In this first installment of our series on leases, we offer insights into one of the key questions in complying with the new leases standard (ASC 842) — do you or do you not have a lease to account for?
A lot has changed in the world since 2016 when the FASB approved and released ASC 842, Leases. However, because of the complexity, time and cost of adoption requirements, not to mention a worldwide pandemic, the standard was delayed for private companies and not-for-profits.
Finally, effective for periods beginning after December 15, 2021, private companies and not-for-profits will be required to adopt the new leases standard. All companies will effectively be required to record on the balance sheet both a right-of-use asset and a lease liability for substantially all leases, instead of the previous off-balance sheet accounting used for operating leases.
The bright side is, since public companies were already required to adopt the standard effective for calendar year 2019, there is a significant amount of information and numerous examples readily available to draw from. Some of the challenges and implications specifically identified to date include grossing up of balance sheets, effects to covenant compliance and potential impact to EBITDA.
Knowing whether or not you have a lease to account for and what assets are included in that lease are the first key steps to implementing the new standard.
How to Identify a Lease
One of the primary challenges you must deal with is identifying whether or not your company even has a lease.
Under the new standard, a lease is defined as a contract that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.
A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. With this definition of a contract, it is important to consider that leases may not always be explicitly identified as a lease agreement.
The standard also explicitly excludes the following assets and leases from the scope of the accounting standard:
- Leases of intangible assets
- Leases to explore for or use minerals, oil, natural gas and similar nonregenerative resources. This includes the intangible right to explore for those natural resources and rights to use the land in which those natural resources are contained (that is, unless those rights of use include more than the right to explore for natural resources), but not equipment used to explore for the natural resources.
- Leases of biological assets, including timber
- Leases of inventory
- Leases of assets under construction
Once you’ve determined the contract is within the scope of ASC 842, you must then begin to evaluate whether the contract contains a lease as defined above. Although available guidance references a step-by-step process to help in understanding, it’s not always necessary to use that formal process. For example, if the “right to control” the property, plant or equipment is clearly maintained by the supplier, then there would be no need to spend time determining if there is an identified asset.
How to Identify an Asset (Property, Plant and Equipment)
The second critical step is to determine whether there is a specific asset — property, plant and equipment (PP&E) — identified in the contract. Under the new standard, the asset must be identified either explicitly or implicitly. Explicit identification of an asset could be as simple as an address of a building or a VIN number for a vehicle. There are times, however, in which the contract may not explicitly identify the asset being leased, or the contract may be silent to the asset all together. If a supplier/lessor can only provide one specific asset to satisfy a contract, this is an example of an implicitly identified asset.
One exception to this standard, different from the prior rules, relates to substantive substitution rights for the PP&E under consideration. If a supplier/lessor has both the practical ability to substitute alternative assets during the period of use and would economically benefit from doing so, substantive substitution rights would exist and the agreement would not be considered a lease.
A common example is if you entered into a contract with a supplier for a certain amount of space within a warehouse. If the contract allows the supplier to place you in various locations throughout the warehouse, and they could benefit from moving you and giving your space to a new customer, that would be considered a substantive substitution and, therefore, your contract does not qualify as a lease.
Control Determination Analysis
The FASB carried forward into ASC 842 the control concepts from other areas of U.S. GAAP, such as ASC 810 and ASC 606. Accordingly, to have the right to control the use of the PP&E in a contract in which the PP&E is an identified asset, the customer must have both of the following:
- The right to obtain substantially all of the economic benefits from the use of the PP&E, and
- The right to direct the use of the PP&E.
Right to Obtain Substantially all of the Economic Benefits from the Use of the Identified Asset
As you work on identifying whether or not a specific contract contains a lease, you must evaluate whether or not you have the right to obtain substantially all of the economic benefits from the use of the identified asset. You may obtain economic benefit from the asset by using, holding or subleasing that particular asset. When considering this, you should consider the primary outputs, cash flows and by-products from this contract.
Right to Direct the Use
The entity also needs to consider if it has the right to direct how and for what purpose the asset is used throughout the designated period. If you can direct the use, then you have a lease. If this condition is not met, meaning how the asset is used is predetermined, you must meet one of the following lease criteria to treat this as a lease:
- You have the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use without the supplier having the right to change those operating instructions, or
- You designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use. (ASC 842-10-15-21).
One important item to note is that protective rights of an asset do not, in isolation, prevent customers from directing the use of an asset. Protective rights include terms and conditions to protect a supplier’s interest in an asset, including maintenance requirements, limitations on usage, and compliance with laws and regulations.
Be Aware of Embedded Leases
It’s important to note the definition of a lease under ASC 842 may result in new, “embedded,” leases contained in complex contracts that did not meet the previous criteria of a lease. Common examples of embedded leases from publicly traded companies include IT service contracts, supply, sales and manufacturing contracts.
Considering all of these factors, it’s very important that your organization review all of your contacts to determine if you actually have a lease and are prepared for the implementation effective in 2022.
Contact Gino Scipione at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.