What Qualifies as a Lease?

Adopting a new accounting standard is an undertaking for any accounting team and requires advance planning and strategy prior to implementation. Key considerations include identifying the impact to accounting and operational procedures, reporting processes and stakeholder communication. Bringing in the right team to help you navigate the intricacies of the new accounting standard will be key.

Despite the fact that the effective date for ASC 842, Leases (Leases) is quickly approaching, the disruption to business operations throughout this past year may have shifted implementation from top of mind. Getting out in front of it now, before the effective date, will help ease any challenges that may come with implementation and will ensure enough time to be able to tackle them without a compressed workload and timeline.

Under the new standard, the lease criteria have been updated from the legacy guidance and all lease contracts and terms will need to be re-evaluated.  The new Leases standard is intended to bring more clarity to financial statement users by reporting substantially all lease arrangements on the balance sheet and to provide a clearer picture of a company’s commitments than under prior standards.

The implementation may require some analysis and legwork to avoid material missteps in your financial reporting.

Background

For fiscal years beginning after Dec. 15, 2018, the new standard went into effect for public entities and certain not-for-profit organizations. Calendar year private companies, including private not-for-profit entities, were to follow the new standard by Jan. 1, 2021, but the FASB voted to delay Leases until Jan. 1, 2022 due the pandemic for most private entities. For many businesses, Leases took a backseat while companies worked through the implementation of another new standard, ASC 606, Revenue from Contracts with Customers.

Legacy Standard

Under the extant standard, ASC 840, leases are either classified as operating or capital leases.

Historically, to be classified as a capital lease, certain criteria had to be met and these were recorded on the balance sheet to demonstrate the financing nature of the arrangement. Operating leases, however, were not recorded on the balance sheet and only required disclosure of future payments in the notes to the financial statements.

New Standard Requirements

Under the new standard, leases will be classified as either operating or finance leases. The biggest change to note for lessees, is that the majority of a company’s leases are recorded on the balance sheet, regardless of their classification.

Key Takeaways

The largest impact will be to the balance sheet (or statement of position) related to the capitalization of operating leases on the balance sheet. Key changes going forward:

  • Lessees will now “capitalize” all leases, including existing leases at the time of adoption.
  • Lessees will separately present operating and financing leases
  • Limited impact on the income statement upon adoption
  • Substantial new disclosure requirements will be in place for operating leases
  • Impact on debt covenants will vary depending on whether covenants are impacted by the new liabilities presented on the balance sheet.

Determining Whether a Contract Contains a Lease

The new accounting standard changes the definition of what is considered a lease. In the legacy standard, a lease is “an agreement conveying the right to use property, plant or equipment, usually for a stated period of time.” A lease is defined under the new standard 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.” Accordingly, accounting departments should be on guard for leases that are embedded within other contracts.

Who Enters Into a Lease

When evaluating whether or not a contract contains a lease, consider:

  • Who, in your organization, are negotiating leases? You want to understand whether it’s the accounting department, or someone within operations. It may be multiple people in multiple departments.
  • Who, in your organization, has the authority to enter into a lease?  If there isn’t good communication interdepartmentally, there be missed opportunities to record leases accurately. Even worse, contracts containing leases may be missed entirely.
  • Payments to vendors could bring about leases you were unaware of.
  • What is the substance of a contract you are entering into? Does it identify an asset that could qualify as a lease?

Quick Questions to Ask: Is there a lease?

Non-Qualifying Exceptions

There are situations where a contract does not qualify for a lease under ASC 842, but each situation can be complex and will require significant analysis of the facts and circumstances of each contract.

For example, let’s assume that Company ABC enters into a contract to rent a truck for five days from Rental Company XYZ. Rental Company XYZ directs the use of the asset to Company ABC by limiting where the truck can be used, how many miles per day are allowed, and has the ability to substitute this truck for another comparable truck at any time during the rental period.

Based on these facts and circumstances, the above example would not qualify as a lease due to the following reasons:

  • There is no specific asset as Rental Company XYZ has substantive substitution rights of the asset being rented, and
  • Company ABC is unable to control the use of the truck being rented.

When evaluating new leases, you’ll want to consider:

  • Lease terms
  • Non-lease components
  • Discount rates (rate implicit versus incremental borrowing rate) – this can be surprisingly complex
  • informal related party leases

You can also view our previous article on ideas for tracking new leases or changes in existing leases.

Contact Us

Should your business need help adopting and implementing the Leases standard, contact your Windham Brannon advisor or Bobby Vercoe, CPA.

 

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