Editor’s note: This is the first article in a three-part series on ASC 842.
While a couple of deferrals and a global pandemic may have led entities to put the new lease accounting standard on the back burner the past few years, ASC 842 is now right around the corner.
The new standard is effective for nonpublic entities for fiscal years beginning after December 15, 2021, which means calendar year-end private companies have an effective date of January 1, 2022.
As lessees, entities should expect a few big changes to how they evaluate their leases, how those leases are presented on their financial statements, and what information is required to be disclosed.
There are some areas of ASC 842 that have been causing trouble as entities work through implementation of the new standard. Part one of this article explores three of them: defining a lease, defining an embedded lease and identifying the terms of a lease.
1. What is the definition of a lease under the new standard?
ASC 842 defines a lease as:
“A contract, or part of 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.”
This definition outlines four primary characteristics to consider: 1) an identified asset, 2) the right to control the use of that asset, 3) a period of time and 4) consideration.
The latter two are relatively straightforward, as they are typically readily determinable within the terms and conditions of a contractual arrangement. For example, a contract might outline that an entity will pay $1,000 per month (consideration) for 36 months (a period of time).
The first two, however, may not be as clear-cut and may involve some complexity and uncertainty; let’s take a closer look:
Identified assets: An identified asset is an item of property, plant or equipment (or a portion thereof) that is clearly defined and separately identifiable or distinct. For example, a vehicle lease will usually involve an identified asset, as the asset has a specific VIN that makes it easily identifiable. An agreement to rent office space might identify the asset as the sixth floor of the multistory office building at a specific address.
While these are relatively simple examples, it can become tricky to determine whether an underlying asset can be identified. Consider the following example:
A contract for 3,000 square feet of space within a 50,000 square foot warehouse might be considered an identifiable asset if the square footage can be separately identifiable and distinct from other square footage, even if it isn’t a separate room or floor. Similarly, a kiosk location within a mall might be considered an identifiable asset if it is distinct from other space in the mall.
To complicate the matter, some underlying assets may not be physically distinct, but could still meet the definition of an identified asset if the contract provides for substantially all of the capacity of the asset. For example, a contract with a telecommunications company may provide the customer with the 95% of the capacity of an underground fiber optic cable. Since 95% of the capacity of the cable represents substantially all of the capacity of the cable, the cable may represent an identified asset, and the agreement outlining the use of the cable may meet the definition of a lease.
Lastly, in order to be an identified asset, the supplier in the arrangement cannot have substantive substitution rights. If the supplier has a right to substitute the asset for another asset and that substitution would be economically beneficial to the supplier, there may be a substantive substitution right within the agreement.
Many contracts may contain provisions that allow the supplier to replace an asset if it malfunctions or to provide a substitute while the supplier provides repair and maintenance services on the asset. These would not represent a substantive substitution right as the supplier does not receive an economic benefit for providing those substitutions.
Generally, a substantive substitution right will not exist if the asset is physically located at the customer’s site (because the cost to substitute the asset may be prohibitive of an economic benefit), if the substitution is only allowed after a certain period of time or contingent event, or if the substitution is the result of an obligation to provide repairs or maintenance or to replace a damaged asset.
Substantive substitution rights may not be common in most arrangements but should be carefully evaluated given the accounting conclusions may potentially be significantly different if a substantive substitution right exists.
The right to control the use of an asset: An entity’s ability to control the use of an asset has two criteria. The first is the right to substantially all of the economic benefits of the asset. If an entity has the exclusive use of an asset, it will generally meet this first criterion.
For example, the entity will receive substantially all of the outputs of a piece of equipment (whether to produce inventory for resale or to produce items for its own use), or will be able to use office or warehouse space to operate or provide other services. If another party will receive some economic benefits of the asset, the entity will need to determine whether the benefits received by the other party represent more than an insignificant portion of the overall benefits of the asset.
The second is the right to direct the use of the asset. An entity is deemed to have the right to direct the use of an asset if it can direct how and for what purpose the asset is used. Some contracts may include a predetermined use for the underlying asset. In these scenarios, if the customer has a right to operate the asset without the supplier changing the operating instructions or if the customer was involved in designing the asset for its predetermined use, the customer would still meet this criterion as having the ability to direct the use.
Some decision-making rights that may indicate an entity’s ability to direct the use of the asset might include the right to change the type of output, the right to change when the output is produced, the right to change where the output is produced, and the right to change whether it is produced and the quantity.
To sum up, if all four of the above-discussed characteristics — an identified asset, the right to control the use of the asset, a period of time, and consideration — are met, the contract is or contains a lease.
2. What is an embedded lease?
The second challenge for organizations has been determining what an embedded lease is.
As described in the definition, a lease is a contract, or part of a contract, that meets the four characteristics we discussed. Therefore, some service agreements or other executory contracts may contain leases if they grant the customer the right to use an identifiable asset throughout the term of the agreement. While this is not technically a change from ASC 840 (the “old” guidance), the accounting implications under ASC 842 are significantly different.
Embedded leases are oftentimes operating leases. Under ASC 840, operating leases were not presented on the balance sheet, so an entity would only record rent expense as incurred. However, under ASC 842, all leases (including operating leases) create a lease liability and right-of-use asset on the balance sheet. Therefore, entities will need to carefully assess service agreements and other contracts to determine whether they are or contain a lease and will need to account for those leases under the principles of the new standard (i.e., present an asset and liability based on the terms of the arrangement).
For example, an agreement with an IT company for data storage services for three years may include the use of a server to store the customer’s data. If that contract identifies a server that will be provided for the customer’s exclusive use — that is, it will contain only the customer’s data — the IT service contract may contain a lease, which would need to be evaluated for proper accounting treatment under the new standard.
Another example might be a construction contractor that has a subcontractor agreement where the subcontractor will provide a specified quantity of scaffolding to be erected as and where needed at the general contractor’s project site. The subcontractor will provide the services of erecting, maintaining and removing the scaffolding when directed by the general contractor. This subcontractor agreement might contain a lease that would be recorded on the general contractor’s books. The scaffolding is an identifiable asset that the general contractor controls (receives the benefits and directs the use of) during the course of the project, presumably in exchange for cash consideration.
All sorts of contracts that we don’t typically think of as leases and don’t contain the words “lease” or “rent” will need to be carefully evaluated to determine whether those contracts contain the characteristics of a lease and would be required to be accounted for under the principles of ASC 842.
3. How does one identify the term of a lease?
The lease term is the noncancellable period for which a lessee has the right to use an underlying asset. It should be determined based on the period over which the contract is enforceable. ASC 842 takes a position of “form over substance” regarding lease agreements, which emphasizes the contractually enforceable terms and conditions of the lease.
Evaluating the lease term, however, can get complicated when the agreement contains renewal options. Options to renew would be included in the lease term (for the finance vs. operating classification test, as well as the measurement of the lease liability and right-of-use asset) if the entity is reasonably certain to exercise the renewal option. Unfortunately, the term “reasonably certain” is not specifically defined anywhere in the guidance.
However, ASC 842 does mention that an entity should consider various factors when evaluating whether an entity is likely to exercise a renewal option. Those factors include:
- Asset-specific factors: What is it about the specific asset that would lead the entity to want to renew? For example, an entity may be more likely to renew a lease for office space if the entity has recently made significant leasehold improvements to the space. It would not make economic sense to walk away from a lease before recovering the value of the improvements.
- Contract-specific factors: Is there a monetary penalty for early termination or a monetary incentive to renew the lease?
- Entity-specific factors: Are there factors specific to the entity that would lead it to renew the space? For example, an entity may be more likely to renew the lease for a building that acts as an entity’s home office where it has a significant customer base than renew a lease for warehouse storage space on the other side of town.
- Market-specific factors: Are there factors in the general market that would make it more or less likely to exercise an option? For example, are there comparable properties nearby that could be leased, or have the market rates for leased space increased dramatically compared to the contractual terms?
As noted by these factors, entities should consider penalties that are both monetary (e.g., a termination fee, relocation costs, etc.) and economic (e.g., value of improvements, customer base, market rates, etc.).
For building leases, leasehold improvements will be one of the most common factors entities will need to consider. Would the entity be willing to walk away from the value of the improvements? If the entity terminated the lease, would it incur significant costs to remove the improvements?
Many entities have considered the idea of making some of their leases one-year leases with no renewal clause, particularly leases with related parties. This may have some benefits in that there is no evaluation of the likelihood of renewal options being exercised since no renewal options exist in the contract.
Additionally, as will be discussed below, entities may elect not to evaluate leases with a term of 12 months or less, resulting in no balance sheet impact for those leases.
However, executing one-year leases with no renewal clauses will also have some downsides. There may be some time and cost incurred in drafting and signing new leases every year. But more importantly, leasehold improvements are to be amortized over the lesser of the useful life or lease term. If the lease term is one year, the value of leasehold improvements will be amortized over one year, regardless of the entity’s “intent.” The language in ASC 842 underscores that entities should follow the enforceable terms and conditions of the written contract.
The standards indicate that these factors should be considered for all leases and does not provide relief for leases with related parties, affiliated entities or entities under common control. In all circumstances, entities should look to the legally enforceable terms and conditions of the contract, rather than the intent of the arrangement.
How Wipfli can help
If you have questions about implementation of the new standard, its impact on your organization, potential software solutions to assist in tracking and maintaining your organization’s lease information, please contact us.
Read more in our series