Accounting Standards Update No. 2016-02, Leases (ASC 842) released on February 25, 2016, emphasizes increased comparability of financial information for financial statement users, and increased transparency of financial statements by effectively eliminating off-balance sheet financing in the form of operating leases. In order to understand the application of ASC 842, it is important to first define the parameters of a leasing arrangement. Here, leasing arrangements from the perspective of the lessee is discussed.
A lease is a “contract, or part of a contract, that 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.” While this definition appears straightforward, particularly for direct leases such as office space, contractual agreements that may contain leasing arrangements embedded within contracts require entities to review all service agreements in place and identify whether or not the definition of a leasing arrangement is met. Therefore, the agreements meeting the definition require inclusion on the balance sheet.
A contract that contains the sole right of use of an asset for a specified time period in exchange for money defines a lease transaction. In order for leasing conditions to be met, an arrangement must identify a defined asset and control of that asset for a time period. Contracts that do not convey the right of use of an asset do not contain leasing arrangements, and the contracts should not be capitalized. Entities implementing ASC 842 must review service contracts and licensing agreements in addition to their direct leases to appropriately identify leasing transactions requiring capitalization.
Once a lease is identified, at the beginning of the leasing arrangement, the lessee must recognize a right-of-use asset and corresponding liability. For all leases, the balance sheet presentation is the same. The lessee records the lease liability as the present value of the future lease payments. The lessee records the lease asset as the lease liability plus any initial lease payments and initial direct lease costs, minus any lessor incentives provided.
The income statement and cash flow effect of a lease depends on whether the lease is classified as an operating lease or a financing lease. For a lease designated as a financing lease, amortization expense is recorded to reduce the lease asset over the life of the lease and interest expense is recorded to reduce the lease liability. The rental payments incurred consist of principal and interest expense utilizing the effective interest rate method. For a lease classified as an operating lease, the lessee records payments on a straight-line basis over the life of the lease; no interest expense is calculated or incurred.
A financing lease is defined by any of the following conditions:
- There is a transfer of ownership of the corresponding lease asset at the end of the lease,
- There is an option to purchase the corresponding lease asset and it is reasonably certain the lessee will do so,
- The lease term represents a majority of the economic life of the leased asset,
- The present value of the lease payments plus any residual value of the leased asset is equal to the majority of the fair value of the leased asset, and
- The leased asset is a special purpose asset that does not have an alternative use.
If any of the conditions above apply to a lease, the lease is classified as a financing lease. If none of the conditions apply, the lease is classified as an operating lease. In assessing the present value of a leasing arrangement, the lessee should determine the discount rate of the present value calculation by either using the rate implicit within the lease agreement if it’s readily available, or the entity’s incremental borrowing rate if the implicit rate is not determinable.
In Part Three of this series, leasing arrangements from the perspective of the lessor will be discussed. Stay tuned for further discussion on the lease accounting topic from Rubino & Company, Charted, certified public accountants and consultants providing expertise and solutions for government contractors, nonprofits, public housing authorities and state and local governments nationwide.
Did you miss Part One? Read it here.
Karis Call is a manager in Rubino & Company’s audit practice. Her experience includes supervising and managing audit, review and compilation engagements for a wide range of clients, including nonprofit organizations and government contractors. She oversees all phases on on-site audit working including planning, fieldwork and financial reporting.
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