Lease classification: Implementing the new leases accounting standard

Authored by: Phil Santarelli

Previously, we discussed how contracts are assessed to determine whether or not they contain a lease. Once you have determined there is a lease, the next step is to determine the classification of the lease (or lease component of a contract with multiple components).

ASC 842, requires each separate lease to be classified at its commencement date, which is at the time that the lessee has the leased asset available for use. That classification will be retained throughout the life of the lease, unless there is a contract modification1, or there is a change in either the estimated lease term or the initial determination of whether a purchase option will be exercised.

Although all lease obligations are required to be reflected on the balance sheet as a “right to use” asset and a related lease liability, US GAAP requires initial classification to determine how an entity will account for the lease through the income statement. Leases classified as finance leases will recognize depreciation and interest expense as with the current capital lease model, thus recognizing more expense in the early part of the lease, and less expense later in the term. Operating leases will recognize a rent expense on a straight line basis over the expected term. As such, the classification is an important issue with respect to operating metrics.

The classifications

Finance lease: The first classification option is a finance lease. This term is defined in the glossary as: From the perspective of a lessee, a lease that meets one or more of the criteria in ASC 842-10-25-2. These criteria are as follows:

a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.1

It is notable that the finance lease requirements do not differ significantly from the guidance in ASC 840 for classification as a capital lease. The new standard, ASC 842, changes the terminology to finance lease and, as expected, uses principle based requirements. Where ASC 840 specifies 75% of the estimated economic life, ASC 842 states major part. Where ASC 840 specifies the present value of the sum of the lease payments to be 90% of the fair value of the leased asset at inception, ASC 842, states the present value of the lease payments equals or exceeds substantially all of the fair value of the asset. These concepts, however were not eliminated entirely. The implementation guidance provides 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:

a) 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.
b) 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.
c) Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.2

So while the standard is meant to be principle based, some of the existing “rules” still ended up in the final FASB standard.3 As such, applying the classification should not differ substantially from current practice.

Operating lease: When none of the criteria noted above is met, the lessee shall classify the lease as an operating lease.

Components of the classification

In order to make the determination as to whether the lease is a finance lease, the entity must consider several variables and apply judgment to the assessment of whether any of the conditions noted above are met:

  1. Transfer of ownership
  2. Purchase options
  3. Remaining economic life of the asset
  4. The expected term of the lease
  5. Lease payments
  6. Rate implicit in the lease (discount rate)
  7. Fair value of the underlying asset

Transfer of ownership: If the terms of the lease call for a transfer of ownership at the end of the term the lease is a finance type lease. This would also apply even if the lessee was required to pay a nominal fee for legal transfer of ownership. However, if the lessee does not agree to the payment of such a fee, the transfer of ownership criteria cannot be assumed.

Purchase options: If the purchase option is reasonably certain to be exercised, the lease is a finance lease. FASB has determined that “reasonably certain,” is a high threshold, such as a probability exceeding 75-80%. Some indicators that the reasonably certain criteria: an economic penalty for not exercising, the uniqueness of the asset, cost of moving, cost of disruption to operations, cost of abandoning leasehold improvements, etc. All of the relevant facts and circumstances should be considered.

Remaining economic life: Determining the economic life of an asset is similar to the process an entity would use in assigning depreciable lives to purchased assets. The historical approach would be a logical starting point for new leased assets. For leased assets that have been used, the entity would consider its experiences as to how much life is remaining before the economic functionality of the asset will be used up. Obviously this is an area of judgment.

Once the economic life has been estimated, as noted above, the application guidance states that a reasonable approach for applying the “major portion,” criteria would be 75%, and that leases that commence in the last 25% of economic life, would not be considered finance leases.

In order to apply the present value test noted in criteria (d), the entity needs specific information to make the calculation. These are:

  • The expected term of the lease;
  • Lease payments; and
  • Rate implicit in the lease (discount rate).

The expected term of the lease: Leases often contain an initial term with options to extend the initial term. Entities need to determine what the probability is of exercising any or all of the options. The FASB uses the reasonably certain criteria again for this judgment. The lease term is considered the noncancellable period of the lease, which includes:

a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
b. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
c. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.4

The entity should consider all of the relevant facts and circumstances and the associated economic impacts of not exercising options or of early termination penalties when determining the estimate term of the lease for purposes of the present value calculation.

For instance, if an entity constructs a building on leased land for an initial period that is shorter than the economic life of the building, it may be reasonably certain that the entity will exercise extension terms in order to realize the full economic benefit of the building it constructed. And therefore the expected lease term will include options.

Conversely, if an entity leases a forklift, with an economic life of five years, for a term of four years and option for an additional four year term, the entity might conclude that it was unlikely to exercise the option due to the remaining life of the asset.

Once again judgment will be required in making the assessment.

Lease payments: The lease payments at commencement consist of the following:

a. 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).
b. 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.
c. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option (assessed considering the factors in paragraph 842-10-55-26).
d. Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease.
e. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d).
f. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).5

The types of variable lease payments to include in the calculation, are only those that are determined based on the application of an index or rate. Variable leases payments related to the use of the asset, such as excess mileage costs or sales percentage overrides, should not be considered.

Variable lease payments tied to an index or rate should be calculated at inception based on the then current rate without any adjustment for future changes in the index or rate. Note the subtle difference in the following example:

An entity leases office space for five years at an annual rent of $10,000.

The lease has a feature that increases the rent for the change in the consumer price index (CPI). At the commencement of the lease, the CPI is 250. At the end of year one, the CPI has increased to 260.

Therefore the year 2 lease is $10,000*260/250=$10,400.

The entity assumes lease payments of $50,000 for the PV calculation as the increases in CPI cannot be known or estimated.

Alternatively, if the rent increase was based on a rate such as the prime rate of interest, the calculation would be based on the rate at the commencement of the lease. In the example above, instead of the CPI, the rent is increased by applying the prime rate of interest. At commencement the prime rate is 3.25%; therefore, the entity should inflate the initial rent by 3.25% per year through the term of the lease. The series of rents would be $10,000, $10,325, $10,661, $11,007, and $11,365. Estimates of future increases or decreases in the prime would not be a factor.

Note: Payments for non-lease components

The only payments that should be considered when making the determination are payments related to the right of use of the underlying asset. ASC 842 provides the following on what types of payments are not lease components:

a. Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee
b. 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 asset6

In a real estate lease, it is common to have other required payments such as for common area maintenance. Typically, these would be considered non-lease components and not included in the total lease payments. Another example is related to an equipment lease, where as part of the lease payment, the lessor provides periodic maintenance throughout the life of the lease.

Often the lease contract states one rent payment to cover both the lease components, as well as the non-lease components. In those situations, you must allocate the payments using relative standalone selling price for the components. However, the standard provides a practical expedient (available to all entities):

As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.7

Rate implicit in the lease (discount rate): The discount rate to be used is the “rate implicit in the lease,” which the Glossary defines as:

The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.

A lessee may be unable to easily obtain the fair value of the underlying asset. As such, a lessee may use its incremental borrowing rate in the calculation, which is defined in the Glossary as:

The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

The FASB has also provided a practical expedient for nonpublic business entities, which may use the risk free interest rate for a comparable period. This will result in a higher lease liability, while reducing the interest expense for a finance lease. This is an accounting policy election that must be used consistently for all leases once elected.

Fair value of the underlying asset: In order to undertake the present value calculation, the entity must determine the fair value of the underlying asset, rather than the fair value of the right to use asset. This is defined in the ASC 842 Glossary as:

Fair value (second definition): The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

In many cases, determining the fair value of the underlying asset may not be practical for the lessee. As such the standard provides some relief:

In some cases, it may not be practicable for an entity to determine the fair value of an underlying asset. In the context of this Topic, practicable means that a reasonable estimate of fair value can be made without undue cost or effort. It is a dynamic concept; what is practicable for one entity may not be practicable for another, what is practicable in one period may not be practicable in another, and what is practicable for one underlying asset (or class of underlying asset) may not be practicable for another. In those cases in which it is not practicable for an entity to determine the fair value of an underlying asset, lease classification should be determined without consideration of the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).8

Here again, judgment will need to be applied in making this determination.

Other matters:

Related party leases: Leases between related parties should be classified in the same manner as with other parties, based on the legally enforceable terms and conditions of the lease contract.

Portfolio approach: The standard permits entities to group similar leased assets into a portfolio for purposes of determining classification and measurement as long as the result is not materially different from applying the standard to individual contracts. Necessarily this will most likely be limited to portfolios of homogenous assets.

Enhanced need for ICFR

As noted above, the determination of classification of a lease as financing or operating is little changed from concepts well established in ASC 840. However, entities will need to carefully evaluate their internal control over financial reporting (ICFR) over lease classification decisions to establish policies supporting the significant judgments necessary in applying the reasonably certain criteria to purchase options and expected term. These decisions will ultimately determine the relative size of the right to use asset and related liability, as well as the expense recognized in the income statement.

For more information on revenue recognition, or to learn how Baker Tilly’s specialists can help, contact our team.

ASC 842-10-25-2
2 ASC 842-10-55-2
3 Note the IFRS #16 Leases does not retain the two classifications so this concept is not included. All leases are considered finance leases
4 ASC 842-10-30-1
5 ASC 842-10-30-5
6 ASC 842-10-15-30
7 ASC 842-10-15-37
8 ASC 842-10-55-3