8.1 Overview
ASC 842-20
05-1 This Subtopic addresses accounting by lessees for leases that have been classified as finance leases
or operating leases in accordance with the requirements in Subtopic 842-10. Lessees shall follow the
requirements in this Subtopic as well as those in Subtopic 842-10.
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic.
8.1.1 Setting the Stage
As discussed in Chapter 1, the primary objective of the FASB’s leasing project was to address the
off-balance-sheet treatment of leases from the lessee’s perspective. As a result, ASC 842 improves
financial statement transparency related to the rights and obligations arising from leases by requiring
the recognition, on the balance sheet, of the lessee’s right to use the asset subject to the lease (the ROU
asset) over the period of use and its corresponding commitment to the lessor (lease liabilities). ASC 842
also enhances transparency by introducing a number of new qualitative and quantitative disclosure
requirements for lease agreements.
Connecting the Dots
Impact of ASC 842 on Debt Covenants and Bank Capital
Requirements
Since ASC 842 requires a lessee to recognize a lease liability and corresponding
ROU asset for all of its leases (including
operating leases), financial statement preparers
and users raised questions about the impact of the
new requirements related to operating lease
liabilities and ROU assets on an entity’s metrics
(e.g., debt covenants and bank capital
requirements).
Impact on Debt Covenants
During its redeliberations, the Board considered concerns about the potential impact of
additional liabilities resulting from the application of ASC 842. Specifically, paragraph BC14 of
ASU 2016-02 states:
The Board further considered the concern that the additional lease liabilities recognized as a result
of adopting Topic 842 will cause some entities to violate debt covenants or may affect some entities’
access to credit because of the potential effect on the entity’s GAAP-reported assets and liabilities.
Regarding access to credit, outreach has demonstrated that the vast majority of users, including
private company users, presently adjust an entity’s financial statements for operating lease obligations
that are not recognized in the statement of financial position under previous GAAP and, in doing
so, often estimate amounts significantly in excess of what will be recognized under Topic 842. The
Board also considered potential issues related to debt covenants and noted that the following factors
significantly mitigate those potential issues:
- A significant portion of loan agreements contain “frozen GAAP” or “semifrozen GAAP” clauses such that a change in a lessee’s financial ratios resulting solely from a GAAP accounting change either:
- Will not constitute a default.
- Will require both parties to negotiate in good faith when a technical default (breach of loan covenant) occurs as a result of new GAAP.
- Banks with whom outreach has been conducted state that they are unlikely to dissolve a good customer relationship by “calling a loan” because of a technical default arising solely from a GAAP accounting change, even if the loan agreement did not have a frozen or semifrozen GAAP provision.
- Topic 842 characterizes operating lease liabilities as operating liabilities, rather than debt. Consequently, those amounts may not affect certain financial ratios that often are used in debt covenants.
- Topic 842 provides for an extended effective date that should permit many entities’ existing loan agreements to expire before reporting under Topic 842. For those loan agreements that will not expire, do not have frozen or semifrozen GAAP provisions, and have covenants that are affected by additional operating liabilities, the extended effective date provides significant time for entities to modify those agreements.
While the FASB has clearly articulated its view that lease liabilities resulting
from operating leases under ASC 842 are intended
to be characterized as operating liabilities
outside of debt, the Board could not dictate how
banks and other lenders viewed such amounts.
Banks and other lenders differ in their approaches to evaluating liabilities for
debt covenant purposes. Therefore, we encourage
preparers and other stakeholders to communicate
with these organizations to better understand
their views on the impact of debt covenants on
lease liabilities.
Impact on Bank Capital Requirements
Bank regulatory capital (expressed as a ratio of capital to risk-weighted assets or average assets) is the amount of capital that banking regulators (e.g., the FDIC, the Federal Reserve Board, and the OCC) require banks or bank holding companies to hold. Most intangible assets are deducted from regulatory capital, while tangible assets are not. Since ASC 842 does not provide definitive guidance on whether an ROU asset represents a tangible or an intangible asset, stakeholders have asked how bank regulators will treat ROU assets when establishing required capital.
On April 6, 2017, the Basel Committee on Banking Supervision (of which the United States is a member) issued FAQs on how an ROU asset would be treated for regulatory capital purposes. Specifically, the FAQs note that the ROU asset:
- “[S]hould not be deducted from regulatory capital [since] the underlying asset being leased is a tangible asset.”
- “[S]hould be included in the risk-based capital and leverage [ratio] denominators.”
- “[S]hould be risk-weighted at 100%, [which is] consistent with the risk weight applied historically to owned tangible assets and to a lessee’s leased assets under leases accounted for as [capital] leases” under ASC 840.
8.1.2 Navigating the Lessee Model
This chapter of the Roadmap highlights the guidance and interpretations that a lessee must apply when accounting for its leases, including guidance on classifying leases and recognizing and measuring the lease liability as well as the corresponding ROU asset. In addition, this chapter discusses the income statement expense recognition profile and related presentation for both operating and finance leases. Other aspects of lessee accounting addressed in this chapter include:
- Remeasurement of the lease liability (Section 8.5).
- Accounting for lease modifications (Section 8.6).
- Lease derecognition (Section 8.7).
- Master lease agreements, leases denominated in foreign currencies, accounting for leasehold improvements, and accounting for maintenance deposits (Section 8.8).
- Codification examples (Section 8.9).
The following chapters of this Roadmap also contain information relevant to the lessee model:
- Chapter 2 — Discusses how to identify whether an arrangement involving an underlying asset is within the scope of the leasing standard.
- Chapter 3 — Addresses factors related to evaluating whether a contract is or contains a lease.
- Chapter 4 — Explains how to identify the separate lease components and nonlease components within a contract and how the consideration is allocated to components.
- Chapter 5 — Discusses how the lessee should determine the lease term of its leases at lease commencement as well as when it should reassess the lease term.
- Chapter 6 — Covers the identification of lease payments as well as the initial and subsequent measurement of consideration that must be allocated to the components identified.
- Chapter 7 — Addresses how a lessee determines the appropriate discount rate as well as when it should reassess this rate.
- Chapter 14 — Discusses the balance sheet, income statement, and cash flow statement presentation requirements from the lessee’s perspective.
- Chapter 15 — Outlines the interim and annual lessee disclosure requirements.