8.2 Policy Decisions That Affect Lessee Accounting
Before applying the accounting requirements in ASC 842, a lessee will need to
make certain key accounting policy decisions.
These decisions could have a significant impact on
the amounts that are ultimately recognized,
presented, and disclosed in the lessee’s financial
statements. For discussion of a lessee’s decision
on the election of a practical expedient to
account for the nonlease components in a contract
as part of the single lease component to which
they are related, see Section
4.3.3.1.
This section discusses key policy decisions related to the following topics:
- The short-term lease recognition exemption (Section 8.2.1).
- Accounting for leases at a portfolio level (Section 8.2.2).
In addition, when making such key policy decisions, it would be reasonable for an entity to establish
a balance sheet recognition capitalization threshold for its leases. See Section 2.2.5.2 for additional
considerations.
8.2.1 Short-Term Lease Recognition Exemption
ASC 842-20
Short-Term Lease
A lease that, at the commencement date, has a lease term of 12 months or less
and does not include an option to purchase the
underlying asset that the lessee is reasonably
certain to exercise.
25-2 As an accounting policy, a lessee may elect not to apply the recognition requirements in this Subtopic to
short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis
over the lease term and variable lease payments in the period in which the obligation for those payments is
incurred (consistent with paragraphs 842-20-55-1 through 55-2). The accounting policy election for short-term
leases shall be made by class of underlying asset to which the right of use relates.
25-3 If the lease term or the assessment of a lessee option to purchase the underlying asset changes such that, after the change, the remaining lease term extends more than 12 months from the end of the previously determined lease term or the lessee is reasonably certain to exercise its option to purchase the underlying asset, the lease no longer meets the definition of a short-term lease and the lessee shall apply the remainder of the guidance in this Topic as if the date of the change in circumstances is the commencement date.
25-4 See Example 1 (paragraphs 842-20-55-13 through 55-16) for an illustration of the requirements on short-term leases.
Illustration of a Short-Term Lease
55-13 Example 1 illustrates the assessment of whether a lease is a short-term lease.
Example 1 — Short-Term Lease
55-14 Lessee has made an accounting policy election not to recognize right-of-use assets and lease liabilities that arise from short-term leases for any class of underlying asset.
55-15 Lessee enters into a 12-month lease of a vehicle, with an option to extend for another 12 months. Lessee has considered all relevant factors and determined that it is not reasonably certain to exercise the option to extend. Because at lease commencement Lessee is not reasonably certain to exercise the option to extend, the lease term is 12 months.
55-16 The lease meets the definition of a short-term lease because the lease term is 12 months or less. Consequently, consistent with Lessee’s accounting policy election, Lessee does not recognize the right-of-use asset and the lease liability arising from this lease.
ASC 842-20 defines a short-term lease as a lease whose lease term, at
commencement, is 12 months or less and that does
not include a purchase option whose exercise is
reasonably certain. ASC 842 permits a lessee, as
an accounting policy election, not to recognize on
its balance sheet assets and liabilities related
to short-term leases. This accounting policy, if
elected, would be applied by underlying asset
class and would result in a lessee’s recognition
of its lease payments on a straight-line basis
over the lease term in a manner similar to how
operating leases were accounted for under ASC 840
(see Section 4.3.3.1
for considerations related to determining an
underlying asset class). While this exemption will
result in off-balance-sheet accounting for
short-term leases, ASC 842 does include specific
presentation and disclosure requirements for these
leases. (See Sections 14.2
and 15.2.4.3,
respectively, for additional information.)
As with other leases, the option to extend or terminate the lease, or to
purchase the underlying asset that is subject to
the short-term lease exemption, needs to be
reassessed upon the occurrence of certain discrete
reassessment events. (See Section
8.5.1 for additional information.) A
lease will no longer meet the definition of a
short-term lease and thus no longer qualify for
the exemption if, as a result of a reassessment
event, (1) the lease term changes and the change
causes the remaining term to extend more than 12
months beyond the end of the previously determined
lease term or (2) the lessee now concludes that
the lessee’s exercise of a purchase option is
reasonably certain. When a lease no longer
qualifies for the short-term lease exemption, a
lessee will need to apply ASC 842’s guidance on
initial recognition and measurement; the
commencement date of the lease for this purpose is
the date of the change in circumstances.
A lessee, for tax or other
business purposes, may enter into a lease
agreement for a period approximating but exceeding
one year. For example, in certain jurisdictions, a
vehicle lease subject to a TRAC often has a
noncancelable period of 367 days. Such a lease
would not qualify for the short-term lease
exemption because the lease term in this example
is greater than a year (i.e., 367 days). In
addition, we believe that a lease that originally
had a term of less than 365 days, but that was
subsequently extended in such a way that the total
lease term is greater than 365 days but the
remaining lease term as of the lease extension
date is less than 365 days, would still qualify
for the short-term lease exemption if that
exemption was initially applied to that lease. The
short-term lease exemption only applies to leases
(1) with a term of 12 months or less and (2) that
do not include a purchase option whose exercise by
the lessee is reasonably certain.
Example 8-1
Scenario A
BuildCo enters into a lease for a crane. The lease is for a six-month noncancelable term, can be extended
on a month-to-month basis after the six months, and does not include a purchase option. On the lease
commencement date, BuildCo determines that (1) it will need the crane for a project that will take 18 months to
complete and (2) the monthly rental payments during the extension period are significantly below market rates.
On the basis of these factors, BuildCo concludes that it is reasonably certain that it will keep the lease for the
18-month period. BuildCo has an established accounting policy of using the short-term lease exemption for the
class of underlying asset subject to this lease.
In this scenario, because BuildCo needs the underlying asset for its project and the pricing of the extension
period is below the market rate, it is reasonably certain that BuildCo will extend the noncancelable period to 18
months. Therefore, the lease term is greater than 12 months (i.e., 18 months) and the lessee may not account
for the lease as a short-term lease.
Scenario B
SalesCo enters into a vehicle lease that is subject to a 12-month noncancelable
period, after which the lease will continue on a
month-to-month basis. At any point after the
noncancelable period, SalesCo can return the
vehicle to the lessor and will be responsible for
paying to the lessor any shortfall (or will
receive any surplus) in the selling price of the
vehicle compared with the remaining book value
(TRAC). SalesCo estimates that there will be a
shortfall at the end of the first year that will
be significant in such a way that SalesCo is
likely to renew the lease and avoid the shortfall
payment.
In this scenario, since SalesCo concludes that the estimated shortfall at the end of the first year is expected to
be significant, it would not be reasonable to conclude that the term is 12 months since returning the vehicle
after 12 months would generally result in an economic penalty to SalesCo. Therefore, it is reasonably certain
that SalesCo will extend the lease beyond the 12-month period. Because the lease term in this scenario is
greater than 12 months, the lessee may not account for the lease as a short-term lease.
Scenario C
Retailer enters into a lease of warehouse space. The lease is for a nine-month noncancelable term, can be
extended for four months, and does not include a purchase option. On the lease commencement date, Retailer
concludes that it is not reasonably certain that it will renew the lease beyond the nine-month noncancelable
period because (1) the noncancelable period coincides with the period in which Retailer expects to need the
additional storage and (2) the monthly lease payments during the optional extension period are expected to be
at market rates.
In this scenario, because Retailer only needs the warehouse space to support its operations for a nine-month
period and the pricing for the optional period is expected to be consistent with the expected market rates, it
would be reasonable to conclude that the lease term is limited to the nine-month cancelable period. Therefore,
the lease term is 12 months or less and Retailer applies the short-term lease exemption in accounting for the
lease (i.e., it recognizes lease payments as an expense on a straight-line basis over the lease term and does not
recognize a lease liability or ROU asset on its balance sheet).
Connecting the Dots
Applying the Short-Term Lease
Exemption
While deliberating the new lease accounting standard, the FASB and IASB concluded that the inclusion of a balance sheet recognition exemption for short-term leases could reduce the cost and complexity of applying the new requirements. However, while a lessee can elect an accounting policy of not recognizing, on its balance sheet, liabilities and assets related to leases with a term of 12 months or less, the lessee must disclose in the notes to the financial statements its short-term lease expense. See Section 15.2.4.3 for additional information.
Moreover, the recognition exemption for short-term leases is an accounting policy election that is applied at an asset class level. Once a lessee elects to apply (or not apply) the exemption for a particular asset class, any future leases with a term of 12 months or less within that asset class would have to be accounted for consistently. In addition, if a lessee would like to change its policy at a future date, it would need to evaluate the potential change in accordance with ASC 250.
Changing the Conclusion About the
Short-Term Lease Exemption Is a One-Way
Street
Irrespective of whether a
reassessment event causes the lease term to be
less than 12 months, because an entity assesses
its ability to apply the short-term lease
exemption at lease commencement, an arrangement
that previously did not qualify for the short-term
lease exemption never would subsequently qualify
for it. In other words, once a lease is recorded
on the balance sheet, it cannot be derecognized as
a result of a term reassessment, even if the
revised term is 12 months or less. This would be
the case irrespective of whether the lessee
extends the term of a lease by exercising a
renewal option whose exercise was not originally
deemed reasonably certain or by extending the
lease term by renegotiating an extension not
included in the original contract terms (i.e.,
lease modifications not considered to be separate
contracts).
Bridging the GAAP
Differences Between the Accounting for
Short-Term Leases Under U.S. GAAP and That Under
IFRS Accounting Standards
The definition of a short-term lease under IFRS 16 differs slightly from that
under ASC 842. Specifically, under IFRS 16, a
lease that includes a purchase option would never
qualify for the short-term lease exemption;
however, under ASC 842, the short-term lease
exemption would only be precluded if it is
reasonably certain that the lessee will exercise
the purchase option. As a result, more leases may
qualify for the short-term lease exemption under
U.S. GAAP than under IFRS Accounting
Standards.
8.2.2 Accounting for Leases at a Portfolio Level
ASC 842 permits a lessee to account for its leases at a portfolio level provided that the leases
commenced at or around the same time and the resulting accounting at this level would not differ
materially from the accounting at the individual lease level. We therefore believe that this approach
would be permitted when the portfolio includes leases that are (1) similar in nature (e.g., similar
underlying assets) and (2) have identical or nearly identical contract provisions.
Connecting the Dots
Applying the Portfolio
Approach
In applying the portfolio approach, a lessee will need to use judgment to conclude that
the accounting for a group of assets at the portfolio level would not materially differ from
the accounting for the leases in the portfolio on an individual lease basis. To reach such a
conclusion, the lessee will need to critically assess the size and composition of the portfolio.
While it may appear that an entity would be required to perform a quantitative
assessment to evaluate the appropriateness of applying the portfolio
approach, the Background Information and Basis for Conclusions of ASU
2016-02 notes that such an assessment may not be necessary and that a
more holistic evaluation could be appropriate. Specifically, paragraph
BC120 of ASU 2016-02 states, in part, that the “Board indicated that it
did not intend for an entity to quantitatively evaluate each outcome
but, instead, that the entity should be able to take a reasonable
approach to determine the portfolios that would be appropriate for its
types of leases.”
Further, paragraph BC121 of ASU 2016-02 notes, in part:
[T]he cost relief offered by applying the leases guidance at a portfolio level need not be limited to
simply grouping contracts together. The cost relief also could be particularly high for certain aspects
of the leases guidance for which entities need to make judgments and estimates, such as determining
the discount rate or determining and reassessing the lease term.
See Section 7.2.5
for additional considerations related to determining a discount rate for a
portfolio of leases and the next section for more information about applying the
lease classification criteria.