New Lease Standard a Bird’s-eye view

Undoubtedly the biggest change coming with FASB ASC 842 is that operating leases (with certain exception) are now requires to be reflected on an entity’s balance sheet.

Undoubtedly the biggest change coming with FASB ASC 842 is that operating leases (with certain exception) are now requires to be reflected on an entity’s balance sheet. FASB notes in its BCs that “this approach will result in a more faithful representation of a lessee’s assets and liabilities and, together with the enhanced disclosures required by FASB ASC 842, greater transparency about a lessee’s financial leverage and its leasing activities

One of the first considerations with respect to the revised guidance is whether an arrangement an entity enters is considered a lease and is within the scope of the new FASB ASC 842. Determining whether an arrangement contains a lease or another type of agreement (like a service agreement for example) is critical because there are significant differences in accounting for each type of arrangement. Let’s look back at the change:

Previous lease definition:

An agreement conveying the right to use property, plant, or equipment (land or depreciable assets, or both) usually for a stated period.

Revised lease definition

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 in exchange for consideration.

Please note the two important changes “control” and “exchange for consideration”. Now that we understand what’s a lease, contract needs to be evaluated to determining whether a contract is a lease or contains one. If it’s a lease, FASB ASC 842 lays out three new classifications:

Finance Lease

Operating Lease

Short-term Lease

The new capital lease—finance lease

Although FASB ASC 842 is the focus of this blog, it is also important to step back and refresh ourselves on the classification criteria for the former capital lease. Based on the previous lease standard, a lease is classified as a capital lease if it meets any of the following conditions

  • The lease transfers ownership of the property to the lessee by the end of the lease term.
  • The lease contains a bargain purchase option.
  • The lease term is equal to 75% or more of the estimated economic life of the leased property.
  • The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payment representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90%.

The finance lease recognition criteria a lessee is required to classify a lease as a finance lease when it meets any one of the following criteria:

  • 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.
  • 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 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

The key differences are:

  • No “bright lines” incorporated into the new criteria, FASB does not mandate or prescribe the 75% of useful life and a 90% minimum lease payment threshold, these two criteria have been replaced with judgmental terms such as “major part of the remaining economic life” and “substantially all of the fair value of the underlying asset”
  • Also “bargain purchase option” has been replaced with terminology that implies a bargain purchase

 

The new operating lease

Although the name has not change much from the previous FASB ASC 840 standard, the effect on the balance sheet reporting perspective is extraordinary.

I will make a practical example of how the operating lease is now recognize from a reporting perspective. Important terms:

Commencement date. Is the date on which a lessor makes an underlying asset available for use by a lessee. This date is important because it’s the moment the lessee knows the total lease payments and can calculate the present value of future minimum lease payments and record the lease liability and the right-of-use asset.

Lease terms. FASB ASC 842 prescribes that a lease term should be the sum of the noncancelable period of the lease along with any periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option, as well as any periods covered by options to extend or terminate that would be controlled only by a lessor.

Discount Rate: is the rate an entity uses to discount future lease payments

Here is an example of the journal entry for an operating lease at commencement date:

10-year lease
Lease payments $30,000 per year
Discount rate: 3%

Date Account Name Debit Credit
1/1/2022 Right-of-use asset 372,017
Lease liability    342,017
Cash      30,000

 

The short-term lease

A lease that, at the commencement date has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

In this simpler type of lease, the lessee may recognize the lease payments in the income statement.

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