Topic 842, Leases
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In early February 2016, the Financial Accounting Standards Board (“FASB” or “the Board”) issued its highly-anticipated leasing standard in ASU 2016-021 (“Topic 842” or “the new standard”) for both lessees and lessors. Under its core principle, a lessee will recognize right-of-use (“ROU”) assets and related lease liabilities on the balance sheet for all arrangements with terms longer than 12 months. The pattern of expense recognition in the income statement will depend on a lease’s classification.
The following table summarizes lessee accounting for finance and operating leases:
Lessor accounting remains largely consistent with previous U.S. GAAP, but has been updated for consistency with the new lessee accounting model and with the new revenue standard, ASU 2014-09.2
For calendar-year public business entities the new standard takes effect in 2019, and interim periods within that year; for all other calendar-year entities it takes effect in 2020, and interim periods in 2021. The full standard is available here
This publication summarizes the new leasing guidance, including practical examples to assist practitioners. It also includes our observations on key concepts, as well as insights into how certain aspects of the new standard compare with prior U.S. GAAP.
The FASB leases project began as one of several joint projects with the International Accounting Standards Board (IASB) aimed at converging U.S. GAAP and International Financial Reporting Standards (IFRS). The objective of updating the leases guidance is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The new guidance is intended to address stakeholder concerns that previous leases guidance did not result in a faithful representation of leasing transactions, specifically that the rights and obligations associated with operating leases were not recognized on the balance sheet.
After several years of deliberations and two exposure drafts, the FASB and IASB reached different conclusions regarding the treatment of leases, and each of the Boards issued separate guidance early in 2016. Refer to the IFRS section of document
for a brief summary of the differences between Topic 842 and IFRS 16, Leases.
The scope of the new standard is generally consistent with prior guidance, and limits the definition of a lease to physical assets. The glossary defines a lease 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”. In order to meet this definition, a contract must grant the customer the right to direct the use of the identified asset during the term of the contract, as well as obtain substantially all of the economic benefits from the asset’s use.
BDO Observation: Although the Board acknowledged in paragraph 110 in the Basis for Conclusions that the conceptual basis for excluding leases of intangible assets, inventory and assets under construction from the scope of the new standard is unclear at best, it nonetheless decided to continue to limit the scope of the new standard to physical assets only. As a result, those arrangements will continue to be accounted for under Topic 350, Topic 330 and Topic 360, respectively. In addition, leases to explore for or use minerals, oil, natural gas and other similar resources, including leases of mineral rights, will continue to be accounted for under Topics 930 and 932, while leases of biological assets, including timber, will continue to be accounted for under Topic 905.
In order to be considered an identified asset, a lease must either explicitly or implicitly specify the asset subject to the lease. Similar to prior requirements, an asset is not considered specified if the lessor has the right to substitute similar assets during the term of the lease and therefore maintain control. However, the new standard clarifies that in order to preclude an arrangement from being deemed a lease, substitution rights must be substantive, which is defined in ASC 842-10-15-10 as the lessor’s practical ability to substitute alternative assets throughout the term and the ability to derive an economic benefit from the substitution. The right to substitute only on or after a particular date or event, for repairs and maintenance or based on the availability of a technical upgrade are not considered substantive substitution rights. In addition, the standard states that if the asset is located on the lessee’s premises, it is likely that the costs associated with substituting the asset would outweigh the related benefits, and thus the substitution right would not be substantive. If the lessee cannot determine whether the substitution rights would be substantive to the lessor, the lessee must presume that they are not substantive.
BDO Observation: As noted above, the requirement that a right of substitution must provide economic benefits to the supplier in order to be considered substantive is new, and may require significant judgment. As a result of this guidance, more contracts may be considered leases than under prior guidance. This determination becomes more important under the new guidance due to the balance sheet implications for the lessee.
Example 1: Customer enters into a contract with Manufacturer for the use of a copy machine for three years. Under the contract, the copier is explicitly specified by serial number, but Manufacturer has the right to replace the copier at any time during the agreement, including in lieu of repairing it. While the contract specifies a location for the copier, Customer has the right to move the copier to any of its facilities upon three days written notice to Manufacturer.
The contract contains a lease. There is an identified asset, and Customer has the right to control the use of the asset under lease throughout the three year period of the contract. Customer has the right to obtain substantially all of the economic benefits from the use of the copier as the copier is located on Customer’s property, and Customer has the right to direct the use of the copier, including the right to move it to another location.
Although Manufacturer has the right to replace the copy machine at any time, such substitution would not generate an economic benefit for Manufacturer. As noted in 842-10-15-12, if the asset is located at the customer’s premises, then the costs associated with substitution are likely to exceed the benefits associated with substituting the asset.
Right to Control Use
In addition to relating to a specified asset, a contract must convey the right to control the use of the asset, which is defined as both the right to obtain the economic benefits from the use of the asset, as well as the right to direct the use of the asset. When determining whether a contract conveys the right to obtain the economic benefits of the identified asset, the lessee should only consider the economic benefits that result from the use of the asset within the scope of the contract. In addition, terms that provide protective rights to the lessor, such as requiring the customer to follow industry-standard operating procedures, specifying the maximum amount of usage or requiring notification of changes in how or where the asset will be used, do not in isolation prevent the lessee from having the right to direct the use of the asset. For example, if a customer leases a corporate jet for a two-year period, restrictions within the lease agreement limiting the number of hours the jet can be flown prior to obtaining preventative maintenance will not preclude the arrangement from meeting the definition of a lease as long as the customer has the right to control the use of aircraft during the two-year term, including deciding where and when it will travel and what passengers and cargo it will transport.
The lessee has the right to direct the use of the asset if it can change how and for what purpose the asset is used throughout the term of the agreement, or if those relevant decisions are predetermined and the lessee either designed the asset in a way that predetermined its use or the lessor does not have the right to change the operating instructions during the term. Decision-making rights include the right to decide how to use the output produced by the asset, the right to change when or where the output is produced, and the right to change how much output is produced, if any. These rights are examples only, and are neither determinative nor prescriptive. For example, a requirement to use an asset in a specified location does not necessarily imply that the lessee does not direct the use of the asset.
Example 2: Telco enters into an agreement with Logistics Company. Under the agreement, Telco requires Logistics Company to build or otherwise obtain a warehouse in a specified geographic location. While Logistics Company has latitude in selecting the facility, it must be located in the specified area, and once selected cannot be relocated, even within the specified area, absent extraordinary circumstances (for example, destruction by fire). For the five year term of the agreement, Logistics Company will process all returned handsets directed by Telco to this warehouse pursuant to repair instructions provided by Telco. If Telco does not direct handsets to the warehouse, then the warehouse does not operate. Logistics Company is not allowed to service any customers other than Telco in the warehouse under the agreement. Logistics Company is required to operate and maintain the warehouse on a daily basis in accordance with industry-approved operating procedures.
Even though in form this arrangement appears to be a service contract, the agreement contains a lease. Telco has the right to use the warehouse for five years. The arrangement includes an identified asset. Once selected, Logistics Company does not have the right to substitute the specified warehouse. Telco has the right to control the use of the warehouse throughout the five-year term of the contract because it has the right to obtain substantially all of the economic benefits from the use of the warehouse, and it has the right to direct the use of the warehouse. Telco makes the relevant decisions about how and for what purpose the warehouse is used because it has the right to determine whether, when and how much activity will occur at the warehouse. Because Logistics Company is precluded from using the warehouse for any other customer or purpose, Telco’s decision making about the timing and quantity of handsets processed in effect determines when and whether the warehouse will be utilized.
The new standard provides lessees with a practical expedient related to short term leases. Lessees can elect an accounting policy under which the recognition provisions of the standard are not applied to leases with terms of 12 months or less and that do not include an option to purchase the underlying asset that is reasonably certain to be exercised. Instead, lease payments related to these short term leases are recognized on a straight- line basis over the lease term, consistent with current accounting standards. This election must be made by asset class.
Example 3: Builder is engaged to construct a 60 story building, and leases a crane from Supplier Co. for the six months during which the frame will be erected. The lease agreement specifies a crane to be used, and although it does not allow the crane to be relocated without Supplier Co.’s approval, it otherwise allows Builder to direct the use of the crane. The lease does not include any renewal options, although in practice Builder could release the crane at then current market rates at the end of the lease term.
The agreement includes a lease. However, because the duration of the contract is only six months, it qualifies for the practical expedient. Builder can elect to account for the lease on a straight-line basis through income, without recognizing an ROU asset and a related lease liability.
Example 4: Assume the same facts as in Example 3, with the exception that the contract does not specify a fixed duration. Instead, the crane is subject to a daily rental rate, with weekly rent payments, and can be retained indefinitely.
The agreement still contains a lease. In order to determine whether the lease qualifies for the practical expedient for short term leases, Builder must analyze the lease term, as further discussed below in the “Lease Term” section. In this scenario, given that Builder determines the most likely duration based on need to be six months, coupled with the physical difficulties of replacing the equipment during that period with another crane with this functionality and the limited number of available cranes of this magnitude in the market, Builder determines that the term is six months. Therefore, Builder can elect to apply the practical expedient for short-term leases, consistent with the FASB’s intent (see paragraph 379 in the Basis for Conclusions).
BDO Observation: Topic 842 does not provide a scope exception for small value leases, similar to the exception provided in IFRS 16, the leasing standard issued by the IASB. Nonetheless, the FASB does note in paragraph 122 in the Basis for Conclusions that entities may adopt reasonable capitalization thresholds below which lease assets and lease liabilities are not recognized, consistent with other applications of accounting policies, such as capitalization of property, plant and equipment. We believe that any application of a lease capitalization threshold should result in materially the same result when considering all leases, not solely the impact from applying the policy to a single lease.
Unit of Account
Because the definition of a lease includes a specified asset, the unit of account is typically the individual asset. Therefore, if a contract includes the lease of multiple assets, it should be separated into multiple lease components if the lessee can benefit from the right to use each asset on its own or in conjunction with other readily available resources, and the right of use is neither highly dependent on nor highly interrelated with the other rights to use assets in the contract. The standard also contains guidance requiring separate accounting for land and a building, unless the effect of separation would be insignificant. Conversely, two or more leasing contracts must be combined when they are entered into at or near the same time with the same counterparty or related parties, if (1) they were negotiated as a package with the same commercial purpose, (2) the amount
of consideration to be paid in one contract depends on the price or performance of the other one, or (3) the rights to use the underlying assets conveyed in the contracts are a single lease component based on the separation guidance described above.
Example 5: Clean Air Co. provides air purification systems, primarily to hospitals and other healthcare facilities, under leasing arrangements. Each system consists of multiple air filters installed throughout the lessee facility, in an amount and at locations determined based on the
size and design of the facility.
Because of airflow throughout the lessee facility, any individual air filter is ineffective on its own. Achieving air purification requires the full complement of air filters provided in the arrangement. Therefore, the use of each air filter is highly dependent upon the use of the other air filters, and the arrangement is deemed to contain only one lease component.
BDO Observation: The guidance in ASC 842-10-15-28 on determining whether one or more lease components should be accounted for separately is similar to the guidance in ASC 606-10-25-19 through 25-21 on determining whether a good or service promised in a revenue contract is distinct, and therefore represents a separate performance obligation. By the same token, the guidance in ASC 842-10-25-19 on when to combine contracts is almost identical to the guidance in ASC 606-10-25-9 on combining revenue contracts. This linkage is intentional, as the new lease standard incorporates concepts from the new revenue recognition guidance, in particular the concept of control.
In addition, both lessees and lessors must separate lease components from non-lease components. For purposes of this analysis, administrative tasks to initiate a lease and reimbursement of the lessor’s costs are not considered lease components, and no lease consideration should be allocated to them. The new standard does allow lessees a practical expedient under which entities can elect not to separate non-lease components under the contract, but instead account for them as part of the lease component. The practical expedient is not available for lessors.
BDO Observation: While previous GAAP also requires separation of lease and non-lease components, given the similarities between current operating lease treatment and accounting for service contracts, this distinction often was not critical to the accounting. However, given the balance sheet implications of the new guidance for lessees, this distinction will become more important. For example, if a company leases one floor of a multi-story building as its office, and the lease payments include the cost of common area maintenance, the portion of the lease payment related to the maintenance will need to be bifurcated and accounted for separately unless the company elects the practical expedient and accounts for it in conjunction with the lease. However, that results in a larger ROU asset and lease liability, so companies will need to consider whether they will avail themselves of the practical expedient.
The consideration in a contract must be allocated among the lease and non-lease components of the contract. Lessees must allocate the lease consideration to the separate lease and non-lease components on a relative standalone selling price basis. If observable standalone prices are not readily available, lessees must estimate standalone prices using observable information to the extent possible. The residual approach may be acceptable if the standalone price for a component is highly variable or uncertain. Lessors must allocate the lease consideration using the revenue guidance in ASC 606-10-32-28 through 32-41.
Example 6: Lessee leases a car for its salesperson from Dealership for three years. Under the lease, Lessee has the right to drive the car for up to 15,000 miles per calendar year and to bring the car into the maintenance department of Dealership once per quarter for regularly scheduled maintenance as defined in the lease agreement. In addition to fixed lease payments of $415 per month, Lessee is required to maintain full coverage insurance on the car and to pay for any maintenance services required beyond regularly scheduled maintenance defined in the lease agreement. At the end of the lease term, Lessee is also required to make additional lease payments on a per mile basis for any mileage greater than 45,000 miles.
In this example, the lease contains two components, a car lease and a maintenance agreement. If Lessee has elected the practical expedient in 842-10-15-37, Lessee would not separate the two components, but would instead account for the combined contract as a single lease component. Lessee must elect the practical expedient by class of underlying asset, in this case, automobile leases.
If Lessee has not elected the practical expedient, Lessee would allocate the total consideration in the contract between the car lease and the maintenance agreement on a relative selling price basis. Although Lessee is required to maintain insurance coverage, that requirement represents a protective right. In addition, because Lessee must contract directly with an insurance agency of its choice, those payments are not consideration in the contract with the dealership. By the same token, any additional maintenance services or charges for excess mileage would also be considered variable consideration and not included in the computation of total consideration under the contract. Thus the only amounts to be included in this calculation are the fixed monthly lease payments, which total $14,940 over the lease term.
In order to allocate the total consideration in the contract between the car lease and the maintenance services, Lessee should identify observable standalone prices for the maintenance services and for the vehicle lease. Lessee determines that it could enter into a maintenance agreement with an unrelated service center for $30 per month, and Dealership commonly leases the same car on a standalone basis for
$400 per month. Therefore, the consideration in the contract is allocated to the lease and non-lease components as follows:
||Relative Standalone Price
The new lease standard allows for a portfolio approach. Specifically, paragraph 120 in the Basis for Conclusions indicates that the standard permits both a lessee and a lessor to apply the leases guidance at a portfolio level for leases with similar characteristics as long as the use of the portfolio approach would not differ materially from the application of the new standard to the individual leases in the portfolio. Paragraphs 842-20-55-18 through 55-20 provide an example in which the portfolio approach is utilized in determining the discount rate for the lease.
The new lease standard carried forward consistent lease classifications, with one exception. For lessees, leases are classified as either an operating lease or a finance lease, while for lessors, leases are classified as sales-type, direct financing or operating. The one exception is that the new standard no longer allows leveraged lease treatment for leases that are entered into or modified after the effective date of the standard. As a result, new or modified leases that previously met the definition of a leveraged lease will be accounted for as one of the other three types of leases. Existing leveraged leases are grandfathered into the standard, and should continue to be accounted for by the lessor under prior guidance until they expire or are modified.
BDO Observation: Under Topic 840, a leverage lease is one that meets the criteria to be classified as a direct financing lease, but also includes a long-term creditor that provides financing in an amount sufficient to provide the lessor with significant leverage in the arrangement. In addition, the lessor’s net investment in the lease must decline during the early years and rise during the later years of the lease, typically due to tax-related cash flows. Given the requirement in Topic 840 for leveraged leases to first meet the criteria for direct financing leases, we believe it is likely that many new or modified leases that would have historically been accounted for as leveraged leases will be accounted for as direct financing leases under the new standard.
Lease classification should be determined upon, and recognition begun on, lease commencement, which is defined as the date when the lessee obtains the right to use the asset. Any changes to the assumptions between lease commencement and the start of payments under the lease should be accounted for as a reassessment, as further described below.
Example 7: Burgers R Us enters into a ground and building lease to be used for a new restaurant. The lease provides for payments of $16,000 per month if Burgers R Us begins operations in the location on or before November 1, 2012. Monthly lease payments increase by $500 for every month the grand opening is delayed beyond November 1, 2012. The lease term ends ten years after the first payment, which is due when the restaurant opens for business. The lease is entered into on May 1, 2012, at which time both lessee and lessor begin the work to obtain the relevant permits required to operate a Burgers R Us restaurant in that location. The relevant permits are obtained, and the lessor grants access to Burgers R Us to the site on August 1, 2012. At that time, Burgers R Us begins leasehold improvement construction and other efforts required to conform the building to its brand requirements. The restaurant opens for business on December 1, 2012, at which time payments under the lease begin.
The lease commencement date is August 1, 2012. Although payments have not begun, Burgers R Us has the right to control access to and use of the building, as evidenced by starting construction on leasehold improvements. Lease classification should be determined, and lease recognition should begin, as of that date. Because Burgers R Us does not know at lease commencement when lease payments will begin or the amount of lease payments, the total payments and term must be estimated. The lease liability and ROU asset should be remeasured when the contingencies are resolved to reflect any difference between the estimate at lease commencement and the final amounts. See “Reassessment” section below for further information on performing the remeasurement.
Leases must be classified as finance leases by a lessee and sale-type leases by a lessor if any one of the following five criteria are met:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, this criterion is not used if the lease commences at or near the end of the asset’s economic life.
- 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 equals or exceeds substantially all of the fair value of the underlying asset.
- 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.
If the lease agreement includes the right to use multiple assets with different useful lives, and they are not separated into separate lease components as discussed above, then the economic life of the predominant asset should be used when determining whether the lease term is for the major part of the remaining economic life of the underlying asset.
The first four criteria are consistent with the criteria in prior guidance, albeit without the bright line thresholds. If the lease transfers ownership of the underlying asset prior to the end of the lease term, or includes a purchase option that the lessee is reasonably certain to exercise, then the lease should be accounted for as a finance lease/sale-type lease. In determining whether the lessee is reasonably certain to exercise a purchase option, both lessee and lessor should consider the purchase price inherent in the option, as well as other market factors related to the asset and the company’s economic environment, as further discussed below under “Lease Term”.
Under the new standard, the FASB removed the bright line thresholds from the third and fourth criteria, while retaining the intent and substance of the prior guidance. However, paragraph 842-10-55-2 indicates that one reasonable approach to determining whether either of these criterion have been met would be to conclude that 75% or more of the remaining economic life represents a major part, while 90% or more of the fair value of the underlying asset amounts to substantially all. In addition, a company might conclude that a commencement date that falls within the last 25% of the useful life of the underlying asset results in a commencement date at or near the end of the asset’s economic life.
BDO Observation: Paragraph 73 in the Basis for Conclusions indicates that the guidance in 842-10-55-2 was provided in order to assist companies as they establish internal accounting policies and controls in order to ensure that the leasing guidance is operational in a scalable manner. Thus, we believe that a strict adherence to the bright lines of prior leasing guidance is no longer required. Lessees should consider how best to articulate accounting policies in order to achieve consistent classification for similar leases, while adhering to the economic structure of the arrangement and the principle of the new standard. For example, a lessee might adopt a policy that establishes ranges that represent a major part of the remaining economic life and substantially all of the fair value of the underlying asset, similar to the approach taken when determining whether a contingent liability is probable under Topic 450-20.
The new standard added a fifth criterion in determining whether a lease is a finance lease or sales-type lease, specifically whether 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. Most lessors would be expected to structure such a lease to ensure that they are able to recover their investment in the underlying asset through required lease payments, thus resulting in finance/sales-type lease treatment because the present value of future lease payments represents substantially all of the fair value of the underlying asset. However, to the extent that is not the case, an inability of the lessor to repurpose the asset without undue cost at the end of the lease term will result in finance/sales-type lease treatment.
Example 8: Widget Co. enters into a lease agreement with Bob’s Custom Manufacturing. Under this agreement Bob’s will construct a piece of equipment to be used in Widget’s production process. The requirements for the asset will be provided by Widget, and are subject to a U.S. patented design. Because of the existence of the patent, Bob’s would be precluded from reusing the equipment at the end of the lease through redirecting it through a sale or subsequent lease. In addition, it would likely be cost prohibitive to modify the equipment in such a way that it no longer complies with the patented design requirements. Therefore, the fifth lease criterion applies, and Widget would account for the lease as a finance lease, while Bob’s would account for the lease as a sales-type lease.
If none of the five criteria discussed above are met, a lessee will account for the lease as an operating lease. However, a lessor must still consider whether the present value of the future lease payments plus the value of any residual value guaranteed by the lessee or an unrelated third party equals or exceeds substantially all of the fair value of the underlying asset. If that is the case, and it is probable that the lessor will collect the lease payments plus any amount due under the residual value guarantee, then the lessor will account for the lease as a direct financing lease. Unless both criteria are met, the lessor will account for the lease as an operating lease.
The lease term must include the noncancellable period for which the lessee has the right to use the underlying asset plus any period covered by an option to extend the lease if the lessee is reasonably certain to exercise the option or if the exercise of the option is controlled by the lessor. In addition, if the lease contains an early termination provision, the period covered by the termination option should be included unless the lessee is reasonably certain to exercise the termination option.
The concept of “reasonably certain” is a relatively high threshold, and is intended to be interpreted consistently with the “reasonably assured” concept in previous guidance. In determining whether it is reasonably certain that an option will be exercised, a company should consider all economic factors relevant to that assessment, including contractual terms and conditions, significant leasehold improvements that are expected to have significant economic value after the initial lease term, costs related to exiting the lease including negotiating a new lease and relocation costs, costs associated with returning the leased asset to its contractually specified condition and/or location, and the importance of the underlying asset to the company’s operations.
BDO Observation: In paragraphs 193 through 195 in the Basis for Conclusions, the Board explained that the concept “reasonably certain” is consistent with the term “reasonably assured” in prior guidance, and is intended to take into consideration all relevant economic factors, including contractual, asset, entity and market-based factors. The Board rejected an approach that would include renewal periods and purchase options based solely on management’s intent. However, we believe that a company’s historical practice of exercising renewal or purchase options may indicate the existence of significant economic factors when assessing whether the exercise of renewal or purchase options is reasonably certain to occur under the new standard.
This definition of lease term applies equally to lessors and lessees. While it may be difficult for a lessor to determine whether a lessee is reasonably certain to exercise a renewal option or purchase option if the determination is based on lessee-specific factors, a lessor must nonetheless assess the likelihood, and must consider all known information.
Example 9: Retailer leases a building from Owner. The lease includes an initial term of 15 years, plus five optional renewal terms of five years each. Prior to opening the store to the public, Retailer must complete the construction of significant leasehold improvements in order to align the building with Retailer’s brand image. The leasehold improvements are expected to cost $500,000. The building is expected to have a remaining economic life of 30 years at lease inception; however, Retailer concludes that the leasehold improvements have an economic life of only 20 years as it is Retailer’s experience that after 20 years the building will require a major remodel in order to refresh the brand and remain competitive in the market. At the end of the lease term (or renewal term if exercised), any leasehold improvements transfer to Owner. While the building is in a desirable location, Retailer concludes that it could obtain a similar building within the trade area at a similar cost at any time during the remaining economic life of the building.
The lease term should include the initial term plus one renewal term. At the end of the initial term, Retailer will continue to own leasehold improvements with a remaining economic life of five years and an undepreciated carrying value of $125,000 which would transfer to Owner if a renewal option is not exercised. Thus, Retailer concludes that it is reasonably certain to exercise the first renewal option because it will have leasehold improvements that are expected to have significant economic value when the renewal option becomes exercisable.
Conversely, Retailer concludes that it is not reasonably certain at lease inception that it will exercise the second, third, fourth and fifth renewal terms. At the end of the first renewal period, Retailer will no longer have leasehold improvements with a significant economic value. Instead, Retailer believes that it would be required to incur significant costs to remodel the building in order to remain competitive in the market if it were to exercise the second renewal term. In addition, at lease inception the lease payments for the renewal periods are considered at market, and a similar building could be found at a reasonable cost.
Example 10: Consider the same facts as Example 9, with the exception that the building is located in a highly desirable location in mid- town Manhattan close to Times Square. Retailer believes that a presence in this market is essential to its national growth strategy, and there are no similar structures in this area that would be acceptable at a reasonable cost. The building has a remaining useful life of 30 years.
In this scenario, the lease term includes the initial term plus three renewal terms. Although Retailer would no longer own leasehold improvements with significant economic value at the end of the first renewal term, because of the importance of the location to Retailer’s strategy, and the lack of alternative options, Retailer determines that it would not be able to identify and obtain a lease on a similar building in this area without significant cost. Therefore, it is reasonably certain that Retailer will exercise the first three renewal terms, which will result in use of the building through the end of its remaining economic life. Because the building is not expected to have a useful life beyond 30 years, it is not reasonably certain that Retailer would exercise any renewal options beyond that period.
Lease payments include all fixed payments during the term of the lease, including in-substance fixed payments, less any lease incentives paid or payable by the lessor to the lessee. Lease payments also include any variable lease payments that depend on an index or rate, measured using the index or rate in place at lease commencement, as well as the exercise price of a purchase option that the lessee is reasonably certain to exercise, penalties related to a termination provision if it is reasonably certain that the lessee will exercise the termination option, any fees paid to the owners of a special-purpose entity for structuring the transaction, and for a lessee, amounts probable of being owed to the lessor under a residual value guarantee.
BDO Observation: While fixed payments, purchase options and termination penalties are typically specified in the lease agreement, it may require judgment to determine whether variable payments are in substance fixed, and at what amount. Likewise, estimating the amount expected to be owed under a residual value guarantee will also require judgment.
Variable lease payments include any payments that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time. Examples of variable lease payments include payments measured as a percentage of sales, payments based on units produced, payments that increase based on changes in the value of an index such as the Consumer Price Index, and payments that are triggered upon occurrence of an event.
BDO Observation: Because variable payments are generally not included in lease payments, they would not be included in the lease receivable to be recognized by a lessor in a sales-type lease. While this treatment is consistent with Topic 840, it is considerably different than the treatment of variable payments in revenue arrangements accounted for in accordance with ASC 606, which includes the estimated amount of variable consideration that is not probable of reversal in the transaction price. Therefore, the timing of recognition could be different for sales of assets versus for sales-type leases of similar assets when both transactions include variable consideration.
In addition, paragraph 842-10-55-37 clarifies that costs to dismantle and remove an underlying asset at the end of the lease term which are imposed by the lease agreement and which cannot be avoided generally would be considered lease payments. Conversely, obligations imposed by a lease resulting from a modification of the underlying asset (for example, a requirement to remove any leasehold improvements at the end of the lease term) would generally be considered an asset retirement obligation and accounted for in accordance with ASC 410-20.
Example 11: Susie’s Stitch-n-Sew enters into a five-year lease agreement with a mall operator that includes three five-year renewal options. Rent payments are $5,000 per month plus one percent of sales during the initial term, with base rent increasing by 10% in each renewal period. Susie’s incurs costs of $100,000 installing leasehold improvements to customize the space to its brand requirements. These leasehold improvements have a useful life of eight years. The lease requires Susie to remove the leasehold improvements at the end of the lease term. Because the leasehold improvements have a useful life that is longer than the initial lease term, Susie’s is reasonably certain to exercise the first renewal option.
The payments under the lease include both fixed and variable payments. The portion based on sales is variable and not based on an index or rate, and is therefore not included in lease payments. In addition, because the removal requirement is related to modifications made to the space by Susie’s, it would be considered an asset retirement obligation, and also not included in lease payments. Therefore, the total lease payments consist solely of the base rent for the initial lease term of $60,000 per year plus $66,000 per year in the first renewal period, for a total of $630,000.
Example 12: Assume the same facts as in Example 11, with the exception that rent payments for all periods are seven percent of sales, with no base rent. In addition, the lease specifies that annual sales for the initial lease term must exceed $1,000,000, while annual sales for the first renewal period must exceed $1,100,000.
While the payments under the lease appear variable in nature, the existence of a minimum sales threshold results in payments that are in substance fixed. Therefore, in this example lease payments equal $70,000 per year for the initial period and $77,000 per year for the first renewal period, for a total of $735,000.
Initial Direct Costs
Initial direct costs are defined as incremental costs that would not have been incurred if the lease had not been obtained, such as commissions and payments made to an existing tenant to incentivize that tenant to terminate its lease. Costs to negotiate or arrange the lease that would have been incurred regardless of whether the lease was obtained are not considered initial direct costs. Examples of such costs are fixed employee salaries, general overheads, costs incurred by the lessor to solicit potential lessees including advertising, costs to service existing leases, and costs related to activities that occur before a lease is obtained such as costs to negotiate the lease, obtain legal or tax advice, or evaluate a potential lessee’s financial condition.
BDO Observation: The definition of initial direct costs in the new standard is substantially more narrow than the definition in prior leasing guidance, and aligns with the definition of incremental costs of obtaining a contract under the new revenue recognition guidance (see ASC 340-40-25-1 through 25-3). This will likely represent a significant change in practice, as many companies with active leasing programs currently capitalize external legal and other consulting fees and may capitalize internal legal fees and costs associated with an internal leasing department as initial direct costs of their leases. Under the new standard, these costs will be expensed as incurred.
At the commencement date, the lessee recognizes a right-of-use (ROU) asset and a lease liability. The lease liability is calculated as the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement. The lease payments used in this calculation are the same lease payments, over the same term, used in determining the lease classification. The discount rate should be the rate implicit in the lease, which is the rate that causes the aggregate present value of the lease payments and the residual value of the underlying asset to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor, minus any related investment tax credit expected to be retained and realized by the lessor, if that rate is readily determinable. If not, the lessee should use its incremental borrowing rate, which is defined as the rate that the lessee would have incurred to borrow the funds necessary to purchase the leased asset over a term similar to the lease term.
BDO Observation: The concept of using the rate implicit in the lease when it is readily determinable is similar to prior leasing guidance. As such, we believe that “readily determinable” implies information that is known without undue effort.
The standard includes an optional practical expedient whereby non-public entities may use a risk-free rate, determined using a period comparable to that of the lease term, as an accounting policy applied to all leases.
The value of the ROU asset to be recognized equals the amount of the lease liability, plus any lease payments made to the lessor at or before lease commencement and any initial direct costs of the lessee, less any lease incentives received from the lessor.
After initial measurement, the lessee must recognize the costs associated with the lease each period. For finance leases, the lessee amortizes the ROU asset over the term of the lease on a straight-line basis or another basis if it more closely represents the benefits obtained under the lease. The lessee also recognizes interest on the lease liability calculated using the discount rate established at lease commencement. Any variable lease payments not included in the measurement of the ROU asset and lease liability are recognized in earnings in the period in which they become payable.
For an operating lease, the lessee recognizes a single lease cost, calculated so that the remaining cost of the lease is recognized over the remaining lease term on a straight-line basis, unless another systematic and rational basis is more representative of the pattern of benefit under the lease. The lease liability is remeasured each period as the present value of the lease payments not yet paid, discounted using the discount rate established at lease commencement. The difference between the single lease cost and the change in the carrying value of the lease liability is applied to the ROU asset to determine the subsequent carrying value of the ROU asset. Variable lease payments related to operating leases are also recognized in earnings in the period in which they become payable.
Insert Example 13
The accounting for the investment in the lease by the lessor varies depending on the lease classification, and remains substantially unchanged from prior guidance. For an operating lease, the underlying asset continues to be recognized and depreciated over its remaining useful life, while initial direct costs are deferred. After the commencement date, lease payments are recognized in income over the lease term on a straight-line
basis unless another systematic and rational basis better reflects the pattern of benefit to be derived from use of the underlying asset, while variable lease payments are recognized in the period in which they occur. Initial direct costs are amortized into income on the same basis as lease payments are recognized.
BDO Observation: During the deliberations of the new standard, the FASB considered requiring a symmetrical approach for operating leases, which would have resulted in the lessor recognizing a lease receivable, consistent with the lease liability recognized by the lessee. However, the Board ultimately concluded in paragraph 88 in the Basis for Conclusions that continuing to recognize the underlying asset and separately recognizing rental income provides more useful information to financial statement users and better reflects the business model of many lessors. An asymmetrical approach also reduces the complexity that would be inherent in applying a derecognition model to leases of portions of larger assets, such as one floor of a building.
For a sales-type lease, the lessor derecognizes the underlying asset and recognizes the net investment in the lease, as well as selling profit or loss. The net investment in the lease is calculated as the present value of lease payments not yet received and any residual value guarantee, discounted at the rate implicit in the lease, plus the present value of any unguaranteed residual asset. The selling profit or loss is calculated as the sum of the lease receivable and any prepaid lease payments (or the fair value of the underlying asset if less), minus the carrying amount of the underlying asset net of any unguaranteed residual asset. Any deferred initial direct costs should also be included in selling profit or loss unless the fair value of the asset equals its carrying amount, in which case initial direct costs are included in the net investment in the lease.
Subsequent to lease commencement, the lessor increases the carrying amount of the net investment in the lease to reflect interest income using the effective interest method, and reduces the carrying amount as payments are received. In addition, any variable lease payments will be recognized in income in the period in which they are earned. At the end of the lease term, any remaining net investment in the lease (which would represent the residual value of the underlying asset) is reclassified to the appropriate category of asset, typically property, plant and equipment.
Under the new standard, collectibility is not a criterion to be assessed when determining whether a lessor should classify a lease as a sale-type lease or not. If one of the five criteria in 842-10-25-2 is met, then the lease must be classified as a sales-type lease. If the lessor determines that it is not probable that the lease payments will be collected, then the arrangement is accounted for under the deposit method. The underlying asset is not derecognized, and any payments received are recorded as a deposit liability. This treatment continues until the lessor concludes that the remaining payments are probable of collection, at which time the lessor derecognizes the asset and recognizes the net investment in the lease, along with any selling profit.
BDO Observation: The treatment of sales-type leases when collectibility is not probable is consistent with the guidance in ASC 606 related to contracts with customers for which collectibility is not assured. However, it represents a change from prior guidance, which resulted in operating lease treatment when collectibility was not probable
Direct financing leases are accounted for in a similar manner to sales-type leases, with one important difference. While any selling loss is recognized at lease commencement, any selling profit and initial direct costs are deferred and included in the net investment in the lease. Subsequent accounting is also consistent with sales-type leases.
Unlike a sales-type lease, collectibility is a criterion that must be met in order to classify a lease as a direct financing lease. Therefore, if collectibility is not assured despite meeting the other criteria to be classified as a direct financing lease, the lessor must account for the lease as an operating lease.
Insert Example 14.
A lessee that enters into a sublease agreement should first consider whether it is relieved of the primary obligation under the original lease or not. If the lessee is relieved of the primary obligation under the original lease, then the sublease transaction is considered a termination of the original lease, and the ROU asset and lease liability are written off and gain or loss recognized for any difference. Any termination penalty paid that was not already included in the lease payments used to determine the ROU asset and lease liability would be expensed as incurred. If the lessee remains secondarily liable, any guarantee obligation should be accounted for in accordance with ASC 405-20-40-2.
If the lessee remains primarily liable under the original lease, then the lessee should account for the sublease in a manner similar to that of a lessor. If the sublease is classified as an operating lease, the lessee continues to account for the original lease as it did prior to the sublease. Any sublease income is recognized on a straight-line basis in earnings, unless another systematic and rational method is more representative of the benefits to be obtained by the sublessee. If the sublease is classified as a sales-type or direct financing lease, the lessee should derecognize the ROU asset associated with the original lease, recognize a net investment in the sublease, and continue to account for the original lease liability as it did prior
to the sublease.
The sublessor must use the rate implicit in the original lease in order to determine the sublease classification, unless it is not readily available, in which case the discount rate established for the original lease may be used. The sublessee should look to the original underlying asset in order to determine classification.
Insert Example 15
A lessee should reassess the lease term or a lessee option to purchase the underlying asset only if one of the following events occurs:
- There is a significant event or significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise a renewal or termination option.
- There is an event written into the contract that obliges the lessee to exercise or not exercise a renewal or termination option.
- The lessee elects to exercise an option even though it had previously determined that it was not reasonably certain to do so.
- The lessee elects not to exercise an option even though it had previously determined that it was reasonably certain to do so.
Examples of significant events or changes in circumstances that are within the lessee’s control include but are not limited to constructing leasehold improvements that are expected to have significant value when the option becomes exercisable, making significant modifications or customizations to the underlying asset, making a business decision that is directly relevant to the ability to exercise an option such as extending the lease of a complementary asset, and subleasing the underlying asset for a period beyond the exercise date of the option. Changes in market factors, such as market rates to lease comparable assets, do not in isolation trigger reassessment.
In addition, a lessee should remeasure the lease payments if there is deemed a change in the lease term as described above or one of the following other events occurs:
- The lease is modified, and the modification is not accounted for as a separate contract.
- A contingency upon which some or all of the variable payments during the remaining lease term is resolved, so that the payments become fixed.
- There is a change in the assessment of whether the lessee is reasonably certain to exercise a purchase option.
- There is a change in the amount expected to be paid under a residual value guarantee.
If the lessee remeasures its lease payments, any variable payments that depend on a rate or index should be remeasured using the rate or index at the remeasurement date.
Example 16: Assume the same facts as in Example 9 related to determining the lease term. At lease inception, Retailer concludes that the lease term consists of the initial 15-year lease term and one five-year renewal period due to the existence of significant leasehold improvements with a 20-year life. After 13 years, Retailer adopts a new brand strategy which requires a complete reconstruction of the store front, plus various aspects of the internal structure and design. The reimaging costs $300,000, and the new leasehold improvements are expected to have a useful life of 10 years.
Because the construction of the reimaged leasehold improvements is within Retailer’s control, and they are expected to have significant value at the end of the first renewal period, Retailer must reassess the lease term. Retailer concludes that it is now reasonably certain to exercise both the first and second renewal periods. Retailer must remeasure the lease liability using the remaining lease payments from the last two years of the initial term plus lease payments for the first and second renewal periods, discounted at Retailer’s incremental borrowing rate at the time of reassessment. The difference between the remeasured lease liability and its current carrying amount is recorded as an adjustment to the related ROU asset to reflect the cost of the additional rights.
A lessor should only reassess the lease term, a lessee option to purchase the underlying asset or lease payments if the lease is modified and that modification is accounted for as a separate contract, as further discussed below. If a lessee exercises a previously unplanned renewal, termination or purchase option, the lessor should account for that exercise as a modification of the lease.
Modifications are accounted for as a separate contract if the modification grants the lessee an additional right of use not included in the original lease and the increase in the lease payments is commensurate with the standalone price of the additional right of use.
If either of the criteria above is not met, then the lessee and lessor must reassess the classification of the lease as of the effective date of the modification, based on the modified terms and other circumstances as of that date. In addition, a lessee will reallocate the remaining consideration to the lease and any nonlease components; the lessee will also remeasure the lease liability using the discount rate determined at the effective date of the modification. If the modification results in an additional right of use, extends or reduces the term of the existing lease other than through the exercise of a contractual option, or changes the consideration in the contract, any difference resulting from remeasuring the lease liability is recognized as an adjustment to the corresponding ROU asset. If the modification fully or partially terminates the existing lease, then the lessee will decrease the carrying amount of the ROU asset on a basis proportionate to the full or partial termination. Any difference between the reduction in the lease liability and the proportionate reduction in the ROU asset is recognized as a gain or loss at the effective date of the modification.
BDO Observation: Example 18 in the new standard, which is provided in 842-10-55-177 through 55-185, provides two different methodologies for determining the proportionate reduction in the ROU asset and thus the gain or loss when a modification partially terminates an existing lease. Either methodology is acceptable. However, we believe companies should select one methodology and apply it consistently to all lease modifications.
Example 17: Company T leases one floor of an office building totaling 10,000 square feet, which it uses to house its headquarters. The lease commences on January 1, 2013, has a term of 10 years, and a price of $70/square foot. Company T determines that the lease should be classified as an operating lease. During 2015, Company T experienced significant growth, and on January 1, 2016, modified the lease to include 6,000 square feet on a second floor of the office building. The modification allowed for the lease of the 6,000 square feet at $80/ square foot, the then current market price, and made the lease of the additional space coterminous with the lease for the original space.
In this example, the modification results in a new lease because the terms of the existing lease are not changed, and the new space is leased at the then current market price. As such, the lease of additional space should be accounted for as a new lease, with an additional right-of- use asset and related liability recognized.
Example 18: Consider the same facts as in Example 17, with the exception that the lease was modified to reprice the entire space (existing floor plus new 6,000 square feet) at $75/square foot, and the term of the lease was extended for an additional five years.
In this fact pattern, the new lease agreement changes the terms of the original lease such that a modification has occurred. First, Company T reassesses the lease classification, and concludes that operating lease classification is still appropriate. Next, Company T must remeasure the existing lease liability on January 1, 2016 based on the new terms, as well as recognizing a lease liability related to the second floor, which represents a second component. Because the new terms grant Company T additional rights not included in the original lease, the difference between the remeasured lease liability related to the first floor and the carrying value of the existing lease liability is recognized as an adjustment to the right-of-use asset. Company T allocates the lease payments in the modified lease agreement to the two components (i.e. the two floors) on a relative standalone price basis. Because the current market rental rate of $80 per square foot is the same for both floors, the consideration can be allocated based on relative square footage. The first floor represent 62.5% of the total space leased, and thus 62.5% of the total remaining future lease payments of $14,400,000 will be allocated to that lease component, while the remaining 37.5% will be allocated to the second floor component.
If a lessor modifies an operating lease in such a way that the modification is not accounted for as a separate lease, the lessor should account for the modification as a termination of the existing lease and the creation of a new lease. If the modified lease is also classified as operating, then any prepaid or accrued lease payments related to the original lease are accounted for as part of the lease payments for the modified lease. If the modified lease is classified as a direct financing or sales-type lease, then any accrued rent asset or deferred rent liability should be included in the calculation of selling profit or loss.
If a lessor modifies a sales-type lease or a direct financing lease without resulting in a separate lease, the resultant accounting depends on the classification of the modified lease, as follows:
- If the modified lease is also classified as a direct financing lease, the lessor simply adjusts the discount rate so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification.
- If the modified lease is classified as a sales-type lease, the net investment in the original lease immediately before the effective date of the modification is assumed to be the carrying amount of the underlying asset. The carrying value is derecognized, and represents the cost of goods sold portion of selling profit or loss.
- If the modified lease is classified as an operating lease, the net investment in the original lease immediately before the effective date of the modification is also assumed to be the carrying amount of the underlying asset. The carrying amount is amortized into profit or loss over the remaining term of the modified lease.
ROU assets must be monitored for impairment, similar to other long-term nonfinancial assets. Impairments of both operating lease ROU assets and finance lease ROU assets are accounted for in accordance with ASC 360-10-35 on impairment or disposal of long-lived assets. The new standard indicates that a sublease arrangement in which the sublease revenue is less than the original lease cost is an indicator that the carrying amount of the ROU asset associated with the original lease may not be recoverable and thus must be assessed for impairment.