Separating the old from the new in the leases standard for lessees
The Financial Accounting Standards Board’s new leasing standard will have a major impact on lessees, but its origins can be traced back to the old rules.
What used to be called operating leases are now financing leases, and are now classified as “service contracts.” To examine issue from the vantage point of lessees, let’s begin by looking at the old lease rules encompassed in SFAS No. 13, which became Topic No. 840 under the new Accounting Standards Codification or ASC system. The new rules are in Topic 842 of the ASC.
The old rules measured the difference between “operating leases” and “capital leases” included in the balance sheet. Operating leases were expensed in the income statement and capital leases were not. Very simple. The new rules make it clear that any kind of lease, including operating leases, might need to be considered an asset and liability. The distinction in the new rules relate to contracts because an actual lease may not exist or the agreement may not be called a lease. So a contract can be either a “service contract” or a “lease contract.” It has to be said that a “short term” lease can be classified as a service contract and immediately expensed.
The distinction between the two derives from Financial Accounting Concepts No. 6, which defines assets and liabilities. The asset created in the lease contract is considered a “right-of-use” asset and is defined by who has “control” over the asset. I have to note that the lessor’s obligation to maintain and repair the asset doesn’t mean the lessee doesn’t have control.
The determination of whether or not the lessee has an asset is made in several ways. First, the lessee’s right-of-use permits the lessee to obtain substantially all the benefits from use of the asset during the lease term and to control others’ access to the identified underlying asset through its right to control the use of the underlying asset throughout the lease term. Second, the lessee’s control of an asset resulting from its right of use is demonstrated by its ability to determine how and when it uses the underlying asset and, therefore, how it obtains future economic benefits from that right of use. Third, the lessee’s control of the right of use arises from a past event—the lessor’s performance of making the underlying asset available for use by the lessee at the commencement date
Under ASC Topic 840, a lease was considered a “capital lease” under the standards that existed at that time. But we have to remember that those old standards still exist, except they are now a subset of the much broader rules that apply. Those broader rules adopt the same principles as the original rules, but do not contain hard and fast numbers. Still, it is acceptable to classify a lease based on the old standards, but not entirely under the old standards.
For example, whether or not a lease has a bargain purchase option is larger now. The question is whether or not the lease has any incentive for the lessee that would make it reasonably certain the lessee would exercise that option and purchase the asset at the end of the lease term. So it doesn’t have to be a “bargain purchase.” Instead, it can be any purchase option that would entice the lessee to buy the asset at the end of the lease term.
The second issue, of course, is whether ownership passes at the end of the lease term. This has not materially changed when compared to the old rule. If title passes, it passes. There is absolute clarity on this point.
And when you look at the old 75 percent measure, which stated that if the lease term occupied at least 75 percent of the useful life of the asset, then it would be considered a capital lease. But the new rules expand on that. So it is possible to “use up” the utility of an asset over a lesser lease period. Say 60 percent. The rule states that a lease is a financing lease if the lease term is for the major part of the remaining economic life of the asset. It would appear that this criteria could be very subjective, but I don’t think it is. I think it is a more realistic measurement.
Then we consider the 90 percent criteria, where the lease was a capital lease if the present value of minimum lease payments equaled at least 90 percent of the value of the asset at the time of the lease. This is also a broader measure under ASC Topic 842. The value of an asset could be used up or rendered not as useful if, let’s say, the present value of the minimum lease payments is 80 percent of the value of the asset. The rule states that the lease is a financing lease if the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset. All in all I think it depends on the asset and the utility it has at the point where minimum lease payments reach certain levels.
And then FASB added one more criteria that I think encapsulates all the rules. That is whether or not the lessor has any use for the asset at the end of the lease term. Again, this could be seen as a subjective measure, but not so. I think this is a criteria that can be easily measured. If the lessor does use the asset, then the test is not met. I think it is the most objective measure of them all.
So let’s look at what companies are required to do with this new standard. It is said that companies will literally have to set up “Lease Departments” within their prospective companies to capture all the leases. A lease does not have to be called a lease to be considered. It can be part of any contract, so management would have to have a review of all contracts to see if they include a lease. The overriding issue here is whether or not there is an asset involved. Identifying an asset is the purpose of this review. And then once an asset is identified, it would be incumbent upon management to determine if any of the aforementioned criteria exists to call it a lease.
Finally, the effective date of the lease standard is Jan. 1, 2019 for public companies using a calendar year and Jan. 1, 2020 for nonpublic companies using a calendar year.