14.2 Lessee
14.2.1 Statement of Financial Position
ASC 842-20
Statement of Financial Position
45-1 A lessee shall either 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 from other assets
- Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities. . . .
45-2 If a lessee does not present finance lease and operating lease right-of-use assets and lease liabilities separately in the statement of financial position, the lessee shall disclose which line items in the statement of financial position include those right-of-use assets and lease liabilities.
45-3 In the statement of financial position, a lessee is prohibited from presenting both of the following:
- Finance lease right-of-use assets in the same line item as operating lease right-of-use assets
- Finance lease liabilities in the same line item as operating lease liabilities.
A lessee must present in the statement of financial position (or disclose in the
notes thereto) (1) finance lease ROU assets separately from operating lease ROU assets and
(2) finance lease liabilities separately from operating lease liabilities. The rationale
for separate presentation is that the lease classifications differ with respect to the
subsequent-measurement patterns for their respective assets and, in the Board’s view,
represent economically different transactions. In addition, as discussed in paragraph BC57
of ASU 2016-02, finance lease liabilities
may not be presented with operating liabilities because finance lease liabilities are the
equivalent of debt and are generally treated as such in the event of an entity’s
bankruptcy. ASC 842 does not specifically prescribe which financial statement line item is
appropriate for presentation (e.g., separate presentation of finance-lease ROU assets in a
PP&E financial statement line item).
Connecting the Dots
Balance Sheet Presentation Is Favorable for
Debt Covenants
Preparers may be in favor of the requirement to present finance leases
separately from operating leases because this requirement may reduce an entity’s
exposure to potential debt covenant violations that could have resulted if the entity
was required to characterize all lease liabilities as debt. See Section 8.1.1 for more
information.
While the standard does not require distinct presentation on the face of the
statement of financial position, the assets and liabilities related to each lease
classification must be presented separately (i.e., in either distinct or separate
financial statement line items). A lessee that discloses the amounts in the notes must
also disclose in which financial statement line items the amounts are included in the
statement of financial position.
Connecting the Dots
SEC Regulation S-X Requirements Related to
Separate Presentation of Assets and Liabilities
SEC Regulation S-X, Rule 5-02, requires registrants to separately present, in
the balance sheet or a note thereto, (1) “other assets” that are in excess of 5
percent of total assets and (2) any item in excess of 5 percent of other current
liabilities and any other liability in excess of 5 percent of total liabilities.
Although these SEC Regulation S-X requirements do not appear to mandate any
disclosures that are not already prescribed by ASC 842, companies should nonetheless
consider the requirements in evaluating whether separate presentation on the face of
the financial statements is warranted.
14.2.1.1 Considerations Related to Presentation of ROU Assets and Lease Liabilities in a Classified Statement of Financial Position
ASC 842-20
Statement of Financial Position
45-1 . . . Right-of-use assets and lease liabilities shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in classified statements of financial position.
14.2.1.1.1 Presentation of ROU Assets in a Classified Statement of Financial Position
As stated above in ASC 842-20-45-1, the ROU asset “shall be subject
to the same considerations as other nonfinancial assets . . . in classifying them as
current and noncurrent in classified statements of financial position.” Therefore, an
entity that presents a classified balance sheet is not required to classify its ROU
assets as current and noncurrent. Entities typically exclude depreciated or amortized
assets (e.g., PP&E and intangible assets, respectively) from current assets in
accordance with ASC 210-10-45-4(f). Under ASC 842, ROU assets must be amortized and
are therefore akin to other amortizable assets.
14.2.1.1.2 Presentation of Lease Liabilities in a Classified Statement of Financial Position
As stated above in ASC 842-20-45-1, “lease liabilities shall be
subject to the same considerations as other . . . financial liabilities in classifying
them as current and noncurrent in classified statements of financial position.”
Therefore, an entity that presents a classified balance sheet must classify its lease
liabilities as current and noncurrent. ASC 210-10-45-6 states, in part, that the
“concept of current liabilities includes estimated or accrued amounts that are
expected to be required to cover expenditures within the year for known obligations.”
Therefore, an entity should classify the portion of its lease liabilities that it
expects to be required to pay within the year (or the entity’s operating cycle) as a
current liability.
As illustrated in the example below, the calculation of the current
portion of the liability includes the portion of the lease payments that will be
applied to the liability’s principal over the next 12 months. This observation is
consistent with the guidance in ASC 210-10-45-9, which states, in part, that current
liabilities should include “[o]ther liabilities whose regular and ordinary liquidation
is expected to occur within a relatively short period of time, usually 12 months.”
Example 14-1
On December 31, 20X2, Company X, a lessee, commenced a
lease with a term of three years and an annual lease payment of $4,660 due
on each anniversary of the commencement date. Company X uses a year (12
months) to classify other current assets and liabilities in its classified
balance sheet in accordance with ASC 210. After discounting the lease
payments at a discount rate of 8 percent, X determines that (1) its total
lease liability is $12,009 and (2) $3,699 of the liability will be paid
within one year from the balance sheet date. As of December 31, 20X2, X
classifies $3,699 as a current liability and the remaining $8,310 as a
noncurrent liability when it presents its classified balance sheet.
The table below illustrates the calculation of the
current liability in each year of the lease term by using an approach in
which the current portion of the liability is equal to the payment amount
to be applied to the liability’s principal.
In addition to the approach described above, we are aware of certain
alternatives that entities may apply in determining the current portion of the lease
liability. We recommend that entities consult with their accounting advisers in
evaluating the reasonableness of any alternative applied.
14.2.1.1.3 Considerations When the Current Portion of a Lease Liability Would Be Negative
Section
6.2.2 discusses certain lease agreements that may include provisions
requiring lessors to make payments to lessees during the lease term (e.g.,
contractual lease incentives in the form of reimbursements for leasehold
improvements). These lease incentives reduce a lessee’s total lease payments during
the lease term. In some circumstances, for example, when in conjunction with a
rent-free period at the beginning of a lease, it is possible that a lessee could
expect to receive lease incentives within one year from the balance sheet date that
exceed the fixed rental payments (i.e., outflows) due within that same period,
resulting in a net cash inflow for the next 12 months of the lease term. ASC
842-20-45-1 states that “lease liabilities shall be subject to the same
considerations as other . . . financial liabilities in classifying them as current
and noncurrent in classified statements of financial position.” However, there is
limited guidance in other GAAP that applies to the classification of a financial
liability with a current portion that is a net cash inflow in the next 12 months.
In these situations, there is diversity in practice. We are aware of the following
two approaches that entities have applied in such circumstances:
-
Noncurrent lease liability — Under this common approach, an entity presents the entire lease liability, including the net cash inflow in the next 12 months, as a noncurrent lease liability. As discussed in Sections 6.2.2 and 8.5.3.2, lease incentives to be received during the lease term are lease payments that entities may treat1 as reductions of the lease liability. Because a lease arrangement is a single contract, the associated lease liability may be considered a single unit of account; accordingly, it is acceptable to present the lease liability as a single noncurrent lease liability even when the next 12 months are expected to yield a net cash inflow (i.e., representing a present right to receive cash). Supporters of this view believe that the arrangement is analogous to an unexercised draw-down of future debt in a manner consistent with the presentation guidance in ASC 842-20-45-1, which states that the “lease liabilities shall be subject to the same considerations as other . . . financial liabilities.” Accordingly, proponents of this view think that it is appropriate to present a lower noncurrent liability as of the balance sheet date since the lease liability is a single unit of account that, like a financial liability, the entity has the intent to repay over a term greater than 12 months and for which the obligation to repay that higher amount over the long term has not yet occurred. That is, when the cash is received, the noncurrent (financial) liability will increase to the amount of the expected future cash flows calculated in the lease’s amortization table.
-
Present current portion (to be received) as a current receivable — Another acceptable approach in our view is one in which an entity presents cash flows representing the current portion (i.e., the net cash inflow for the next 12 months) as a current asset (receivable). The ASC master glossary defines current assets as “other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.” This definition supports the view that entities that are party to these leasing arrangements have a contractual right to receive cash in the normal operating cycle (i.e., within the next 12 months) and may record a current asset that provides a faithful representation of liquidity for the next 12 months. This view is similar to our views on classifying derivatives in hedging relationships with multiple settlements. That is, we believe that the amounts related to (all) the cash flows that must occur within one year of the balance sheet date would represent the current asset or current liability (see Section 6.2.2 of Deloitte’s Roadmap Hedge Accounting for more information).
We do not believe that it would be appropriate for a lessee to net
the current receivable associated with one lease arrangement against other
short-term lease liabilities from other lease contracts. In other words, when
applying the current receivable approach, an entity must present an asset as current
either separately or within an appropriate asset category. Also, in both approaches,
entities must present a current portion of a lease liability in accordance with the
approach outlined in Section
14.2.1.1.2 once there is no longer a net cash inflow under the lease
arrangement for the next 12 months.
The example below illustrates a leasing arrangement in which a lessee must
determine the classification of a lease liability that includes lease incentives to
be received in the next 12 months in excess of fixed rental payments (i.e.,
outflows) to be made to the lessor in the next 12 months (i.e., the current portion
is a net cash inflow).
Example 14-2
Company A (Lessee) is party to a 10-year lease for an
office building with Landlord B (Lessor). The lease commencement date is
July 1, 20X1. The lease contains an 18-month free rent holiday between
July 1, 20X1, and December 31, 20X2; accordingly, fixed rental payments
commence on January 1, 20X3, and continue until the end of the lease
term. As an incentive for signing the lease, Lessor will provide Lessee
with $10 million in reimbursements for leasehold improvements that
Lessee is planning on making to the property. While Lessee must submit
receipts for eligible expenditures to Lessor on or before June 31, 20X2
(for payment on July 15, 20X2), Lessee has an expenditure budget greater
than $15 million and, upon lease commencement, has determined that it is
probable that it will receive the entire $10 million lease improvement
allowance. Further, Lessee has elected a policy of including the
leasehold improvement allowance in the measurement of the lease
liability upon commencement. Assume that other than fixed rental
payments commencing on January 1, 20X3, and the leasehold improvement
allowance to be received by Lessee, no other lease payments are included
in the contract.
As of lease commencement, Lessee has concluded the following:
- The reimbursements received from Lessor represent lease incentives for leasehold improvements (rather than reimbursements for landlord-owned assets).
- Lessee is reasonably certain to complete the construction of leasehold improvements and receive 100 percent of the $10 million of reimbursements on July 15, 20X2. In a manner consistent with the discussion in Section 8.5.3.2, Lessee elects an accounting policy of including the lease incentive of $10 million within lease payments. Because Lessee believes that it is probable at lease commencement that the payments will be received, there is a reduction in the ROU asset and the lease liability.
- The lease is classified as an operating lease.
During the initial 18-month “free” rent period, the lease contract does
not require Lessee to make rental payments to Lessor, and the only lease
payment included in the measurement of the lease liability is the $10
million lease incentive expected to be received (a cash inflow to
Lessee) on July 15, 20X2, which results in a net cash inflow as of
December 31, 20X1. In preparing the annual financial statements as of
December 31, 20X1, Lessee may present the entire lease liability —
including the measurement of (1) the $10 million lease incentive
receivable and (2) all contractual fixed rent payments commencing on
January 1, 20X3, and through the end of the lease term — as a noncurrent
lease liability.
It would also be acceptable for Lessee to present the measurement of
the net cash inflow in the next 12 months (i.e., the $10 million lease
incentive) as a current receivable and to separately present, as a
noncurrent lease liability, the measurement of the combined contractual
fixed rent payments commencing on January 1, 20X3, and continuing
through the end of the lease term.
As discussed above, because of the complexities associated with such lease
arrangements, we recommend that entities consult with their accounting advisers and
auditors when establishing an acceptable policy in such situations.
14.2.2 Statement of Comprehensive Income
ASC 842-20
Statement of Comprehensive Income
45-4 In the statement of comprehensive income, 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 not 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 leases, lease expense shall be included in the lessee’s income from continuing operations.
14.2.2.1 Finance Leases — Presentation of Interest Expense on the Lease Liability and Amortization Expense Related to the ROU Asset
The requirements for finance leases in ASC 842-20-45-4(a) with respect to presentation of interest expense and amortization expense are consistent with the capital lease presentation requirements under ASC 840-10-45-3. These provisions of ASC 842 are in line with the FASB’s view that a finance lease is economically similar to a financed asset purchase (i.e., the proceeds of a loan used to acquire an asset). Therefore, in a manner consistent with a financed purchase transaction, an entity would incur interest expense on its financing (loan) and would depreciate its asset acquired.
Connecting the Dots
Variable Lease Payments in Finance Leases
(or Sales-Type Leases and Direct Financing Leases)
ASC 842 is silent on the appropriate classification of variable lease expense arising from finance leases. Many preparers have asked whether such expense should be recognized as amortization, interest expense, or lease expense (in a manner similar to recognition of an operating lease expense). Because of the variable and often contingent nature of such expense and its exclusion from the balance sheet ROU asset and liability, it does not involve the amortization of an asset or, similarly, the accrual of interest against a liability balance. Therefore, questions have arisen about how this expense should be recognized once the variability or contingency is resolved (or is deemed probable in accordance with ASC 842-20-55-1) and recognized as an expense.
Paragraph BC271 of ASU 2016-02 states:
[T]he Board decided that cash flows from operating leases and variable lease payments that are not included in the lease liability should be classified as operating activities because the corresponding lease costs, if recognized in the statement of comprehensive income, will be presented in income from continuing operations. The previous sentence notwithstanding, Topic 842 states that lease payments capitalized as part of the cost of another asset (for example, inventory or a piece of property, plant or equipment) should be classified in the same manner as other payments for that asset. [Emphasis added]
Paragraph BC271 of ASU 2016-02 seems to indicate that, from the lessee’s
perspective, variable lease payments would be recognized in income from continuing
operations in a manner similar to operating lease expense. (By analogy, this could
also mean that variable lease payments from sales-type or direct financing leases
should be recognized as a component of income from continuing operations, rather
than as interest income.) Therefore, we believe that there is a basis for presenting
variable lease expense as lease expense (i.e., instead of as amortization or
interest).
However, we would accept presentation of variable lease expense in the statement of comprehensive income as either (1) interest expense or (2) a component of income from continuing operations (e.g., lease expense). (Similarly, we believe that lessors could present variable lease income related to payments that are not included in the initial measurement of a net investment in a sales-type or direct financing lease as either interest income or lease income.) Entities should disclose their presentation approach, if material.
14.2.2.2 Operating Leases — A Single Lease Expense
A lessee should evaluate its lease cost and, in a manner consistent with other types of expenses, should classify the single lease expense as cost of sales; selling, general, and administrative expenses; or another operating expense line item in the entity’s statement of comprehensive income.
14.2.2.2.1 Presentation of Lease Expense for Operating Leases With Impaired ROU Assets
As discussed in Section 8.4.4, when recognizing an impairment of an ROU asset associated
with an operating lease, a lessee subsequently amortizes the ROU asset by using a
finance lease model approach (i.e., the ROU asset is amortized on a straight-line
basis, and incremental expense is recognized under the effective interest method). In
accordance with ASC 842-20-25-7, while the recognition pattern changes for operating
leases after impairment (i.e., the finance lease exhibits a “front-loaded” expense
profile because a higher liability corresponds to higher interest in earlier periods
of the lease coupled with a straight-line amortization of the ROU asset), the
character of the expense does not. Specifically, ASC 842-20-25-7 states:
After a right-of-use asset has been impaired in accordance with
paragraph 842-20-35-9, the single lease cost described in paragraph 842-20-25-6(a)
shall be calculated as the sum of the following:
- Amortization of the remaining balance of the right-of-use asset after the impairment on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset
- Accretion of the lease liability, determined for each remaining period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability.
Despite the different pattern of expense recognition after impairment, an operating
lessee should not separately present its expense incurred between interest expense and
amortization of the ROU asset. Rather, these expenses must continue to be presented as
a “single” lease expense and must be included in the operating lessee’s income from
continuing operations in a manner consistent with its operating lease
classification.
Similarly, when a lessee recognizes a gain or loss upon the early termination of an
operating lease, the lessee should present that gain or loss within the “single” lease
expense in the operating lessee’s income from continuing operations.
14.2.3 Statement of Cash Flows
ASC 842-20
Statement of Cash Flows
45-5 In the statement of cash flows, a lessee shall classify all of the following:
- Repayments of the principal portion of the lease liability arising from finance leases within financing activities
- Interest on the lease liability arising from finance leases in accordance with the requirements relating to interest paid in Topic 230 on cash flows
- Payments arising from operating leases within operating activities, except to the extent that those payments represent costs to bring another asset to the condition and location necessary for its intended use, which should be classified within investing activities
- Variable lease payments and short-term lease payments not included in the lease liability within operating activities.
Upon commencement of an operating lease, a lessee records an ROU asset and a
lease liability. Such noncash activity should be disclosed (see Section 15.2.4.8). For operating leases, repayments of
liabilities should be classified in operating activities. Similarly, in a manner
consistent with the income statement presentation discussed in Section 14.2.2, when a lessee recognizes a gain or
loss upon the early termination of an operating lease, the lessee should present that
activity within operating activities in the statement of cash flows. If any payments made
for operating leases represent the costs of bringing another asset to the condition and
location necessary for its intended use, such amounts should be classified as investing
activities.
Upon commencement of a finance lease, a lessee records an ROU asset and lease liability. The noncash activities will be reflected in the noncash investing and financing disclosures (see Section 15.2.4.8). Such noncash activity should be included in the investing and financing activities sections of the statement of cash flows for the asset and liability, respectively. This is consistent with the guidance in ASC 230-10-50-4, which states:
Examples of noncash investing and financing transactions are converting debt to equity; acquiring assets by assuming directly related liabilities, such as purchasing a building by incurring a mortgage to the seller; obtaining a right-of-use asset in exchange for a lease liability; obtaining a beneficial interest as consideration for transferring financial assets (excluding cash), including the transferor’s trade receivables, in a securitization transaction; obtaining a building or investment asset by receiving a gift; and exchanging noncash assets or liabilities for other noncash assets or liabilities. [Emphasis added]
In addition to noncash disclosures associated with the initial recognition of a lease, a lessee should also consider noncash disclosure requirements based on other noncash changes (increases or decreases) to the lease balances, such as those resulting from lease modifications or reassessment events.
When the lessee makes lease payments under a finance lease, the lessee should reflect the principal portion of the payments as a cash outflow from a financing activity in the statement of cash flows. The portion of finance lease payment that reflects the interest payment should be classified as a cash outflow from an operating activity.
The example below illustrates the financial statement presentation for a finance lease and operating lease.
Example 14-3
A lessee enters into a three-year lease and agrees to make the following annual payments at the end of each year: $10,000 in year 1, $15,000 in year 2, and $20,000 in year 3. The initial measurement of the ROU asset and liability to make lease payments is $38,000 at a discount rate of 8 percent.
This table highlights the differences in accounting for the lease as a finance lease and an operating lease:
For the finance lease model, the interest expense calculated is a function of the lease liability balance and the discount rate (i.e., $38,000 multiplied by 8 percent in year 1). For the finance lease, the lessee includes amortization expense as a noncash add-back to the operating activities section of the statement of cash flows, which is calculated on a straight-line basis ($38,000 divided by 3). The principal portion of the cash payment is reflected in the financing section as principal paid. There is no need to separately add interest expense since it is already included in net income in the operating section. The supplemental section includes interest paid.
For the operating lease model, the lessee may include noncash lease expense as a noncash add-back to the operating section of the statement of cash flows ($15,000 – $3,038 = $11,962); this reflects the portion of the lease expense that amortized the ROU asset. While this presentation reflects a best practice, there may be other acceptable methods of presentation for the change in ROU assets; however, it would be inappropriate to present the change in ROU assets in amortization expense. Entities contemplating a different method of presentation are encouraged to discuss the method with their accounting advisers. The cash payment is reflected in the operating section as a change in operating liabilities. Because interest expense is not included in operating leases, there are no separate disclosures for this activity.
Footnotes
1
If the lease payments to be received during the lease
term are fixed, they must be treated as reductions to the lease liability.
However as described in Section 8.5.3.2, lessees that receive lease incentives
during the term that are based on the resolution of future contingencies
may elect an accounting policy of including lease payments in the
measurement of the lease liability at lease commencement if the receipt of
those incentives from the lessor is probable at lease commencement.