Lease Accounting: Lessees (Users) & Lessors (Owners)

Lease Accounting: Lessees (Users) & Lessors (Owners) John D Rossi III MBA, CPA CMA, CFM, CFP 1,000 Postal Road; Suite 90025 Allentown, PA 18109 (610) 502-0674

Introduction (lessees) • Prior guidance under ASC 840 (FASB 13) required lessees to classify leases as either capital or operating. • Lessees recognized assets and liabilities for capital leases only. • Expenses related to capital leases consisted of interest expense on a straight line basis and depreciation of the underlying leased asset. • Expenses related to operating leases required no capitalizing of the asset nor recognition of a liability. • Operating leases were generally recognized on a straight line basis over the term of the lease.

Introduction • Critics of the existing system complained that users of financial statements could not understand the entity’s leasing activities. • Existing literature does not provide users with the understanding of the cost of leased property nor the related liability. • Financial statement users frequently had to utilize the disclosures to perform financial statement analysis. • Users of financial statements were often unable to determine how leasing activity was being funded.

Introduction • In 2008, FASB and the IASB initiated a joint project to develop a new lease accounting standard. At the conclusion the FASB and IASB did not end up the same standard. • Although the focus was on accounting by lessees, the 2 boards considered the impact on both lessors and lessees in the new standard. • The FASB intended that lessor accounting would work in tandem with the new ASC 606, Revenue from Contracts with Customers. The final standard did not accomplish this objective. • The FASB issued ASC 842 in February 2016. • Whereas the IASB chose to eliminate dual lease reporting (financing [capital] & operating) and all leases became capital, FASB chose to retain a dual lease accounting model.

Introduction • Under the FASB model as prescribed in ASC 842, lessees will classify leases as finance (capital) or operating leases while lessors will classify leases as either sales-type, direct financing, or operating. • Lessees will now classify leases based on whether the arrangement is effectively a purchase of the underlying asset based on “transfer of control.” • Leases that transfer “control” of the asset to the lessee will be classified as finance (capital) (most equipment leases) and all other leases will be classified as operating (most real estate leases). • In operating leases, the lessee obtains control of only the “use of” the asset but does not obtain control of the underlying asset itself.

Introduction • The dual model does not impact the initial recognition of the asset and liability on the balance sheet, but differentiates how a lessee should recognize lease expense in the income statement. • Accounting for lessors remains largely unchanged by the new standard for US GAAP. • Interest and depreciation will continue to be recognized under capital leases. • Straight line single line lease expense will continue to be recognized for operating leases. • Operating lease expense will continue to be reported as a single line item under cash flow from operations for cash flows purposes.

Introduction • FASB concluded that a lessee’s obligation to make lease payments meets the definition of a liability as described in FASB Concept Statement No. 6. • It involves a present obligation that arises from a past event and the obligation is expected to result in a future economic benefit. • FASB believes that a lessee’s right to use an asset during the lease term meets the definition of an asset in Concept Statement No. 6. • Despite owning the asset during the lease term, the lessor typically cannot use the underlying asset or even gain access to it without lessee consent.

Scope of Guidance • The lease arrangement must convey the use of an asset from one party to another without transferring actual ownership. • ASC 842 identifies arrangements that are to be accounted for as leases. • Exceptions to applying the new lease accounting standard: • Leases of intangible assets subject to ASC 350 • Leases for exploration of natural resources including oil and gas • Leases of biological assets (such as plants and animals) • Leases of inventory • Leases of assets under construction • Short term leases (durations less than 12 months)

Scope of Guidance • Under ASC 842-20-25-2, a lessee may elect not to apply the recognition requirements of ASC 842 to short term leases. • The election must be made by asset class. • If elected, lease payments are expensed to operations on a straight line basis. • Variable lease payments are to be recorded in the period that the obligation for the payment is incurred. • The existence of a renewal or termination option will require the lessee to determine at lease commencement the length of the lease term based on “reasonable certainty” of the renewal or termination occurring.

Scope of Guidance • A lease requires that one party obtain the “right of use” of an asset legally owned by another party. • The lessee has control over economic resources and will benefit from the use of the asset. • The right of use of an asset may not necessarily be documented in a formal lease, yet a lease exists under the new standard. Such rights may exist as part of service contracts or supplier arrangements. • For example, a supplier contract for materials wherein use of an asset is conditional upon the purchase of a particular raw material • Companies must analyze arrangements to see if a lease exists. Multiple arrangements may be aggregated to reflect a single transaction in determining if a leasing arrangement exists.

Scope of Guidance • To meet the definition of a lease, an arrangement MUST require the use of an “explicitly or implicitly” identified asset that is physically distinct. • If a contract explicitly identifies the asset but contains contractual terms that allow the supplier to fulfill the contract without the identified asset, the contract does not meet the definition of a lease. • The key consideration is whether the substitution right is substantive based on all facts and circumstances at the inception of the contract.

Scope of Guidance • Contracts that do not explicitly identify the asset may nonetheless meet the definition of a lease through “implicitly” identified assets. • If it is understood that only one asset can meet the requirements of the contract due to economic or legal factors, the asset is considered implicitly identified. • An asset may be implicitly identified because it cannot be physically relocated due to logistic challenges to be encountered by entering the customer’s space to substitute equipment. • If the contract gives the supplier substantive substitution rights, the contract may be determined to fail the specific asset identification test.

Scope of Guidance • Once the asset has been identified, the parties to the transaction must evaluate whether the customer controls the “use of” the asset. • Arrangements that do not pass control of the asset do not meet the definition of a lease agreement, even if the asset is specifically identified. • ASC 842 defines control of an asset as: • The right to obtain substantially all of the economic benefits from use of the identified asset • The right to direct the use of the identified asset • Control may occur over a consecutive period, nonconsecutive periods or only a portion of the term of the contract.

Scope of Guidance • Lease contracts may contain nonlease components that should be accounted for using other accounting models (e.g. common area maintenance, security services, etc.) • Only components that are “integral to the right of use of the asset” are considered lease components. • For example, the lease payment may include service agreements, supply agreements, etc. that are not a part of the basic lease • ASC 842 requires an allocation of the contract to the various lease and nonlease components. • No asset is recorded in relation to nonlease components.

Scope of Guidance • To be a component of a lease agreement, an activity must transfer a good or service. The transfer of the right of use of the asset is considered one component. • Only items that contribute to securing the output of the asset are lease components. As such: • The portion of a payment related to the actual right of use of the asset is a lease component • The portion of a payment related to maintenance, materials, or supplies is a nonlease component • Costs related to securing the asset (insurance, real estate taxes) should be included in the lease payments if part of the fixed lease payment for purposes of classifying and measuring the lease.

Scope of Guidance • Contractual considerations must be allocated by lessees between components and noncomponents. • According to ASC 842 • The lessee shall determine the relative standalone price of the separate lease components and the nonlease components on the basis of their observable standalone prices. If not available, the lessee shall estimate the standalone prices, maximizing the availability of observable information. • The lessee shall allocate the consideration in the contract on a relative standalone price basis to the separate lease components and the nonlease components of the contract.

Scope of Guidance • Lessees may elect an accounting policy by asset class to include both the lease and nonlease components as a single component and account for it as a lease. • This election eliminates the need to calculate the lease value using a pricing allocation model. • This election will increase both the asset and liability on the balance sheet. • This option is not available for lessors.

Lease Classification • Under ASC 842, virtually all leases will require balance sheet recognition. • Determination of capital vs. operating leases is crucial as it drives the subsequent ongoing accounting for the lease activity. • When lease terms effectively transfer control of the underlying asset to the customer, the lease represents a financed purchase and the lease is to be accounted for as a finance (capital) lease. • When lease terms do not transfer control of the underlying asset to the customer but simply a “right of use”, the lease is to be accounted for as an operating lease.

Lease Classification • Related party leases must be accounted for in accordance with this standard. • The classification of the lease is to be made on the date the lessor makes the underlying asset available for use by the lessee, this may not be the lease commencement date. • The classification approach is similar to previous guidance. • If any of the five criteria specified at ASC 842-10-25-2 are met, a lessee should classify the lease as a finance (capital) lease. • Failng the five criteria test, an operating lease exists for the lessee.

Lease Classification • The five criteria • A lease is considered a finance type if ownership of the underlying asset transfers to the lessee by the end of the lease term. This criteria is met if a nominal fee is due at the conclusion of the lease. • If a lease contains an option to purchase and the option is “reasonably certain” to be exercised by the lessee, a finance lease exists. The purchase option should be evaluated to determine if it represents significant economic incentive such as the lessee is reasonably certain exercise it.

Lease Classification • If the lease term is for the major part of the remaining economic life of the asset, the lessee has effectively obtained control of the asset. Thus the lease is a finance lease • The bright line tests of ASC 840 are gone. • Despite removal of the bright line tests, the FASB indicated that use of the greater than 75% of the underlying asset’s remaining economic life may be used as a consideration. • Renewal or termination options considered reasonably certain of being exercised should be included in the lease term during this analysis. • Potential exercise of lease options is made under a facts and circumstances test.

Lease Classification • If the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair market value of the underlying asset then a finance lease exists. • Although the bright line test is eliminated it is still appropriate to consider if the lease payments will be greater than 90% of the underlying asset’s fair market value. • Variable lease payments that depend on an index or a rate should be included in the calculation of lease payments when classifying the lease and measuring the lease liability. • Variable lease payments dependent on other factors should not be included in lease payments for purposes of lease classification and measurement.

Lease Classification • Discount rates to be used for classification and liability measurement should be based on the interest rate implicit in the lease. • When the implicit lease rate cannot be determined, the lessees should utilize their incremental borrowing rate for purposes of classification and measurement. • ASC 842-20-30-3 permits a nonpublic business entity to use the risk free rate for a period comparable to the lease term. • Use of the risk free rate as determined by government securities • The use of a risk free rate will be lower than the incremental borrowing rate resulting in a larger asset and liability amount on the balance sheet.

Lease Classification • Leases for assets of a specialized nature such that they have no viable alternative use to the lessor at the end of the lease term result in classification of the lease as a financing type lease. • The analysis should consider whether any contractual restrictions or practical limitations on the lessor’s ability to change or redirect the use of the underlying asset.

Accounting for Leases • Initial classification of the lease between operating and finance does not impact the initial balance sheet entry. • However, classification of the lease has a significant impact on the subsequent accounting over the life of the lease. • At inception, lessees record a “right of use” asset and a lease liability for all leases that at inception have a lease term 12 months or greater (assuming the company adopts the short term lease exception).

Accounting for Leases • On commencement date, the lessee is required to measure and record a lease liability equal to the present value of the remaining lease payments, discounted using the implicit lease rate (or incremental borrowing rate). • Such lease liability excludes payments made prior to lease inception. • Lease payments used for measurement are the same used for classification purposes except for: • Classification includes lease payments made before commencement date whereas measurement does not. • Classification includes entire potential payment under a residual value guarantee whereas measurement includes only amounts probable of being owed by the lessee under the residual value guarantee.

Accounting for Leases • At the lease commencement date, the right of use asset is recorded and shall consist of the following: • The amount of measurement of the initial lease liability • Any lease payments made by the lessor at or before the commencement date less any lease incentives received. • Any initial direct costs incurred by the lessee. • Lease payments made prior to lease commencement date should be recorded as prepaid rent and reclassified to the right of use asset upon commencement. • Initial direct costs only include costs that would not have been incurred but for the lease.

Accounting for Leases • Over the lease term, the lessee must amortize the right of use asset and record interest expense on the lease liability created at lease commencement. • The income statement presentation is determined by the lease classification. • Finance leases are accounted for in a manner similar to financed purchases. Interest expense is recorded in connection with the lease liability. The right of use asset is depreciated to depreciation expense using straight line method over the shorter of the useful life of the asset or the lease term.

Accounting for Leases • When a lease is classified as a finance lease due to a purchase option reasonably expected to be exercised, the lessee is required to factor the additional lease payment into the liability. • Interest is calculated on the full amount of the liability which includes the present value of the purchase option payment. • The right of use asset should be amortized over the useful life of the asset rather than the lease term.

Accounting for Leases • When a lease is classified as an operating lease, the expense must be recorded as a single line item on the income statement using the straight-line basis over the term of the lease. • The lessee should compute the periodic straight line expense at the lease commencement date based on the following components divided by the lease term: • The initial amount of the lease liability; plus • Any lease payments made at or before the commencement date; plus • Any indirect costs incurred by the lessee; plus • Any lease incentives received

Accounting for Leases • The amortization of the right of use asset is the difference between the straight-line lease expense as computed above and the interest expense reflected on the lease liability each period. • Thus, the right of use asset cannot simply be recorded in the fixed asset software and amortized on a straight line basis. • The periodic amortization of the right of use asset will be the amount necessary to adjust the calculated interest expense on the liability to a straight line amount over the term of the lease. • As interest expense declines over the lease term, amortization of the underlying right of use asset will increase proportionally.

Accounting for Leases • Right of use assets are subject to the impairment guidance found at ASC 360 as applied to all other elements of property, plant and equipment. • If a lessee records an impairment charge related to a right of use asset under a finance lease, it must revise the amortization expense by calculating a new straight line amortization using the revised asset value. • If there is an impairment charge to a right of use asset under an operating lease, it would not impact the value of the recorded lease liability absent a modification to the lease terms or renewal options.

Accounting for Leases • Once the right of use asset for an operating lease is impaired, the lease expense will no longer be recognized on a straight line basis. • A lessee should continue to amortize the lease liability using the same effective interest method as before the impairment charge. • The right of use asset should subsequently be amortized on a straight line basis similar to that used for a finance leased asset impairment despite the fact the lease is still deemed an operating lease.

Presentation and Disclosure • The objective of disclosure is to enable financial statement users to understand the amount, timing and uncertainty of cash flows arising from leases. • Lessees and lessors must disclose both qualitative and quantitative information about their leases, significant judgments made in applying the lease guidelines, and amounts recognized in the financial statements related to those leases. • The presentation of assets and liabilities for all types of leases is similar for lessees. • The presentation of expenses and cash flows will differ based on the classification of the lease.

Presentation and Disclosure • According to ASC 842-20-45-1, a lessee must present in the statement of financial position or disclose in the notes all of the following: • Finance lease right of use assets and operating lease right of use assets separately from each other and separately from other assets. • Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities. • The classification of right of use assets and liabilities between current and noncurrent shall be subject to the same considerations as given to other nonfinancial assets and financial liabilities in classified statements of financial position.

Presentation and Disclosure • Finance and operating lease right of use assets should either be presented separately from each other and other assets on the balance sheet or disclosed in the notes to the financial statements along with the balance sheet line items in which those assets are included. • ASC 842-20-45-1 permits disclosure in the notes in lieu of separate balance sheet presentation on the balance sheet, however ASC 842-20-45-3 prohibits combining finance lease and operating lease right of use assets on the balance sheet. • Initial direct costs should be included in the initial measurement of the right of use asset.

Presentation and Disclosure • Finance lease and operating lease liabilities should be presented separately from each other and other liabilities on the balance sheet or disclosed in the notes to the financial statements along with the balance sheet line items in which those liabilities are included. • Although ASC 842-20-45-1 permits disclosure in the notes in lieu of separate presentation on the balance sheet, ASC 842-20-45-3 prohibits combining finance lease and operating lease liabilities on the balance sheet.

Presentation and Disclosure • ASC 842-20-45-4 discusses lease presentation in the income statement as follows: • A lessee shall present both of the following • For finance leases, the interest expense on the lease liability and amortization of the right of use asset are required to be presented as separate line items and shall be presented in a manner consistent with how the entity presents other interest expense and depreciation or amortization of similar assets, respectively. • For operating leasers, lease expense shall be included in the lessee’s income from continuing operations. • For finance leases, existing practice continues. For operating leases, a single operating line item will be reflected. A lessee is not required to provide the components of lease expenses.

Presentation and Disclosure • Statement of Cash Flows: • A lessee should classify cash payments with respect to finance leases as follows • Cash payments of principal should be classified as financing activities • Cash payments of interest should be classified as operating activities • Variable lease payments and short-term lease payments not included in the lease liability should be classified as operating activities • A lessee should classify cash payments with respect to operating leases as operating activities.

Presentation and Disclosure • Qualitative disclosures include: • A general description of the lease. • The basis and terms and conditions on which variable lease payments are determined. • The existence of terms and conditions of options to extend or terminate the lease. A lessee should provide narrative disclosure about the options that are recognized as part of its right of use assets and lease liabilities and those that are not. • The existence of terms and conditions of residual value guarantees provided by the lessee. • Restrictions or covenants imposed by leases for example those relating to dividends or incurring additional financial obligations.

Presentation and Disclosure • Additional qualitative disclosures: • Information about leases that have not yet commenced but that create significant rights and obligations for the lessee including involvement with any construction or design of an asset. • Information about significant assumptions and judgments made in applying the lease standard which may include. • The determination of whether a contract contains a lease • The allocation of consideration in a contract between lease and nonlease components • The determination of the discount rate for the lease • The election of the short term lease exception.

Presentation and Disclosure • expenses relating to leases with a lease term of one month or less, determined in accordance with the standard. • ASC 842-20-50-4 mandates that for each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other topics in GAAP, and cash flows arising from lease transactions: • For finance lease cost, segregated between the amortization of the right of use asset and interest on the lease liabilities. • Operating lease cost determined in accordance with the standard. • Short-term lease cost, excluding

Presentation and Disclosure • Continued: • Variable lease cost determined in accordance with the standard • Sublease income disclosed on a gross basis, separate from the finance or operating lease expense • Net gain or loss recognized from the sale and leaseback transactions • Amounts segregated between those for finance and operating leases for the following: • Cash paid for amounts included in the measurement of lease liabilities segregated between operating and financing activities • Supplemental noncash information on lease liabilities • Weighted average remaining lease term • Weighted average discount rate

Presentation and Disclosure • Both buyers and sellers should disclose terms of any sale-leaseback transaction. • Any leveraged lease components should be disclosed. • Activities and leases with related parties should be disclosed. • Transitional disclosures as required by ASC 250 Accounting Changes and Error Correction.

Effective Date • Public entities (includes not for profit entities that have issued securities that are traded and employee benefit plans that furnish financial information to the SEC) are required to implement for fiscal years beginning after 12/15/18. • Nonpublic entities are required to implement for fiscal years beginning after 12/15/19. • Upon adoption, a modified retrospective approach is required for each lease that existed at the beginning of the earliest comparative period presented in the financial statements as well as for leases entered into after that date.

Transitional Guidance • If a lease was classified as an operating lease under the old guidance, and will continue as such the lessee should recognize a right of use asset and lease liability at the later of the earliest period presented or the lease commencement date. • The lease liability should be the present value of the sum of the remaining minimum rental payments and any amounts probable of being owed by the lessee under a residual value guarantee. • The discount rate used to calculate the present value should be determined at the later of the earliest period presented or the lease commencement date. • Prior capital leases remain largely unchanged other than the reclassification of the asset as a right of use asset.

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Lease Accounting: Lessees (Users) & Lessors (Owners)