Tag Archives for " Leases "

Finance and operating leases
Dec 11

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.

Lease accounting

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.

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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

lease accounting
Dec 09

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.”

lease accounting

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.

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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:

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

Lease Standard
Dec 05

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.

Lease Standard

Picture from AdobeStock.com

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.

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