Although the new accounting standard for leases - ASC 842 was published back in 2016, many business may only now be addressing the guidance on transitioning to the standard.
ASC 842 will, for those using operating leases as a regular means of asset acquisition, greatly increase the number of leases that may need to be recorded on the balance sheet. This brings into focus not only the difficulty, but also the importance of accurately estimating the discount rates for the operating leases in a lease portfolio. Difficult because they will have been taken out at different times, for different terms and for different amounts and important because the discount rates can have a significant impact on a business’s lease liabilities as the right-of-use assets are placed on the balance sheet.
Under the new standard, every lease with a lease term of more than a year must be recorded on the balance sheet as a right-of-use (“ROU”) asset with a corresponding lease liability. An exception under the new standard is for leases for low-value assets where a business has set a capitalization threshold for leased assets such that leases below this threshold are not material to the entity and thus need not be recognized.
As stated above the lease liability is measured by using an appropriate discount rate to calculate the present value of future lease payments but first a lessee determines whether the leases, based on five lease classification criteria, should be classified as operating or finance. They are similar to the four criteria under the previous guidance but require greater judgment by the lessee as they no longer contain explicit and unambiguous guidelines. An “operating” lease meeting any one of the following five criteria will need to be reclassified as a finance lease but is otherwise an operating lease:
- Ownership is transferred at the end of the lease term.
- There exists a bargain purchase option which is reasonably certain to be exercised for the leased assets.
- The lease term, which does not commence near the end of the economic life of the leased asset, is primarily for the remaining economic life of the leased asset.
- The present value of the lease payments and residual value guarantees is equal to, or more than, substantially all of the fair value of the leased asset.
- The leased asset has no alternative use to the lessor at the end of the term because of its specialized nature.
When looking at any agreement a lessee must determine whether a lease exists within the scope of the new guidance. If a lease does exist, then the lessee must next establish whether there is more than one lease involved. Each lease would then be accounted for separately, and if any non-lease components are present then the elements of them will need to be accounted for under other appropriate GAAP guidance. Based on ASC 842-10-15-3 and 842-10-15-4, the lessee must have direct control over the asset or be in a position to direct the manner and nature in which it is used – such control will depend on whether the lessor has “substantive substitution rights” and whether that lessor can derive a significant portion of the benefits from that ability to substitute alternative assets. Additionally, the lessee will need to be able to prove that it derives most of the benefits from the use of the asset over the lease term.
Whilst it may mean having to contact a lessor to gain a better understanding of the discount rate “enjoyed” in the lease, lessees are required to use the rate implicit in the lease (“RIIL”), if it can be readily determined. To establish the RIIL the lessee needs to know several assumptions used by the lessor in pricing the lease, including the underlying asset’s fair value, the estimated residual value of the underlying asset at the end of the lease term, and any initial direct costs deferred by the lessor.
Where it is not possible to obtain the RIIL, the new lease standard requires lessees to apply their own incremental borrowing rate (“IBR”), which is defined by ASC 842 as “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”
As outlined above, different leases will have begun on different dates with different lessors for different periods with different asset types and for various market values and so finding a similar borrowing rate incurred at the same time may require the lessee to look across its business sector to determine an appropriate IBR by referencing the costs of borrowing for competing entities with credit ratings similar to that of the lessee for the same lease parameters – failing that the lessee may resolve the issue by obtaining borrowing costs from other credible sources such as lenders. The IBR needs to reflect the interest rate that would be charged to borrow a sum equal to the lease payments whilst at the same time reflecting any influencing circumstances such as the collateral value of the asset or a third-party guarantee.
With due regard to the ASC 842 definition of IBR the lessee should ensure the adopted approach is documented and the process is applied to all of its leases, whatever the period, whoever the lessor and whatever the assets. The definition specifies that the IBR reflects a borrowing rate over the term of the lease and that it takes into account the credit quality of the borrower, together with any security or collateralization. A tough and complex set of judgements but one that has been reviewed and decided upon before and so what may at first glance appear a minor technical issue is worth taking the time and effort in establishing the applicable discount rates as their accuracy will have a dramatic impact on the balance sheet. The lessee should adopt a robust, documented and auditable approach reflecting all of the relevant impactors, including factors such as the general economic conditions prevailing at the lease commencement date, the credit rating of the lessee, lease period, asset as a collateral, interest rate trends at the commencement date and company structures. However, being an issue that others will have already tackled and as it requires significant judgments, lessees are encouraged to speak with their auditors to discover the assumptions and approaches available.
For further advice and guidance on how to comply with the new ASC 842 or IFRS 16 lease accounting standards, download the 7 Step Guide To Lease Accounting Compliance:
Disclaimer: this article contains general information about the new lease accounting standards only, and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.