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Understanding the New Leasing Standard: Definition of a Lease

In February 2016, the Financial Accounting Standards Board (FASB) issued its highly-anticipated leasing standard in ASU 2016-02[1] (“ASC 842” or “the new standard”) for both lessees and lessors. Under its core principle, a lessee will recognize right-of-use (“ROU”) assets and related lease liabilities on the balance sheet for all leases[2]. The pattern of expense recognition in the income statement will depend on a lease’s classification.

For calendar-year public business entities the new standard takes effect in 2019, and interim periods within that year; for all other calendar-year entities it takes effect in 2020, and interim periods in 2021. The full standard is available here.

One of the most challenging aspects of the new standard can be identifying when a contract is or contains a lease, in particular determining when service contracts contain embedded leases.

Definition of a Lease

The Master Glossary defines a lease as “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.”

For a contract to be or include a lease, there must be an identified asset and the contract must grant to the customer throughout the period of use both:

  1. The right to obtain substantially all of the economic benefits from the asset’s use (the economic criterion), and
  2. The right to direct the use of the identified asset (the power criterion).

Identified Asset
To have an identified asset, a contract must either explicitly or implicitly specify the asset.  Similar to prior requirements, an asset is not considered specified if the supplier has the right to substitute similar assets and therefore maintains control over the asset during the period of use.  However, under the new standard substitution rights are considered substantive as described in paragraph 842-10-15-10 only if the supplier:

  1. Has the practical ability to substitute alternative assets throughout the period of use, and
  2. Would benefit economically from the substitution.

Importantly, the evaluation of whether a supplier substitution right is substantive must be based on facts and circumstances at contract inception and must exclude consideration of future events that are not likely to occur (for example, an agreement with a future customer to pay an above-market price for use of the asset).

If a supplier’s substitution right is substantive, then there is no identified asset, and thus the contract does not contain a lease.  A supplier’s right to substitute the asset only on or after a particular date or event, for repairs and maintenance or based on the availability of a technical upgrade, are not considered substantive.  In addition, the new standard highlights that if the asset is located at the customer’s premises, the costs associated with substituting the asset are generally higher than when located at the supplier’s premises, and therefore are more likely to exceed the related benefits. If the supplier costs to substitute exceed the related benefits, the substitution right would not be substantive.  If the customer cannot determine whether a substitution right is substantive, the customer must presume that the substitution right is not substantive (that is, there is an identified asset, and the entity must evaluate the economic and power criteria to determine whether there is a lease).

MFA Observations
As noted above, the requirement that a right of substitution would provide economic benefits to the supplier in order to be considered substantive is new and may require significant judgment.  Due to this guidance, more contracts may be deemed to include a lease than under prior guidance because they include an identified asset.  This determination becomes more important under the new standard due to the balance sheet implications for the lessee.

Right to Control Use (Economic and Power Criteria)
In addition to relating to an identified asset, the customer must also have the right to control the use of that asset which requires the economic criterion and the power criterion to be met.

MFA Observations

Although the right to control the use of an identified asset is not a new concept, the application in ASC 842 is different than in ASC 840.  Specifically, under the guidance in ASC 840, a contract was deemed to contain a lease if:

  1. The customer controlled the operation of the asset while obtaining more than a minor portion of the output of the asset,
  2. The customer controlled physical access to the asset while obtaining more than a minor portion of the output of the asset, or
  3. It was remote that any other party would receive more than a minor portion of the output of the asset and the price for the output was neither fixed per unit nor equal to the market price at time of delivery.

Under ASC 842, the lessee must have both the right to obtain substantially all of the economic benefits and the right to direct the use of the asset, which was not a prerequisite under ASC 840.  As a result, certain contracts that met the definition of a lease under ASC 840 (for example power purchase agreements under (c) above) may no longer meet the definition of a lease under ASC 842.

Economic Criterion
A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding, or subleasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits from using the asset that could be realized from a commercial transaction with a third-party.  The economic criterion requires that a customer has the right to obtain substantially all of the economic benefits from the use of that asset.

MFA Observations

In practice, the term “substantially all” is generally interpreted as being at or around 90% or more.  This term is also used in the lease classification test (see paragraphs 842-10-25-2 and 25-3), as well as in many other areas of U.S. GAAP.  An entity should ensure consistent application of the threshold. And in many cases, it will be straightforward to conclude that the customer obtains substantially all of the economic benefits (for example, when the customer has exclusive use of the asset).

Power Criterion
The power criterion is met if:

  1. The customer can direct how and for what purpose the asset is used throughout the period of use (i.e., the customer directs the relevant decisions during the period of use), or
  2. When the relevant decisions are predetermined,
    1. The customer designed the asset in a way that predetermined the relevant decisions, or
    2. The customer has the right to operate (or direct others in operating) the asset throughout the period of use.

The relevant decision-making rights to consider include, for example, the right to change the type of output produced by the asset, the right to change when or where the output is produced, the right to change whether the output is produced and how much output is produced, if any.  These rights are examples only and are neither determinative nor prescriptive.  For example, a requirement to use an asset in a specified location does not necessarily imply that the lessee does not direct the use of the asset.

Restrictions and Supplier Protective Rights
Both the economic and control criteria are evaluated within the defined scope of the customer’s right to use the asset. Terms that limit the use of the asset a certain way (for example specifying a maximum amount of usage of the asset) or that protect the supplier’s interest in the asset (such as requiring the customer to follow industry-standard operating procedures, or requiring notification of changes in how or where the asset will be used) do not, in isolation, prevent the customer from having the right to direct the use of the identified asset. For example, if a customer enters into a contract for the use of a corporate jet for a two-year period, restrictions within the contract limiting the number of hours the jet can be flown and/or which territories the aircraft can fly over will not prevent the customer from directing the use of the aircraft if, within that defined scope of the contract, the customer for example has exclusive use of the corporate jet throughout the two years (i.e., the economic criterion is met) and the customer decides where and when the aircraft will travel and what passengers and cargo it will transport throughout the two years (i.e., the power criterion is met).

Example

Concepts explored

  • Identified Asset
  • Economic Criterion
  • Power Criterion

Emphasis

  • Substitution rights
  • Scope of use
Background

Paper Co enters into a contract with Printers R Us for the exclusive use of a copy machine for three years.  Under the contract, the copier is explicitly specified by serial number, but Printers R Us has the right to replace the copier at any time during the agreement, including in lieu of repairing it, without Paper Co’s approval.

While the contract specifies a location for the copier, Paper Co has the right to move the copier to any of its facilities upon three days written notice to Printers R Us.  Paper Co also has the right to decide when to use the copier and when it uses it, how many copies it makes (subject to a limit of 5,000 copies per month).

Analysis

Is there an identified asset? Yes
Although Printers R Us has the right to replace the copy machine at any time and without Paper Co’s approval, such substitution would likely not generate an economic benefit for Printers R Us.  As noted in paragraph 842-10-15-12, if the asset is located at the customer’s premises, then the costs associated with substitution are likely to exceed the benefits associated with substituting the asset.  Specifically, in this example Printers R Us would incur costs to substitute the copy machine, such as employee time and costs of transporting and installing another copy machine and removing and transporting back the original copy machine. It is not likely that events or circumstances would arise at contract inception from which Printers R Us would generate more cash flows by substituting the copy machine than the costs it would incur. In addition, as noted in paragraph 842-10-15-14, rights to substitute identified equipment solely for repairs and maintenance are not substantive. Accordingly, Printers R Us’ substitution right is not substantive and there is an identified asset.

Is the economic criterion met? Yes
Paper Co has the right to obtain substantially all of the economic benefits from the use of the copier because it has exclusive use of the copier.

Is the power criterion met? Yes
The 5,000-copy limit per month protects Printer R Us’ copier and in effect defines the scope of the contract. Within that scope, Paper Co has the right to direct the use of the copier, including when to use it and for how long, how many copies to make (subject to the limit) and where to use it, throughout the three-year period. Those decisions are the relevant decisions that impact the economic benefits from use of the copier.

Therefore, the contract is a lease.

The team at The MFA Companies is here to help. If you have questions about how the new lease accounting standard affects your business or how to implement it, contact us today.

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Related Articles
What You Need to Know About Lease Accounting
FASB Issues Clarifications to Leases Standard
Whitepaper: FASB’s New Leasing Standard

[1] Leases (ASC 842)
[2] ASC 842 provides a recognition exemption for leases with terms of one year or less and that do not include a purchase option reasonably certain of exercise. The exemption must be elected by asset class.  If this exemption is elected, the lessee does not recognize the related ROU assets and lease liabilities on the balance sheet for short-term leases within that asset class.

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