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ASC 842 Leases Summary Report

Overview

  1. ASC 842 is the accounting standard of US GAAP for leases in the United States which is regulated by the Financial Accounting Standards Boards (FASB)
  2. ASC 842 supersedes ASC 840
  3. For public companies, ASC 842 has gone into effect for annual period beginning after December 15, 2018, and calendar year 2019
  4. The two standards ASC 842 and ASC 606 are closely related
  5. Lessor accounting remained virtually same with significant alterations to the lessee accounting

Objective

  1. To highlight the key aspects related to the identification, classification, and measurement of the lease standard from the perspective of the lessee

Significant Change of Lessee

  1. A single right-of-use asset model is introduced similar to IFRS 16
  2. The most significant impact of the new standard is that lessees will now recognize both lease liabilities and right-of-use assets on the company’s balance sheet for practically all leases
  3. Companies need significant efforts in terms of complying to ASC 842 due to complexities of the accounting standard

Important Components

  1. The major aspects of lease standard to consider are identification, classification, measurement, and disclosure
  2. Identification – arrangements that would be considered to be leases
  3. Classification – determination of if a lease is an operating lease or finance lease
  4. Measurement – process by which leased assets should be measured for the lease liabilities, right-of-use assets, and the respective expenses
  5. Disclosures – extensive qualitative and quantitative disclosures compared to prior lease standard

Identification

  1. Entities would want to identify the population of leases i.e., perform a contract review for all the leases in their portfolio (example, retail, facilities, warehouse, and infrastructure)
  2. Certain types of leases are specifically excluded from the lease standard. Example – intangibles, inventory, and certain natural resources
  3. A contract not excluded from the scope may be a lease if it provides a customer with the ability to control an asset that is either explicitly or implicitly specified
  4. The foundation for determining whether control is provided is consistent with the guidance in the new revenue standard, ASC 606, Revenue from Contracts with Customers and could require professional judgement
  5. Lease identification is vital since operating leases were previously off-balance-sheet and there was no meaningful impact on balance sheet recognition
  6. Under ASC 842, if an arrangement is a lease or has a lease embedded in the contract, an entity would need to recognize the lease on balance sheet which makes lease identification significant

Classification

  1. A lease would need to be classified as either an operating lease or a finance lease as soon as a lease is identified
  2. Initial recognition is not impacted due to the lease classification of operating lease or finance lease; however, significant impact is seen for both the balance sheet and the income statement over the term of the lease

Finance Lease versus Operating Lease

  1. At lease commencement, a lessee classifies a lease as a finance lease if the lease meets any one of the following criteria as stipulated in ASC 842:
    • Transfer of ownership? – The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
    • Purchase option reasonably certain to be exercised? – The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
    • Lease equal to major part of economic life? – The lease term is for a major part of the remaining economic life
    • Substantial part of Fair Value? – The present value of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of fair value
    • Specialized asset? – 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
  2. If any of the above criteria is met, it implies that control of the asset is effectively transferred to the lessee and it is a finance lease
  3. If all of the above criteria are not met, it is an operating lease
  4. The first 4 criteria are similar to ASC 840 with one important distinction. FASB made a deliberate decision to remove the 75% and 90% from the criteria in order to make ASC 842 more principle based
  5. The fifth criterion is newly included in ASC 842 which was previously part of IAS 17 (old IFRS lease standard). This new criterion is not expected to have notable impact on classification since a lessor would normally require that it be fully compensated for a leased asset that has no alternative use

Measurement

  1. After a lease is classified, a lessee would now need to measure the lease liability and its associated right-of-use asset
  2. At the commencement date, a lessee initially measures the lease liability at the present value of the lease payments to be made over the lease term. The present value is calculated using the discount rate determined on the commencement date
  3. At the commencement date, the lease liability equals the right-of-use assets which is then adjusted for items such as indirect costs, lease incentives, and prepaid rents.  
  4. Initial recognition of lease liability and right-of-use asset is same under both operating lease and finance lease, however, subsequent measurement is significantly different based on the respective classification
  5. Professional judgement is required when determining the expected payment obligations

Common Lease Provisions

  1. In addition to identifying the scheduled payments for the non-cancellable portion of the lease, a lessee would need to consider other possible payments
  2. The three common lease provisions are as follows:
    • Renewal options
    • Variable lease payments
    • Residual value guarantees
  3. Renewal options – payments for renewal periods are included for any periods when it is reasonably certain that the lessee will exercise the renewal options
  4. Variable payments – if the variable payments are based on an index or a rate such as CPI, then the payments will be included in the liability based on the index or rate at commencement. Payments based on usage would be excluded from balance sheet measurement
  5. Residual value guarantees – when measuring a lease liability only the amount probable of being owed under a residual value guarantee would be included

Optional Exemptions

  1. Lessees may elect not to capitalize leases with a lease term of 1 year or less
  2. If a lease has a stated contract term of 1 year with one or more renewal options, then, the lease will not qualify for the short-term lease exception provided that lessee is reasonably certain to exercise one or more of the options

Expense Recognition – Finance Lease & Operating Lease

  1. Finance lease would be similar to a capital lease where interest expense will be recognized based on the outstanding lease liability using the effective interest rate method
  2. The right-of-use asset would be amortized on a straight-line basis throughout the lease term
  3. Front loaded expense recognition pattern gives rise due to the cumulative effect of interest and amortization similar to IFRS 16 right-of-use model
  4. Operating lease would be recognized on a straight-line basis in a unique manner
  5. As lessees are required to reflect a lease liability and related right-of-use asset on the balance sheet, interest expense on the outstanding lease liability is calculated using the effective interest rate method
  6. The right-of-use asset is calculated as the difference between the lease expense and the interest expense in the period i.e., a plug
  7. Although the total lease expense for operating leases economically includes both interest and amortization components, it would be reflected as an operating expense and not as interest or amortization
  8. The total expense over the life of the lease is the same regardless of lease classification

Final Words

  1. In order to comply with ASC 842, an entity would need to build up robust internal controls and processes with significant IT system improvements
  2. Significant efforts and resources from management would need to be allocated on research of accounting implications, lease contract reviews, lease identifications, classifications, amendments, modifications, disclosures, technical accounting memos, reporting and reconciliation of different accounts between subledger and general ledger

Citation

https://www.fasb.org/leases

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