Authored by Phil Santarelli
With this article, we begin a series to explore the new requirements for lessee’s presented by Accounting Standards Codification (ASC) 842, Leases, issued by the Financial Accounting Standards Board (FASB) in February 2016. In broad terms, the headline of the new standard is that virtually all leases now must be brought onto the balance sheet of lessees in accordance with requirements of the standard. After initial recording, the leases are then accounted for as an operating lease or as a finance lease, with different requirements for reporting in the income statement.
Simple enough? The devil is in the details.
Determining if a contract contains a lease
The first step in applying ASC 842 is determining whether a contract, which is defined as an agreement between two parties which creates enforceable rights and obligations, contains a lease. Basically the contract contains a lease if it conveys the right to control the use of identified property or equipment for a period of time.
In order to determine whether a customer has the right to control the use of the specified asset, for a period of time, the customer determines that it has both:
- The right to obtain substantially all of the economic benefits from the use of the asset, and
- The right to direct the use of such asset.
- An asset is identified, usually by specific terms in the contract; however, absent description in the contract, an asset can be implicitly identified at the time the asset is made available to the customer. For example, a lease for a forklift could be worded in two different ways:
- The contract could specify the type, make and serial number of a specific forklift which is then provided to the customer, or
- The contract could specify that a forklift will be provided and at the time of delivery.
In both cases, the customer has a specifically identified asset.
Substantive substitution right
It is possible that the contract permits the supplier to substitute one asset for another. In this situation, the customer must determine whether this is a substantive substitution right. If so, then the contract does not contain a lease. The supplier has a substantive right if both of these conditions exist:
a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).
b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).1
An entity should evaluate at the inception of the lease whether the rights are substantive and should exclude consideration of future events which are unlikely to occur. Certain indicators are noted in the ASC which make it unlikely that the supplier has a substantive right:
- If the asset is physically located at the customer premises, the cost of substitution tends to be higher and may make it more likely the supplier would not substitute.
- If the supplier can only substitute after a certain period or after the occurrence of a specified event, the right would not be considered substantive.
- An obligation to substitute another asset in order to make repairs or maintenance is not a substantive right.
- If it is not determinative if the supplier has such a right, the customer should assume it does not.
An example of the application of this concept:
Contract contains a lease
A trucking company enters into a contract with a supplier of refrigerated trailers for ten trailers to be used for a period of five years. The contract specifies the trailers. The trailers are to be maintained at the customer’s premises. The customer determines when the trailers are used and the freight carried; or may not place them into service, but uses them for terminal storage. The supplier cannot retrieve the trailers until the five years are completed.
This contract contains a lease of ten trailers, because the customer:
- Controls the use of specific trailers;
- Has the right to substantially all of the economic benefits of the use of the trailers; and
- Has a right to direct use of the trailers for transport or storage.
Contract does not contain a lease
A customer enters into a contract with a supplier for transport of goods in refrigerated trailers for a period of five years. The volume specified in the contract will require the use of ten trailers at dates specified in the contract. The trucks and trailers are only at the customer’s premises for purposes of pickup and delivery. The supplier has the ability to substitute other trucks and trailers throughout the period. The supplier would benefit economically from the right of free substitution of equipment.
This contract does not contain a lease, because:
- The assets employed in the contract are not specified; the supplier’s only obligation is to provide transport services;
- The customer does not control the use of specific assets; and, thus,
- The customer does not receive substantially all of the economic benefits associated with the equipment, as the supplier can freely substitute other equipment to fulfill the transport obligation.
Right to control the use of the identified asset
There are two requirements to meet this condition. The customer must have the right to obtain economic benefits from the use of the asset and the customer has the right to direct the use of the asset. These conditions are met as follows:
Right to obtain economic benefits
- The customer has the exclusive right to use the asset through the life of the contract.
- The customer obtains economic benefits by using, holding or subleasing the asset.
- These economic benefits include the direct output of the asset and the related cash flows or other benefits resulting from contracts with third parties.
- Conditions that may limit the scope of economic benefits, such as mileage limits on a vehicle, do not impair the economic benefits obtained. If so, the customer assesses whether substantially all of the economic benefits have been obtained for the period through the mileage limit, but not beyond.
- Additional payments made to the supplier above the base rate, such as a percentage of sales, do not offset the consideration of economic benefits; they are simply considered additional consideration for the use of the asset.
Right to direct the use of the asset
- The customer determines how the asset is used through the life of the contract; or
- The use of the asset is predetermined per the terms of the contract and the terms cannot be changed by the supplier during the life of the contract, or the customer has designed the asset in such a way that the use of the asset is predetermined by virtue of such design.
Separating the components of a contract
It is not uncommon for a contract that contains a lease to have other components included. A customer must analyze the contract to determine if there are other components. Typically, the lease is a separate lease component of the contract if the following conditions are met:
a. The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).
b. The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset, if each right of use significantly affects the other.2
The standard specifies that lease contracts that include land as well as other assets, must be separated with the right to use the land (sometimes referred to as a land easement or right of way) as a separate lease component.
Other lease contract components could include the transfer of other goods and services to the customer. If present, these obligations must be separated and considered separately from the lease, and the consideration in the contract shall be allocated among the components. However, consideration should not be allocated to routine administrative costs in setting up the contract or reimbursements for payments of the lessor’s costs, as they are not considered the transfer of goods or services.
If the contract contains separate components, then the lessee must allocate the consideration specified in the lease as follows:
- The customer shall determine the standalone selling price of the components based on observable prices; if observable prices are not available, the lessee shall estimate the standalone price maximizing the use of observable information.
- The lessee shall allocate the consideration based on the standalone selling prices.3
The consideration to be allocated includes all of the fixed payments, as well as variable payments based on an index or rate as determined at the inception of the lease.3
The standard provides a practical expedient. The customer need not account for the components separately if it makes an accounting policy election to the treat the components as one lease obligation.
Despite the detailed guidance provided in the standard for the most common leasing transaction, such as for space or equipment, the assessment of whether or not a contract contains a lease will be straightforward and unlikely to result in an answer different from current practice. More complex arrangements such as service contracts, which may have not been considered as containing a lease, may need to be reviewed to determine if the customer, as part of the service agreement, obtains the right to use a specified asset which provides substantially all of its economic benefit to the customer.
Making the relevant assessments and allocating lease consideration (when multiple components are elected to be accounted for separately) will need to be addressed as part of an entity’s internal control over financial reporting. For accelerated filers, this will likely be a focus for external auditors conducting an integrated audit.
For more information on the new leases accounting standard, or to learn how Baker Tilly specialists can help, contact our team.
3Note that these concepts are similar to those contained in ASC 606 Revenue from Contracts with Customers