Update & Background
The COVID-19 pandemic has caused unprecedented challenges in all aspects of daily life. In June 2020, FASB issued Accounting Standards Update (ASU) 2020-05, which provided nonpublic entities and not-for-profits (NFP) additional time to implement Accounting Standards Codification (ASC) 842, Leases.
** FASB met on November 10, 2021, to consider a request for additional ASC 842 implementation time for private companies and nonprofits. The request cited continued COVID-19 disruptions, particularly labor constraints in the labor market as well as the time and resources to comply with critical aspects of the standard such as the discount rate and embedded leases. FASB members rejected this request, citing two previous deadline extensions and practical expedients available for nonpublic companies.
This is the first major overhaul of lease accounting since 1973. The new guidance requires lessees to recognize substantially all leases on their balance sheets as lease liabilities with a corresponding right-of-use (ROU) asset. Bright-line tests have been eliminated and management judgment will increase. FASB has updated the lease definition, and some contracts that are not currently accounted for as leases may be considered leases under ASC 842. Less dramatic—but substantial—changes were made to the lessor accounting model to align it with changes to the lessee model and the new revenue recognition standard, ASC 606. Leveraged lease accounting has been eliminated, although grandfathered for existing arrangements. The guidance on related-party leases has changed—under ASC 840, related-party leases are based on the substance of the arrangement, whereas ASC 842 bases them on the legally enforceable terms and conditions.
Early adopters and large public companies found several operational challenges in implementing the standard as written. In response, FASB finalized additional relief and technical corrections to clarify certain aspects of the new model.
||Accounting Policy Elections
|Expedient package – Identification, classification, initial direct costs (ASU 2016-02)
||Separation of lease and nonlease components for both lessee (ASU 2016-02) and lessor
|Hindsight (ASU 2016-02)
||Portfolio approach (ASU 2016-02)
|Land easements (ASU 2018-02)
||Short-term leases (ASU 2016-02)
|Prior-period presentation (ASU 2018-11)
||Discount rate (non-PBEs only) (ASU 2016-02)
Superseded by ASU 2021-09
||Presentation of taxes (ASU 2018-20) (lessor only)
||Lessors only – Variable lease payments (ASU 2021-05)
Depending on the number of leases and variability of contract terms, implementation of the standard can be a significant undertaking. Careful consideration of each optional relief is necessary at the start of the implementation process. This article reviews key aspects of the new guidance for your organization to consider when preparing for implementation.
Core Concepts for NFPs
Scope & Lease Definition
The scope of ASC 842 is substantially the same as ASC 840. The new model applies to all leases, including subleases of property, plant, and equipment (PP&E), with some specific exclusions. FASB has updated the definition of a lease such that a lease is only present when a contract—or part of a contract—conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
NFPs will need to determine at contract inception whether a contract is or contains a lease by assessing whether—throughout the period of use—the lessee has the right to direct an asset’s use and substantially obtain all the economic benefits from directing its use.
In making this determination, NFPs should consider the following:
- An identified asset must be specifically identifiable in the contract either explicitly, e.g., by serial number, or implicitly, e.g., the only asset available to satisfy the lease contract, at the time the asset is made available for use by the customer.
- If the supplier/lessor has the substantive right to substitute an asset throughout the use period, then the supplier—not the customer—controls the asset’s use and the customer/lessee would not meet the criteria for having the right to use the identified asset.
- A contract conveys the right to control an identified asset’s use if, throughout the use period, the customer has the ability to obtain substantially all the economic benefits from the asset’s use and decision-making authority to direct how and for what purpose the asset is used.
** Determining when a customer has the right to direct an identified asset's use may require significant judgment, and FASB has included implementation examples in the standard. Determining whether a contract contains a lease is elevated in importance, since all leases will require recognition of an asset and a liability.
Lease Classification, Commencement, & Measurement
ASC 842 makes several changes from ASC 840 in determining the classification of a lease, including:
- When the classification of a lease is determined
- How the classification criteria are applied
- How lease payments are determined
- The effect of collectibility and future costs on lease classification by a lessor
- Determining the interest rate implicit in the lease
- Determining the incremental borrowing rate
Under ASC 840, lease classification determined both how lease expense was recorded and whether a lessee was required to record an asset and a liability on the balance sheet. Under ASC 842, virtually all leases will require balance sheet recognition; lease classification will only affect the amount and timing of lease income and expense. Lease classification will now be determined at the commencement date. The classification criteria apply to both lessees and lessors, and evaluation focuses on whether control of the underlying asset is effectively transferred to the lessee.
Under ASC 842, if a lease meets any of the conditions below, the lease substantially transfers all risks and rewards incidental to ownership and will be classified as a finance lease (from a lessee’s standpoint) and a sales-type lease (from a lessor’s standpoint). A lease that does not meet any of the following criteria does not effectively transfer control to the lessee and would be classified as an operating lease by the lessee and as either an operating lease or direct financing lease by the lessor.
- Ownership is transferred at the lease’s end
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
- The lease term is for the major part of the economic life of the underlying asset; if the commencement date falls at or near the end of the leased asset’s economic life, this criterion shall not be used to classify the lease
- The present value of minimum lease payments and residual value guarantees (RVG) is equal to or more than substantially all the fair value of the leased asset
- The underlying asset has no alternate use to the lessor at the end of the lease term because of its specialized nature
The fifth criterion is a new consideration for lessors and lessees under ASC 842. In assessing whether an underlying asset has an alternative use to the lessor at lease termination, an entity should consider the effects of substantive, i.e., enforceable, contractual restrictions and practical limitations on the lessor’s ability to readily direct the asset for another use, e.g., selling or leasing it to an entity other than the lessee. A practical limitation on a lessor’s ability to direct an underlying asset for another use exists if the lessor would incur significant economic losses to do so.
Lease Term & Options
When determining the lease term, an entity should consider all relevant factors that create an economic incentive to exercise an option to extend or not terminate a lease; this should include contract, asset, and market factor. A lease term is the noncancelable lease period plus any optional periods if it is reasonably certain—after considering all relevant factors—the lessee will exercise a renewal option or not exercise a termination option. The lease term also includes optional periods if the lessor controls the exercise of the option.
Lease commencement is the date a lessor makes an underlying asset available for use to a lessee. It also is the date for classification, recognition, and initial measurement. The determination of whether a contract is a lease or contains a lease is performed at the lease inception date, which generally is the date of the agreement containing the lease. The difference between lease inception and lease commencement is a change under ASC 842 from the previous guidance under ASC 840.
A lessee can elect (by asset class) not to record on the balance sheet a lease whose term is 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise. If elected, the lease would be treated like an operating lease under current generally accepted accounting principles (GAAP)—payments would be recognized on a straight-line basis over the lease term. When determining whether the lease qualifies for this election, the lessee would include renewal options only if they are considered part of the lease term, i.e., those options the lessee is reasonably certain to exercise. If the lease term increases to more than 12 months, or if it is reasonably certain the lessee will exercise a purchase option, the lessee would no longer be able to apply this practical expedient and would apply ASC 842 guidance. This is a formal policy election that must be disclosed along with certain other information about the short-term lease.
Lease Payments & Measurement of Lease Liability
Lease payments are made by a lessee to a lessor for the right to use an identified asset during the lease term and are used to calculate the lessee’s lease obligation and ROU asset. These amounts may include fixed and certain variable lease payments, purchase options, termination penalties, lessee-paid special-purpose entity structuring fees, and probable RVGs.
Fixed lease payments consist of the lease payments per the lease agreement plus in-substance lease payments less any lease incentives paid or payable to the lessee. Variable lease payments will typically be excluded except for those that depend on an index or rate because those are unavoidable and therefore economically similar to fixed lease payments. Variable lease payments are calculated at lease commencement and no future changes in the rate or index should be estimated. If the payments change as the result of a change in an index or rate subsequent to lease commencement, the difference is recognized in the income statement in the period in which the change occurs.
If a lessee is reasonably certain to exercise a purchase option, the exercise price is included in lease payments. A lease termination penalty is excluded from lease payments if it is reasonably certain a lessee will not terminate a lease. Whether to include or exclude a purchase option or termination penalty depends on whether it is reasonably certain to be exercised, focusing on whether the lessee has an economic incentive. All relevant facts and circumstances that create an economic incentive should be considered, such as:
- Contractual terms and conditions for the optional periods compared with market rates
- Significant leasehold improvements undertaken over the contract term that are expected to have significant economic benefits for the lessee
- Lease termination costs
- Importance of the underlying asset to the lessee’s operations
The discount rate used can materially affect the valuation of the lease liability and asset recognized and will be one of the most challenging aspects of implementation. The higher the discount rate is, the lower the lease liability will be; the lower the discount rate is, the higher the lease liability will be. Determining the discount rate will be a significant area of judgment that will require supporting documentation and may necessitate new internal controls. FASB has provided substantial relief for private companies and NFPs, which many are likely to take advantage of.
Rate Implicit in the Lease
The discount rate used by the lessee and lessor is the rate implicit in the lease at the lease commencement date. For lessees, determining the rate implicit in the lease is challenging because that rate is a lessor-specific internal measure that is rarely disclosed. To determine the implicit rate, a lessee must know both the lessor’s estimate of the residual value of the underlying asset and the amount of initial direct cost the lessor will defer for the lease.
Incremental Borrowing Rate
Consistent with current guidance, if the lease’s implicit interest rate is not readily determinable, the lessee’s estimated incremental borrowing rate (IBR) should be used. ASC 842 has an updated IBR definition—the rate of interest a lessee would have to pay to borrow on a collateralized basis, over a similar term, an amount equal to the lease payments in a similar economic environment.
Discount Rate Relief
The definition of the IBR under ASC 842 presents operational challenges as many organizations borrow on an unsecured basis. Non-PBEs are permitted to make an accounting policy election to use the risk-free rate when measuring their lease obligations; once elected, it must be used consistently for all leases.
** A lower discount rate will lead to a higher lease liability. The discount rate also affects the allocation of total expense between depreciation and interest expense—a higher discount rate will reduce depreciation and increase interest expense each period in the lease term.
On November 11, 2021, FASB issued ASU 2021-09, Leases (Topic 842), Discount Rate for Lessees That Are Not Public Business Entities, to provide relief to private companies, all NFPs (whether or not they are conduit bond obligors), and all employee benefit plans in determining the discount rate to use. The ASU addresses two issues:
- Changing the existing accounting policy election to use a risk-free rate from entitywide to asset class
- Clarifying that a lessee using the discount rate accounting policy election must use the rate implicit in the lease when it is readily determinable instead of the risk-free rate
The ASU will allow NFP lessees to make the risk-free rate election by class of underlying asset rather than at the entitywide level. If elected, the entity would be required to disclose which asset classes it has elected to apply a risk-free rate. For example, an entity may want to use its IBR for a material asset class, e.g., real estate, but use the simpler and less costly option of using a risk-free rate for asset classes that have lower values or greater volumes of leases, e.g., office equipment.
A lessee may use a portfolio approach in accounting for its leases, including in determining lease classification, accounting for lease components, and determining the discount rate. The results from using the portfolio approach should not differ materially from the accounting at the individual lease level. In addition, the portfolio approach should be applied by stratifying the population of leases into similar populations such as by lease commencement date, lease term, amount of lease payments, form of underlying collateral, nature of the underlying asset, and renewal, termination, and purchase options. Common types of leases that would be appropriate for using the portfolio approach may include office equipment such as copiers, computers, and phone systems.
Payments made by the lessee for improvements to the underlying lease asset, e.g., upgrades to lighting and flooring, should be recorded as prepaid rent and included in fixed lease payments if the payment relates to an asset of the lessor. Lessor reimbursement of the lessee’s costs for improvements to the lessor’s asset is a reduction of prepaid rent. Determining whether payments made by a lessee for improvements to the underlying asset should be accounted for as lease payments to a lessor or as leasehold improvements of the lessee requires judgment. In general, if a lease does not specifically require a lessee to make an improvement, the improvement should be considered an asset of the lessee.
Contract Combinations & Contracts with Multiple Components
An NFP should combine two or more contracts entered into at or near the same time with the same counterparty and consider the contracts as a single transaction when at least one of the contracts contains a lease and any of the following criteria are met:
- The contracts are negotiated as a package with the same commercial objective
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract
- The rights to use underlying assets conveyed in the contracts (or some of the rights of use conveyed in the contracts) are a single lease component
This is similar to the revenue guidance in ASC 606. If a combination of contracts is determined to contain a lease, the same combined transaction should be used for lease classification, recognition, and measurement under ASC 842.
Under ASC 840, operating leases were not recorded on the balance sheet and many companies did not evaluate leases embedded in service agreements; as a result, one of the biggest challenges for early adopters was identifying and inventorying all contracts that may contain leases. Common agreements that may contain embedded leases include:
- Data center, manufacturing, and other outsourced arrangements that grant exclusive use of equipment or space in a supplier’s facility
- Arrangements that bundle a service and a device, e.g., cloud computing services, telecommunication services, cable services that lease supporting equipment or assets
- Sale of consumables with “free” equipment
Contracts with Multiple Components
Previous GAAP provided limited guidance on how to separate lease and nonlease components. ASC 842 provides expanded guidance on how entities should account for such contracts. Identifying separate lease components in a lease is similar to the identification of performance obligations in a revenue contract. An NFP must determine whether a lessee is contracting for a number of separate outputs or for a single output that incorporates a number of inputs.
||Not a Separate Component
A separate right to use an asset
Lessee can benefit from the ROU of the underlying asset either on its own or together with other readily available resources. The use is neither highly dependent on nor interrelated with other assets
Payments accounted for as a separate lease
An activity that transfers a separate good or service to the customer
Includes maintenance services
Allocated payments are nonlease period expense
Related to administrative tasks to initiate the lease and payment of lessor costs that do not transfer a separate good or service separate from the ROU asset
Includes payments for insurance or property taxes
Payments are only allocated to lease and nonlease components
An arrangement may contain lease and nonlease components that are subject to different accounting models and, therefore, must be identified and separated. This distinction also is important because it is not always appropriate to record an asset and liability for nonlease components. An activity is a separate nonlease component if it transfers a separate good or service to the lessee. Only items that contribute to securing the asset’s output are lease components. Examples of a nonlease component include common area maintenance in real estate and maintenance service included with an equipment lease.
Lessees have a practical expedient—by class of underlying assets—to not separate lease and nonlease components. If elected, a lessee is required to account for the lease and nonlease components as a single lease component with special disclosures. The election must be applied to all leases in a class. While the expedient eliminates the pricing allocation process, it will increase the total lease liability recorded on the balance sheet.
Separate Rights of Use
An NFP also must identify multiple lease components for a contract’s different underlying assets. For contracts with multiple rights of use, organizations must identify and account for each separate component as an operating lease or finance lease if both of the following criteria are met:
- The lessee can benefit from the ROU either on its own or together with other readily available resources
- The ROU is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract
- An NFP must account for the right to use land and other assets, e.g., a building, separately, unless the effect of doing so would be insignificant to the overall accounting for the transaction.
Upon adoption of the leases standard, NFPs are permitted to choose one of two methods to recognize and measure leases within the scope of ASC 842:
|Adjust Comparative Periods
||Do Not Adjust Comparative Periods
Apply the leases standard to each lease that existed at the beginning of the earliest comparative period presented in the financial statements, as well as leases that commenced after that date.
Under this method, prior comparative periods presented are adjusted.
For leases that commenced prior to the beginning of the earliest comparative period presented, a cumulative effect adjustment (if necessary) is recognized at that date.
The period from the beginning of the earliest comparative period up until immediately before the effective date is referred to as the "look-back period."
For example, if an entity adopts ASC 842 as of January 1, 2022, and presents 2021 comparative financial statements, it would:
Apply the ASC 842 transition guidance to leases existing as of January 1, 2021, e.g., record lease liabilities and ROU assets
Recognize and measure leases commencing during the look-back period in accordance with the ASC 842 transition guidance
Account for lease reassessment and lease modification circumstances during the look-back period in accordance with the guidance in ASC 840 if lease classification did not change or ASC 842 if lease classification did change
Provide the disclosures required by ASC 842 for all periods presented
Apply the guidance to each lease that had commenced as of the beginning of the reporting period in which the entity first applies the leases standard with a cumulative effect adjustment (if necessary) as of that date. Prior comparative periods would not be adjusted under this method.
An entity that applies this method must provide the required disclosures under ASC 840 for all periods to which ASC 840 is applied, i.e., the prior period(s).
For example, if an entity adopts ASC 842 as of January 1, 2022, it would:
Apply the ASC 842 transition guidance to leases existing as of January 1, 2022, e.g., record lease liabilities and ROU assets
Apply ASC 842 guidance related to lease reassessment, lease modifications, lease impairment, etc., for relevant circumstances occurring during 2022
Recognize and measure leases commencing during 2022 in accordance with ASC 842
Provide the disclosures required by ASC 842 for the period of adoption, i.e., the current year, and provide the disclosures required by ASC 840 for all periods that continue to be presented in accordance with ASC 840, i.e., the prior year
Entities are allowed to apply the lease guidance at a portfolio level and elect a package of transition relief. If elected, an NFP would not need to reassess the following at adoption:
- Whether any expired or existing contracts are or contain leases
- The lease classification for any expired or existing leases
- Initial direct costs for any existing leases
An NFP that elects the transition relief must adopt all three provisions for all leases and they may not be applied on a lease-by-lease basis. The relief package should not be applied to grandfather incorrect assessments determined under ASC 840. Organizations should ensure that an analysis of contracts for embedded leases has been performed under ASC 840 before using the practical expedient to carry over the conclusions upon adoption of ASC 842.
Other Transition Considerations
NFPs also should evaluate and consider the following matters upon adoption and transition to ASC 842:
- Entities may elect to use hindsight in evaluating lessee options to extend or terminate a lease in determining the lease term and assessing impairment of its ROU asset
- Entities may elect to not apply ASC 842 to existing or expired land easements that are not currently accounted for under ASC 840
- At the effective date, a lessee’s ROU asset is subject to impairment guidance in ASC 360, Property, Plant, and Equipment, which requires analysis of impairment indicators at each reporting date
- Whether the organization is involved in any build-to-suit leases where the lessee is involved in the construction or design of an underlying asset prior to lease commencement
- Methodology for quantifying minimum rental payments for the disclosures related to future operating lease commitments, specifically on the treatment of executory costs and lease payments that depend on an index or rate
For more detailed information related to these core concepts and transition considerations, see BKD article “ASC 842, Leases: September 2021 Update.”
Presentation & Disclosure
There are new qualitative and quantitative disclosures that should be considered upfront in the planning process for implementation of ASC 842. See BKD article “Lease Presentation & Disclosure Requirements: Lessee” for more detailed information on this topic.
ASC 842 adoption will be complex and likely will require significant hours to correctly implement. BKD can help educate your team, provide implementation tools, and assist with analysis and documentation. If you would like assistance in complying with ASC 842, contact your BKD Trusted Advisor™. BKD has prepared a library of BKD Thoughtware® on this issue. Visit our website to learn more.