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Road to Compliance
The Definition of a Lease
Inventorying your entire lease portfolio is an important part of compliance to the new FASB and IFRS lease accounting standards. But first, you need to be able to identify your entire lease portfolio – including your real estate, equipment and embedded leases. The exercise is potentially more challenging than you might suspect.
Bart Waldeck, Tango’s CMO and SVP of Product Strategy, is joined by Kristin McLaughlin, Senior Director, Technical Accounting Consulting (TAC) at RSM US LLP, and Rick Zelinsky, Vice President of Product Strategy at Tango. In the podcast, they discuss what constitutes a lease, how to identify embedded leases, and how the treatment of leases is changing under the ASC 842.
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 everybody, and welcome back to Tango’s Road to Lease Compliance podcast series. My name is Bart Waldeck and I’m the chief marketing officer and senior vice president of product strategy at Tango.
Today’s episode focuses on the policy stage in the road to lease compliance and, specifically, the definition of a lease. Joining me today are Rick Zelinsky, Tango’s Vice President of Product Strategy and the main architect behind our lease administration and accounting solution, as well as a special guest, Kristin McLaughlin, Senior Director of Technical Accounting at RSM US, LLP. We’re excited to have Kristin’s expertise to help us better understand the definition of a lease under the new FASB 842 standard.
Let’s jump right into it. Kristin, why don’t you kick us off with giving us a definition of a lease?
A lease is a contract or part of a contract that conveys the right to control the use of an identified asset, generally property, plant or equipment, for a period of time in exchange for consideration. Under 842, at the inception of a contract companies will need to determine whether or not that contract is or contains a lease. The identification of an asset is an essential requirement of a lease contract and the identified asset could either be implicitly or explicitly identified in a contract.
When looking at do you have a lease, one of the key elements is whether the contract conveys the right to control the use of an identified asset for a period of time if, throughout the use, the customer has both of the following. The right to obtain substantially all of the economic benefits from the use of the identified asset and the right to direct the use of the identified asset. To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from the use of the asset throughout the period of use. An example of this is having the exclusive use of the asset throughout that period. A customer can obtain economic benefits from the use of an asset directly or indirectly in many ways such as using, holding, or subleasing the asset.
The next criteria, the right to direct the use of the identified asset, exists in the following situations. The customer has the right to direct how and for what purpose the asset is used throughout the period of use, the relevant decisions about how and for what purpose the asset is used are predetermined and at least one of the three conditions exists. The customer has the right to operate the asset throughout the period of use without the supplier having the right to change those instructions. The customer designs the asset in a way that predetermines how and for what purpose the asset will be used throughout the period. A contract may include terms and conditions designed to protect the supplier’s interest in the asset, which is considered a protective right. An example of this would be a lease car that has a mileage cap and just because a mileage cap is in place doesn’t necessarily enable you to conclude that the customer will not have the right to direct the use of that asset but the protective right just allowing the customer to use that asset for a certain amount.
Kristin, one of the challenges that we’re seeing with our customers is really around the identification of embedded leases and how they’re able to discern if a contract has a lease embedded in it. Perhaps this is something you could share some insights on.
Yeah. This is a very challenging area for a lot of companies because under legacy gap, although the requirement to identify embedded leases and account for them as leases was contained within the standards, there was no balance sheet implication of that conclusion if you concluded you had an operating lease. With the new guidance, if you identify a lease, and it’s an operating lease, it’s going to go on the balance sheet, so it’s a much more significant financial statement impact.
An example of an embedded lease would be, a simple example, is a supply agreement in an office for coffee. You reach an agreement with a company to purchase their coffee capsules for your machine and they provide a free coffee machine. So people look at that type of agreement and think it’s a supply agreement for coffee, but they’re really providing a fixed asset in the form of the coffee machine. That’s a simple example. There are significant issues in the embedded lease space with supply arrangements in the automotive arena or with IT arrangements where you may have a dedicated server, so companies are really needing to go and look through contracts that are not papered as leases, different service agreements, to see if there’s any components within those that meet the definition of a lease.
So, Kristin, does that essentially mean that any time an asset is referenced that that would imply that there’s a lease?
Unfortunately no. Even if an asset is specified, a customer does not have the right to use that identified asset if the supplier has substantive substitution rights to substitute that asset throughout the period of use. In looking at whether a supplier has the right to substitute an asset and whether that right is substantive, the following conditions must exist. The supplier would have to have the practical ability to substitute alternative assets throughout the period of use and the supplier would also benefit economically from the exercise of its right to substitute that asset. An evaluation of whether a right to substitute is substantive is based on facts and circumstances. For example, if an asset is located at the customer’s premises or elsewhere and the costs associated with substitution are higher than when it’s located on a supplier’s premises, it’s unlikely that the supplier would be economically advantaged by making that substitution. The supplier’s right or obligation to substitute an asset for repairs and maintenance does not preclude the customer from having the right to use an identified asset. It is somewhat common to have a repairs and maintenance clause in these agreements and that does not get you outside of considering that you have a lease.
So, Kristin, help us understand how the treatment is changing under the 842 guidelines.
Yeah. There are some significant differences, the main one being under ASC 840, the previous guidance, the critical accounting determination was fundamentally lease classification because lease assets and lease liabilities were only recognized for capital leases. A lot of leases were structured to get a particular balance sheet treatment. Under ASC 842 the lease definition is now the critical test in determining whether a contract will be recorded on or off the balance sheet. Lessees, under ASC 842, will recognize lease assets and lease liabilities for all leases, other than short term leases, if a policy election to exclude these leases has been made. Another difference is while the definition of a lease under ASC 842 is similar to that under ASC 840, some of the details have changed. The condition that a customer must now have the right to control the use of the identified asset is more closely aligned with how control is defined in ASC 606, the revenue recognition guidance. While evaluating a customer’s right to obtain economic benefits from the underlying asset is similar to the evaluation performed under ASC 840, the concept of evaluating whether the customer has the right to direct the use of the asset is new in the guidance under ASC 842.
That concludes today’s Road to Lease Compliance podcast episode, the definition of a lease. Thanks for joining Rick, 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.
Tango does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any lease compliance related activities.