Frequently Asked Questions About the FASB’s New Leases Standard
Introduction
It’s been over a year since the FASB issued ASU 2016-02,1 its new standard on accounting for
leases (codified in ASC 842).2
Although the standard will not be effective until 2019,3 entities have already begun raising
implementation issues.4 In addition, many questions have arisen about the
standard’s fundamental concepts, including the definition of a lease, lease
payments, and presentation and disclosure.
In this Heads Up, we share our perspectives on such
topics and address FAQs about the standard. We have also included several
Driving Discussions to highlight certain key issues related to the new guidance,
some of which remain unresolved as of the issuance date of this publication.
For a comprehensive overview of ASU 2016-02, see Deloitte’s
March 1, 2016, Heads
Up.
Scope
Q&A 1 Capitalization Policy Considerations
Many entities have accounting policies that establish a
materiality threshold for capitalizing fixed assets (i.e., property, plant,
and equipment (PP&E)). Under such policies, expenditures below the
established threshold are expensed in the period incurred, as opposed to
being capitalized on the balance sheet and depreciated over the life of the
asset.
Because ASC 842 requires entities to recognize a
right-of-use (ROU) asset and lease liability for all leases (other than
short-term leases) and does not contain a “small-ticket item” exception
similar to that in IFRS 16,5 many entities have asked whether a similar
capitalization threshold may be established for lease assets and lease
liabilities under ASU 2016-02.
Question
Can a lessee use an appropriate capitalization threshold
when evaluating the requirement to recognize, on the balance sheet, leases
that otherwise require recognition under the ASU?
Answer
Yes. Paragraph BC122 of ASU 2016-02 states, in part:
[E]ntities will likely be able to
adopt reasonable capitalization thresholds below which lease assets
and lease liabilities are not recognized, which should reduce the
costs of applying the guidance. An entity’s practice in this regard
may be consistent with many entities’ accounting policies in other
areas of GAAP (for example, in capitalizing purchases of property,
plant, and equipment).
While the new leases standard does not provide for a
specific exemption, an entity is not required to apply U.S. GAAP to
immaterial items; therefore, materiality is always a consideration in the
preparation of financial statements. However, an entity should not simply
default to its existing capitalization threshold for PP&E for the
following reasons:
- The existing capitalization threshold for PP&E is unlikely to include the effect of the additional asset base introduced by the ASU. That is, the addition of another set of assets not recognized on an entity’s balance sheet may require a refreshed analysis of the entity’s capitalization thresholds to ensure that the aggregated amounts will not become material.
- The existing capitalization threshold for PP&E does not affect the liability side of the balance sheet. Under the new standard, if an entity wishes to establish a threshold that will be used to avoid accounting for both ROU assets and lease liabilities on the balance sheet, it must consider materiality, in the aggregate, of all of its ROU assets and related lease liabilities that would be excluded as a result of its adoption of such a threshold.
One reasonable approach to developing a capitalization
threshold for leases is to use the lesser of the
following:
- A capitalization threshold for PP&E, including ROU assets (i.e., the threshold takes into account the effect of leased assets determined in accordance with ASU 2016-02).
- A recognition threshold for liabilities that takes into account the effect of lease liabilities determined in accordance with the ASU.
Another reasonable approach to developing a capitalization
threshold for leases is to record all lease liabilities but subject the
related ROU assets to such a threshold. Under this approach, if an ROU asset
is below the established capitalization threshold, it would immediately be
recognized as an expense. In subsequent periods, entities would amortize the
lease liability by using the effective interest method, under which a
portion of the periodic lease payments would reduce the liability and the
remainder would be recognized as interest expense.
In addition, when evaluating and applying a capitalization
threshold for leases determined in accordance with the ASU, entities should
consider the following:
- The gross balance of each side of the lease entry — It would be inappropriate for an entity to consider only the net balance sheet effect of the lease entry (which is often zero) when assessing materiality.
- Disclosure requirements — We expect that entities will often want to omit disclosures about leases that they have determined do not require balance sheet recognition on the basis of their use of capitalization thresholds as discussed above. We believe that while it may be appropriate to omit such disclosures, an entity will need to consider the impact of the omitted disclosures when performing a materiality assessment to establish the thresholds.
- Internal control over financial reporting (ICFR) implications — As entities revisit and change (or create new) capitalization thresholds for financial reporting purposes, they should be cognizant of the related ICFR implications. In addition, the Form 10-K and Form 10-Q disclosure requirements under SEC Regulation S-K, Item 308(c), related to material changes in ICFR should be considered.
- "SAB Topic 1.M (SAB 99)" — Entities may find the guidance on materiality in SAB Topic 1.M helpful when identifying an appropriate capitalization threshold for leases.
Example
A
lessee enters into a five-year lease of a machine to
use in its operations. The lessee determines that
its ROU asset and lease liability are measured at
$3,260 at lease commencement.
To identify an appropriate capitalization threshold
for its ROU assets and lease liabilities, the lessee
considers the following:
- The gross balances (rather than the net balance) of its ROU assets and lease liabilities.
- The disclosures that would be omitted if certain ROU assets and lease liabilities were not recognized.
- The appropriate internal controls needed for the lessee to apply and monitor the capitalization threshold.
- Overall materiality considerations in SAB Topic 1.M.
After considering these
factors, the lessee determines that (1) an
appropriate capitalization threshold for PP&E,
including ROU assets, is $3,500 and (2) an
appropriate recognition threshold for lease
liabilities is $3,000. The lessee should apply the
lower of the two thresholds when determining whether
to record the lease on its balance sheet. Given that
the initial measurement of the lessee’s ROU asset
and lease liability exceeds the $3,000 threshold
established for lease liabilities (i.e., the lower
of the two thresholds), the lessee should recognize
the ROU asset and lease liability on its balance
sheet at lease commencement.
Alternatively, the lessee may choose to recognize
the lease liability of $3,260 but not the ROU asset
on the basis of the established $3,500 threshold for
PP&E, including ROU assets (i.e., the lessee may
choose to expense the cost of the ROU asset at lease
commencement).
Definition of a Lease
Q&A 2 Assets With a Significant Service Component
Background
An entity may enter into a service arrangement that involves
PP&E necessary to meet the contract’s performance obligations. The
importance of the PP&E to the overall delivery of the service may vary
depending on the type of arrangement.
For example, a customer contracting for transportation
services to ship a package from Munich to Milwaukee cares little about the
PP&E used to perform the services. In contrast, a customer contracting a
vessel and crew for a specified period to transport its goods where and when
it chooses is likely to be more concerned with the PP&E used in the
arrangement. Both arrangements, however, involve a significant service
component provided by the supplier to operate the PP&E used to fulfill
its transportation obligations.
Often, the assessment of whether a contract is or contains a
lease will be straightforward. However, the evaluation will be more
complicated when a service arrangement involves a specified physical asset
or when both the customer and the supplier make decisions about the use of
the underlying asset. Examples of these more ambiguous and complex
arrangements include arrangements that involve cloud computing services
(i.e., if there is a lease of the supporting equipment, such as mainframes
and servers) and cable television services (i.e., if the cable box provided
to the customer is a leased asset).
Question
Does an entity need to evaluate a service arrangement that
involves the use of PP&E to determine whether the arrangement contains a
lease?
Answer
Yes. In accordance with ASC 842-10-15-2, an entity is
required at contract inception to identify whether a contract contains a
lease. Not all leases will be labeled as such, and leases may be embedded in
larger arrangements. For example, supply agreements, power purchase
agreements, and oil and gas drilling contracts may contain leases (i.e.,
there may be an embedded lease of a manufacturing facility, generating
asset, or drill rig, respectively). If PP&E are identified in an
arrangement (either explicitly or implicitly), the customer and supplier
must both determine whether the customer controls the use of the PP&E
throughout the period of use.
Under ASC 842, the determination of whether an arrangement
is or contains a lease is critical. A lessee’s failure to identify leases,
including those embedded in service arrangements, is likely to lead to a
financial statement error given the requirement in ASC 842 that all leases,
other than short-term leases, be reflected on the balance sheet. On the
other hand, if a customer concludes that a contract is a service arrangement
and does not contain an embedded lease, the customer is not required to
reflect the contract on its balance sheet (unless required by other U.S.
GAAP). The assessment of the arrangement may be more critical under ASC 842
than under the current guidance on leases since under ASC 840, the balance
sheet and income statement treatment of operating leases is often the same
as that of service arrangements.
Q&A 3 Economic Benefits and Tax Attributes
Background
ASC 842-10-15-3 states that a “contract is or contains a
lease if the contract 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.” ASC 842-10-15-4 specifies that in determining
whether the customer has the right to control the use of the identified
asset, an entity would need to evaluate whether the customer has both of the
following:
- “The right to obtain substantially all of the economic benefits from use of the identified asset” (emphasis added).
- “The right to direct the use of the identified asset.”
Economic benefits consist of direct or indirect benefits
from the use of the asset (e.g., using, holding, or
subleasing the asset) and include the asset’s primary output and
by-products. They may be tangible or intangible (e.g., renewable energy
credits).
Certain types of underlying assets may provide unique tax
benefits or tax attributes to the owner. Often, such tax benefits or tax
attributes are provided because a government has decided to incentivize
investments in the development of the assets. These benefits or attributes
may be critical to a buyer’s investment decision and often economically
justify an investment in an otherwise uneconomic asset or technology.
Question
Should an entity consider tax attributes associated with the
ownership of the underlying asset when evaluating whether a customer has the
right to obtain substantially all of the economic benefits from the use of
the asset?
Answer
No. An entity should not consider any tax attributes
associated with the ownership of the underlying asset when evaluating
whether a customer has the right to obtain substantially all of the economic
benefits from the use of the asset.
ASC 842-10-15-17 indicates that economic benefits can be
realized from a commercial transaction with a third party. Tax attributes,
by nature, cannot be sold in a commercial transaction because they are
related to the ownership of the asset.
This approach is consistent with the manner in which outputs
are determined under ASC 840 and therefore is not expected to change in
practice upon the adoption of ASU 2016-02.
Example 1
The owner of an electric automobile may receive an
investment tax credit that is either a fixed dollar
amount or a portion of the purchase price. However,
the reporting entity should not consider the
investment tax credit associated with the electric
automobile in its evaluation of whether a customer
has the right to obtain substantially all of the
economic benefits from the use of the asset.
Because a lease conveys only the
right to use (and not ownership of) the underlying
asset, benefits related to ownership of an asset
should not be included in the assessment of whether
an arrangement contains a lease. Rather, this
evaluation should be limited to those economic
benefits resulting from the use of the asset during
the contract period that can be realized from a
commercial transaction with a third party.
Investment tax credits are related to the ownership
of an asset, and the benefits associated with the
credits may not be sold to third
parties.
Example 2
The owner of a renewable energy generation facility
such as a wind or solar farm may receive production
tax credits based on a dollar amount per unit of
electricity that the facility produces. However, the
reporting entity should not consider production tax
credits associated with the renewable energy
generation facility in its evaluation of whether a
customer has the right to obtain substantially all
of the economic benefits from the use of the
asset.6
Although the amount of the
production tax credit is derived from the output
produced by an underlying asset (e.g., the credit is
calculated as $0.023 per kilowatt hour of
electricity produced by a renewable energy
generation facility), the benefits of the credit may
be received only by the owner of the underlying
asset. Similar to investment tax credits, production
tax credits are related to the ownership of an
asset, and the benefits associated with the credits
may not be sold to third parties.
Driving Discussions — Definition of a Lease
Determining Whether a Lease Exists in
Arrangements Involving Rights to Use Portions of Larger
Assets
We have received a number of questions about
so-called “secondary use” arrangements in which a customer shares
the use of part of a larger asset for a defined period. Examples of
such arrangements include advertising placed on the side of a fixed
asset and nonutility customers’ attachment of distribution wires
(e.g., cable wires) to utility poles. Often, we have been asked (1)
how to assess economic benefits when two parties contemporaneously
use the same asset and (2) what unit of account to use for the
evaluation of control (the larger asset or the portion being
shared).
ASC 842-10-15-16 provides guidance on evaluating
whether a portion of an asset would be considered an “identified
asset” and be potentially subject to ASC 842. Under this guidance, a
“capacity or other portion of an asset that
is not physically distinct . . . is not an identified asset, unless
it represents substantially all of the capacity of the asset and
thereby provides the customer with the right to obtain substantially
all of the economic benefits from use of the asset” (emphasis
added).
Questions sometimes arise regarding physical
distinction, particularly in scenarios involving a larger asset, a
specific portion of which is shared by one or more parties over a
defined period for use in different ways. An example would be a
building’s exterior wall that one party is granted the exclusive
right to use for advertising while the occupants of the building
continue to use the wall for support of their residence, protection
from the elements, and so forth. Unlike situations involving the
lease of one floor of a multistory building, which is functionally
independent and unique, these scenarios involve simultaneous but
different uses of a portion of a larger asset. Other examples
include the placement of solar panels on a specific section of
rooftop and the attachment of cable wires to a specific spot on a
utility pole (in both cases, the owner continues to use the entire
asset while allowing another party to use a portion of the asset for
a different purpose over a defined period). To the extent that there
are substantive substitution rights in these arrangements, a lease
will generally not be present. However, we understand that many of
the scenarios found in practice do not allow for substitution.
We are continuing to work with others in the
profession to develop guidance that can be used to analyze these
arrangements. The following are some of the considerations we have
discussed to date that may ultimately be relevant to the
determination of whether a lease exists:
- Does the arrangement involve a shared use of the larger asset, including the portion specified in the arrangement?
- Is the portion being used by the customer functionally independent and therefore separable from the larger asset?
- Is the portion being used by the customer commercially significant to the asset owner by design?
Shared Use
Shared-use arrangements will typically involve the
contemporaneous use of the same asset (or the same portion of a
larger asset) for different purposes. An example might be an
easement that gives the easement holder the right to bury a pipeline
underground while the landowner retains meaningful rights to use the
land for farming or other purposes. Likewise, many advertising
scenarios feature shared use (e.g., an ad displayed on top of a
baseball dugout, on the side of a bus, or on the floor of a grocery
store). On the other hand, if the owner of the asset is not
contemporaneously using the asset (or is not contractually allowed
to use the asset), shared use may not exist. This might be the case
for a cell tower operator that allows a customer to use a specific
hosting site on the tower for a defined period. Shared-use
arrangements may be less likely to contain leases, while
exclusive-use arrangements (i.e., arrangements in which a customer
has exclusive use of a portion of a larger asset) may be more likely
to contain leases. Judgment may be involved in the determination of
whether a particular arrangement features shared or exclusive use of
the portion of the larger asset.
Functional Independence
It may be useful to evaluate the functional
independence of the portion being used by the customer, including
the functional use and design of the asset that is subject to the
arrangement. To the extent that the portion being used by the
customer has a discrete functional use (e.g., a specific floor of a
building), it could be more likely that the portion being used is
physically distinct and an identified asset. On the other hand, if
the portion being used is not functionally distinguishable from the
larger asset (e.g., a spot on a utility pole), there may be a
reasonable basis to view the larger asset as the identified asset in
the arrangement.
Commercial Significance by
Design
It may also be useful to consider commercial
significance by design — that is, the commercial objectives of the
asset owner when it built or purchased the asset. To the extent that
the asset was built or purchased with the commercial objective of
leasing a specific portion or portions to others (e.g., specific
hosting locations on a cell tower), it could be more likely that the
portion being used for these purposes is physically distinct and
therefore an identified asset. On the other hand, if the asset was
built or purchased without such a commercial objective (e.g., a
utility pole), there may be a reasonable basis to view the larger
asset as the identified asset in the arrangement.
Determining Whether a Lease
Exists
The above indicators may help entities assess
circumstances in which the use of a portion of an asset might
reasonably be viewed as a secondary, or incidental, use of that
portion of the asset such that the owner retains substantive
economic benefits from the use of the portion. Sometimes, it may be
reasonable to view the larger asset as the identified asset in the
arrangement and to assess control (including economic benefits) on
that basis. Such an approach would generally result in an increased
likelihood that the arrangement does not contain a lease since the
customer does not obtain substantially all of the economic benefits
from the use of the larger asset (the customer’s economic benefits
are limited to the portion it uses).
Next Steps
This issue continues to evolve, and it is possible
that the FASB and SEC will want to share perspectives before any
related implementation guidance is finalized. Companies that are
involved in these types of arrangements should consult with their
accounting advisers and monitor developments on the topic.
Contract for Network Services (Example 10, Case
A, in ASC 842-10-55-124 Through 55-126)
We have received a number of questions regarding the
outcome of Example 10, Case A, in ASC 842-10-55-124 through 55-126.
That example involves a contract for network services under which a
telecommunications company (the supplier) installs and configures
multiple servers at a customer site to support the customer’s
network needs (primarily the storage and transportation of data).
During the term of the arrangement, the supplier makes decisions
about how to deploy the fleet of servers to satisfy customer
requests. Although the arrangement involves dedicated equipment,
some of which is maintained on the customer’s premises, the
conclusion reached in the example is that the arrangement does not
contain a lease since the customer does not control the individual
servers.
Some may find this outcome counterintuitive since
the servers are dedicated solely to the customer for the term of the
arrangement. However, the conclusion highlights an important change
from the current guidance on leases. Specifically, under ASC 842,
the customer must obtain control of the asset(s) in the arrangement
to have a lease, and control is not limited to having the right to
all of the productive output of the asset (one of the circumstances
that would allow an entity to conclude that an arrangement is a
lease under the current guidance in ASC 840). Rather, control under
ASC 842 is a two-part test that focuses on (1) economic benefits and
(2) the right to direct the use of the identified asset(s). In the
example, the second condition is not met; therefore, the arrangement
does not contain a lease.
A number of stakeholders have asked about the key
factors that result in the conclusion that the customer in the
example does not have the right to direct the use of the servers.
For instance, if the right to dispatch a power plant (i.e., tell the
owner-operator when to produce electricity) conveys to the customer
the right to direct the use of the plant (as illustrated by Example
9, Case C, in ASC 842-10-55-117 through 55-123), why wouldn’t the
right to determine when and which data to store or transport by
using the network likewise convey to the customer control of the
underlying servers?
We understand the following with regard to the key
factors behind the conclusion in Example 10, Case A:
- The focus of the analysis is on whether each individual server, as opposed to the entire network, is a lease. In the example, the supplier is providing a service (a network of a certain capacity and quality) by using dedicated assets. Therefore, the control analysis should be performed at the asset level (i.e., at the individual server level).
- The consideration of “how and for what purpose” the asset is used, as described in ASC 842-10-15-25, is likewise focused on decisions related to each individual server — not the output produced by the overall network.
- The fact pattern involves multiple assets (multiple individual servers), and the supplier retains the discretion to deploy each individual server in whatever manner the supplier decides will best fulfill the overall network service.
- Since each server on its own can perform different functions (e.g., store data, transport data), the supplier has the right to make meaningful decisions about which server(s) should be used to satisfy a particular customer request.
- The customer cannot decide how and for what purpose each individual server is used and cannot prevent the supplier from making those decisions. The customer’s decisions are limited to how the customer uses the network and do not extend to the individual servers.
We believe that these key factors help differentiate
the conclusion in Example 10, Case A, from the conclusion in Example
10, Case B (ASC 842-10-55-127 through 55-130). In Case B, the
arrangement involves a single server, and the customer makes the
critical decisions about which data to store or transport by using
that single server as well as how (or whether) to integrate that
single server into its broader operations. Therefore, we believe
that Case B is more analogous than Case A to Example 9, Case C,
which involves dispatch rights over a power plant (also a single
asset).
Understanding the key distinguishing factors in the
above examples should help preparers identify leases under ASC 842.
However, the illustrative examples are just that — examples. They
each represent an application of the framework, which requires a
detailed analysis of specific facts and circumstances. If you have
questions about your arrangements and whether they should be
analyzed in a manner similar to the analysis in Example 10, Case A,
we recommend discussing those questions with your auditors or
accounting advisers.
Easements
An easement is a right to cross or otherwise use
someone else’s land for a specified purpose. Most easements provide
limited rights to the easement holder, such as the right to cross
over land or the right to construct and maintain specified equipment
on the land. For example, an electric utility will typically obtain
a series of contiguous easements to allow it to construct and
maintain its electric transmission system on land owned by third
parties. Easements can be perpetual or term-based and can be paid in
advance or paid over time.
Historically, some companies have considered
easements to be intangible assets under ASC 350. In fact, ASC 350
contains an illustrative example of easements acquired to support
the development of a gas pipeline. In contrast, some companies may
have considered easements to be leases or executory contracts. When
preparing their financial statements, many companies have presented
prepaid amounts related to easements in the PP&E section of
their balance sheets because PP&E are closely associated with
the easements that support them. We understand that FERC reporting
requirements may have also influenced the balance sheet geography
for companies regulated by that agency.
Questions have arisen about whether easements or
rights-of-way are within the scope of the new leases standard. Many
have asserted that these arrangements are intangibles under ASC 350
and would therefore qualify for the scope exception to ASC 842
related to leases of intangible assets. However, since easements
generally involve rights related to the use of land, easements
should first be analyzed under ASC 842 to determine whether they are
or contain a lease. This assessment should be performed by all
entities, including those that had a prior policy of treating
easements as intangibles (see below for special considerations for
companies that elect to apply the practical expedient in ASC
842-10-65-1(f) when transitioning to ASC 842).
When an easement is perpetual, we would not expect
the arrangement to meet the definition of a lease given the lack of
a stated term. For term-based easements (including those with long
terms, such as 100 years), the analysis will most likely be more
extensive and involve a consideration of control of the underlying
land. Many easement arrangements may not convey control of the land
to the easement holder given the limited rights conveyed as well as
the economic benefits that the owner continues to enjoy (i.e., the
easement holder may not obtain substantially all of the economic
benefits of the land). For example, in an arrangement in which a
company is allowed to run electric transmission assets through a
farmer’s fields, it will be important to understand whether the
farmer can still use the acreage over or under which the assets run.
If so, the easement holder may conclude that it does not control the
associated land because the farmer retains (1) usage rights (e.g.,
the ability to grow crops), (2) economic benefits associated with
the land that are other than insignificant, or (3) both (1) and (2).
On the other hand, there may be easement arrangements that
effectively convey control of the land to the easement holder
through the rights conveyed or through use restrictions imposed on
the landowner. The required accounting will depend on the facts and
circumstances of each arrangement.
For high-volume users of easements, we recommend (1)
segregating these arrangements on the basis of similar terms, (2)
isolating the term-based arrangements, and (3) investigating the
rights retained by the landowner as a starting point in the
analysis. This may streamline the process since many easements will
have similar or identical terms and therefore would be expected to
result in similar accounting.
With respect to transition, the practical expedient
in ASC 842-10-65-1(f) allows a company to forgo reassessing whether
expired or existing contracts contain leases in accordance with the
new definition of a lease under ASC 842. We believe that this
guidance, if elected, will generally extend to a company’s prior
accounting conclusions about easements as long as those conclusions
were appropriate under historical GAAP. That is, ASC 842-10-65-1(f)
does not grandfather prior accounting conclusions that were
incorrect. Thus, if an arrangement should have historically been
accounted for as a lease under ASC 840 but was not, it would not be
safeharbored by the transition guidance.
We are aware of ongoing dialogue between certain
industry participants and the FASB regarding the accounting for
easements. The discussion above represents our current thinking
based on knowledge of those interactions. To the extent that there
is further standard setting related to the accounting for easements
(under ASC 842 or otherwise), we will update our views
accordingly.
Joint Operating Agreements
Companies in a number of industries enter into joint
arrangements to achieve a common commercial objective. These
arrangements may include the use of specified PP&E for a stated
time frame. For example, entities in the oil and gas industry often
enter into joint operating agreements (JOAs) in which two or more
parties (i.e., operators and nonoperators) collaboratively explore
for and develop oil or natural gas properties by using the
experience and resources of each party. These agreements often
require the use of leased equipment. Questions have arisen regarding
the lease assessment requirements under the new leases standard for
parties to joint arrangements. While we expect that the analysis of
joint arrangements will be very much based on facts and
circumstances, the example and analysis below should be helpful to
companies as they consider these arrangements.
Example
Three companies, A, B, and C,
form a JOA to execute an offshore drilling
program. For the companies to fulfill the JOA’s
objective, a specific asset (e.g., a drill rig)
will be necessary. Company A will act as the
counterparty to major contracts of the JOA,
including a five-year contract to lease a specific
drilling rig from its owner (Lessor X).
Question 1:
Which Party, If Any, Is Leasing the Rig?
Given A’s role as primary obligor
in the drilling rig’s lease (the rig’s owner may
not be aware of the JOA and the parties that
constitute it), A will generally be deemed the
lessee in the arrangement. Accordingly, A will
record the entire lease on its balance sheet. Even
though other parties will receive economic
benefits from the rig, those benefits arise from
the JOA and do not affect the economic benefits
analysis7 of
the contract between A and the rig’s owner,
X.
Question 2: What Is the Effect of the
JOA?
The JOA’s terms
may represent a sublease of the rig from A to the
JOA. That is, the new leases standard requires the
parties to the JOA to consider the terms and
determine whether the JOA is a “virtual” lessee of
the rig. Although the JOA is typically not a legal
entity that prepares financial statements, a
conclusion that the JOA is a lessee of the rig
would have the following implications:
- Company A, as sublessor, would separately account for its sublease to the JOA (apart from its head lease with X, the rig’s owner).
- Each party to the JOA would need to consider other GAAP (e.g., proportionate consolidation guidance) that may require it to record its pro rata portion of the lease (as a lessee).
Note that the “other GAAP” mentioned in Question 2
of the example above may vary by industry (e.g., proportionate
consolidation guidance may not be relevant in some industries). Also
note that the analysis should be performed at the appropriate level,
which may not always be the JOA. ASC 842 speaks to arrangements
involving a “joint operation or joint arrangement,” and this could
be a subset of a JOA to the extent that multiple parties have agreed
to jointly use an identified asset for a defined time frame. For
example, in a five-year JOA involving five parties, if three of the
parties agree to jointly develop a property by using a specified
drill rig for the first two years, it may be necessary to evaluate
that two-year agreement to determine whether it contains a
lease.
Finally, the above example is not meant to suggest
that most JOAs will contain leases. Rather, it is meant to highlight
and explain the analysis that ASC 842 requires in circumstances
involving joint arrangements that feature the use of specified
PP&E.
Joint arrangement accounting remains a topic of
discussion between companies and auditors, and we would encourage
entities affected by this issue to check with their auditors and
accounting advisers for input on the accounting for specific
arrangements.
Lessee Model
Q&A 4 Considerations Related to the Impairment of an ROU Asset
A lessee must subject an ROU asset to impairment testing in
a manner consistent with its treatment of other long-lived assets (i.e., in
accordance with ASC 360). If the ROU asset related to an operating lease is
impaired, the lessee would amortize the remaining ROU asset in accordance
with the subsequent-measurement guidance that applies to finance leases —
typically, on a straight-line basis over the remaining lease term. Thus, the
operating lease would no longer qualify for the straight-line treatment of
total lease expense. However, in periods after the impairment, a lessee
would continue to present the ROU asset amortization and interest expense as
a single line item.
Question
How should a lessee include the effects of a lease that is
part of an asset group when testing the asset group for impairment in
accordance with ASC 360?
Answer
Under the new leases standard, since operating and finance
leases are both accounted for as financings in the balance sheet, the
effects of both types of leases should generally be included in the
impairment calculation in a manner similar to the accounting for capital
leases under ASC 840. That is, a lessee should:
- Include both the ROU asset and the lease liability in the carrying amount of the asset group.
- Include only the principal component of lease payments as cash outflows in the undiscounted cash flows of the asset group. Although the total lease expense in an operating lease is presented as a single line item in the income statement, the lease payments include both an interest component and a principal component. In a manner consistent with ASC 360-10-35-29, the lessee should exclude the interest component of the lease payments from the asset group’s undiscounted cash flows.
Editor’s Note
At the FASB’s November 30, 2016, meeting, the Board
generally agreed that lessees should exclude interest payments from
calculations of the undiscounted cash flows when assessing an asset
group for impairment under ASC 360. However, some Board members
noted that an entity’s decision to include interest in its
impairment analysis could be viewed as an accounting policy
election. Since including interest on operating leases would
increase the possibility of an asset group impairment, we would not
expect entities to elect such an accounting policy.
Lessor Model
Q&A 5 Commencement Loss Resulting From Significant Variable Payments in a Sales-Type or Direct Financing Lease
While the FASB’s goal was to align lessor accounting with
the new revenue guidance in ASC 606, an important distinction between the
two may affect lessors in a number of industries. Under ASC 606, variable
payments are estimated and included in the transaction price subject to a
constraint. By contrast, under ASC 842, variable lease payments not linked
to an index or rate are generally excluded from the determination of a
lessor’s lease receivable.
Accordingly, sales-type or direct financing leases that have
a significant variable lease payment component may result in an entity’s
recognition of a loss at commencement because the measurement of the lease
receivable plus the unguaranteed residual asset is less than the net
carrying value of the underlying asset. This could occur, for example, if
lease payments are based entirely on the number of units produced by the
leased asset (i.e., payments are 100 percent variable), or when a portion of
the expected cash flows from the lease is variable (e.g., 50 percent of the
total expected cash flows are variable). However, these transactions
typically do not represent an economic loss for the lessor.
Question
Should a lessor recognize a loss at lease commencement when
its initial measurement of the net investment in a sales-type or direct
financing lease is less than the carrying value of the underlying asset?
Answer
Yes. At the FASB’s November 30, 2016, meeting, the Board
acknowledged that a lessor’s initial measurement of a sales-type or direct
financing lease that includes a significant variable-lease payment component
may result in a loss at lease commencement if the lease receivable plus the
unguaranteed residual asset is less than the net carrying value of the
underlying asset being leased. The Board discussed whether a loss at
commencement would be appropriate in these situations or whether other
possible approaches would be acceptable, such as (1) incorporating variable
lease payments subject to a constraint (by reference to ASC 606) or (2)
using a negative discount rate to avoid the loss at commencement. The Board
expressed its belief that while stakeholders may disagree with the outcome
of recognizing a loss at commencement, the new leases standard is clear
about how the initial measurement guidance should be applied to sales-type
and direct financing leases.
In discussions with the FASB staff, we observed that in
situations similar to those outlined in Examples 1 and 2 below, the outcome
of the calculation of the “rate implicit in the lease,” which is based on
how that term is defined in ASC 842-30-20, may result in a negative discount
rate. However, at the FASB’s November 30, 2016, meeting, the Board
acknowledged that using a negative discount rate to determine the rate
implicit in the lease (as defined in ASC 842-10-20) is inappropriate. After
the Board discussed the issue at that meeting, the FASB staff indicated to
us that it expects lessors to use a 0 percent discount rate when measuring
the net investment in a lease if the rate implicit in the lease is
negative.
Example 1
A
lessee and manufacturer lessor enter into a
five-year sales-type lease of the lessor’s R2-series
equipment. Before lease commencement, the lessor
customizes the R2-series equipment specifically for
the lessee.8 The
asset has a carrying value of $100, fair value at
commencement of $120, and an estimated unguaranteed
residual value of $50 at the end of the lease term.
Payments are based entirely on the lessee’s usage of
the R2-series equipment. The lessor has significant
insight into the lessee’s equipment needs over the
five-year term, and although the payments are 100
percent variable, the lessor has priced the lease
with the expectation that it will receive an annual
payment of $20. The lessor thus charges the lessee a
rate of 6.4 percent.9
The
tables below illustrate the terms of the sales-type
lease and the lessor’s accounting for the lease
under ASC 842.
Example 2
Assume the same facts as in Example 1. The lessor
still charges the lessee a rate of 6.4 percent based
on expected annual cash flows of $20.10 However, the lessor
prices the lease with 50 percent of the cash flows
fixed and 50 percent of the cash flows variable
based on the lessee’s usage of the R2-series
equipment.
The tables below
illustrate the terms of the sales-type lease and the
lessor’s accounting for the lease under ASC
842.
Editor’s Note
It is common for lease arrangements in a number of
industries to include significant or wholly variable lease payments.
It is not uncommon for such arrangements to result in sales-type or
direct financing lease classification.
Arrangements in the energy sector are frequently
accounted for as leases with wholly variable payment streams. For
example, power purchase agreements related to renewable energy
(i.e., from solar or wind generation facilities) (1) are commonly
long-term and the major part of the economic life of the generation
facility, (2) provide for payments at a fixed price per unit of
electricity output (e.g., $50 per megawatt hour (MWh)), and (3)
require the lessee to take all of the output produced by the
facility but do not specify a minimum level of production (i.e., the
volume of output is wholly variable). Although the output quantity
is weather-dependent, the lessor expects the arrangement to be
profitable on the basis of historical weather data.
We are also aware of arrangements in the oil and gas
industry in which a company builds a gathering and processing system
and leases it to a single user under a variable payment structure.
For example, an exploration company with rights to multiple oil
wells on dedicated acreage may contract with a midstream company to
construct and lease the infrastructure necessary to gather and
process the oil extracted from the wells. The arrangement may be
long-term and for a major part of the economic life of the
infrastructure, and the payment for the use of the infrastructure
may be 100 percent variable (e.g., a fixed price per unit multiplied
by the number of units gathered or processed) without a minimum
volume requirement. The midstream company would be willing to accept
variable consideration in the arrangement if reserve data related to
the wells suggest that a sufficient volume of oil will be extracted
over the term of the contract to make the arrangement
profitable.
In the real estate sector, a commercial real estate
lease arrangement (e.g., a lease of retail space) may be priced in
such a way that a significant amount of the expected payments are
contingent on the lessee’s sales (e.g., payments that are a fixed
percentage of the retail store’s sales for a month). The lessor
would account for the arrangement as a sale-type lease if the lease
(1) is for a major part of the economic life of the retail location
or (2) contains a purchase option that the lessee is reasonably
certain to exercise. Arrangements of this type allow the property
owner to participate in the upside of the retail store’s business
and are expected to be profitable.
Finally, in the health care industry, it is not
uncommon for a hospital to contract with a medical device owner for
the use of specific medical equipment for a major part of the
economic life of the equipment. This type of arrangement is often
priced in such a way that the consideration is based entirely on the
hospital’s ongoing purchase of “consumables,” which allow the
equipment to function as designed, and may have no minimum volume
requirement. The medical device owner is willing to accept variable
consideration in the arrangement because demand for the associated
health care services suggests that a sufficient volume of
consumables will be purchased by the hospital over the term of the
contract to make the arrangement profitable.
Q&A 6 Operating Lease Income Statement Profile
ASC 842-30-25-11 requires a lessor to recognize lease
payments in an operating lease as income in profit or loss on a
straight-line basis over the lease term “unless another systematic and
rational basis is more representative of the pattern in which benefit is
expected to be derived from the use of the underlying asset.”
Some stakeholders have asked whether lessors should use
“another systematic and rational basis” to recognize income from operating
leases when the lease payments are uneven to reflect or compensate for
anticipated market rentals or market conditions. This question is based on
paragraph BC327 of ASU 2016-02, which states that a “lessor is expected to
recognize uneven fixed lease payments on a straight-line basis when the payments are uneven for reasons other than to
reflect or compensate for market rentals or market conditions (for
example, when there is significant front loading or back loading of payments
or when rent-free periods exist in a lease)” (emphasis added).
Question
Can a lessor depart from straight-line income recognition
for operating leases when lease payments are uneven or stepped to reflect
anticipated market rentals or market conditions?
Answer
No. A lessor should continue to recognize lease payments as
income in the same manner as generally required under ASC 840 — that is, on
a straight-line basis.
On the basis of discussions with the FASB staff, we
understand that regardless of whether uneven rents are designed to reflect
anticipated market conditions, paragraph BC327 of ASU 2016-02 is not
intended to require or permit a lessor to deviate from straight-line
recognition.
Example
Company A (lessee) enters into a 10-year lease with
Company B (lessor) to lease a floor in a commercial
building for use as office space. Company A agrees
to make an annual payment at the end of each year as
follows:
- Years 1 and 2 — $100,000.
- Years 3 and 4 — $120,000.
- Years 5 and 6 — $140,000.
- Years 7 and 8 — $160,000.
- Years 9 and 10 — $180,000.
The stepped increase in
lease payments is intended to compensate B for
anticipated changes in market rentals throughout the
lease term.
Assume that B
concludes that the lease is an operating lease.
Although the uneven lease payments are intended to
reflect market rentals for the future periods, B
should recognize lease payments as income on a
straight-line basis. Accordingly, B recognizes
annual lease income of $140,000 for all 10 years of
the lease.
Q&A 7 Determining an Impairment of the Net Investment in a Lease
ASC 842-30-35-3 provides guidance on how a lessor should
determine an impairment related to the net investment in the lease. In
describing the collateral that a lessor should consider when performing its
evaluation, the guidance indicates that such collateral would exclude the
cash flows that the lessor would expect to derive from the underlying asset
following the end of the lease term. In particular, ASC 842-30-35-3
states:
A lessor shall . . . recognize any
impairment in accordance with Topic 310 on receivables (as described in
paragraphs 310-10-35-16 through 35-30). When determining the loss
allowance for a net investment in the lease, a lessor shall take into
consideration the collateral relating to the net investment in the
lease. The collateral relating to the net investment in the lease
represents the cash flows that the lessor would expect to derive from
the underlying asset during the remaining lease term (for example, from
sale of the asset or release of the asset for the remainder of the lease
term), which excludes the cash flows that the lessor
would expect to derive from the underlying asset following the end
of the lease term (for example, cash flows from leasing the
asset after the end of the lease term). [Emphasis added]
Although the guidance is explicit, some have questioned
whether the FASB intended to require a lessor to exclude cash flows related
to the residual asset or whether it would be appropriate to include such
amounts because excluding them may lead to earlier recognition of an
impairment loss on the net investment in the lease.
Question
Should a lessor include the cash flows that the lessor would
expect to derive from the underlying asset at the end of the lease term when
evaluating impairment of the net investment in a lease?
Answer
Yes. In response to a technical inquiry, the FASB staff
confirmed that the unit of account used when the impairment model is applied
from the lessor’s perspective is meant to encompass amounts related to the
entire net investment in the lease, which would include the residual asset.
Therefore, when evaluating the net investment in a sales-type or direct
financing lease for impairment, a lessor should use the cash flows it
expects to derive from the underlying asset during the remaining lease term
as well as the cash flows it expects to derive from the underlying asset at
the end of the lease term (i.e., cash flows expected to be derived from the
residual asset). When determining the cash flows to be derived from the
residual asset, a lessor should consider amounts it would receive for
re-leasing or selling the underlying asset to a third party but should not
consider the expected credit risk of the potential lessee or buyer of the
underlying asset (i.e., it would not be appropriate for the lessor to
include a credit risk assumption in its analysis since it does not know the
identity of the theoretical buyer).
Lease Classification
Q&A 8 Use of ASC 840’s Bright-Line Thresholds for Lease Classification Under ASC 842
ASC 840 requires an entity to classify a lease on the basis
of an evaluation of, among other things, certain quantitative bright-line
thresholds. That is, under ASC 840, a lease would be classified as a capital
lease if the lease term is 75 percent or more than the remaining economic
life of an underlying asset or if the sum of the present value of the lease
payments and the present value of any residual value guarantees amounts to
90 percent or more of the fair value of the underlying asset. However, when
developing the lease classification guidance in ASC 842-10-25-2, the Board
decided not to require the use of bright lines.
Question
Although entities are no longer required to assess certain quantitative bright-line thresholds when
classifying a lease, are they permitted to use
quantitative thresholds when classifying a lease under ASC 842?
Answer
Yes. The implementation guidance in ASC 842-10-55 states
that a reasonable approach to applying the lease
classification criteria in ASC 842 is to use the same bright-line thresholds
that exist in ASC 840. ASC 842-10-55-2 states the following:
When determining lease classification, one reasonable
approach to assessing the criteria in paragraphs 842-10-25-2(c) through
(d) and 842-10-25-3(b)(1) would be to conclude:
- Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
- A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
- Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.
On the basis of this implementation guidance, we would not
object to an entity’s application of ASC 840’s bright-line thresholds when
classifying a lease under the new leases standard. We would expect that
under such an approach, an entity would classify a lease in accordance with
the quantitative result. That is, if an entity applies ASC 840’s bright-line
thresholds and determines that a lease term is equal to 76 percent of an
asset’s useful life, the entity should classify the lease as a finance
lease. The entity should not attempt to overcome the assessment with
qualitative evidence to the contrary. Likewise, if the same entity
determines that a lease term is equal to 74 percent of an asset’s useful
life, the entity should classify the lease as an operating lease. If an
entity decides to apply the bright-line thresholds in ASC 840 when
classifying a lease, we would expect the entity to apply those thresholds
consistently to all of its leases.
Ingredients of the Lease Model
Q&A 9 Including Noncash Consideration in Lease Payments
Some leases require the lessee to make some or all of the
lease payments with noncash consideration. For example, a lessee could be
required to provide value in the form of hard assets, stock of the lessee or
others, or guarantees of certain obligations of the lessor. The final value
of the consideration at the time of payment may be different from the
estimate at lease commencement.
Question
Should an entity (lessee or lessor) include noncash
consideration in its determination of lease payments?
Answer
Generally, yes. Noncash consideration should generally be
included in an entity’s determination of lease payments and should be
measured at fair value at lease commencement. That is, we believe that the
fair value of the noncash consideration would generally be akin to an index
or rate, which is included in lease payments at commencement.11 Any fluctuations in the fair value of
noncash consideration to be provided between the initial measurement of the
ROU asset and liability and the final measurement determined in accordance
with other U.S. GAAP should be recognized as variable lease payments. For
noncash consideration in the form of a guarantee (other than a guarantee of
the lessor’s debt, as discussed below), the amounts accrued and ultimately
paid under the guarantee would not be considered variable lease payments.
Rather, the providing of the guarantee is the final
lease payment because the lessee has delivered its stand-ready obligation
under the guarantee.
Note, however, that a guarantee of the lessor’s debt is
specifically excluded from the scope of lease payments.12
Example 1
Company A provides Company B with materials and
labor needed to build a tavern, and A has agreed to
lease the tavern from B at the end of the
construction period. Company A does not control the
asset under construction.13 The fair value
of the materials and labor provided to B should be
recognized as a prepaid lease payment and included
in the measurement of the ROU asset at lease
commencement.
Example 2
Company X (the lessee) enters into an arrangement
to lease an aerosol can factory from Company Y (the
lessor) for three years. As consideration for the
right to use the aerosol can factory, X agrees to
transfer to Y 50, 60, and 70 shares of stock in
Company Z, in arrears each year, respectively. As of
lease commencement, the fair value per share of Z’s
stock is $20. Company X uses its incremental
borrowing rate of 9 percent when discounting the
lease payments since the rate implicit in the lease
is not known.
In accordance
with the lease classification tests (for lessees and
lessors) under ASC 842-10-25-2(d), the lease
payments should include the amount of $3,009, the
present value of the three payments made in shares
of Company Z stock. Assume that the lease is an
operating lease. The lessee’s lease liability should
be measured at $3,009. Further assume that the fair
value of the stock during year 1 of the lease is $25
per share on the final measurement date of the 50
shares. The lessee should recognize the incremental
fair value not included in the lease liability as a
variable lease cost (i.e., $250, which represents 50
shares multiplied by the increase in the value of
the stock since lease commencement). However, the
shares to be delivered in years 2 and 3 should not
be adjusted to their fair value on those dates
because the fair value of the stock is an index or
rate that is not adjusted after lease commencement
until it is recognized.
Q&A 10 Nonrefundable and Refundable Deposits
Certain leasing arrangements may include a security deposit
that is required to be paid to the owner of the leased asset at or before
lease commencement. The security deposit is generally provided to support
the lessee’s intent and commitment to lease the underlying asset (i.e., upon
receipt of a security deposit, the lessor typically stops marketing the
asset for lease). Security deposits can be either nonrefundable or
refundable depending on the terms of the contract.
ASC 842-10 defines lease payments for purposes of
identifying the types of payments that an entity should consider when
determining the classification, initial measurement, and subsequent
measurement of a lease. Specifically, ASC 842-10-30-5 states, in part:
At the commencement date, the lease payments shall
consist of the following payments relating to the use of the underlying
asset during the lease term:
- Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).
- Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.
Question 1
Is a nonrefundable deposit a lease
payment under ASC 842?
Answer
Yes. A nonrefundable deposit is a lease payment under ASC
842.
A nonrefundable deposit is an amount the lessee pays the
lessor to secure the terms of the contract for both parties. This payment
represents a portion of the consideration to be transferred during the
contract term and is not refunded by the lessor. Because the payment to the
lessor is nonrefundable, it is considered a fixed payment under ASC
842-10-30-5.
Question 2
Is a refundable deposit a lease
payment under ASC 842?
Answer
No. A refundable deposit is not a
lease payment under ASC 842.
A refundable security deposit is an amount that the lessee
is required to submit to the lessor to protect the lessor’s interest in the
contract and the property. This amount is held by the lessor until the
occurrence of an event that would allow the lessor to use some or all of the
deposit to meet the contract requirements (e.g., use the deposit to recover
any shortfall in payment by the lessee or to repair any damages to the
leased property). In the absence of such a need, the lessor would be
required under the contract to return the remaining, unused security deposit
to the lessee at the end of the lease. Because the payment is refundable, it
would not meet the definition of a lease payment
under ASC 842-10-35-5.
Note that the portion of a refundable security deposit
retained by the lessor to recover a shortfall in a lease payment would
effectively be settling a portion of the lease liability associated with the
missed payment. In contrast, any portion of the refundable security deposit
retained by the lessor for other reasons (e.g., excess wear and tear on the
underlying asset) would generally be considered a variable lease payment.14 In addition, any interest
earned on the refundable security deposit retained by the lessor would be a
variable lease payment in the period in which it is earned. As with other
variable payment requirements, lessees should consider the implementation
guidance in ASC 842-20-55-1 and 55-2 when evaluating whether a lessee should
recognize costs from variable payments before the achievement of a specified
target (see Q&A
14).
Q&A 11 Variable Payments Based on an Index or Rate
Background
Frequently, leases contain terms that revise or reset the
amounts payable to the lessor over the lease term. Those adjustments to the
amounts payable to the lessor are described in ASC 842 as variable lease
payments. Generally, ASC 842 differentiates between two categories of
variability in lease payments:
- Variability based on an index or rate (e.g., escalators based on the CPI, or rents that are referenced to or are increased on the basis of LIBOR).
- Other variability, including variability that is typically described as based on performance or usage of the asset (e.g., rents based on the percentage of retail store sales or on mileage driven using a leased car).
The new leases standard requires only limited types of
variable payments to be included in the lease payments that will affect the
lease classification and measurement. Specifically, ASC 842-10-30-5 provides
that “[a]t the commencement date, the lease payments shall consist [in part]
of the following payments relating to the use of the underlying asset during
the lease term”:
- Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).
- Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.
In addition, ASC 842-10-30-6 explicitly states that “[l]ease
payments do not include [v]ariable lease payments other than those in [ASC]
842-10-30-5(b).”
Question
How should a lessee15
initially measure its lease liability and ROU asset at lease commencement
when there are variable payments based on an index or rate?
Answer
The initial measurement of the lease liability and ROU asset
should be determined on the basis of the lease payments, which, as stated in
ASC 842-10-30-5(b), include “[v]ariable lease payments that depend on an
index or a rate (such as the Consumer Price Index or a market interest
rate).” An entity initially measures variable payments based on an index or
rate by using the index or rate at lease commencement (i.e., the spot or
gross index or rate applied to the base rental amount). The use of the spot
rate at lease commencement is largely based on the FASB’s view that (1) the
cost associated with forecasting future rates would not outweigh the
benefits provided and (2) the use of forecasted rates or indexes would be
inconsistent among preparers and often imprecise.
In contrast, payments based on a change in an index or a rate should not be
considered in the determination of lease payments. Given the cost-benefit
considerations related to the use of forecasting techniques, ASC 842 does
not allow an entity to forecast changes in an index or rate to determine
lease payments. Rather, adjustments to lease payments that are based on a
change in an index or rate are treated as variable lease payments and
recognized in the period in which the obligation for those payments was
incurred.
For example, assume that lease payments are made in arrears
and are based on a fixed amount (e.g., a $100,000 base amount) adjusted each
year by the CPI at the end of the year. If the CPI at lease commencement was
2.7 percent, the total lease payments used to measure the lease liability
would be $102,700 per year of the lease, which includes $2,700 in variable
lease payments based on an index or rate at lease commencement. In contrast,
if the payments were based on a fixed amount ($100,000) that will
subsequently be adjusted in a manner corresponding to the change in the CPI each year throughout the lease
term, the initial measurement of the lease liability and ROU asset would not take into account the future expected
adjustments in the CPI. Therefore, the initial measurement of the lease
liability and ROU asset would be based only on the fixed payments through
the lease term (see the example below).
Example
A
retailer enters into a lease of a retail space for
five years with the following terms:
The first lease payment
was made on January 1. Each subsequent payment is
made on December 31. There were no initial direct
costs or lease incentives. The lessee recognizes
total lease expense and measures the lease liability
and ROU asset in the manner shown in the table
below.
Q&A 12 Implications of Index- or Rate-Based Payment Adjustments
The subsequent remeasurement of a lease depends on whether
the variability is associated with an index or rate or arises for other
reasons. Specifically, ASC 842-10-35-4 and 35-5 require, in part, the
following:
35-4 A lessee shall remeasure the lease payments if any of
the following occur:
- The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
- A contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term.
- There is a change in any of the following:
- The lease term, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments on the basis of the revised lease term.
- The assessment of whether the lessee is reasonably certain to exercise or not to exercise an option to purchase the underlying asset, as described in paragraph 842-10- 35-1. A lessee shall determine the revised lease payments to reflect the change in the assessment of the purchase option.
- Amounts probable of being owed by the lessee under residual value guarantees. A lessee shall determine the revised lease payments to reflect the change in amounts probable of being owed by the lessee under residual value guarantees.
35-5 When a
lessee remeasures the lease payments in accordance with paragraph
842-10-35-4, variable lease payments that depend on an index or a
rate shall be measured using the index or rate at the remeasurement
date.
Question
Do index- or rate-based payment adjustments in a lease
require the lessee to remeasure the lease?
Answer
No. Changes in an index or rate alone would not give rise to
a requirement to remeasure the lease. On the basis of discussions with the
FASB staff, we understand that the guidance on remeasuring a lease liability
after the resolution of a contingency is not meant to apply to index-based
escalators even when those escalators serve to establish a new floor for the
next lease payment. Therefore, even when the index or rate establishes a new
floor (such as when the CPI increases and establishes a new rate that will
be used as a benchmark for determining future lease payment increases), that
adjustment would not result in a remeasurement of the lease liability and
ROU asset. As a result, the additional payments for increases in the CPI
will be recognized in the period in which they are incurred.
However, as highlighted in ASC 842-10-35-5, if a lessee
remeasures the lease payments for any of the other reasons detailed in ASC
842-10-35-4, the lessee is required to remeasure variable lease payments
that depend on an index or rate by using the index or rate in effect on the
remeasurement date.
Editor’s Note
While the FASB’s and IASB’s respective new leases
standards are generally converged with respect to the recognition
and measurement of variable lease payments, there is a notable
difference. Under IFRS 16, for lease payments based on an index or
rate, the lease liability and ROU asset are remeasured each period
to reflect changes to the index or rate. Therefore, entities that
are subject to dual reporting under both U.S. GAAP and IFRSs (e.g.,
a parent entity that applies U.S. GAAP and has international
subsidiaries applying IFRSs for statutory reporting) will be
required to account for their leases under two different
remeasurement models.
Q&A 13 Rents Based on Fair Value
Some lease agreements (typically real estate leases) include
variability in the form of a rent reset provision that requires the future
lease payments after a specified point in time to be reset to the fair value
rates at that time. For example, a 10-year lease of property in Chicago that
requires annual rental payments of $100,000 for years 1 through 5 may also
include a provision to reset the rental payments in years 6 through 10 of
the lease to the updated fair value rent as benchmarked to published rates
for Chicago.
Question
Should the fair market rent reset feature described above be
accounted for in accordance with the guidance on variable payments that are
based on an index or rate?
Answer
Yes. Paragraph BC211 of ASU 2016-02 states the FASB’s
rationale for including certain variable lease payments that depend on an
index or rate in the measurement of the lease liability and ROU asset:
For reasons similar to those for including in substance
fixed payments in the measurement of lease assets and lease liabilities,
the Board also decided to include variable lease payments that depend on
an index or a rate in the measurement of lease assets and lease
liabilities. Those payments meet the definition of assets (for the
lessor) and liabilities (for the lessee) because they are unavoidable
(that is, a lessee has a present obligation to make, and the lessor has
a present right to receive, those lease payments). Any uncertainty,
therefore, relates to the measurement of the asset or liability that
arises from those payments and not to the existence of the asset or
liability.
While ASC 842 does not define “index” or “rate,” we believe
that an index or rate is based on underlying economic performance (e.g., the
CPI measures the variation in prices paid by a consumer household for
certain retail goods and services). Similarly, fair market rent is
indicative of the economic performance of a specific geographic region and
is analogous to a formally published index or rate. Further, the FASB and
IASB converged certain aspects of their new guidance on leases, including
the treatment of rents subject to market rate resets as lease payments that
vary on the basis of an index or rate. Paragraph 28 of IFRS 16 explicitly
states that a variable payment that is based on an index or rate would
include, among other things, “payments that vary to reflect changes in fair
market rental rates.”
Since variable rent based on fair market rental rates was
determined to be analogous to variable rent based on an index or rate, we
believe that the specific guidance on variable rental rates based on an
index or rate (see Q&As
11 and 12)
should be applied to variable rent based on fair market rental rates.
Accordingly, a lessee should measure the lease liability and ROU asset on
the basis of the rental rate in effect at lease commencement. Any subsequent
change in the fair market rental rate would not require remeasurement of the
lease liability and ROU asset (although remeasurement could be required for
another reason) but would be recorded as variable lease income or expense in
the appropriate period depending on the change in the fair market rental
rate.
The example below illustrates the accounting for variable
rent based on fair market rental rates.
Example
A
retailer entered into a lease of a retail space for
10 years with the following terms:
The first lease payment was made on
January 1. Each subsequent payment is made on
December 31. The lessee recognizes total lease
expense and measures the lease liability and ROU
asset in the manner shown in the table below. As a
reminder, variable lease payments that are based on
an index or rate (including fair market rents) are
considered lease payments and would be initially
measured on the basis of the index or rate in place
at lease commencement. Therefore, at lease
commencement, the fair market rent expected for
years 6 through 10 would be $100,000 since that is
the fair market rent at lease commencement.
In this example, assume
that the actual fair market rent increases to
$150,000 in year 6. When the lease payments are
updated to reflect this increase, the lease
liability and ROU asset are not remeasured for the
change in fair market rent from $100,000 in years 1
through 5 to $150,000 in years 6 through 10. Rather,
the additional $50,000 is recorded as variable lease
expense in each of the years in which it was
incurred.
Next, assume the
same facts, except that the fair market rental rate
decreased from $100,000 in years 1 through 5 to
$90,000 in years 6 through 10. In those
circumstances, the lessee would record a $10,000
reduction in lease expense in each of years 6
through 10 and would not remeasure the lease
liability and ROU asset.
Q&A 14 Lessee Timing of Variable Payments
Background
Many lease arrangements contain variable payments based on
the use or performance of the underlying asset. Examples include (1) a
retail store lease that requires the lessee to pay a percentage of store
sales each month, (2) a car lease that requires the driver to pay for each
mile driven, and (3) a power purchase agreement that requires the lessee
(the off-taker) to buy all electricity produced by a weather-dependent
generating plant such as a wind farm.
Under ASC 842, variable payments not dependent on an index
or rate are excluded from the initial measurement of the lease liability and
ROU asset.
ASC 842-20-25-5(b) (for finance leases) and ASC
842-20-25-6(b) (for operating leases) both state that variable lease
payments not included in the initial measurement of the lease should be
recognized in profit or loss “in the period in which the obligation for
those payments is incurred” (emphasis added). In
addition, the implementation guidance in ASC 842-20-55-1 states that a
“lessee should recognize costs from variable lease payments (in annual
periods as well as in interim periods) before the achievement of the
specified target that triggers the variable lease payments, provided the
achievement of that target is considered probable”
(emphasis added).
Question
In a lease arrangement in which the lessee pays a variable
amount based on usage or performance, is the lessee required to assess the
probability of future performance throughout the lease term and record a
charge (and a corresponding liability) for the variable lease payment amount
assessed as probable?16
Answer
It depends. We believe that the guidance in ASC 842-20-55-1
on the probable achievement of variable lease payment targets is meant to be
narrowly applied to scenarios involving discrete performance targets or
milestones that will be achieved over time (e.g., a specified level of
cumulative store sales) and, in those limited scenarios, is meant to require
recognition in each period over the lease term at an amount that reflects an
appropriate apportionment of the expected total lease cost. This guidance
ensures that the cost of the lease is appropriately allocated to both the
periods of use that contribute to the variable payment requirement and the
periods of use in which the variable payment requirement has been met. Such
allocation is necessary when performance targets are cumulative and have the
potential to cross reporting periods.
We do not believe that the guidance on the probable
achievement of variable lease payment targets is meant to otherwise require
an assessment of a probable level of performance over the lease term and
require a charge in advance of actual performance when the variability
arises and is resolved within a reporting period. For example, in a vehicle
lease, a variable charge per mile driven that starts with the first mile and
continues throughout the lease term can be discretely measured and expensed
in the reporting period in which the charge is incurred. That is, it is
unnecessary to assess probability of future mileage to ensure proper period
attribution of the variable charges. Applying a probability model to this
type of variable payment structure could lead to an inappropriate
acceleration of variable expense attributable to future use.
The examples below illustrate the difference between the
treatment of variability when discrete cumulative targets exists and the
treatment when the variability is resolved within the reporting period.
Example 1
Retailer X is a lessee in an arrangement that
requires X to pay $500 plus 3 percent of store sales
each month over a five-year lease term. Retailer X
is not required to forecast its sales over the lease
term and accrue for a level of sales deemed probable
of occurring. Rather, X will recognize variable
lease expense each month equal to 3 percent of
sales.
Example 2
Utility Y is a lessee in a power purchase agreement
in which it purchases all of the output from a wind
farm owned by an independent power producer (IPP) at
a fixed price per MWh. Since the wind farm is 100
percent weather-dependent, Y’s lease payments are
100 percent variable (Y pays only for electricity
produced). Studies performed before the wind farm
was constructed indicate that there is a 95 percent
likelihood that electrical output will equal or
exceed 25,000 MWh per month. Despite the very high
likelihood (95 percent is well above the “probable”
threshold) of a minimum performance level, Y is not
required to accrue for a corresponding amount of
lease payments (i.e., an expectation of variable
lease payments based on future production). Rather,
Y will recognize variable lease expense each month
as electricity is delivered and billed by the
IPP.
Example 3
Retailer Z is a lessee in a five-year operating
lease that requires it to pay base rent of $500 per
month plus an additional $100 per month beginning
when cumulative store sales exceed $100,000.
Retailer Z believes that it is probable that this
sales target will be achieved by the end of year 2
(i.e., rent will become $600 per month after the
target is met).
Retailer Z
should quantify the amount that it is probable for
the entity to incur on the basis of its achievement
of the target ($3,600, or $100 per month for 36
months) and should apportion that amount to each
period beginning at commencement. That is, since
eventual achievement of the cumulative sales target
is deemed probable at commencement, the $3,600
should be recognized ratably over the five-year term
(i.e., $500 per month for 24 months plus $600 per
month for 36 months, resulting in an expense of $560
per month) even though the target has not yet been
achieved. This is an appropriate accounting outcome
because sales in years 1 and 2 contribute to the
achievement of the target. Accordingly, years 1 and
2 should be burdened by an appropriate amount of the
incremental lease expense.
On
the basis of the above fact pattern, Z would
recognize an incremental lease expense of $60 per
month beginning at lease commencement (i.e., $3,600
divided by the 60 months of the lease term) to
reflect the expected additional rent associated with
the anticipated achievement of the sales
target.
In addition, once the
target is actually achieved, Z would remeasure the
ROU asset and corresponding liability in accordance
with ASC 842-10-35-4(b) since the entity would be
able to conclude that a “contingency upon which some
or all of the variable lease payments that will be
paid over the remainder of the lease term are based
is resolved such that those payments now meet the
definition of lease payments.”
Assuming that Z achieves the sales
target as planned at the end of year 2 (and also
assuming a 0 percent discount rate for simplicity),
Z would recognize the following amounts in its
financial statements:
January 1, 20Y1
(Commencement)
Initial
recognition of the ROU asset and corresponding lease
liability (calculated as $500 per month for a
five-year period)
December 31,
20Y1
Annual activity
(reduction of ROU asset/lease liability and
recognition of lease expense)
Recognition and accrual of variable
lease expense (($3,600 ÷ 60 months of term) × 12
months per year)
December 31,
20Y2
Annual activity
(reduction of ROU asset/lease liability and
recognition of lease expense)
Recognition and accrual of variable
lease expense (($3,600 ÷ 60 months of term) × 12
months per year)
Adjustment of ROU asset and
corresponding liability (resolution of
contingency)
December 31,
20Y3
Annual activity
(reduction of ROU asset/lease liability and
recognition of lease expense posttriggering
event)
December 31,
20Y4
Annual activity
(reduction of ROU asset/lease liability and
recognition of lease expense posttriggering
event)
December 31,
20Y5
Annual activity
(reduction of ROU asset/lease liability and
recognition of lease expense posttriggering
event)
Q&A 15 Determining a Subsidiary’s Incremental Borrowing Rate When the Lease Terms Were Influenced by Parent or Group Credit
When initially measuring its lease liability, a lessee is
required to use the rate implicit in the lease unless that rate cannot be
readily determined. If the rate cannot be readily determined (which will
generally be the case), the lessee should use its incremental borrowing rate
when initially measuring its lease liability. In addition to performing the
initial measurement, a lessee is required to remeasure its lease liability
by using a revised discount rate upon the occurrence of certain discrete
reassessment events (e.g., a change in lease term or a modification of a
lease that does not result in a separate contract).
In some cases, leases are negotiated by a parent on behalf
of its subsidiary so that the subsidiary can obtain the benefit of the
parent’s superior credit. In other cases, a consolidated group might have a
centralized treasury function that negotiates on behalf of all of its
subsidiaries for the same reason. The negotiations often include guarantees
or other payment mechanisms that allow the lessor to look beyond just the
subsidiary for payment. This raises the question of whether it would be
appropriate for an entity to use a rate other than the subsidiary’s
incremental borrowing rate when accounting for a lease at the subsidiary
level (assuming that the implicit rate cannot be readily determined).
Question
Would it be appropriate for a subsidiary to use an
incremental borrowing rate other than its own to measure its lease liability
when the implicit rate cannot be readily determined?
Answer
It depends. The appropriate incremental borrowing rate for
measuring the lease liability would generally be based on the terms and
conditions negotiated between the lessee and the lessor. Often, the pricing
of the lease will solely depend on the credit standing of the subsidiary
itself (i.e., the lessee in the arrangement). In other cases, the pricing
may be significantly influenced by the credit risk evaluated at another
level in an organization (e.g., the parent or consolidated group) on the
basis of guarantees or other payment mechanisms that allow the lessor to
look beyond just the subsidiary for payment. If the pricing of the lease
depends solely on the lessee’s credit standing when the lease was
negotiated, the lessee’s incremental borrowing rate should be used to
measure the lease liability. However, if the pricing of the lease depends on
the credit risk of an entity other than the lessee when the lease was
negotiated (e.g., the lessee’s parent or a consolidated group), it will
generally be more appropriate to use the incremental borrowing rate of that
other entity.
Decentralized treasury functions within an organization may
be an indicator that it is appropriate for the reporting entity to use the
incremental borrowing rate of the subsidiary (i.e., the lessee in the
arrangement) when measuring the lease liability. However, this fact is not
individually determinative and should be considered along with the
determination of whether the subsidiary’s (lessee’s) credit standing was
used in the negotiation of the lease agreement. This view is consistent with
paragraph BC201 of ASU 2016-02, which states, in part:
The Board . . . considered that, in some cases, it might be reasonable
for a subsidiary to use a parent entity or group’s incremental borrowing
rate as the discount rate. Depending on the terms and conditions of the
lease and the corresponding negotiations, the parent entity’s
incremental borrowing rate may be the most appropriate rate to use as a
practical means of reflecting the interest rate in the contract,
assuming the implicit rate is not readily determinable. For example,
this might be appropriate when the subsidiary does not have its own
treasury function (all funding for the group is managed centrally by the
parent entity) and, consequently, the negotiations with the lessor
result in the parent entity providing a guarantee of the lease payments
to the lessor. Therefore, the pricing of the lease is more significantly
influenced by the credit standing of the parent than that of the
subsidiary.
The examples below highlight scenarios found commonly in
practice. Both assume that the credit of the parent or group is superior to
the credit of the subsidiary/lessee.
Example 1
On January 15, 20X1, Group A negotiates and
executes a lease on behalf of Subsidiary A, one of
the subsidiaries consolidated by Group A. The
treasury function is maintained at the Group A level
(i.e., Subsidiary A does not have a stand-alone
treasury function), and pricing of the lease was
based on the creditworthiness of Group A. While both
Group A and Subsidiary A are the named parties in
the lease agreement, Subsidiary A is identified as
the party that will occupy the leased
property.
Since treasury
operations (including the negotiation of lease
agreements) are conducted centrally at the Group A
level, it would generally be appropriate for
Subsidiary A to use Group A’s incremental borrowing
rate (as opposed to Subsidiary A’s rate) when
measuring Subsidiary A’s lease liability. This is
because the negotiations with the lessor and the
resulting pricing of the lease were based on the
creditworthiness of Group A rather than that of
Subsidiary A.
Example 2
On April 15, 201X, Lessee A negotiated a building
lease with Lessor B. Lessee A has its own treasury
function that negotiates all significant agreements,
including leases. However, A’s parent, ParentCo,
provided a guarantee of lease payments to B as part
of the negotiated terms of the lease.
Even though A has its own treasury
function and negotiated the term of its lease, it
would be reasonable to conclude that the pricing of
the lease was significantly influenced by the
creditworthiness of ParentCo (as evidenced by
ParentCo’s guarantee to the lessor). As a result, it
would generally be appropriate for A as the
reporting entity to measure the lease liability by
using ParentCo’s incremental borrowing
rate.
Presentation and Disclosure
Q&A 16 Whether an Entity That Presents a Classified Balance Sheet Is Required to Classify Its ROU Assets and Lease Liabilities as Current and Noncurrent
ASC 842-20-45-1 states:
ASC 842-20-45-1 states:
- 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.
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.
Question 1
Is an entity that presents a classified balance sheet
required to classify its ROU assets as current and noncurrent?
Answer
No. Entities typically exclude from current assets those
that are depreciated or amortized (e.g., PP&E and intangible assets,
respectively) in accordance with ASC 210-10-45-4(f). Under ASC 842, the ROU
asset is required to be amortized and is therefore akin to other amortizable
assets.
Question 2
Is an entity that presents a classified balance sheet
required to classify its lease liabilities as current and noncurrent?
Answer
Yes. ASC 210-10-45-6 states, in part:
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.
An entity should classify the portion of its lease
liabilities that is expected to be paid within the year as current
liabilities.
Example
On December 31, 202X, Company A, as lessee,
commenced a lease with a term of three years and an
annual lease payment of $4,660. After discounting
the lease payments at a discount rate of 8 percent,
A determines that (1) its 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, 202X, A should classify $3,699 as a current
liability and the remaining $8,310 as a noncurrent
liability in its classified balance
sheet.
Q&A 17 Excluding Leases With a Term of One Month or Less From Short-Term Lease Expense Disclosure
A short-term lease is a lease that, on 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. A lessee may elect not to apply the recognition requirements in
ASC 842 (under which a lease liability and an ROU asset are reflected on the
balance sheet) 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. The accounting policy election for short-term leases must be made and
applied consistently by class of underlying asset.
While lessees in short-term leases are provided relief from
the requirements in the new leases standard related to the recognition and
measurement of lease liabilities and ROU assets on the balance sheet, such
lessees are required to disclose short-term lease cost. However, the
disclosure requirement indicates that the short-term lease cost excludes
expenses related to leases with a term of one month or less.17
Although we expect that most entities will find respite in the “one month or
less” exclusion, entities may sometimes find it more burdensome to extract
leases with a term of one month or less and prefer to disclose expenses
related to all short-term leases.
Question
Is it acceptable for a lessee to include expenses related to
leases with a term of one month or less in its short-term lease expense
disclosure?
Answer
Yes. We believe that an entity may elect to include all
expenses related to leases with a term of one month or less (or all
short-term lease expenses by class of underlying asset) in the shortterm
lease expense disclosure (despite the explicit exclusions). Since it is our
understanding that the one month or less exclusion was intended to provide
relief, we believe that it would not be inconsistent with the disclosure
principles to disclose all of the short-term lease expenses (including
expenses related to leases with a term of one month or less) if doing so
would be less burdensome. Entities should consider disclosing their policy
if leases with a term of one month or less are included in their short-term
lease expense disclosures.
Driving Discussions — Presentation and Disclosure
SAB Topic 11.M Disclosure
Requirements
The SEC staff has recently been reminding SEC
registrants of the best practices to follow in the periods
leading up to the adoption of new accounting standards,
including ASU 2016-02. The staff’s comments have focused on
ICFR, auditor independence, and disclosures related to
implementation activities. SAB Topic 11.M provides disclosure
requirements for those accounting standards not yet adopted.
Specifically, when an accounting standard has been issued but
does not need to be adopted until some future date, an SEC
registrant should disclose the impact that the recently issued
accounting standard will have on the SEC registrant’s financial
position and results of operations when the standard is adopted
in a future period.
At the September 22, 2016, EITF meeting, the SEC
staff made an announcement regarding SAB Topic 11.M. While the
SEC staff acknowledged that an SEC registrant may be unable to
reasonably estimate the impact of adopting the new leases
standard, the SEC registrant should consider providing
additional qualitative disclosures about the significance of the
impact on its financial statements. In particular, the staff
indicated that it would expect such disclosures to include a
description of:
- The effect of any accounting policies that the SEC registrant expects to select upon adopting the ASU.
- How such policies may differ from the SEC registrant’s current accounting policies.
- The status of the SEC registrant’s implementation process and the nature of any significant implementation matters that have not yet been addressed.
As a result of these recent remarks, we would expect the
SAB Topic 11.M disclosure to be further refined and be more robust as
the effective date of the new leases standard approaches. For additional
information, see Deloitte’s September 22, 2016, Financial Reporting
Alert.
Annual Disclosures Needed in First Quarterly
Filing
Although the new leases standard may not require
certain of its prescribed disclosures to be provided in interim
financial statements, SEC registrants are required under SEC
rules and staff interpretations to provide both annual and
interim disclosures in the first interim period after the
adoption of a new accounting standard and in each subsequent
quarter in the year of adoption. Specifically, Section 1500 of
the SEC’s FRM states:
[Regulation] S-X Article 10 requires disclosures about
material matters that were not disclosed in the most recent
annual financial statements. Accordingly, when a registrant
adopts a new accounting standard in an interim period, the
registrant is expected to provide both the annual and the
interim period financial statement disclosures prescribed by
the new accounting standard, to the extent not duplicative.
These disclosures should be included in each quarterly
report in the year of adoption.
As a result, a calendar-year-end SEC registrant
will need to comply with the new leases standard’s full suite of
disclosure requirements in each quarter, beginning with the
registrant’s first quarter ended March 31, 2019, to the extent
that the disclosures are material and do not duplicate
information.
Transition
Q&A 18 Transition Considerations Related to the Impairment of an ROU Asset
Background
ASC 360 provides guidance on identifying, recognizing, and
measuring an impairment of a long-lived asset or asset group18 that is
held and used. Under the ASC 360 impairment testing model, a lessee is
required to test a long-lived asset (asset group) for impairment when
impairment indicators are present. Under this testing approach, a lessee
would be required to test the asset (asset group) for recoverability and,
when necessary, recognize an impairment loss that is calculated as the
difference between the carrying amount and the fair value of the asset
(asset group).
A lessee must subject an ROU asset to impairment testing in
a manner consistent with its treatment of other long-lived assets (i.e., in
accordance with ASC 360). Also, upon transition, a lessee is required to
include any associated impairment losses in its initial measurement of an
ROU asset.
If the ROU asset related to an operating lease is impaired,
the lessee would amortize the remaining ROU asset in accordance with the
subsequent-measurement guidance that applies to finance leases — typically,
on a straight-line basis over the remaining lease term. Thus, the operating
lease would no longer qualify for the straight-line treatment of total lease
expense. However, in periods after the impairment, a lessee would continue
to present the ROU asset amortization and interest expense as a single line
item.
Question
Upon transition to ASC 842, is a lessee required to
reallocate prior impairment losses of an asset group to the ROU asset?
Answer
No. An ROU asset will typically be added to an existing
asset group under ASC 360. However, the effect of recognizing an ROU asset
on an asset group’s allocation of a prior impairment loss is an indirect
effect of a change in accounting principle. In accordance with ASC 250-10-
45-3 and ASC 250-10-45-8, indirect effects of a change in accounting
principle should not be recognized.
At the FASB’s November 30, 2016, meeting, the Board
indicated that on the effective date of the new leases standard and in all
comparative periods presented, a lessee should not revisit prior impairment
loss allocations within the asset group. In addition, the Board indicated
that a lessee should not include in the initial measurement of an ROU asset
at transition any allocation of prior impairment losses recognized within
the asset group. Therefore, lessees should not revisit any impairment losses
that were allocated to the asset group before the effective date of the
standard regardless of whether an impairment loss was recognized in a
comparative period. Further, the Board emphasized that the only
impairment-related circumstances that could affect the ROU asset before the
effective date of ASC 842 are (1) amounts related to the impairment of a
sublease subject to the ASC 840 guidance and (2) recognition of a liability
for operating leases subject to the exit and disposal guidance in ASC
420.
Editor’s Note
The FASB’s clarification that a lessee should not
revisit any impairment losses that were allocated to the asset group
before the effective date of the standard regardless of whether an
impairment loss was recognized in a comparative period would appear
to render inoperable the transition guidance that requires an entity
to include any impairment in the measurement of an ROU asset. That
is, the conclusion reached by the FASB at its November 30, 2016,
meeting may be interpreted to mean that it is not possible to have
an impairment of an ROU asset at transition. Although such an
interpretation would relieve entities from the requirement to
recalculate and allocate previous impairments, we believe that an
entity could reasonably conclude that an ROU asset is impaired at
transition or as of the earliest comparative period. For example, a
retail company may treat each of its stores as an asset group and
may have previously determined that all of the assets in a
particular group (primarily leasehold improvements) were impaired to
zero in a prior period. Further, assume that incremental impairments
would have been required had other recognized assets existed within
the asset group. In this instance, the retailer may determine that
the ROU asset is also partially or fully impaired and that as a
result, the ROU asset should be adjusted as of the earlier
impairment date for the asset group. This matter will most likely be
raised with the FASB staff. Affected companies should monitor
developments and consider consulting with their auditors or
accounting advisers.
Q&A 19 Classification Date When “Package of Three” Is Not Elected
ASU 2016-02 provides various practical expedients, including
ASC 842-10-65-1(f)(2), which states:
An entity need not
reassess the lease classification for any expired or existing leases
(that is, all existing leases that were classified as operating leases
in accordance with Topic 840 will be classified as operating leases, and
all existing leases that were classified as capital leases in accordance
with Topic 840 will be classified as finance leases).
Therefore, under this practical expedient, an entity would
not reassess the lease classification. Instead, the lease classification
determined under existing U.S. GAAP (ASC 840) would be retained. This
practical expedient is part of the “package of three” transition practical
expedients. The package must be elected in its entirety; otherwise, none of
the transition practical expedients in the package may be applied at
all.
Question
Upon transition to ASC 842, if a lease commenced before the
earliest comparative period presented and an entity did not elect the practical expedient package in ASC 842-10-65-1(f),
what date should the entity use to determine lease classification as of the
earliest comparative period presented?
Answer
The lease should be classified in accordance with the ASC
842 lease classification criteria and facts and circumstances as of the
later of (1) the lease commencement date or (2) the date the lease was last
deemed modified in accordance with the modification guidance in ASC 840.19 If a lease was renewed or extended before the
earliest period presented, the renewal or extension date would be considered
the lease commencement date for this purpose unless the renewal was assumed
to be reasonably certain as of the initial lease commencement date.
Example
Entity A, a public calendar-year entity, enters into a lease
agreement and obtains the right to use an office building on June 1, 2013.
On June 1, 2016, A and the lessor modify the terms of the lease whereby the
leased space is reduced and the lease payments on the remaining space is
increased to reflect current market rates. The change to the terms
represents a modification in accordance with ASC 840-10-35-4. As a public
calendar-year entity, A must determine the appropriate classification of the
lease as of January 1, 2017, the beginning of the earliest comparative
period presented. Because the lease was modified after lease commencement,
the lease classification assessment is performed under ASC 842 as of June 1,
2016 (the ASC 840 modification date).
Editor’s Note
The Q&A above addresses the date as of which to
assess lease classification and what inputs should be used as of the
assessment date. The inputs used (e.g., lease payments and discount
rate) as of the classification date would not be the same for
measurement of the lease. For example, for an operating lease that
commenced before the earliest comparative period presented, an
entity should measure the lease liability and ROU asset by using the
remaining lease payments and discount rate that existed as of the
beginning of the earliest comparative period presented.
Q&A 20 Application of the Use-of-Hindsight Practical Expedient
ASC 842-10-65-1(g) states that an entity may elect, as a
practical expedient, to use hindsight in determining the lease term and in
assessing impairment of ROU assets when transitioning to ASC 842.
Specifically, ASC 842-10-65-1(g) states:
An entity also may elect a practical expedient, which must be applied
consistently by an entity to all of its leases (including those for
which the entity is a lessee or a lessor) to use hindsight in
determining the lease term (that is, when considering lessee options to
extend or terminate the lease and to purchase the underlying asset) and
in assessing impairment of the entity’s right-of-use assets. This
practical expedient may be elected separately or in conjunction with the
practical expedients in [ASC 842-10-65-1(f)].
Question 1
When applying the use-of-hindsight practical expedient in
ASC 842-10-65-1(g), should an entity consider only discrete events (e.g.,
the lessee’s renewal of the lease) that occurred from the original lease
commencement date to the date of adoption?
Answer
No. When applying the use-of-hindsight practical expedient,
an entity would not be limited to considering only known events that had or
had not occurred. Rather, a broader view is appropriate, and therefore, in
addition to discrete events, an entity should consider changes in facts and
circumstances from commencement through the effective date of ASC 842 when
determining the lease term and assessing the impairment of the ROU asset.
For example, in addition to considering known events such as renewal options
that had been exercised by the lessee, an entity should consider other
events and changes in factors as discussed in ASC 842-10-55-26 (e.g., a
strategic shift in business, changes in market rentals, evolution of the
industry as a whole) that may affect whether it is reasonably certain that
the lessee will exercise (or not exercise) any remaining renewal
options.
The response to this question was informally discussed with
the FASB staff, which agreed with the overall conclusion reached.
Question 2
What date does the hindsight assessment extend to when an
entity applies the use-ofhindsight practical expedient in ASC
842-10-65-1(g)?
Answer
When performing its hindsight assessment, an entity should
consider events and circumstances that occurred up to the effective date of
the new leases standard.
Example
In 2004, Company A entered into a 15-year lease of
a store that included three 5-year renewal options.
On January 1, 2019, when A adopts and transitions to
the new leases standard, it elects to apply the
use-of-hindsight practical expedient in ASC
842-10-65-1(g). Since the execution of the lease,
the following events had occurred:
- On November 9, 2017, A exercised the first of the three 5-year renewal options.
- During 2018, the market rent in the area had increased to a point such that A’s rent is now significantly discounted.
- On January 15, 2019, the CEO of A decided on a strategic shift in business such that the company would exit brick-and-mortar retail and move to online only.
When applying hindsight
in determining the lease term, A should consider the
events that occurred up to the effective date of the
new leases standard. Therefore, since A adopted the
new guidance as of January 1, 2019, A should
consider (1) that it exercised the first renewal
option in 2017 and (2) the effect of the significant
increase in market rent in 2018 on its assessment of
whether it would exercise additional renewal
options. Company A should not consider its decision to exit
brick-andmortar retail when evaluating the lease
term since this event occurred after the effective
date of the new leases standard.
Q&A 21 Accounting for Other Lease-Related Balances When Transitioning From a Direct Financing Lease or Sales-Type Lease to an Operating Lease
Upon transition, if an entity does not elect the practical
expedients in ASC 842-10-65-1(f), it is required to evaluate the
classification of its leases under ASU 2016-02 (see Q&A 19 for additional information
about assessing the classification of a lease at transition when the
“package of three” is not elected). While it is expected that lease
classification under ASC 842 would generally be consistent with that under
ASC 840, there are instances in which a lease classification could change
when the new guidance is adopted.
Example
On October 1, 2010, Company A acquired an office
building that had various leases in place; as a
result, A became a lessor of office space. The lease
agreements with the existing tenants included
escalating lease payments over the contract period.
Company A determined on the basis of the ASC 840
lease classification criteria that the existing
leases should be classified as direct financing
leases (DFLs). Therefore, on the acquisition date, A
recognized a net investment in the leases and
accounted for them in accordance with ASC 840.
On January 1, 2019, A adopts the
new leases standard and does not elect the practical
expedients in ASC 842-10-65-10-65-1(f). As a result,
A evaluates the classification criteria in ASU
2016-02 and concludes that its existing DFLs should
be classified as operating leases under the new
guidance. Such an outcome could arise for a variety
of reasons, including the use of hindsight that
results in a different lease term assumption.
Assume that as a result of the rent
escalations in the lease agreement, if the lease had
been classified as an operating lease in accordance
with ASC 840, A would have recognized a
“straightline rent receivable”20 of $25,000 as of
the earliest period presented. Similarly, as of
lease commencement, A would have recognized an
in-place lease intangible,21 net of amortization, of
$55,000, which represents the inherent value
associated with full occupancy of the property by
tenants on the acquisition date.
Question
Should A recognize the straight-line rent receivable or the
in-place lease intangible asset when transitioning from a DFL under ASC 840
to an operating lease under ASU 2016-02?
Answer
Yes. The straight-line rent receivable and the in-place
lease intangible should be established in transition as if they had always
be recorded in connection with the operating lease.
The transition guidance in ASC 842-10-65-1(y) addresses how
to transition leases previously classified as DFLs under ASC 840 to
operating leases under ASC 842. In particular, ASC 842-10-65-1(y) states the
following:
For each lease classified as an operating
lease in accordance with this Topic, the objective
is to account for the lease, beginning on the later of the
beginning of the earliest comparative period presented in the financial
statements and the commencement date of the lease, as if it had always been accounted for as an operating lease in
accordance with this Topic. Consequently, a lessor shall do all
of the following:
- Recognize the underlying asset22] at what the carrying amount would have been had the lease been classified as an operating lease under Topic 840.
- Derecognize the carrying amount of the net investment in the lease.
- Record any difference between the amounts in (y)(1) and (y)(2) as an adjustment to equity.
- Subsequently account for the operating lease in accordance with this Topic and the underlying asset in accordance with other Topics. [Emphasis added]
The transition method in ASC 842 is not a full retrospective
approach. However, the objective under ASC 842-10-65-1(y), as validated by
the FASB staff, is to account for a lease as if it had always been accounted
for as an operating lease in accordance with ASC 842.
Therefore, while the transition guidance discusses only
certain balances (e.g., the recognition of the underlying asset at what the
carrying amount would have been had the lease been classified as an
operating lease under ASC 840), we believe that the guidance is not intended
to be all-inclusive and that the broad objective would be applicable to all
balances that would have otherwise been recognized had the lease always been
accounted for as an operating lease.
Straight-Line Rent Receivable
On the basis of the analysis above, when Company A
transitions to ASC 842, it should do the following as of the beginning
of the earliest period presented (i.e., January 1, 2017):
- Derecognize the net investment in the lease.
- Recognize the underlying asset at the carrying amount of what the asset would have been if it were always accounted for as an operating lease under ASC 840.
- Recognize a straight-line rent receivable balance in the amount at which it would have been recorded if the lease was always accounted for as an operating lease under ASC 842 (i.e., $25,000, which is the build-up of a straight-line rent receivable from lease commencement to the earliest period presented when A transitions to ASC 842).
In addition, A should recognize any resulting difference
as an adjustment to opening equity and subsequently account for the
operating lease in accordance with ASC 842.
In-Place Lease Intangible
Company A should apply the guidance in ASC 805-20-25-10A
and recognize an in-place intangible as of January 1, 2017 (i.e., the
beginning of the earliest year presented). That is, A should determine
what the in-place intangible would have been as of October 1, 2010 (the
date of initial acquisition) and factor in amortization of the
intangible through January 1, 2017, the beginning of the earliest year
presented. The resulting amount would be the in-place lease intangible
amount that would have been recognized if the lease had always been
accounted for as an operating lease. Company A should recognize an
in-place lease intangible of $55,000 and amortize it over the remaining
lease term.
Editor’s Note
While the facts above appear specific to a more
unique fact pattern that may not be common for many entities
upon transition, we believe that the principle outlined above —
account for the operating lease in transition as if it had
always been an operating lease — is the critical takeaway.
Specifically, we think that it is important to consider the
objective of the transition guidance in each relevant paragraph
of ASC 842-10-65-1 versus the explicit and at times very
prescriptive mechanical application guidance.
For example, while ASC 842-10-65-1(h) explicitly
describes the applicability of the guidance depending on whether
“an entity has previously recognized an asset or a liability in
accordance with [ASC] 805 on business combinations relating to
favorable or unfavorable terms of an operating lease acquired as
part of a business combination,” we believe that it would be
similarly appropriate to consider and carry forward other
lease-related balances that would have been recognized, such as
in-place lease intangibles.
Q&A 22 Build-to-Suit Transition
Background
Build-to-suit arrangements broadly describe situations in
which a lessee is involved in construction of an asset it will eventually
lease, including projects undertaken from the ground up as well as
construction of major structural improvements on existing assets. Under ASC
840, an entity considers whether it has taken on substantially all of the
risks of construction and as a result must be considered, from an accounting
perspective, the deemed owner during construction. The accounting prescribed
for a deemed owner requires the lessee to record the entire cost of the
asset and a corresponding financing obligation on its balance sheet for
amounts not directly funded during the construction period. Further, upon
completion of construction, the lessee must apply sale-leaseback accounting
to determine whether it can derecognize the project. Many entities are
unable to derecognize the project after construction because of various
forms of continuing involvement that preclude sale treatment. This has been
a particularly pervasive outcome for build-to-suit arrangements that involve
real estate. Overall, the build-to-suit rules in ASC 840 are widely
considered to be overly complex in application and to result in overly
punitive accounting outcomes.
ASU 2016-02 removed the risk principle governing the deemed
owner determination and replaced it with a model in which a lessee will be
deemed to own an asset during construction only if the lessee has
“control”23 of the asset during the construction
period. See Q&A 27
for our interpretive guidance on how to assess whether the lessee controls
the asset during the construction period.
The transition guidance in ASC 842-10-65-1(u) for
build-to-suit lease arrangements states:
A lessee shall
apply a modified retrospective transition approach for leases accounted
for as buildto- suit arrangements under Topic 840 that are existing at,
or entered into after, the beginning of the earliest comparative period
presented in the financial statements as follows:
- If an entity has recognized assets and liabilities solely as a result of a transaction’s build-tosuit designation in accordance with Topic 840, the entity should derecognize those assets and liabilities at the later of the beginning of the earliest comparative period presented in the financial statements and the date that the lessee is determined to be the accounting owner of the asset in accordance with Topic 840. Any difference should be recorded as an adjustment to equity at that date. The lessee shall apply the lessee transition requirements in (k) through (t) to the lease.
- If the construction period of the build-to-suit lease concluded before the beginning of the earliest comparative period presented in the financial statements and the transaction qualified as a sale and leaseback transaction in accordance with Subtopic 840-40 before the date of initial application, the entity shall follow the general lessee transition requirements for the lease.
The transition guidance above specifies that any
build-to-suit assets and liabilities recognized under ASC 840 should be
derecognized in transition. However, the transition guidance does not
explicitly address whether the new standard’s principles of controlling an
asset under construction should be applied during the comparative periods,
which may result in immediately rerecognizing those assets and
liabilities.
Question 1
Must the new standard’s principles of controlling an asset
during construction be applied to the comparative periods when construction
was completed and the lease commenced before the ASU’s effective date?24
Answer
No. An entity is not required to assess the ASU’s principles
of control during the comparative periods (regardless of whether the lessee
was the deemed owner under ASC 840) as long as construction is complete and
the lease commenced before the ASU’s effective date. The FASB staff agreed
with this application of transition for build-to-suit arrangements.
Therefore, the transition derecognition guidance in ASC
842-10-65-1(u) should be applied. Accordingly, the lessee should (1)
derecognize the impact of any build-to-suit arrangements in which the lessee
was the deemed owner in the comparative periods and (2) recognize the
difference in equity.
Question 2
How should a lessee transition for a build-to-suit
arrangement when construction was not completed and the lease had not
commenced as of the effective date?
Answer
The transition approach in those circumstances is summarized
in the table below.
ASC 840 Determination | ASC 842 Determination25 | Transition Approach |
|---|---|---|
Lessee was the deemed owner | Lessee has control during construction | No change in accounting; asset and financing
obligation remain on the balance sheet during the
comparative periods and as of the effective
date. |
Lessee was the deemed owner | Lessee does not have control during
construction | Derecognize the asset and financing obligation, and
reflect the difference in equity at the later of the
beginning of the earliest comparative period
presented in the financial statements and the date
as of which the lessee was determined to be the
accounting owner of the asset in accordance with ASC
840. |
Lessee was not the deemed owner | Lessee has control during construction | Recognize the asset and financing obligation at the
later of the beginning of the earliest comparative
period presented in the financial statements and the
date as of which the lessee is determined to be the
accounting owner of the asset in accordance with ASC
842. See the example below. |
Example
Company A, a calendar-year public entity, has
entered into an agreement with Company B to lease a
newly constructed television studio. Company B began
building the television studio on June 8, 2017, and
construction is expected to be complete on November
5, 2019. The lease will commence once construction
is complete. During the construction period, A can
acquire the television studio in process of
construction and therefore is deemed to control the
construction project under ASC 842. Assume that A
was not determined to be the deemed owner in
accordance with ASC 840. When A initially applies
ASC 842, it must recognize the cost of the
in-process asset (and an offsetting financing
obligation) during the comparative periods beginning
June 8, 2017.
Q&A 23 Selected Financial Data Table Requirements Under SEC Regulation S-K, Item 301
SEC Regulation S-K, Item 301, requires an SEC registrant to
disclose certain financial data for “[e]ach of the last five fiscal years of
the registrant” and “[a]ny additional fiscal years necessary to keep the
information from being misleading.” The SEC staff generally expects all
periods to be presented on a basis consistent with the annual financial
statements, including the two earliest annual periods presented before those
included in the audited financial statements (“years 4 and 5”).
Question
Is an SEC registrant required to reflect the accounting
requirements of ASU 2016-02 in all five annual periods presented in the
selected financial data table prescribed by SEC Regulation S-K, Item
301?
Answer
No. As noted in the highlights of the March 21, 2016, CAQ SEC Regulations
Committee joint meeting with the SEC staff, the SEC staff stated that it
would not expect SEC registrants, when adopting the
ASU, to reflect the requirements of the new leases standard for all five
periods in the selected financial data table. Rather, the staff would expect
the selected financial data table to conform to the transition provisions of
the new guidance, which require lessees to apply the new standard to capital
and operating leases that exist on or after the date of the standard’s
initial application (i.e., the beginning of the earliest comparative period
presented in the financial statements). Accordingly, the table should
include financial information that reflects the application of the ASU for
only the most recent three years presented (i.e., years 4 and 5 would not be
presented on the same basis as the annual financial statements).
Since the more recent periods reflect the requirements of
the new leases standard and the earlier periods do not, the SEC registrant
should disclose the lack of comparability of the data presented for the
earlier periods in the selected financial data table (if applicable and
material).
Q&A 24 Requirements for Revised Financial Statements — New or Amended Registration Statements
As a result of certain subsequent events, SEC registrants
may be required to retrospectively adjust previously issued financial
statements. For example, items in certain SEC registration statements (e.g.,
Item 11(b)(ii) of Form S-3)26 may require SEC registrants
to provide revised financial statements in a new or amended registration
statement if there has been a material retrospective change in accounting
principle. For situations in which an SEC registrant adopts the new leases
standard and subsequently files a registration statement that incorporates
by reference interim financial statements reflecting the impact of the
adoption of the new standard, questions have arisen about how the SEC
registrant would be required to retrospectively revise its annual financial
statements that are incorporated by reference in that registration statement
(i.e., the annual financial statements in its Form 10-K). Those annual
financial statements would include one more year (the “fourth year”) than
what would otherwise be required if the SEC registrant did not file a
registration statement.
Question
If an SEC registrant files a new or amended registration
statement during an interim period in the year it initially adopts ASU
2016-02, is it required to retrospectively revise the financial statements
for all three annual periods that are included or incorporated by reference
in the filing (i.e., including the “fourth year”)?
Answer
No. The transition requirements of ASU 2016-02 do not
require retrospective revision of the “fourth year.” The reissuance of the
financial statements in the new registration statement would accelerate the
requirement to retroactively restate financial statements, but it does not
change the date of initial application.
For example, the date of initial application is typically
January 1, 2017, for a calendar-year company that adopts ASU 2016-02 on
January 1, 2019, because that will be the first day of the comparative
three-year period presented in the December 31, 2019, financial statements
in the year of adoption. Paragraph 11210.1 in the SEC’s FRM clarifies that, in this adoption fact
pattern, if a company files a new registration statement after the first
quarter of adoption but before the filing of the December 31, 2019, Form
10-K, the date of initial application would still be January 1, 2017. This
fact pattern assumes that the new registration statement would require the
financial statements for the fiscal years ended December 31 of 2018, 2017,
and 2016, respectively, along with any required fiscal 2019 interim
financial statements. The FRM also clarifies that reissuance of the
financial statements in the new registration statement would accelerate the
requirement to retrospectively restate financial statements for the years
ended December 31 of 2018 and 2017, respectively, but does not change the
date of initial application. Accordingly, the financial statements for the
year ended December 31, 2016, that are included or incorporated by reference
in the new registration statement would not be retrospectively restated. The
financial statements for the year ended December 31, 2016, the earliest year
presented, will reflect the legacy ASC 840 accounting requirements.
See Section 11210 of the SEC’s FRM for further guidance.
Other Key Provisions
Q&A 25 Identifying, and Allocating Consideration to, the Components of a Contract
ASC 842 provides guidance on identifying components of a
contract (i.e., lease and nonlease components). In particular, ASC
842-10-15-30 states:
The consideration in the contract
shall be allocated to each separate lease component and nonlease
component of the contract (see paragraphs 842-10-15-33 through 15-37 for
lessee allocation guidance and paragraphs 842-10-15-38 through 15-42 for
lessor allocation guidance). Components of a contract include only those
items or activities that transfer a good or service to the lessee.
Consequently, the following are not components of a contract and do not
receive an allocation of the consideration in the contract:
- Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee
- Reimbursement or payment of the lessor’s costs. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset.
Question
How are fees charged as reimbursement of the lessor’s costs
accounted for in a lease?
Answer
An entity would first need to identify the various
components of a contract. ASC 842-10-15-30 notes that “[c]omponents of a
contract include only those items or activities that transfer a good or
service to the lessee.” For example, a contract may include a separate lease
component (e.g., the right to use the underlying asset that is the subject
of the agreement) as well as additional goods or services that are
transferred to the lessee (e.g., maintenance services).
Contracts often include other costs or fees that do not provide a separate good or service to the
lessee — for example, costs paid by the lessee, such as (1) the cost of
administrative tasks performed to set up a contract or initiate the lease or
(2) reimbursement or payment of the lessor’s costs (e.g., property taxes and
insurance related to the leased asset). These types of costs do not transfer
a good or service to the lessee and would therefore not be considered a separate component.
An entity is required to allocate the total consideration in
a contract (inclusive of all amounts charged for administrative start-up,
property taxes, and some insurance27) to its identified separate lease component(s)28 and nonlease component(s). The manner of
allocating the consideration depends on whether the entity is the lessee or
lessor in the arrangement.
Lessee
A lessee that does not elect to account for its lease
and nonlease components as a single lease component in accordance with
the practical expedient in ASC 842-10-15-37 would allocate the
consideration in the contract to the separate lease and nonlease
components on a relative stand-alone price basis by using observable
stand-alone prices when available. When observable stand-alone prices
are not available, a lessee can estimate the stand-alone price by
maximizing the use of observable information. Any activity in a contract
that does not transfer a separate good or service to the lessee is not
considered a separate component and therefore would not receive an
allocation of consideration in the contract (e.g., property taxes and
some insurance would not represent a separate component, and any
contractually stated amounts related to these activities would therefore
be allocated between the identified lease and nonlease components).
Lessor
A lessor would allocate the consideration in the
contract to the separate lease components and the nonlease components by
applying the guidance in ASC 606-10-32-28 through 32-41 of the new
revenue standard (which generally requires an allocation based on the
relative stand-alone selling prices of the components). In addition, as
stated in ASC 842-10-15-38, a lessor would “allocate any capitalized
costs (for example, initial direct costs or contract costs capitalized
in accordance with [ASC] 340-40 . . . ) to the separate lease components
or nonlease components to which those costs relate.” As would be the
case under the lessee allocation method, any activity in a contract that
does not transfer a separate good or service to the lessee is not
considered a separate component and therefore would not receive an
allocation of consideration in the contract (e.g., property taxes and
some insurance would not represent a separate component, and any
contractually stated amounts related to those activities would therefore
be allocated between the identified lease and nonlease components).
Example
Lessee X enters into a five-year
lease (a gross lease) of a building from Lessor Y
under which X is required to make a fixed annual
lease payment of $35,000 (payments total $175,000
over the five-year term). In accordance with the
terms of the contract, the $35,000 annual payment
comprises $20,000 for building rent, $7,000 for
common area maintenance, $5,000 for property
taxes, and $3,000 for building insurance. From the
lessee’s perspective, the estimated stand-alone
price29 of the building rent
(excluding taxes and insurance) is $22,000, and
the estimated standalone price of the maintenance
service is $8,000. From the lessor’s perspective,
the stand-alone selling price30 of the building rent
(excluding taxes and insurance) is $21,500, and
the stand-alone selling price of the maintenance
services is $7,650.
In
evaluating the separate components in the
contract, both the lessee and lessor would need to
determine what goods and services are being
provided in the contract, which may include both
lease and nonlease components. In this contract,
the primary good or service is the right to use
the underlying asset and is considered a lease
component. In addition, the contract requires Y to
provide maintenance services, which represent a
nonlease component (i.e., a service to be
accounted for in accordance with ASC 606).
The contract also requires the
lessee to pay the lessor additional consideration
attributable to property taxes and insurance.
However, in accordance with ASC 842-10-15-30,
those additional fees would not be considered separate components (either
lease components or nonlease components) since
each fee is a reimbursement of the lessor’s costs.
Therefore, despite requiring the payment of four
separately described fees in the contract, the
arrangement includes only two components. The
total fees of $35,000 are required to be allocated
between the two identified goods and services
representing the lease component and nonlease
component.
As a result, the
lessee allocates the consideration in the
arrangement as follows:
In contrast, the lessor allocates
the consideration in the arrangement as
follows:
Editor’s Note
Lessee’s Election Not to
Separate Nonlease Components From Lease Components
As a reminder, ASC 842-10-15-37 allows a lessee,
as an accounting policy election by class of underlying asset,
to choose not to separate its nonlease
components from its lease components. If this practical
expedient is elected, the lessee is permitted to account for
each separate lease component31 and the
nonlease component associated with that lease component as a
single lease component. It is important to note that if an
entity makes this election, the calculated lease liability and
corresponding ROU asset will be higher than it would be if the
nonlease components were subject to separate accounting. In
addition to grossing up the balance sheet, not separating lease
and nonlease components may affect lease classification (i.e.,
the present value of the sum of the lease payments, inclusive of
the nonlease components, and any residual value guaranteed by
the lessee may equal or exceed substantially all of the fair
value of the underlying asset).
Lessee’s Payment of
Lessor-Related Costs
Often, a lessee is responsible for the payment
of lessor-related costs (e.g., some types of insurance and real
estate taxes). Depending on the terms of the contract, these
costs may be remitted to the lessor as a reimbursement of what
was paid or may be directly paid to the third party (e.g.,
insurance company or taxing authority). These costs are often
variable and paid on the basis of the actual costs and are not
considered part of the consideration in the contract. Payments
for insurance and real estate taxes would not be considered a
separate component in the contract and would be allocated
between any lease and nonlease components in the contract
regardless of whether:
- The payments are fixed and considered part of the consideration or are variable and outside of the consideration in the contract.
- The lessee is paying the insurance company and taxing authority directly or is reimbursing the lessor.
Q&A 26 Impact of Sublease Renewals on Head Lease Term
Background
An entity must determine the lease term to perform lease
classification and measurement. ASC 842-10-30-1 requires an entity to
determine the lease term as follows:
An entity shall
determine the lease term as the noncancellable period of the lease,
together with all of the following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. [Emphasis added]
ASC 842-10-55-26 provides that an entity should consider all
economic factors in determining whether it is reasonably certain that a
renewable option will be exercised. Further, an entity must consider a
sublease in determining the lease term of the head lease.
Question
If a sublessee has contractual renewal options on a leased
asset, does the head lease automatically include all periods covered by
those renewal options since their exercise would force renewal of the head
lease and the sublease renewals are outside the head lessee’s control?
Answer
Not necessarily. At the FASB’s November 30, 2016, meeting,
the Board indicated that the head lessee must determine whether the
sublessee is reasonably certain to exercise its renewal options because the
head lessee must determine the lease term for the head lease. If the
exercise of the sublease renewal options is reasonably certain, the renewal
of the head lease is also reasonably certain. However, if the head lessee
determines that it is not reasonably certain that the sublessee will
exercise its renewal options, the head lessee should not include additional
renewal options that extend past the sublessee’s noncancelable term in the
absence of other economic factors. That is, the sublease is one of many
factors for an entity to consider in determining the lease term of the head
lease.
Note that the head lessee would reassess its lease term in
accordance with ASC 842-10-55-28 upon the occurrence of certain events,
including “[s]ubleasing the underlying asset for a period beyond the
exercise date of the option.” Therefore, upon notice by the sublessee that
it is renewing or extending its sublease, the head lessee must reassess the
lease term of the head lease, including whether the exercise of any
remaining renewal options is reasonably certain.
Example
Under a lease agreement (the “Head Lease”), Company
A leases equipment from Company B. Under another
lease agreement (the “Sublease”), A immediately
leases the equipment to Company C. The noncancelable
lease period of the Head Lease is 10 years, with two
5-year renewals at A’s option for a fixed amount.
The Sublease has a mirrored 10-year noncancelable
period, with two 5-year renewals at C’s option. If C
exercises its renewal option on the Sublease, it
will force A to renew the Head Lease.
If it is not reasonably certain
that C will exercise its renewal options, A could
determine, in the absence of other asset- or
market-based factors, that the lease term of the
Head Lease is limited to 10 years (i.e., the
noncancelable period). If and when C renews its
Sublease, A must reassess the lease term by
including the first 5-year renewal and determining
whether C’s exercise of the second 5-year renewal
option is reasonably certain.
Q&A 27 Lessee Control of the Asset During Construction
Background
Under ASC 840, controlling an asset during construction is
based on risks and rewards. In contrast, ASC 842 introduces provisions that
are based on control. See Q&A 22 for additional information about the impact of these
changes.
ASC 842-40-55-5 provides the following specific criteria
that indicate (if at least one of the criteria is met) that the lessee
controls the underlying asset during construction before the lease
commences:
- The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor).
- The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.
- The lessee legally owns either:
- Both the land and the property improvements (for example, a building) that are under construction
- The non-real-estate asset (for example, a ship or an airplane) that is under construction.
- The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements.
- The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements, and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.
However, ASC 842-40-55-5 also indicates, in part:
The list of circumstances [in ASC 842-40-55-5] in which
a lessee controls an underlying asset that is under construction before
the commencement date is not all inclusive. There may be other
circumstances that individually or in combination demonstrate that a
lessee controls an underlying asset that is under construction before
the commencement date.
Question
In the absence of meeting one of the specific criteria in
ASC 842-40-55-5, how should a lessee determine whether it “controls an
underlying asset” during construction?
Answer
In general, the determination should be based on the concept
of control in ASC 606.32 The first
three criteria in ASC 842-40-55-5 are grounded in principles of ASC 606,
which indicate that the lessee has control of the asset during construction
if (1) the lessee holds a call option, (2) the lessor has an enforceable
right to payment for performance to date and the asset does not have an
alternative use, or (3) the lessee has title to the asset under
construction. The concept in the last two criteria is not in ASC 606 but, in
our view, is based on an assumption that the lessor should be able to
legally use the underlying land (e.g., cannot be forced to vacate the
property) during substantially all of the economic life of the property
improvement that is being constructed on the land (see Q&A 30).
We do not believe that the concept of controlling an asset
under construction should be based on the definition of a lease under ASC
842, which includes guidance on whether a contract conveys the right to
control the use of an identified asset. Although the concepts sound similar,
the FASB explicitly excluded from the scope of ASC 842 leases of assets
under construction, partially as a result of the difficulty of applying the
lease definition before an asset is placed in service (e.g., the difficulty
of assessing the economic benefits associated with an asset that is not yet
operational).
When the above principles are applied, it would not be
appropriate to conclude that a lessee controls the asset under construction
solely because of its involvement in designing the asset or acting as the
general contractor over the construction project. This involvement is
typical of many “build-to-suit” arrangements. In these cases, the lessee
would typically not control the asset during construction because the lessee
does not (1) take title to the asset, (2) provide the lessor with an
enforceable right to payment, or (3) prevent the lessor from using the
underlying land for substantially all of the economic life of the property
improvements.
Example
Lessee enters into a construction and lease
agreement with Lessor to build a new corporate
headquarters. Lessor will retain title to the
building throughout the construction period and
agrees to pay up to $50 million toward construction.
Lessee designed the building to Lessee’s
specifications and is contracted by Lessor to be the
general contractor during the construction project.
Assume that none of the specific criteria in ASC
842-40-55-5 are present.
Lessee would not control the asset during
construction because its role as general contractor
and designer of an asset is not an indicator of
control under the specific criteria of ASC
842-40-55-5 or the ASC 606 principles of control.
Likewise, Lessee’s exposure to overrun risk (since
Lessor will pay only up to $50 million of the
construction costs) does not affect the control
analysis, whereas before the adoption of ASC 842,
this would have resulted in a determination that
Lessee is the deemed accounting owner because of its
exposure to construction risk.
Q&A 28 Right to Obtain a Partially Constructed Asset During Construction
ASC 842-40-55-5(a), which provides one of the specific
criteria that indicate that the lessee controls the underlying asset during
construction before the lease commences, states the following:
The lessee has the right to obtain the partially
constructed underlying asset at any point during the construction period
(for example, by making a payment to the lessor).
Question
Does the lessee have control of an asset during the entire
construction period if it holds a call option that is exercisable at any
time?
Answer
It depends. If a call option is exercisable by the lessee at
any point during construction, the lessee controls the underlying asset and
should recognize the construction in process. Importantly, “at any point”
does not mean at all points; therefore, entities
must also consider options that arise (or become exercisable) during the
construction period regardless of whether they are based on the passage of
time or a substantive contingency. In the case of a substantive contingency,
an entity would be deemed to control the asset under construction once it
has the current ability to exercise the option. On the other hand, if the
only barrier preventing exercise is the passage of time, we believe that an
entity would be deemed to control the asset under construction from the
beginning of the construction period.
An entity should carefully analyze a call option that
becomes exercisable upon the occurrence of a contingent event to determine
whether the lessee can unilaterally cause the call option to become
exercisable. For example, some construction and lease agreements provide
that if the lessee defaults on its obligation to perform under the
agreement, the lessee could be obligated to purchase the construction in
process. Under this provision, the lessee would control the underlying asset
because it could unilaterally default under the agreement and thereby become
able to obtain the underlying asset. In contrast, if the obligation or
option to purchase the construction in process was outside the control of
the lessee (e.g., bankruptcy or third-party events), the lessee would not
have control over the construction in process until the contingent event
occurred. Once the lessee is deemed to control the construction in process,
the lessee must apply sale-leaseback accounting rules to determine whether
it can derecognize the project. Scenarios in which the lessee must apply
sale-leaseback accounting rules to make such a determination include those
in which the lessee maintains control up to completion of construction, as
well as those in which the option that conveyed control expires unexercised
during the construction period.
Example
Lessee enters into a construction and lease
agreement with Lessor to build a new corporate
headquarters. Lessor will retain title to the
building throughout the construction period and
agrees to pay up to $50 million toward construction.
The construction is expected to be completed in 18
months. At any point during the construction, Lessee
has the right (but not the obligation) to purchase
the construction in process at Lessor’s cost plus a
profit margin. If the call option is not exercised
and construction is completed, Lessee will lease the
asset from Lessor for a lease term of 15 years with
an option to purchase the building at the end of the
lease term at a fixed price.
Lessee would control the asset during construction
and recognize the construction in process. At the
end of construction, Lessee must consider the
sale-leaseback guidance in ASC 842-40-25-1 through
25-3. In this case, Lessee would not qualify for
sale accounting because of the call option that
exists during the lease period (see Q&A
31).
Editor’s Note
Lessor put options should also be considered in
scenarios involving construction of an asset to be leased. In a
manner consistent with the guidance on put options in ASC 606, an
entity should assess a put option held by the lessor to determine
whether the lessor has a significant economic incentive to exercise
the option. If such an incentive exists, it would be assumed that
the lessee controls the construction in process.
Q&A 29 Enforceable Right to Payment During Construction
ASC 842-40-55-5(b), which provides one of the specific
criteria that indicate that the lessee controls the underlying asset during
construction before the lease commences, states the following:
The lessor has an enforceable right to payment for its
performance to date, and the asset does not have an alternative use (see
paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the
asset has an alternative use to the owner-lessor, an entity should
consider the characteristics of the asset that will ultimately be
leased.
Question
When would the criterion in ASC 842-40-55-5(b) apply?
Answer
The criterion in ASC 842-40-55-5(b) would apply only when
(1) the lessor has an enforceable right to payment for all of its performance to date (i.e., throughout the development or
construction of the asset) and (2) the asset has no
alternative use to the owner-lessor. This criterion is derived from the
guidance in ASC 606 on recognizing revenue as control is transferred to a
customer over time33 (e.g., when the transfer of control
results in the customer’s ownership of a partially completed asset during
the asset’s development or construction).
We expect the circumstances listed above to be uncommon for
an asset under construction because a lessee is not typically required to
pay for all of the performance to date throughout
construction. Rather, the lessor will be paid, at least in part, through
lease payments over the period of the lease term after construction has
ended. A significant amount of required prepaid rent would not meet the
criterion in ASC 842-40-55-5(b) unless the lease provided for the
nonrefundable right to payment for all the costs incurred by the lessor plus
a reasonable profit margin. That is, the required payments must compensate
the developer for all construction efforts throughout the asset’s
construction for the future lessee to control the asset and, therefore, to
be the deemed owner of the asset during construction.
Further, many build-to-suit arrangements may require the
lessee to pay the lessor upon the occurrence of certain contingent events
outside the control of the lessor (e.g., default by the lessee). This
requirement alone would not meet the criterion in ASC 842-40-55-5(b) because
the lessor cannot force the lessee to make payment in the absence of a
default under the lease agreement.
Finally, in the rare circumstances that the first part of
this criterion is met, the asset under construction may have an alternative
use to the lessor under ASC 842-10-55-7.
Q&A 30 Controlling an Asset During Construction When the Land Is Sold in a Failed Sale-Leaseback
ASC 842-40-55-5(d), which provides one of the specific
criteria that indicate that the lessee controls the underlying asset during
construction before the lease commences, states the following:
The lessee controls the land that property improvements
will be constructed upon (this includes where the
lessee enters into a transaction to transfer the land to the lessor,
but the transfer does not qualify as a sale in accordance with
paragraphs 842-40-25-1 through 25-3) and does not enter into a
lease of the land before the beginning of construction that, together
with renewal options, permits the lessor or another unrelated third
party to lease the land for substantially all of the economic life of
the property improvements. [Emphasis added]
Examples of when the transfer of land may not qualify as a
sale include circumstances in which the seller/lessee retains a call option
on the land or the leaseback is determined to be a finance lease.
Question
How should the criterion in ASC 842-40-55-5(d) be assessed
when land is sold to the lessor but is accounted for as a financing rather
than a sale?
Answer
In our view, the concept in this criterion is based on an
assumption that the lessor of the property improvements should be able to
use the underlying land during substantially all of the economic life of the
property improvements that are being constructed on the land. When the
lessor does not have appropriate rights to the land, the lessee would
control the property improvements during construction if the following
conditions are met:
- The lessee of the property improvements controls the land — This condition is met if any of the following can be shown:
- The lessee holds title to the land.
- The lessee previously sold the land but did not qualify for sale accounting.
- The lessor of the property improvements has title to the land, but the lessee sold the land to the lessor in a failed sale-leaseback.
- The lessee controls the constructed asset — Even if the first condition is met (i.e., the lessee controls the land), the lessee does not control the constructed asset if the lessee has leased the land to the lessor for substantially all of the economic life of the to-be-constructed asset.
Read literally, the second condition can never be met in a
financing of the land through a previous failed sale or sale-leaseback
because the lessee cannot lease out the land that it has already legally
sold to the lessor. However, we believe that the principle underlying the
criterion in ASC 842-40-55-5(d) should be considered. That is, does the
lessor have the right to legally use the land for substantially all of the
economic life of the property improvements? An entity must consider all
facts and circumstances when determining whether this principle is met.
Example 1
Company A sells land to Company B and
contemporaneously enters into a construction and
lease agreement for B to build a new corporate
headquarters for A. Upon completing construction of
the new headquarters building, B will lease the land
and the building to A for a period of 40 years. At
the end of 40 years, A will have the right to
purchase the land and corporate headquarters at a
fixed price. The corporate headquarters has an
estimated economic life of 40 years. Assume that
none of the other criteria in ASC 842-40-55-5 are
present in the arrangement related to the
to-be-constructed property improvements.
Company A determines, in accordance
with ASC 842-40-25-3, that the call option precludes
accounting for the transfer of the land as a sale.
However, in the assessment of whether A controls the
corporate headquarters during construction, it is
noted that B has the legal right to use the land for
the entire 40-year economic life of the asset to be
constructed. That is, the option is not exercisable
until the property improvement has no remaining
economic life. Therefore, on the basis of these
facts and circumstances, A concludes that it does
not control the corporate headquarters during
construction.
Example 2
Assume the same facts as those in Example 1, except
that Company A does not have a purchase option on
the land. However, the leaseback of the land is
determined to be a finance lease under ASC 842
because the present value of the lease payments
equals or exceeds substantially all of the fair
value of the land transferred.
Company A determines, in accordance
with ASC 842-40-25-2, that B is not considered to
have obtained control of the land because the
leaseback is a finance lease. However, in assessing
whether A controls the corporate headquarters during
construction, A notes that B has the legal right to
use the land for the entire 40-year economic life of
the asset to be constructed. That is, although A did
not derecognize the land for accounting purposes,
the lessor uses the land in the construction and
lease of the property improvements for the entire
economic life. Therefore, on the basis of these
facts and circumstances, A concludes that it does
not control the corporate headquarters under
construction.
Q&A 31 Real Estate Sale and Leaseback With Repurchase Option
Background
Under ASC 842, the seller-lessee in a sale-leaseback
transaction must evaluate the transfer of the underlying asset (sale) in
accordance with ASC 606 to determine whether the transfer qualifies as a
sale (i.e., whether control has been transferred to the buyer).
The existence of a leaseback by itself would not indicate
that control has not been transferred (i.e., it would not preclude the
transaction from qualifying as a sale) unless the leaseback is classified as
a finance lease. In addition, if the arrangement includes an option for the
seller-lessee to repurchase the asset, the transaction would not qualify as
a sale unless (1) the option is priced at the fair value of the asset on the
date of exercise and (2) there are alternative assets that are substantially
the same as the transferred asset and readily available in the
marketplace.
If the transaction does not qualify as a sale, the
seller-lessee and buyer-lessor would account for it as a financing
arrangement (i.e., the seller-lessee would record a financial liability, and
the buyer-lessor would record a receivable).
Question
Would the inclusion of a seller-lessee repurchase option in
a sale and leaseback of real estate preclude the transfer from qualifying as
a sale under ASC 606?
Answer
Yes. Sale-leaseback transactions involving real estate that
include a repurchase option will not meet the criteria of a sale under ASC
606 regardless of whether the repurchase option is priced at fair value.
ASC 842-40-25-3 states that for the transfer of an asset
that is subject to a repurchase option in a sale and leaseback transaction
to qualify as a sale, two criteria must be met: (1) the option is priced at
the fair value of the asset on the date of exercise and (2) there are
alternative assets that are substantially the same as the transferred asset
and readily available in the marketplace. During the FASB’s redeliberations
on ASU 2016-02, the Board noted that sale-leaseback transactions involving
real estate that include a repurchase option would not meet the second
criterion in ASC 842-40-25-3. Paragraph BC352(d) of ASU 2016-02 notes, in
part:
When the Board discussed [ASC 842-40-25-3],
Board members generally observed that real estate assets would not meet
criterion (2). This is because real estate is, by nature, “unique” (that
is, no two pieces of land occupy the same space on this planet) such
that no other similar real estate asset is “substantially the
same.”
Therefore, regardless of whether the repurchase option is
priced at fair value, the unique nature of real estate would prevent a
sale-leaseback transaction involving real estate that includes a repurchase
option from satisfying the second criterion in ASC 842-40-25-3 since there
would be no alternative asset that is substantially the same as the one
being leased. Accordingly, in a manner similar to current U.S. GAAP, the new
leases standard would preclude sale-leaseback accounting for transactions
involving any repurchase options on real estate.
Driving Discussions — Other Key Provisions
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 have raised questions about the impact of the new operating
lease liabilities and ROU assets on an entity’s metrics (e.g., debt
covenants and bank capital requirements).
Impact on Debt Covenants
During the FASB’s redeliberations, the Board
considered concerns about the potential impact of additional
liabilities resulting from the application of ASC 842. In
particular, 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 an operating liability outside of
debt, it is important to note that the FASB does not have the
ability to dictate how banks and other lenders view such
amounts.
It is unclear whether banks and other lenders will
take a consistent approach in evaluating lease liabilities for debt
covenant purposes. Therefore, we encourage preparers and other
stakeholders to start discussions with these organizations to better
understand the implications of the new guidance on existing and
future lending agreements. Our experience to date suggests that
banks and other lenders have been sympathetic and willing to work
with companies affected by the new rules.
Impact on Bank Capital
Requirements
A bank regulatory capital requirement (expressed as
a ratio of capital to risk-weighted assets or average assets) is the
amount of capital that banks or bank holding companies have to hold
as required by banking regulators (e.g., the Federal Deposit
Insurance Corporation, the Federal Reserve Board, and the Office of
the Comptroller of the Currency in the United States). 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:
- Should not be deducted from regulatory capital since the underlying asset being leased is a tangible asset.
- Should be included in the risk-based capital and leverage ratio denominators.
- Should be risk-weighted at 100 percent, 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 the current guidance in ASC 840.
Entities with any questions on the above FAQ
responses should reach out to their accounting advisers or primary
federal regulator.
Find Out More
The following Deloitte publications
and resources contain additional information about
the FASB’s and IASB’s new leases standards:
Appendix A — Glossary of Standards and Other Literature
The following are the titles of standards and other literature
mentioned in this publication:
FASB Accounting Standards Codification (ASC) Topics
ASC 210, Balance Sheet
ASC 250, Accounting Changes and Error Corrections
ASC 310, Receivables
ASC 340, Other Assets and Deferred Costs
ASC 350, Intangibles — Goodwill and Other
ASC 360, Property, Plant, and Equipment
ASC 450, Contingencies
ASC 606, Revenue From Contracts With Customers
ASC 805, Business Combinations
ASC 840, Leases
ASC 842, Leases
FASB Accounting Standards Update (ASU)
ASU 2016-02, Leases (Topic 842)
SEC Staff Accounting Bulletins (SABs)
Topic 1.M, “Materiality” (SAB 99)
Topic 11.M, “Disclosure of the Impact That Recently Issued
Accounting Standards Will Have on the Financial Statements of the Registrant
When Adopted in a Future Period”
SEC Division of Corporation Finance Financial Reporting Manual
Topic 1, “Registrant’s Financial Statements”; Section 1500,
“Interim Period Reporting Considerations (All Filings)”
Topic 11, “Reporting Issues Related to Adoption of New
Accounting Standards”; Section 11200, “New Leasing Standard (FASB ASC Topic
842)”
SEC Regulation S-K
Item 301, “Selected Financial Data”
Item 308(c), “Internal Control Over Financial Reporting;
Changes in Internal Control Over Financial Reporting”
SEC Regulation S-X
Article 10, “Interim Financial Statements”
International Standard
IFRS 16, Leases
Appendix B — Abbreviations
Abbreviation | Description |
|---|---|
AICPA | American Institute of Certified Public
Accountants |
ASC | FASB
Accounting Standards Codification |
ASU | FASB
Accounting Standards Update |
CAQ | Center for Audit Quality |
CEO | chief
executive officer |
CPI | consumer price index |
DFL | direct financing lease |
EITF | Emerging Issues Task Force |
FAQ | frequently asked question |
FASB | Financial Accounting Standards Board |
FERC | Federal Energy Regulatory Commission |
FRM | SEC
Financial Reporting Manual |
GAAP | generally accepted accounting principles |
IASB | International Accounting Standards Board |
ICFR | internal control over financial reporting |
IFRS | International Financial Reporting Standard |
IPP | independent power producer |
JOA | joint
operating agreement |
LIBOR | London Interbank Offered Rate |
MWh | megawatt hour |
P&L | profit and loss |
PCAOB | Public Company Accounting Oversight Board |
PP&E | property, plant, and equipment |
Q&A | question and answer |
ROU | right
of use |
SAB | SEC
Staff Accounting Bulletin |
SEC | Securities and Exchange Commission |
TRG | transition resource group |
Footnotes
1
For full titles of
standards, regulations, and other literature, see Appendix A. For definitions of
abbreviations, see Appendix B.
2
ASU 2016-02 was issued on February 25, 2016. IFRS 16,
the IASB’s new leases standard, was issued on January 13, 2016.
3
For public business entities, certain
not-for-profit entities, and certain employee benefit plans, ASU 2016-02
is effective for annual periods beginning after December 15, 2018, and
interim periods therein. For all other entities, the ASU is effective
for annual periods beginning after December 15, 2019, and interim
periods within annual periods beginning after December 15, 2020. Early
adoption is permitted.
4
On
November 30, 2016, for the first time since issuing ASU 2016-02, the
FASB discussed implementation issues related to the new leases standard.
The Board indicated that it would address implementation issues raised
by stakeholders in future FASB meetings instead of forming a transition
resource group (TRG) similar to the TRGs created to address transition
issues related to the new revenue recognition and credit losses
guidance.
5
Under IFRS 16, an entity may exclude leases for
which the underlying asset is of low value from its ROU assets and
lease liabilities. See paragraphs B3 through B8 in IFRS 16 for
information about how to assess whether an asset is of low
value.
6
Tax attributes such as the
Renewable Electricity Production Tax Credit are
different from renewable energy credits. In
accordance with ASC 842-10-15-17, renewable energy
credits are by-products of the use of a renewable
energy generation facility and reflect benefits
that can be realized from a commercial transaction
with a third party. Example 9, Case A, in ASC
842-10-55-108 through 55-111 illustrates a
contract for energy/power that contains a lease.
In ASC 842-10-55-111(a), the FASB concludes that
the renewable energy credits in the example are an
economic benefit from the use of a renewable
energy generation facility.
7
To control the use of an
identified asset under ASC 842, a customer is
required to have the right to obtain substantially
all of the economic benefits from the use of the
asset throughout the period of use.
8
Accordingly, the lease would meet
the criterion in ASC 842-10-25-2(e) for
classification as a sales-type lease.
9
The lessor determined the
rate it used to price the lease by discounting
expected annual cash inflows of $20, plus a
terminal cash inflow of $50 for the expected
residual value of the asset, to the asset’s fair
value of $120.
10
See footnote 9.
11
See ASC
842-10-30-5(b).
12
See ASC
842-10-30-6(b).
13
See ASC
842-40-55-3 through 55-6.
14
ASC 842 defines
variable lease payments as “[p]ayments made by a lessee to a lessor
for the right to use an underlying asset that vary because of
changes in facts or circumstances occurring after the commencement
date, other than the passage of time.” Therefore, any portion of a
refundable security deposit that is retained by a lessor because of
changes in facts and circumstances after the lease commencement date
represents a variable lease payment and should be recognized as an
expense from the lessee’s perspective and as income in profit or
loss from the lessor’s perspective in the period when incurred
(lessee) or earned (lessor).
15
While this Q&A specifically focuses on the
consideration of variable payments based on an index or a rate when
a lessee initially measures its lease liability and ROU asset, the
concept would similarly apply when a lessor initially measures its
net investment in a sales-type or direct financing lease.
16
“Probable” is defined as the “future event or events are likely to
occur,” in a manner consistent with the term’s meaning in ASC 450 on
contingencies.
17
See ASC 842-20-50-4(c).
18
The ASC master glossary defines an
asset group as “the unit of accounting for a long-lived asset or
assets to be held and used, which represents the lowest level for
which identifiable cash flows are largely independent of the cash
flows of other groups of assets and liabilities.”
19
See ASC
840-10-35-4.
20
A
straight-line rent receivable is a deferred
balance that represents the difference between the
total lease payments received from an entity’s
customer since inception and the straight-line
rent income recognized.
21
In-place
leases provide value to the acquiring entity in
that cash outflows necessary to originate leases
(such as marketing, sales commissions, legal
costs, and lease incentives) are avoided. Also,
in-place leases enable the acquiring entity to
avoid lost cash flows during an otherwise required
lease-up period.
22
ASC 842-10-20 defines an underlying
asset as an “asset that is the subject of a lease
for which a right to use that asset has been
conveyed to a lessee. The underlying asset could be
a physically distinct portion of a single
asset.”
23
ASC
842-40-55-5 provides indicators for lessees to consider when
determining whether the lessee controls the underlying asset that is
being constructed.
24
For this purpose,
“effective date” represents the date on which an entity is first
required to adopt ASC 842. For example, for a public calendar-year
entity, this date would be January 1, 2019, because ASC 842 is
effective in periods beginning after December 15, 2018.
25
The lessee’s
evaluation of whether the lessee controls the
asset under construction should be performed at
all points in time during the comparative periods
presented.
26
Other registration statements, such as Form S-4,
include similar requirements.
27
The cost of insurance that protects the lessor’s
interest in the asset will generally be part of the contract
consideration and require allocation. On the other hand, the cost of
insurance that protects the lessee (e.g., renter’s insurance) will
not be part of the contract consideration regardless of whether such
insurance is required under the terms of the lease since the cost of
that insurance does not represent reimbursement of lessor
costs.
28
A contract could
include one lease component or multiple, separate lease
components.
29
The ASC master glossary defines
“standalone price” as the “price at which a
customer would purchase a component of a contract
separately.”
30
The ASC
master glossary defines “standalone selling price”
as the “price at which an entity would sell a
promised good or service separately to a
customer.”
31
See footnote 28.
32
As stated in paragraph BC400(b) of ASU 2016-02, the FASB “observed
that, in concept, the evaluation under [ASC] 842-40 on whether an
entity controls an asset that is under construction is similar to
the evaluation undertaken in the revenue recognition guidance in
accordance with [ASC] 606-10-25-27 to determine whether a
performance obligation is satisfied over time.”
33
See
ASC 606-10-25-27.