Chapter 1 — Overview
Chapter 1 — Overview
1.1 Background
Legacy lease accounting guidance under U.S. GAAP and IFRS® Accounting
Standards was often criticized as being too reliant on bright lines
and subjective judgments. Many believe that such reliance
historically led entities to account for economically similar
transactions differently and has presented opportunities for
entities to structure transactions to achieve a desired accounting
effect. Such criticism prompted the SEC — in its 2005 report on
off-balance-sheet arrangements — to recommend that the FASB
undertake a project on lease accounting. The FASB and International
Accounting Standards Board (IASB®) added lease accounting
to their agendas in 2006 as part of their Memorandum of
Understanding to work toward convergence.
The primary objective of the leases project was to address off-balance-sheet financing concerns related to lessees’ operating leases. However, it proved to be no small task to develop an approach under which all operating leases must be recorded on the balance sheet. During the process, the FASB and IASB had to grapple with questions such as (1) whether an arrangement is a service or a lease, (2) what amounts should be initially recorded on the lessee’s balance sheet for the arrangement, (3) how to reflect the effects of leases in the lessee’s statement of comprehensive income (a point on which the FASB and IASB were unable to converge), and (4) how to apply the resulting accounting in a cost-effective manner.
After working for more than a decade, in 2016, the FASB issued its standard on
accounting for leases, ASU 2016-02 (codified
as ASC 842) while the IASB issued its own leasing standard, IFRS 16.
The timeline below depicts the stages in the boards’ development of
their leasing guidance, beginning with the FASB’s issuance of
Statement 13 in 1976.
1.1.1 Lease Accounting Timeline
Although the project was initially a convergence effort
and the boards conducted joint deliberations, there are several
notable differences between ASC 842 and IFRS 16. We have highlighted
those differences throughout this publication.1
Footnotes
1
See Appendix B for a
summary of the differences between ASC 842 and IFRS
16.
1.2 Overview
ASC 842-10
05-1 The Leases Topic includes the following Subtopics:
- Overall
- Lessee
- Lessor
- Sale and Leaseback Transactions
- Leveraged Lease Arrangements
05-2 The Subtopics listed in paragraph 842-10-05-1 establish the requirements of financial accounting and
reporting for lessees and lessors.
10-1 This Topic specifies the
accounting for leases. An entity should consider the terms
and conditions of the contract and all relevant facts and
circumstances when applying this Topic. An entity should
apply this Topic consistently to leases with similar
characteristics and in similar circumstances.
10-2 The objective of this Topic is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease.
The most significant change in ASU 2016-02 is its lessee model that brings most leases on the balance sheet. The ASU also addresses other concerns related to the lessee accounting model in ASC 840. For example, it eliminates the required use of bright-line tests for determining lease classification, thus eliminating a potential source of structuring. Furthermore, ASU 2016-02 aligns certain of the underlying principles of lessor accounting with those in ASC 606, the FASB’s revenue standard (e.g., up-front profit recognition through a sales-type lease is governed by whether control of the underlying asset is transferred to the lessee at lease commencement). The ASU also requires lessors to provide more transparent information about their exposure to the changes in the value of residual assets as well as how they manage that exposure.
The structure of the guidance in ASC 842 is depicted in the graphic below. This Roadmap is designed with this structure in mind.
ASU 2016-02 is effective for (1) public companies in periods beginning after
December 15, 2018; (2) certain public NFPs2 in periods beginning after December 15, 2019; and (3) all other
entities in periods beginning after December 15, 2021 (because of the
deferral in ASU 2020-05, which was issued in June 2020). It represents
a wholesale change to lease accounting; as a result, many entities
have faced significant implementation challenges during the periods
leading up to the effective date and beyond.
Footnotes
2
The deferral provided by ASU
2020-05 applies to public NFPs
that have not issued financial statements or made
financial statements available for issuance as of
June 3, 2020. Public NFPs that have issued
financial statements or have made financial
statements available for issuance before that date
must comply with the effective dates prescribed
for public companies above.
1.3 Key Provisions
The table below highlights some of the key provisions of ASU 2016-02 and
includes links to sections of this Roadmap that discuss these provisions in more
detail.
Key Provision
|
ASU 2016-02
|
---|---|
Scope
|
The scope of ASC 842 includes leases of all
property, plant, and equipment (PP&E) and excludes:
|
Identifying a lease
|
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.“
|
Components of a contract
|
An entity is generally required to identify
the lease and nonlease components of a contract that
contains a lease. A contract may also contain multiple lease
components. The right to use an underlying asset is
considered a separate lease component if (1) a lessee can
benefit from the use of the underlying asset either on its
own or together with other resources that are readily
available and (2) the underlying asset is not highly
dependent on or highly interrelated with other assets in the
arrangement.
When a contract includes multiple
components, an entity is generally required to allocate the
consideration in the contract to the various components. The
guidance for lessors on allocating the consideration in the
contract is separate from that for lessees.
|
Lease term
|
The lease term is the noncancelable period
in which the lessee has the right to use an underlying asset
together with optional periods (1) for which it is
reasonably certain that the lessee will exercise the renewal
option or not exercise the termination option or (2) covered
by an option to extend (or not to terminate) the lease in
which the exercise of the option is controlled by the
lessor. Lessees will be required to reassess the lease term
after lease commencement in certain circumstances; however,
lessors are not required to reassess the lease term unless
the lease is modified and the modified lease is not a
separate contract.
|
Lease payments
|
Lease payments include:
Lease payments do not include variable lease
payments that are based on the usage or performance of the
underlying asset (e.g., a percentage of revenues).
|
Discount rate
|
Lessees use the rate charged by the lessor
(i.e., the rate implicit in the lease) if that rate is
readily determinable. If that rate is not readily
determinable, lessees will use their incremental borrowing
rate as of the date of lease commencement.
Lessors use the rate they charge the
lessee.
Private-company lessees can elect to use a
risk-free rate.
|
Lessee accounting
|
As of the lease commencement date, a lessee
recognizes:
The lessee will use the effective interest
rate method to subsequently account for the lease
liability.
Two approaches are used for subsequently
amortizing the ROU asset: (1) the finance lease approach and
(2) the operating lease approach. Under the finance lease
approach, the ROU asset is generally amortized on a
straight-line basis. This amortization, when combined with
the interest on the lease liability, results in a
front-loaded expense profile in which interest and
amortization are presented separately in the income
statement. By contrast, the operating lease approach
generally results in a straight-line expense profile that is
presented as a single line item in the income statement.
The determination of which approach to apply
is based on lease classification criteria that are similar
to the requirements in IAS 17.
|
Lessor accounting
|
The lessor accounting model retains the
approach for operating and capital/ finance (direct
financing and sales-type) leases.
However, the lease classification criteria
will change, and the treatment of selling profit, if any,
will be affected:
Leveraged lease accounting is eliminated
going forward (i.e., existing leveraged leases are
grandfathered).
|
Lease modifications
(Chapters 8 and
9)
|
A lease modification is any change to the
contractual terms and conditions of a lease that results in
a change in the scope of or the consideration for a
lease.
|
Sale-and-leaseback transactions
|
A transaction is accounted for as a
sale-and-leaseback transaction when control of the
underlying asset is transferred from the seller-lessee to
the buyer-lessor in accordance with ASC 606. In addition to
the control transfer principle in ASC 606, the transfer of
the underlying asset is not considered a sale if either of
the following conditions is met:
If control of the underlying asset is
transferred to the buyer-lessor, the transaction is
accounted for as a sale and leaseback and the entire gain on
the transaction would be immediately recognized.
|
While the FASB published ASU 2016-02 in 2016, it has amended certain of the
ASU’s original requirements over time both in an attempt to provide relief from the
costs of implementing the standard and in response to stakeholder feedback. The FASB
also continues to monitor companies’ implementation of the leasing standard’s
requirements as part of its ongoing postimplementation review process.
See Chapter 17 for more information on recent FASB activities.