In our previous blog, we covered the basics of the New Lease Standard.
The new standard is effective for public companies for annual periods beginning after Dec 15, 2018. Non-public companies will have one more year after the above date.
Lessees will have to report right-of-use assets and lease liability for practically all leases. In a very basic situation, right-of-use asset and lease liability will be the same and determined by discounting future lease payments at the appropriate discount rate.
It’s important to understand what components are included in the lease payments and right-of-use assets.
Lease Payment and Right of Use Asset
Lease liability is recorded when the lease starts or at the lease commencement day. The amount of lease liability is measured as discounted value of future lease payments. The question is therefore what is included in lease payments. There are four main components:
- Fixed payments to a lessor made subsequent to the lease commencement day;
- Variable or contingent lease payments payable to the lessor and meeting certain conditions;
- Exercise price of a purchase option to be exercised by the lessee with reasonable certainty;
- Amounts that are probable to be paid to the lessor under the residual value guarantee;
Variable Lease Conditions
Let’s spend more time and talk about variable lease payments. ASC 842 has two main criteria for the variable lease payments to be included in the lease payments and, therefore, discounted to determine the amount of lease liability.
First off, the variable payment should depend on an index or a rate. Examples of an index include Consumer Price Index or S&P 500. Rates could be LIBOR, Prime, or other interest rate.
Secondly, the amount of variable consideration that would be included in lease payments should be calculated using the index/rate value on the lease commencement and not subsequent to that. The impact of subsequent changes in the index/rate is recorded as the changes occur and not before that.
Let’s say lease payments would be calculated based on the amount of lessee’s revenue in the year prior to the lease year in question. Revenue is not a rate or an index. That type of variable lease payments will not be included in the lease payments as of the lease commencement day. Therefore, these payments will not be included in the lease liability established when the lease starts.
Let’s focus on the right-of-use asset. In the very basic example of the lease, the right-of-use asset and lease liability are the same. This is not always the case. The right-of-use asset has 3 main components listed below:
- Initial measurement of the lease liability;
- Payments made to the lessor before lease commencement date less incentives received by the lessee;
- Direct cost associated with the lease;
Note that payments made by lessee before the lease commencement will not be included in the lease payments and discounted but will be included in the right-of-use asset directly.
For the direct cost to qualify capitalization, they should be truly incremental, i.e. contingent upon signing of the lease. An example could be a lawyer’s commission strictly contingent upon execution of the lease agreement in question.
Let’s consider an example. Let’s say a Company hired a full time lawyer to work on lease and other agreements. The lawyer was hired as an exempt employee. Compensation paid to the lawyer would not be considered incremental because the lawyer would be compensated regardless of whether leases agreements are signed or not. No cost associated with lawyer’s compensation will be recorded on the balance sheet as part of the right-of-use asset.
Short-term Lease Exception
Let’s talk briefly about short-term lease exception. Potentially, the exception can allow not to account for certain leases by discounting lease payments and recording them as liabilities at lease commencement. Short-term leases can be accounted for similar to how operating leases are recorded under the current accounting guidance.
A short-term lease is defined as the lease that, at the commencement date, has a lease term of 12 months or less with no option to purchase the underlying asset that the lessee is reasonably certain to exercise.
As part of the accounting policy choice, lessees are allowed not to record the right-of-use and lease liability measured at discounted value. Note, however, that the way lease term is defined is that it includes both the fixed term as well as a renewal option that a lessee is to exercise with reasonable certainty.
We’ve seen situations when management applied short-term lease exception to leases without regard of the renewal option. This may lead to inappropriate application of ASC 842 reporting requirements. Under normal circumstances, a company would not move into a new office space with an intention to move out in 12 months or less. In other words, the expected lease term including renewal options is likely to exceed 12 months. Having said that, some leases may well be short-term. All in all, appropriate considerations should be given to renewal options and their impact on the application of the short-term lease exception.
ASC 842 introduces new reporting requirements. Many operating leases will have to be accounted for conceptually similar to how capital leases were accounted for under the current guidance (ASC 840). For those leases, lessees will have to determine right-of-use asset and lease liability and record them on the balance sheet at the lease commencement day.