“The beginning of wisdom is the definition of terms.” —Socrates
As you prepare to meet ASC 842/IFRS 16, the new lease accounting standards, is your head spinning to understand the terms? As you plan to book your right of use asset, is it properly calculated with the correct IBR (internal borrowing rate), and have you taken the right expedients during the transition? By the way, are you doing a full retrospective or modified retrospective transition anyway? A great place to start is with understanding the definitions of the new items in the standard. Read on as we explore the most important concepts and terms you must know to understand the new leasing standards.
I’ve been there, both with the lease terms and trying to make sense of a new language. The first time I attended a technical session, I heard about parsing the JSON so you could write a script to call out the https of something. It was like a time in college when I went to a hypnosis show and people in the audience were hypnotized into speaking gibberish. It was funny then, but when the show ended we went back to speaking English.
ASC 842-10-15-3 states: “A contract is or contains a lease if the contract 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. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).” It needs to be physically distinct.
This means that ASC 842/IFRS 16 does not include:
The graphic below explains the relationship between lessors and lessees:
The following chart provided by the FASB under 842-10-55-1 is helpful to identify contracts containing leases:
Once it is determined that a contract contains a lease, ASC 842-10-15-28 requires the entity to separate the contract into the various lease components. Separate lease component exists if:
Paragraphs 842-10-15-33 through 15-37 define what the different contract components represent. A contract can contain the following three components:
The commencement date of a lease is the “date on which the lessor makes an asset available for use by a lessee.” This is not the same as the date of the lease contract, and they can be different. The lease inception is “the date of the lease agreement or commitment, if earlier.” At this point, the commitment should be in writing, signed and have all principal provisions agreed upon. For example, when a retail space begins with a rent holiday, the date the space is available is the commencement date, not the date of the first payment. See paragraphs 842-10-55-19 through 55-21 for implementation guidance on the commencement date.
ASC 842-10-30-1 defines the lease term as the non-cancellable period during which a lessee obtains the right to use an underlying asset, combined with the following:
The discount rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated based on information available at the commencement date.
When determining incremental borrowing rates the following rules apply:
The incremental borrowing rate is the interest rate that a lessee would be required to pay when borrowing over a similar term, and with a similar security, the necessary funds to obtain an asset with a similar value.
The lessee will take its internal cost of funds and make adjustments based on the asset quality, the amount of funds borrowed and the term.
The following table from KPMG is useful in determining the effects of different IBRs on your financial performance.
If you are not a public entity, you can elect the IBR to be the risk-free rate in place at the time of the lease commencement.
A short-term lease is one that has a term of 12 months or less (from the commencement date) and does not include a purchase option that the lessee is reasonably certain to exercise.
As an accounting policy, a lessee may elect to not apply the recognition requirements to short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis over the term of the lease and variable lease payments in the period the obligation for those payments is incurred (842-20-55-1 through 55-2). The accounting policy elected for short-term leases is determined by the class of the underlying asset.
In other words, you can account for short-term leases in the same manner as previous lease guidance.
The lease liability represents the present value of all outstanding lease payments that are not yet paid. It is discounted by using the IBR or the implicit rate in the lease and calculated using an NPV (net present value) of all known payments that are unpaid.
The right of use asset is a new feature of the lease guidance. It represents the unused value of the leased asset remaining over the lease term.
It’s measured by taking the lease liability and adding the initial direct costs and the prepaid lease payments, then subtracting any lease incentives offered (see definitions further below).
The ROU is amortized linearly over the life of the lease.
Depending on the lease type, it can be amortization or ROU or rent expense.
Right of Use is calculated as follows:
ASC 842 diverges from IFRS 16 with respect to lease classifications. Under IFRS, all leases are classified as finance leases. Under US GAAP, there are two lease classifications: finance leases and operating leases.
In sections 842-10-25-1 thru 25-3, a lease is classified as a finance lease if any of the following criteria are met:
If none of the above criteria are met, then the lease should be classified as an operating lease. Note that the majority of real estate leases tend to be classified as an operating lease.
Under the new standard, finance leases and operating leases are measured differently.
When measuring a finance lease, lease costs are recognized using the following pattern:
This process is very similar to how a mortgage works; it uses the effective interest method to reduce the lease liability.
Here’s an example of the journal entry for finance leases:
When measuring an operating lease, lease costs are recognized using the following pattern:
Here’s an example of the plug approach:
This is what the subsequent journal entry would look like for operating leases:
At times, the lease liability may need to be remeasured during the life of the lease. This will change each of the subsequent lease accounting entries. There are three situations where the lease liability will require remeasurement:
After the lease liability is remeasured, an offset is required to adjust the remaining ROU asset. The ROU asset can’t go below zero, and any remaining balance would be included in net income (842-20-35-4).