Are you feeling worried about the looming deadline for FASB and IFRS lease accounting compliance? Well, if you are, you’re not alone. Welcome to Tango’s Road to Lease Accounting Compliance Podcast Series, where we’ll be discussing the steps a company needs to address in order to ensure that your organization is ready. We’ll be covering everything from setting strategy to understanding policy, handling data requirements, picking the best technology, and finally, institutionalizing the right processes and controls to ensure that they represent a permanent shift in the way you account for leases.
Hello, everyone, and welcome back to Tango’s Road to Lease Compliance Podcast Series. My name is Bart Waldeck. I am Chief Marketing Officer and Senior Vice President of Product Strategy at Tango. Today’s episode focuses on the policy stage of the road to lease compliance and will unpack several important policy areas, including fixed and variable payments, discount rates, and sale-leasebacks. Joining me today are Rick Zelinsky, Vice President of Product Strategy here at Tango and the main architect behind Tango’s lease solution, and our good friend Kristin McLaughlin, Senior Director of Technical Accounting at RSM US LLP. As always, it’s great to have Kristin back to provide insight into these key policy areas.
Welcome, Rick and Kristin, and thanks again for joining. Let’s move into a number of different topics. I think first we’ll talk about fixed and variable payments, then, Kristin, I want to ask a couple questions about discount rate, and then we can wrap up with sale-leaseback. So let’s start with the fixed and variable payments. I’ve heard that determining the lease payments can be a challenge. Is this an issue that you’re seeing with your clients today?
We are seeing this with all of our clients, Bart. This is a very challenging issue. Lease payments are also a key input into the calculation of the lessee’s right-of-use asset and lease liability. At lease commencement, the lease payments consist of all of the following payments relating to the use of the underlying asset during the lease term: the fixed payment; variable payments that depend on an index or rate; in-substance fixed payments; lease incentives paid or payable by the lessor to the lessee; the exercise price of a lessee option to purchase the underlying asset that the lessee is reasonably certain to exercise; penalties for terminating the lease if the lease term reflects the lessee exercising a termination option; for lessees only, amounts probable of being owed by the lessee under residual value guarantees; and finally, payments by a lessee to the owner of a special purpose entity for structuring the transaction.
Lease payments do not include variable lease payments other than those that depend on an index or rate. Any guarantee by the lessee of the lessor’s debt or any amounts allocated to non-lease components, unless the accounting policies combine lease and non-lease components, has been elected. The lease payments for a lease are determined at lease commencement. A lessee will need to remeasure its lease payments when there is a lease modification or when any of the following events occur: the resolution of a contingency that would fix previously variable lease payments; a change in the lease term; a change in the assessment of whether the lessee is reasonably certain to exercise an option to purchase the underlying asset; and a change in the amount probable that the lessee will owe under a residual value guarantee.
Variable lease payments that depend on an index or rate are included in lease payments and are measured using the prevailing index or rate at the measurement date. Lessees and lessors recognize changes to indexed and rate-based variable payments in profit or loss in the period of the change. This is similar to other variable lease payment treatment.
Okay, so that’s fixed and variable payments. I know another kind of area of challenge for our clients has been, really, kind of the discount rate, and specifically, how do you determine the discount rate? Have you seen challenge there as well?
We have, and the discount rate is another key input into the lessee’s computations of lease liability and right-of-use assets. Unless the discount rate in a lease is readily determinable, a company will need to determine the appropriate incremental borrowing rate to use for all leased assets, for use in accounting for the leased assets and lease liabilities. The incremental borrowing rate is the rate of interest that the company would have to pay to borrow, on a collateralized basis over a similar term, an amount equal to the lease payments for each lease in a similar economic environment. Said another way, you need a discount rate attributable to each individual lease.
Lessees that are not public business entities, permitted to use a risk-free discount rate, determined using a period comparable with the applicable lease term, as an accounting policy election for all leases; however, doing so may result in the recognition of more significant lease assets and liabilities, therefore potentially increasing the risk of asset impairment. Companies will need to develop and document policies for how they will determine the appropriate incremental borrowing rate to use for all leased assets, to use in the accounting for the leased assets and lease liabilities. These rates will need to be determined upon lease commencement. A lessee would reassess the discount rate for a lease upon a lease modification that is not accounted for as a separate contract, when there is a change in lease term, or a change in the assessment of whether the lessee is reasonably certain to exercise an option to purchase the underlying asset.
Got it. That makes sense. And I know sale-leasebacks have an impact under ASC 842. Can you maybe drill into that, unpack that a little bit?
Happy to, Bart. ASC 842 eliminates sale-leaseback accounting as an off-balance sheet financing option. It was somewhat common under ASC 840. In a sale-leaseback transaction, one entity, typically the seller-lessee, transfers an asset to another entity, the buyer-lessor, and then leases that asset back from the buyer-lessor. Under the new guidance, the accounting for the transaction depends on whether or not a sale and a purchase has occurred. When a sale occurs, both the seller-lessee and the buyer-lessor account for the leaseback under ASC 842 in the same manner as any other lease, with an adjustment for off-market terms.
Seller-lessees may just recognize the leaseback’s right to use the asset and a lease liability. The new control-based sale determination model in ASC 842 aligns with ASC 606 and significant differs from current GAAP. In addition, under ASC 840, there is different guidance for sale-leaseback transactions of real estate versus other assets. Under ASC 842, the same guidance applies to all sale-leaseback transactions. If the transfer of the asset is not a sale, the seller-lessee does not de-recognize the asset, and accounts for any amounts received as a financial liability. The buyer-lessor would not recognize the assets received, and would account for the amounts paid as a receivable.
Kristin, in speaking with clients in the retail sector, I’ve learned impairment of a right-of-use asset is a concern. Does the impairment guidance apply to right-of-use assets?
Yes, it does, Rick. Under ASC 840, capital lease assets were assessed for impairment in accordance with the long-lived asset impairment guidance in ASC 360. However, there are no operating lease assets to evaluate for impairment under current GAAP. Lessees’ right-of-use assets, both for operating and finance leases, are now subject to existing impairment guidance in ASC 360 – Property, Plant and Equipment. ASC 360 provides principles for evaluating long-lived assets for impairment, but does not specifically address how operating lease liabilities and future cash outflows for the lease payments should be considered when performing the recoverability test.
ASC 360 requires an analysis of impairment indicators at each reporting period for assets held for use. Testing and evaluation of impairment of a long-lived asset is performed at the asset or asset group level, depending on the facts and circumstances. If any of the indicators of impairment are present, a recoverability test using undiscounted cash flows is performed. If the right-of-use asset fails the recoverability test, ASC 360 then requires a fair value test. Under ASC 842, if an impairment loss is recognized for a right-of-use asset, the adjusted carrying amount of the right-of-use asset would be its new accounting basis.
Consistent with ASC 360, the impairment test for right-of-use assets will often be performed at an asset group level, with any impairment allocated among the asset group in accordance with ASC 360. However, at adoption, the asset level will be the individual right-of-use asset.
So Kristin, what should clients be considering when assessing impairments?
Rick, some of the key impairment indicators include a significant decrease in the market price of a right-of-use asset, a significant adverse change in the right-of-use asset or the manner in which it’s used, a current period operating or cash flow loss associated with the right-of-use asset or asset group, or a change in the expected utilization of the right-of-use asset.
Great. That wraps today’s Road to Lease Compliance Podcast episode, covering fixed and variable payments, discount rates, and sale-leasebacks. Thanks, Rick, again for joining, and special thanks to you, Kristin, for all the technical accounting guidance. Please join us for future podcasts along the Road to Lease Accounting Compliance.