An excerpt from the e-book, “ Lease Accounting Standards Updates – What You Need to Know for 2019”
In our last blog, we reviewed the highlights and objectives of ASC 842. In this blog, we’ll detail specific applications of ASC 842 for private companies—and we’ll explain what constitutes a lease.
ASC 842 utilizes a dual model for operating and finance leases:
- Balance sheet: Both finance and operating leases will be reflected as a right-of-use asset, and a corresponding lease liability.
- Income statement: The treatment for a finance lease will be similar to any loan agreement with respect to front-loaded interest expense. Operating leases will be recorded on a straight-line basis as a lease expense.
- Cash flow statement: Principal payments on a finance lease will be reflected in cash flows from financing activities. Payments on operating leases will be reflected in cash flows from operating activities.
For lessors, the accounting treatment is largely unchanged from the current standard.
What Constitutes a Lease?
You may think a lease is straightforward. But like most things in the financial and accounting realm, there are nuances; and because nearly all leases will be on the balance sheet as a result of new lease standards under ASC 842, companies must identify every lease, as well as service agreements and other leases embedded in contracts. Therefore, understanding the definition and determining whether a contract is or contains a lease is crucial.
The previous GAAP definition of a lease is as follows:
“An agreement conveying the right to use property, plant or equipment (land and/or depreciable assets) usually for a stated period of time.”
The new definition of a lease under ASC 842 is as follows:
“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.”
There are three key differences in these definitions:
- The new definition refers specifically to a contract and includes a mention that a lease can also be viewed as only being part of a contract.
- It also specifically includes the term “control” within the context of the lease.
- Lastly, the new definition includes mention of the fact that the lease requires an “exchange of consideration.”
Using this new definition as a baseline, how do you know if a lease exists?
Two broad questions can help you make that determination:
1. Does an identified asset exist?
If an agreement includes use of a specific asset – from an office copier or coffee maker to an industrial drill press – and if the asset’s specification is explicit or implicit, then a lease could potentially exist. It’s also important to evaluate whether substantive substitution rights exist—in other words, whether the supplier could substitute the asset in question practically or economically. That industrial drill press likely is situated on the lessee’s factory floor, so “substituting” it isn’t necessarily easy.
2. Are you in control of the asset?
If you’ve determined that an identified asset in a lease agreement can’t be easily substituted, your next step is to determine who controls its use. Generally speaking, the party that exercises decision-making authority in a lease and receives the lion’s share of economic benefits from the asset in question controls that asset.
ASC 842 requires an enterprise to have the power to control the use of a given asset. This, in turn, may mean that fewer contracts in the future will meet the current definition of a lease.