookkeeping, and (3) authorization. I add a fourth: reconciliation. The normal recommendation for lack of segregation of duties is to separate these four accounting duties to different personnel. But many organizations are unable to do so, usually due to a limited number of employees.

Some small organizations believe they can’t overcome this problem. But is this true? I don’t think so.

Here’s two easy steps to create greater transparency and safety when the separation of accounting duties is not possible.

1. Bank Account Transparency

First, consider this simple control: Provide all bank statements to someone other than the bookkeeper. Allow this second person to receive the bank statements before the bookkeeper. While no silver bullet, it has power.

Persons who might receive the bank statements first (before the bookkeeper) include the following:

• A nonprofit board member
• The mayor of a small city
• The owner of a small business
• The library director
• A church leader

What is the receiver of the bank statements to do? Merely open the bank statements and review the contents for appropriateness (mainly cleared checks).

In many small entities, accounting processes are a mystery to board members or owners. Why? Only one person (the bookkeeper) understands the disbursement process, the recording of journal entries, billing and collections, and payroll.

Relying on a trusted bookkeeper is not a good thing. So how can you shine the light?

Allow a second person to see the bank statements.

Fraud decreases when the bookkeeper knows someone is watching. Suppose the bookkeeper desires to write a check to himself but realizes that a board member will see the cleared check. Is this a deterrent? You bet.

Don’t want to send the bank statements to a second person? Request that the bank provide read-only online access to the second person. And let the bookkeeper know.

Even the appearance of transparency creates (at least some) safety. Suppose the second person reviewer opens the bank statements (before providing them to the bookkeeper) and does nothing else. The perception of a review enhances safety. I am not recommending that the review not be performed. But if the bookkeeper even thinks someone is watching, fraud will lessen.

When you audit cash, see if these types of controls are in place.

Now, let’s look at the second step to overcome a lack of segregation of duties. Surprise audits.

2. Surprise Audits

Another way to create small-entity transparency is to perform surprise audits. These reviews are not opinion audits (such as those issued by CPAs). They involve random inspections of various areas such as viewing all checks clearing the May bank statement. Such a review can be contracted out to a CPA. Or they can be performed by someone in the company. For example, a board member.

Additionally, adopt a written policy stating that the surprise inspections will occur once or twice a year.

The policy could be as simple as:

Twice a year a board member (or designee other than the bookkeeper) will inspect the accounting system and related documents. The scope and details of the inspection will be at the judgment of the board member (or designee). An inspection report will be provided to the board.

Why word the policy this way? You want to make the system general enough that the bookkeeper has no idea what will be examined but distinct enough that a regular review occurs. 

Surprise Audit Ideas

Here are some surprise audit ideas:

• Inspect all cleared checks that clear a particular month for appropriate payees and signatures and endorsements
• Agree all receipts to the deposit slip for three different time periods
• Review all journal entries made in a two week period and request an explanation for each
• Inspect two bank reconciliations for appropriateness
• Review one monthly budget to actual report (look for unusual variances)
• Request a report of all new vendors added in the last six months and review for appropriateness

The reviewer may not perform all of the procedures and can perform just one. What is done is not as important as the fact that something is done. In other words, the primary purpose of the surprise audit is to make the bookkeeper think twice about whether he or she can steal and not get caught.

I will say it again. Having multiple people involved reduces the threat of fraud.

Segregation of Duties Summary

In summary, the beauty of these two procedures (bank account transparency and surprise audits) is they are straightforward and cheap to implement. Even so, they are powerful. So shine the light.

What other procedures do you recommend?

For more information about preventing fraud, check out my book: The Little Book of Local Government Fraud Prevention.