On February 25, 2016, the FASB issued ASU 2016-02, Leases, (the new lease standard) culminating a decade long project. The new standard creates ASC 842, Leases, in the FASB Accounting Standards Codification and will supersede ASC 840, Leases.
The new lease accounting guidance was effective for public entities for fiscal years beginning after December 15, 2018. For nonpublic entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
The major difference between the existing guidance on accounting for leases and the new standard is that operating leases will now be recorded in the statement of financial position as assets and liabilities. Current U.S. GAAP requires only capital (to be known now as finance) leases to be recognized in the statement of financial position and amounts related to operating leases largely are reflected in the financial statements as rent expense on the income statement and in disclosures to the financial statements. With all leases over 12 months in lease term being recognized on the balance sheet, the determination of what is a lease will take on much greater significance. Since neither operating leases nor services were recognized on the balance sheet previously, the determination of what is a lease did not usually have significant financial reporting consequence.
The Definition of a Lease
At inception of a contract, an entity should determine whether the contract is or contains a lease as defined by the new lease standard. The new lease standard 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.
The definition of a lease requires both an identified asset and a right to control the identified asset for a period of time. In order to meet the identified asset criteria, the contract must explicitly or implicitly identify an asset and the supplier must not have a substantive substitution right. In order to meet the right to control the identified asset criteria, the contract must provide the customer with the decision-making authority over the asset and the ability to obtain substantially all economic benefits from the use of the asset.
Identified Asset Criterion
ASC 842-10-15-9 indicates that an asset typically is identified by being explicitly specified in a contract. However, an asset also can be identified by being implicitly specified at the time that the asset is made available for use by the customer.
The concept of an implicitly specified asset could be a challenge for an entity to identify as it will require knowledge of its suppliers operations. ASU 2016-02 provides an example of a factory that is implicitly specified because the supplier can fulfill the contract only through use of the factory. In the example, however, the customer does not control the use of the factory (the second criteria needed to meet the definition of a lease) because it does not have the right to obtain substantially all of the economic benefits from the use of the factory because the customer has not contracted for substantially all of the capacity of the factory. The customer also does not control the use of the factory because it does not have the right to direct the use of the factory. Accordingly, the contract fails to meet the right to control the asset during the lease term criteria and is not a lease.
Generally speaking, identification of the asset is straightforward. However, in some cases, this may not be the case. Accordingly, ASC 842-10-15-16 notes that a capacity portion of an asset is an identified asset if it is physically distinct (e.g., a floor of a building or a segment of a pipeline that connects a single customer to the larger pipeline). A capacity or other portion of an asset that is not physically distinct (e.g., a capacity portion of a fiber optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and, thereby, provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.
Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
- The supplier has the practical ability to substitute alternative assets throughout the period of use (e.g., the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time)
- The supplier would benefit economically from the exercise of its right to substitute the asset (i.e., the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset)
Right to Control Criterion
ASC 842-10-15-17 indicates to control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (e.g., by having exclusive use of the asset throughout that period). A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding, or subleasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits from using the asset that could be realized from a commercial transaction with a third party.
When assessing the right to obtain substantially all of the economic benefits from use of an asset, an entity should consider the economic benefits that result from use of the asset within the defined scope of a customer’s right to use the asset in the contract. For example:
- If a contract limits the use of a motor vehicle to only one particular territory during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle within that territory and not beyond
- If a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle for the permitted mileage and not beyond
ASC 842-10-15-20 indicates that a customer has the right to direct the use of an identified asset throughout the period of use in either of the following situations:
- The customer has the right to direct how and for what purpose the asset is used throughout the period of use
- The relevant decisions about how and for what purpose the asset is used are predetermined and at least one of the following conditions exists:
- The customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use without the supplier having the right to change those operating instructions
- The customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use
A customer has the right to direct how and for what purpose an asset is used throughout the period of use if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout that period. In making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose an asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use. The decision-making rights that are most relevant are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract.
ASC 842 notes examples of decision-making rights that, depending on the circumstances, grant the right to direct how and for what purpose an asset is used, within the defined scope of the customer’s right of use. Those rights include the following:
- The right to change the type of output that is produced by the asset (e.g., deciding whether to use a shipping container to transport goods or for storage, or deciding on the mix of products sold from a retail unit)
- The right to change when the output is produced (e.g., deciding when an item of machinery or a power plant will be used)
- The right to change where the output is produced (e.g., deciding on the destination of a truck or a ship or deciding where a piece of equipment is used or deployed)
The right to change whether the output is produced and the quantity of that output (e.g.,deciding whether to produce energy from a power plant and how much energy to produce from that power plant)
The new lease standard places all leases on the balance sheet while largely retaining current income statement treatments and lease classification. New processes, procedures, and controls will be necessary including segregating lease and non-lease components and new accounting for related party leases. Entities can prepare for the impact of the new lease standard by starting to identify their arrangements that meet the new definition of a lease and beginning to quantify the impact to the balance sheet as well as other key financial statement metrics. Further entities can then ensure proper ASC 842 adoption disclosures and estimated balance sheet impact is in this year-end’s disclosure notes to the financial statement. This may minimize the potential that users are surprised when all lease arrangements show up on the 2020 balance sheet.
If you have questions or need more information related to the new lease accounting standard, please contact your Elliott Davis adviser.