Third Quarter Financial Services Update Highlight – Lease Accounting Implementation

This article is a part of a larger third-quarter update. For more information on these quarterly updates, please contact a member of the
Elliott Davis Financial Services Group

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.

OBSERVATION: In August, the FASB issued a proposed ASU that would grant private companies, not-for-profit organizations, and certain small public companies additional time to implement ASC 842. Under the proposal, ASC 842 would be deferred one year from 2020 to 2021 (calendar-year-end). ASC 842 is already in effect for public companies and therefore no date changes can be made for those companies.

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 balance sheet as assets and liabilities. Current U.S. GAAP requires only capital (to be known now as finance) leases to be recognized in the balance sheet and amounts related to operating leases largely are reflected in the financial statements as rent expense in 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.

Determining the Lease Term

As indicated in FASB ASC 842-10-30-1, the lease term is 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

The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor. The commencement date is the date on which a lessor makes the assets being leased available for use by a lessee. Lease commencement date may differ from lease inception date, which is the date of the lease agreement or commitment.

Noncancelable Lease Period
OBSERVATION: A contract does not need to be in writing. Whether the agreed-upon terms are written, oral, or otherwise indicated (for example, by electronic assent), a contract exists if the agreement creates rights and obligations that are enforceable against the parties. Determining whether a contractual right or obligation is enforceable is a question to be considered within the context of the relevant legal framework (or  equivalent framework). The same is true when determining the enforceable period of the lease contract. The factors that determine enforceability may differ between jurisdictions (e.g., states). In many cases, the enforceability of a contract and the enforceable period of the contract will not present a problem. However, in some cases, the enforceability of a contract or the enforceable period of a contract may be unclear. Such issues are matters of law and legal counsel may be necessary to make appropriate determinations.

The noncancelable lease period is identified in the lease contract and is the enforceable period of the contract. A contract must create enforceable rights and obligations between two or more parties. A lease contract is no longer enforceable when both the lessee and the lessor each have the right to terminate the lease without permission from the other party with no more than an insignificant penalty.

Periods Reasonably Certain to Extend

Leases often grant the lessee a right to extend a lease beyond the initial noncancelable period or to terminate a lease before the end of the lease period. Leases also may grant the lessor an option to extend (or not to terminate) the lease. Those options should also be factored into the determination of the lease term.

Lessee Options to Extend or Terminate the Lease

The lease term should only include optional periods to extend the lease if the lessee is reasonably certain to exercise that option. At the commencement date, an entity assesses whether the lessee is reasonably certain to exercise or not to exercise an option by considering all economic factors relevant to that assessment (i.e., factors that create an economic incentive for the lessee). Such factors (not all-inclusive) may be:

  • Contract-based
  • Contractual terms and conditions for the optional periods compared with current market rates, such as:
    • The amount of lease payments in any optional period
    • The amount of any variable lease payments or other contingent payments, such as payments under termination penalties and residual value guarantees
    • The terms and conditions of any options that are exercisable after initial optional periods
    • Costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location
  • Negotiation costs
  • Asset-based
  • Significant leasehold improvements that are expected to have significant economic value for the lessee when the option to extend or terminate the lease or to purchase the underlying asset becomes exercisable
  • Relocation costs
  • Costs of identifying another underlying asset suitable for the lessee’s operations
  • Market-based
  • Market rental rates
  • Relevant laws and regulations
  • Entity-based
  • The importance of that underlying asset to the lessee’s operations, considering, for example, whether the underlying asset is a specialized asset and the location of the underlying asset.

The existence of any one factor does not necessarily signify that a lessee is reasonably certain to exercise or not to exercise an option, as all factors should be considered together.

Definition of Reasonably Certain. The term “reasonably certain” is a high threshold. In practice, the term is similar in meaning to “probable”, which is defined as that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved. Existing U.S. generally accepted accounting standards (U.S. GAAP), including legacy U.S. GAAP related to lease accounting, use the term “reasonably assured.” The FASB views reasonably certain and reasonably assured as synonyms that should be applied in the same way. The FASB decided to use the term “reasonably certain” rather than “reasonably assured” to remain converged in this respect with IFRS.

Termination Penalties. When assessing whether an option to terminate a lease is reasonably certain of being exercised, the lessee should consider the significance of the termination penalty in absolute terms and in relation to the remaining lease payments after the date the termination option becomes exercisable. The other economic factors discussed above would be considered as well.

Lessee Options to Extend (or Not to Terminate) the Lease

The lease term should include periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. Whether the lessor is likely to exercise the option is not a relevant consideration. In other words, if an option to extend the lease is controlled by the lessor, the determination of the lease term assumes the lessor will exercise the option to extend the lease. Similarly, if only the lessor has the option to terminate the lease, the determination of the lease term should assume that such an option will not be exercised.

Fiscal Funding Clauses

A fiscal funding clause is a provision by which the lease is cancelable if the legislature or other funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the lease agreement. The existence of a fiscal funding clause in a lease agreement requires an assessment of the likelihood of lease cancellation through exercise of the fiscal funding clause. If it is more than remote that the fiscal funding clause will be exercised, the lease term should include only those periods for which funding is reasonably certain.

Short-Term Leases

A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. As an accounting policy, a lessee may elect not to recognize right-of-use assets and lease liabilities that arise from short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred. The accounting policy election for short-term leases should be made by class of underlying asset to which the right of use relates. The FASB included the short-term lease accounting policy election in FABS ASC 842 to help reduce the cost and complexity of complying with the new lease accounting guidance. Nevertheless, FASB ASC 842 requires lessees to make certain disclosures about short-term leases.

Month-to-Month, Evergreen, Rolling, and Similar Leases

It is not uncommon for entities to enter into very short-term leases such as month-to-month or week-to-week leases, as well as rolling and evergreen leases. Such leases are subject to the requirements of FASB ASC 842 like other leases, as long as the lease contracts create enforceable rights and obligations between two or more parties. The lease term should be determined based on the requirements of paragraphs 1-4 of FASB ASC 842-10-30, as described above in this report. As such, whether it is reasonably certain that renewal or termination options will be exercised by the lessee will need to be assessed, as well as the existence of similar options controlled by the lessor. Note that many month-to-month leases contain “mutual” renewal options. See the discussion above related to these options.

Assessing whether a lessee is reasonably certain to exercise a renewal option on short-term leases may be challenging at times and require significant judgment. Looking at the economic incentives that the lessee has to exercise the option will be important. A very short noncancelable lease term may indicate a stronger economic incentive for the lessee to exercise renewal options.

Some lease contracts do not contain a lease term. Such leases may be day-to-day with the lessee paying a fee for each day the underlying asset is used. These leases would still be subject to the requirements of determining the lease term under FASB ASC 842. The noncancelable lease period may be determined to be one day and renewal options for each subsequent day would be assessed as to whether they are reasonably certain of being exercised. Given the extremely short lease term, the lessee may have strong economic incentives to continue the lease and exercise renewal options.

Related Party Leases Impact on Lease Term

FASB ASC 842 introduces a significant change from current U.S. GAAP by requiring that the recognition and measurement for all leases should be applied by lessees and lessors that are related parties on the basis of legally enforceable terms and conditions of the contract (rather than looking at substance over form). In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties.

The new requirement to account for leases between related parties based on the legally enforceable terms and conditions of the contract may introduce challenges in determining the lease term of related party leases. In many related party arrangements, little documentation exists and the arrangements often are not in writing. Moreover, the related parties frequently are under common control. Determining whether the lease contract in those situations creates enforceable rights and obligations and whether the contract contains an enforceable lease term is problematic. Legal counsel may be necessary to make such determinations. As under current U.S. GAAP, entities should comply with the disclosure requirements of FASB ASC 850, Related Party Disclosures.

OBSERVATION: Keep in mind that a lease contract is no longer enforceable when both the lessee and the lessor each have the right to terminate the lease without permission from the other party with no more than an insignificant penalty. In such arrangements, neither party has enforceable rights or obligations. Also, some entities may be inclined to set shorter lease terms, especially with related party leases where more flexibility in setting lease terms exists. Those entities are reminded about the effect that setting a shorter lease term will have on the amortization period of leasehold improvements. FASB ASC 842-20-35-12 indicates that leasehold improvements should be amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which case, the lessee should amortize the leasehold improvements to the end of their useful life. Therefore, setting a shorter lease term will often result in a shorter amortization period for leasehold improvements.

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If you have questions or need more information related to the new lease accounting standard, please contact your Elliott Davis adviser.