Purpose
For many reporting entities, leasing is an important way of gaining asset access. Through leasing arrangements, lessees can finance the use of required assets, often simplifies the disposal of used asset, and thereby enables lessee’s to reduce the exposure to the risks inherent in asset ownership.
This publication provides an overview of the key accounting considerations and implementation matters relating to lease accounting after adopting Accounting Standards Codification (ASC) 842, Leases. The technical views and accounting positions on the framework continue to improve depending on the results of further technical evaluations.
We sincerely hope you find the enclosed publication informative. We will be happy to participate in any discussions required to clarify our views, which are enclosed in the attached publication. We look forward to hearing from you.
Background
With the objective of recognizing most of the leases on the balance sheet, the Financial Accounting Standards Board (FASB or Board) issued ASU 2016-02 in February 2016, which was subsequently amended in some aspects by Accounting Standards Updates (collectively the “new leases standard” or “ASC 842”). Under ASC 842, leases are accounted for based on what FASB refers to as a “right-of-use model.” The substance of the model is, at the lease commencement date, for a lessee there exist financial obligation to make lease payments to the lessor for its right to use the underlying asset over the period of lease term. On the other hand, at lease commencement, the lessor conveys that right to use the underlying asset, which is the point in time when lessor makes the underlying asset available for use by the lessee.
In comparison to legacy guidance under ASC 840, Leases, which did not require lessees to recognize assets and liabilities under operating leases, the new leases standard results in a true representation of lessees’ assets and liabilities and more transparency about the lessee’s obligations and leasing activities by recognizing most of the leases on the balance sheet from day one. Accounting for leases under ASC 842 create new risks and require more judgment than accounting for leases under legacy guidance. While ASC 842 does not make fundamental changes to lessor accounting model under legacy guidance, it does modify the criteria for sales-type leases and direct financing leases and related accounting.
Summary of Topic
01. Scope and Scope exceptions
02. Identification of lease
03. Separating lease and nonlease components
04. Lease Term and lease commencement date
05. Lease Payments
06. Discount rate
07. Lease Classification
08. Lessee Accounting
09. Lessor Accounting
10. Sale and leaseback transaction
Key Issues / Considerations
1. Identification of Lease
The Customer and a freight carrier (Supplier) entered into a contract to provide the Customer with the use of 10 rail cars of a particular type for 5 years. The contract specifies the rail cars; the cars are owned by Supplier. As per the terms of the contract, the Customer determines when, where, and which goods are to be transported using the cars. When the cars are not used, they are kept at the Customer’s premises. The Customer can use the cars for another purpose (for example, storage) if it so chooses. However, the contract specifies that the Customer cannot transport particular types of cargo (for example, explosives). If a particular car needs to be serviced or repaired, the Supplier is required to substitute a car of the same type. Otherwise, other than on default by the Customer, the Supplier cannot retrieve the cars during the five-year period.
2. Identification and separation of leases and non-lease components
On 1 January 20X3, Lessee enters a three-year lease for office space with Lessor. The following are the terms of the lease arrangement:
A fixed payment payable on 31 December of each year starting at $300,000 and increasing 10% each year. The lessor shall be providing common area maintenance (CAM) services in the office space for which no separate rentals are charged.
The lessee is provided with 10 dedicated parking slots exclusively reserved for the lessee, which are rented monthly at $300 per slot at its standalone selling price, increasing 10% annually. In addition to the dedicated parking slot, the lessee is also allowed non-reserved parking for 10 additional vehicles, for which the charges are based on daily usage.
Lessee shall be liable to incur Lessor’s real estate taxes and insurance related to the underlying asset. Amounts incurred are payable on 31 December of each year.
All rentals and other incidental expenses shall be subject to additional payment of VAT. The right to use the office space for three years is a lease component and is classified as an operating lease.
The standalone price for the right to use the office space and CAM services for three years is $800,000 and $ 123,000, respectively.
Lessee does not elect the practical expedient to combine the lease and non-lease components.
The incremental borrowing rate at lease commencement is 4%.
3. Determination of lease commencement date
On January 1, 20X1, Lessee X signed a lease with Lessor P for a new building to be constructed that will serve as X’s new headquarters. P will construct the building and is the legal and accounting owner of the building both during and after construction. The construction of the building is expected to be completed on November 1, 20X3. As of September 1, 20X3, construction is mostly completed. P grants X access to the building for X to begin installing leasehold improvements, which X will own. X’s access to the building is restricted by P’s certificate of occupancy to construction personnel working on behalf of X to install leasehold improvements. As of September 1, 20X3, X cannot begin using the building for its intended purpose (i.e., its corporate headquarters).
Construction on the building was completed on November 1, 20X3. On December 1, 20X3, X’s leasehold improvements were completed, and X began using the building as its headquarters.
4. Lease Classification
ABC Inc., a real estate entity (Lessee) enters a ground lease of land in New York City with a term of 99 years. The Lessee will construct and operate an office building on the land and will lease office space to tenants. There is no transfer of ownership or option to purchase the land at the end of the lease term, and Lessee does not guarantee residual value at the end of the lease term. The present value of the lease payments is $100 million. The fair market value (FMV) of the land is $105 million.
5.Tenant Improvement Allowance
ABC Inc. (lessee) enters a 5-year contract with XYZ Inc. (lessor) for the use of office space located on 10th Floor of the building. The arrangement is concluded as a lease since it conveys the right to use the office space over a period of lease term. XYZ Inc. agrees to reimburse for some (or all) of the costs a lessee incurs to complete leasehold improvements. ABC Inc. has the option to terminate the lease after 3 years. The relevant terms of leasehold improvement cost reimbursement are as follows-:
Tenant Improvements
Plans and Specifications approval by lessor
Tenant Improvement Allowance
Removal of Tenant Improvements
6.Leasehold improvements related to common control leases
ABC Inc. leases a building from XYZ Inc. under the same common control group for a lease term of three years for accounting purposes. It installs leasehold improvements with a useful life of seven years to the common control group. Over what period should the leasehold improvements be amortized?
7.Failed Sale and leaseback transactions
A seller-lessee a telecom operator sells data center assets for $1,150,000 cash consideration and agrees to lease the assets back for five years. Consider the following facts about this transaction:
The net carrying amount of the data center assets as of the date of sale is $720,000.
The annual leaseback payment is $130,000. Annual depreciation expense is $80,000
The seller-lessee does not guarantee the asset’s residual value at the end of the leaseback term.
The seller-lessee has a repurchase option that allows it to buy the data center assets at the then-prevailing fair market value at any time during the lease term. There are no alternative data center assets that are substantially the same and readily available in the marketplace.
The seller-lessee’s incremental borrowing rate is 9.5%, and the interest rate implicit in the leaseback is not known.
8.Leases modification
ABC Inc. (Lessee) and Real Work (Lessor) entered into the Real Work membership enterprise agreement dated November 1, 2019 (hereinafter also referred to as membership agreement). As per the membership agreement terms, ABC Inc. was granted dedicated access to and use of the office space on the 18th and 19th floors. As per membership agreement, the lease termination date was November 30, 2023.
On November 1, 2023, ABC Inc. entered into a separate agreement, “Amendment and restatement of the lease agreement (the “Agreement”)” dated November 1, 2023, with the lessor. As per the terms of the Agreement, the Lessee will continue to be in possession of leased premises office space on the 18th and 19th floors effective lease commencement date of November 1, 2023, with an Initial Lease Term of 6 years and 6 months ending on April 30, 2030, as per the terms of the Agreement.
Comparison with IFRS
The FASB issued ASC 842 after joint deliberations with the IASB, which issued a similar standard, IFRS 16, Leases. While ASC 842 and IFRS 16 both require lessees to put most leases on their balance sheets, there are a number of differences between the two standards. The table in the PDF summarizes the key differences
