Leases 101: New Accounting Standard ASC 842

At the very basic level, any lease agreement has three components – the asset, the owner, and the end user. Pretty straightforward, right? The reason this concept gets complex is because of a) how “asset” can be defined in the agreement and b) relations between the end user and the asset. We will clarify this with three examples below.

What is the lease according to ASC 842?

How is it different from the old accounting standard?

What does it mean for your business?

Yes, there are many questions lingering around the new lease accounting standard including different accounting model now required for operating lessees. There are also new disclosure requirements.

Let’s clear the air and understand how this affects you as a business.

What is a lease according to ASC 842?

EXAMPLE 1: A DIRECT LEASE AGREEMENT

Let’s say IKEA needs additional warehouse space to store and distribute its finished goods.

So, what IKEA does is it rents a building that will be used as a warehouse. In this case, according to the lease agreement, there is one tenant and one landlord. There is no other third party involved.

The asset here is the warehouse. The original owner of the warehouse is the one renting the space out to IKEA. And IKEA is the end user. In this case, IKEA will physically operate the warehouse so the relations between the IKEA and the asset itself are pretty straightforward.

But, sometimes, we encounter more complicated transactions that involve less clearly identified assets and their relation with lessees. Let’s see how this unwinds in the coming examples.

EXAMPLE 2: PURCHASE AGREEMENT REQUIRING DESIGNING OF TOOLS

Let’s assume that Boeing signs a deal with a manufacturing company to supply so-called radomes- rounded far end of a cockpit.

Now, this manufacturing company should first develop the mold for the cockpit nose. Boeing is directly involved in the design process to ensure the specifications are in sync with their aircraft’s requirements. The mold will only be used in connection with Boeing’s contract. In other words, the manufacturers won’t be able to use the mold for anything else.

First off, on the surface this is not a lease agreement, it’s a purchase agreement. However, even a purchase agreement may, in fact, contain a lease.

Let’s understand the assets and end users in this case.

In order to fulfill the purchase agreement, the manufacturer will have to produce another asset- a mold. This other asset cannot be used for any purpose other than Boeing’s contract. Here, the asset in question is the mold. Although it may not be even mentioned in the agreement, it’s the key tool that will be used to produce cockpit fronts.

Legally, the mold is owned by the manufacturing company. The ultimate user of the mold is Boeing. This is because the mold can only be used in connection w/ Boeing’s contract.

Now, we see that Boeing is the potential lessee. The end user is not directly involved in the physical operation of the asset because it is actually used by the manufacturing company. However, Boeing participated in the developed of mold’s design.

In this example, we see that the asset is not as obvious as it was in the first example. Relations between the lessee (Boeing) and the asset are also not as straightforward as before.

EXAMPLE 3: GENERAL PURCHASE AGREEMENT

Say that Airbus signs a contract with a small manufacturing plant called “A”. “A” agrees to produce and supply anti-slippery flooring for Airbus’ A320 aircraft model.

In a given year, Airbus happens to purchase a whopping 60% of the plant’s total end products.

In this case, it’s again a purchase, not a lease agreement. The asset is the whole plant used to produce the flooring. Note that the flooring itself cannot be a leased asset because it’s sold and is, therefore, an inventory.

The manufacturing plant is the legal owner of the asset in question. Airbus, a potential lessee, does not operate the asset. However, Airbus consumes a majority (60%) of benefits associated with the use of the asset.

Again, what the asset actually is, is not as clear. Relations of the lessee (Airbus) with the asset is also not as straightforward.

Let’s us take another quick look at the definition of the lease.

According to the new standard, a lease is the rights to control the use of the identified leased property by the lessee for a given period of time in exchange of consideration payable to the lessor.

As you can see, the definition has two main components:

Identified asset (property, plant, and equipment);
Control of the use;

According to ASC 842, lease assets can be identified explicitly or implicitly, that is indirect. Now, control of the use takes place when two criteria are met:

lessee has the right to obtain substantially all economic benefits; AND
lessee has the right to direct the use;

Finally, the right to direct the use takes place when one of the two conditions is met:

customer has the right to physically operate the asset; OR
customer designed the asset in a way that determined asset’s use throughout the term;

All in all, for the contract to contain a lease, it should meet the following 3 criteria:

Asset is identified explicitly or implicitly;
Lessee obtain substantially all economic benefits associated with the use;
Lessee has the right to physically operate the asset OR it designed the asset in a way that determined asset’s use throughout the lease term;

Now, with this in mind, let’s take a look at 3 examples above.

In example 1, the asset is identified clearly. IKEA will likely consume substantially all economic benefits associated with the asset as it will be its only user. IKEA will also be in charge of the actual operation of the assets. So it’s a lease! Phew! You knew that!

In example 2, the asset IS NOT clearly identified. However, it’s identified indirectly. This is because the mold, being the tool, is necessary and required to fulfill the contract with Boeing.

Now, Boeing will not operate the asset itself but is involved with the development of the design. That means that the third requirement (either or) is met. So, it’s a lease again.

Let’s deal with example 3. Now, unlike in the second example, Airbus is not involved with the development of the plant’s design. It also does not operate it. So, according to the definition, it cannot be a lease.
Overall, the definition of the lease became more specific and “narrower” that in the old standard. Some things that were leases before are not leases now.

Real quick on the new disclosure requirements in ASC 842. Lessee will have to disclose the following for each period presented in the financial statements:

Weighted average lease term;
Weighted average discount rate;

This info will have to be shown separately for operating and finance leases.

CONCLUSION

Always check the 3 conditions to see if the contract is a lease or not.

Start addressing new disclosure requirements earlier so you are not caught by surprise.

If you have any further questions regarding ASC 842, post them in the comments and stay tuned!