As discussed in our previous article, now is the time to begin the process of implementing Accounting Standards Update No. 2016-02, Leases (Topic 842).
The first step companies must take to effectively implement the new FASB lease accounting standard is reviewing all significant contracts and agreements to determine if the contract, or part of the contract, falls within the scope of the new standard and contains a lease. The majority of agreements will be easily identifiable as a lease based on the nature and/or terms of the agreement and the underlying asset (e.g., office space, vehicles, copiers). However, with changes to vendor service offerings and the structure of purchasing in today’s economy, certain contracts may fall within the scope of the new lease standard that may not be obvious.
To properly identify all lease agreements and other contracts containing leases, companies should take a step back and look at all agreements in place and consider the terms of the individual contracts in light of the definition of a lease under Topic 842. This will help determine if the contract meets the definition of a lease, requiring application of the new standard.
Definition of Lease
Under the new standard, a lease is defined 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.” Now, let’s break this definition down.
What is an Identified Asset?
Assets will typically be explicitly defined within the contract (e.g., legally defined property). Intangible assets, rights to explore for or use natural resources, biological assets, inventory, and assets under construction are not considered identified assets within the scope of the lease standard. A contract for a portion of an asset qualifies as an identified asset if it is physically distinct (e.g., a specific space in a building or a specific segment of a pipeline).
If the asset is not physically distinct and the leasing entity does not have rights to substantially all output of the asset (e.g., a fraction of capacity on fiber optic cable), the asset is not considered physically distinct and, therefore, the contract would not fall within the scope of the new standard. In certain circumstances, an asset would be considered implicitly identified when the lessor only has one asset which would satisfy the contract.
Furthermore, the agreement may allow for substitution of the asset throughout the term of the contract and still be considered an identified asset. If substitution provisions are included in the agreement, the terms will need to be reviewed to determine if the right to substitute is substantive. See Right to Control below for considerations in determining whether control is lost due to a substitution provision.
What is a Period of Time?
A period of time may be a set time period or set amount of use of an identified asset (e.g., output allowed within the contract), as agreed on within the contract.
What is Considered the Right to Control?
An entity is deemed to have control over the use of the identified asset if, for all or a portion of the contract period, the entity has both:
- the right to obtain substantially all of the economic benefits from the use of the asset
- the right to direct the use of the asset
Obtaining Economic Benefit
Using, holding, or subleasing an asset and/or the asset’s output and byproducts all provide economic benefit. Many lease agreements provide for the exclusive use of the identified asset, in which case the leasing entity has the right to substantially all of the economic benefit.
In evaluating whether the leasing entity has rights to substantially all economic benefits, the entity should evaluate the economic benefits within the terms of the contract. If the contract specifies a portion of an asset or other contract limitations, only that specified portion should be considered in evaluating whether the contract provides for substantially all benefits.
Directing the Use of the Asset
The right to direct the use of the asset is provided when a leasing entity is provided the right under the contract to determine when, how, and for what purpose the asset is used throughout the contract term. Or, in the event the use of the asset is predetermined within the contract, the leasing entity is considered to have the right to direct the use of the asset if the lessor cannot change that predetermined use.
Lastly, if the leasing entity designed all or a part of the asset in such a way that the purpose and timing of use are predetermined, the leasing entity essentially has the right to direct to the use of the asset, based on its ability to design the asset for specific use.
The contract may include limitations on the use of the identified asset to protect the lessor’s interest in the asset, its personnel, or to ensure compliance with laws and regulations. These protective rights clarify the use allowed under the contract but alone are not considered to impair the leasing entity’s right to direct the use of the asset over the contract period. Protective rights may limit the geographical area, distance, amount of use (e.g., mileage on a vehicle), or operating practices required for the asset.
In considering whether the leasing entity has the right to control the asset, the economic benefits and use of the asset should be evaluated within the confines of the limited rights. For example, if the lease provides for use of the asset only within a specific region, the leasing entity should evaluate whether it has the right to substantially all economic benefits and to direct the use of the asset within that specific region only. If the leasing entity has exclusive use of the asset and can determine when, how, and for what purpose the asset is used within the specific region allowed within the contract, the leasing entity would conclude it has the right to control the asset. Protective rights limiting the use of an asset do not prevent the leasing entity from directing the use of the asset under the terms of the agreement.
As discussed above, most leases will specifically define the asset provided under the agreement; however, in certain circumstances, the lessor may have the right to substitute the asset throughout the lease term. If the asset is subject to substitution throughout the term of the contract, leasing entities must determine whether the right is considered a substantive right. The lessor is considered to have a substantive right if they have both:
- the ability to substitute the asset
- the lessor would benefit economically from such substitution
If a lessor has a substantive right to substitute the asset, the entity is deemed to not have the right to control the use the identified asset and would not qualify as a lease under the new standard. This determination is made at the inception of the lease. Any future events which are unknown or unlikely at inception of the lease (e.g., subsequent changes to asset value or changes in consumer demand) should not be considered in evaluating whether the lessor would benefit from substitution. Assets held onsite of the leasing entity are less likely to provide the lessor with an economic benefit in the event of substitution due to the cost of substituting the asset at the customer’s site.
Substitutions resulting from required repairs and maintenance or upgrades available throughout the term of the lease may be provided within the contract and still allow for the asset to qualify as an identified asset. If the leasing entity cannot reasonably determine whether the lessor has a substantive right, the leasing entity would conclude no such right exists and, subject to other requirement previously discussed, account for the contract as a lease.
Accounting Policy Elections
The new standard provides for several accounting policy elections to ease the burden of implementing and accounting for leases under the standard. A few key elections available for determining whether a lease qualifies as falling within the scope of the new standard relate to short-term leases and leases falling below the entity’s capitalization policy.
Entities can elect to not recognize lease assets and liabilities for a lease with a term of 12 months or less, provided the lease does not include an option to purchase the asset or extend the lease which the entity is reasonably certain to exercise. If the entity expects to exercise a purchase option or exercise an option to extend the lease term, the lease should not be excluded based on the short-term exemption alone.
Entities wishing to adopt this provision will make an accounting policy election and must apply the short-term exemption consistently across all leases within each asset class. While leases excluded from recognition under this election will not be required to be recorded on the balance sheet with a right-of-use asset and lease liability, these leases will remain subject to disclosure requirements, including disclosing short-term lease costs incurred. Entities should continue to track expenses associated with these agreements to ensure disclosures are properly made within its financial statements.
Similar to capitalization policies elected for capitalizing or expensing a purchased asset, entities may elect not to account for a lease that is considered immaterial to the financial statements. In setting a capitalization policy, an entity should consider its financial situation, the lease contract(s) in question, and the users of its financial statements to ensure the policy elected will provide for materially accurate financial reporting.
One approach to setting a capitalization threshold for a lease contract is to set a liability threshold and evaluate whether the lease liability for the lease contract in question exceeds such threshold. If the lease liability exceeds the threshold, the lease would be accounted for under the new standard with a right-of-use asset and lease liability. If the liability does not exceed the threshold, the lease would not be recorded on the balance sheet but rather expensed as incurred. Typically, in determining whether a lease meets the capitalization threshold, a net approach (netting the asset with the related liability) should not be taken.
Identifying Your Leases
With the understanding of what constitutes an asset and when the contract is (or contains) a lease, here are a few practical steps to finding all leases held by your company:
- Review annual detail of all rent and lease expense accounts to see which vendors and contracts are included within your current rent and lease expense accounts. Gather any supporting contracts for those expenses and review the contract to determine if it is (or contains) a lease.
- Identify your company’s significant service contracts and review the agreements for any components which could be considered leased assets.
- Discuss with personnel involved in procurement activities. Provide an overview of what constitutes a lease to key personnel responsible for procurement of goods and services for your company and brainstorm whether any other agreements could fall within the definition of a lease.
While identifying the majority of leases will be straightforward, significant judgment and analysis will be needed in evaluating some agreements. Consider all relevant facts and circumstances of the arrangement when determining whether the contract meets the definition of a lease.
This flowchart can be used to walk through the individual tests in considering whether the terms of the contract meet the definition of a lease. If the contract does meet the definition, it should be accounted for in accordance with the new lease accounting standards.
Want to Learn More?
This article highlights the key terms of identifying a lease within a contract. In future articles, we will discuss lease and nonlease components, lease classification, recognition of lease assets and liabilities, and transition methods. In the meantime, please contact your Clark Nuber service team or Shelley Oswald if you would like to discuss the new standard’s impact on your business and contracts.
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