10 Questions Lessees Should be Asking About Their Leases
At first glance, the revamped lease accounting standards may seem straightforward. The changes in ASC Topic 842, Leases, will require leases longer than 12 months to be recorded on the balance sheet, potentially providing greater transparency into a company’s finances.
On closer inspection, however, the new standards may require lessees to do some additional work to be in compliance. Public companies, which are adopting the changes for 2019, are encountering some difficulties with the application of the standard.
The following questions may help illuminate some of these emerging issues with leasing standard adoption.
1. Do I Have Embedded Leases?
Leases may not be standalone contracts; they could be embedded within other contracts, such as service, outsourcing, and maintenance contracts. The most common are:
- Warehousing: Though outsourced contracts, the agreements may contain language that meets the standards of a lease.
- Security: While a service contract, these contracts may grant access to scanners and other equipment that could be considered an embedded lease.
- Transportation: Embedded leases could be included for the trucks that are being used.
- Data storage: These agreements could include embedded leases for servers and the space where servers are stored.
Lessees should thoroughly review these types of contracts and determine whether ASC Topic 842 adoption would affect their contract accounting.
2. How Do I Account for Residual Value Guarantees in My Leases Under the New Standard?
If your organization uses residual value guarantees in its leasing agreements, you should include the maximum amount of any residual value guarantee when determining lease classification. However, lessees should make sure to include only the amount of residual value guarantee payment that is probable of being owed when measuring the lease obligation.
Lessees will be required to remeasure the lease liability if their estimate of the amount expected to be paid under a residual value guarantee changes.
3. How Are Initial Direct Costs Measured?
The FASB made changes to how it defines indirect costs, which could result in fewer items being capitalized. Only incremental costs qualify as initial direct costs. These are costs that would not have been incurred if the lease had not been executed. For example, a commission paid to a broker upon the successful execution of the lease is considered an initial direct cost. On the other hand, legal fees related to reviewing the lease are not considered initial direct costs. Such fees would have to be paid whether or not the lease was executed.
4. How Should I Account for Impairment?
Right-of-use assets for both operating and finance leases will be subject to existing accounting guidance for impairment (ASC Topic 360, Property, Plant, and Equipment). If an impairment is recognized related to an operating lease’s right-of-use asset, the right-of-use asset should be amortized on a straight-line basis, while the lease liability will still be reduced using the effective interest method. As a result, the total combined lease expense for an operating lease with a right-of-use asset that has been impaired will no longer be on a straight-line basis.
5. When Do I Need to Remeasure My Lease Liability?
There are several circumstances that could prompt a lessee to remeasure the lease liability. The first circumstance was referenced above, and would occur if the amount expected to be owed by the lessee under a residual value guarantee changes.
In a second scenario, the lessee would remeasure its lease liability if there has been a change in expectation about the exercise and renewal options due to a significant event or change in circumstances that is within the lessee’s control or if the lessee elects to exercise an option that the entity had previously determined it would not be reasonably certain to exercise.
In a third scenario, the lease liability is remeasured if the lease contains a contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are resolved such that those payments now meet the definition of lease payments. For example, if a variable payment is based on the use of the underlying asset and then switches to become a fixed amount due to the resolution of a contingency, then the lease liability would be remeasured.
Furthermore, if a lease is modified but not accounted for as a separate contract in accordance with ASC Topic 842, then the lease liability would be remeasured.
When remeasuring lease liability, variable payments that are based on an index or rate will need to be remeasured using the index or rate as of the date the remeasurement is required. Lease classification and lease discount rates should be reassessed when the contract is modified and not accounted for as a separate contract or, for lessees, if there is a change in the lease term or the assessment of whether the lessee is reasonably certain to exercise a purchase option.
6. How Do I Account for Remeasurement of the Lease Liability?
Increases or decreases in the lease liability will be offset by an increase or decrease in the right-of-use asset. However, if the carrying amount of the right-of-use asset is reduced to zero, any remaining amount of the remeasurement should be recognized in income. When accounting for the change to the lease liability, lessees will also need to reallocate consideration in the contract between the lease and nonlease components, if applicable.
7. When Is A Lease Modification Accounted for as a New Lease?
A lease modification is defined as any change to the terms and conditions of a contract that results in a change in the scope of (or the consideration for) a lease. Lease modifications should be treated as new leases when:
- The modification grants the lessee an additional right-of-use asset not included in the original lease, and
- The additional right-of-use asset is priced commensurate with its standalone selling price.
Modifications that only extend the term of the lease would not be accounted for as a separate lease. Any modification that does not constitute a new lease should be recognized as of the effective date of the modification. Note, however, that a modification could result in a change in lease classification.
8. Do I Have Variable Lease Payments?
Recognize variable lease payments (other than the base amount included in the lease liability) in the period in which the variable lease payment is incurred. Lessees must reassess variable lease payments based on an index or rate only when lease payments are remeasured due to a reassessment or a modification.
9. What if I Have Leases Between Related Parties?
Lessees should account for related party leases on the basis of the legally enforceable terms and conditions of the lease, as well as provide the financial statement disclosures normally required for related party transactions.
10. What if The Lease Contains Multiple Lease Components?
If a lessee can benefit from the right of use of an underlying asset either on its own or together with other resources that are readily available to the lessee, and the right to use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract, then it should be accounted for as a separate lease component. For example, if a lease contract contains a bulldozer and a crane, which are not highly interrelated or dependent on each other, then the bulldozer and the crane should be evaluated and accounted for separately under ASC Topic 842. Land and building should be accounted for as separate lease components unless the accounting effect is insignificant.
For More Information
Our webinar, “Oddities in Leasing,” includes more information about these and other provisions that may make leasing adoption more complicated. View the recording here or download the presentation slides.
If you have specific comments, questions, or concerns about your leasing arrangements, please contact us.