To properly identify all leases to be accounted for under FASB Accounting Standards Codification 842, Leases (the “Standard” or “ASC 842”), you first need to know the definition of a lease because it was modified in the new guidance. Under the prior lease guidance, a lease was defined as an agreement conveying the right to use property, plant, or equipment, usually for a stated period of time. Whereas, under the new Standard, a lease is defined 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.
Use of identified assets
To contain a lease, an arrangement must have explicitly, or implicitly, identified a physically distinct asset. If an arrangement explicitly identifies the asset to be used, but the supplier has a substantive contractual right to substitute the asset, then the arrangement does not contain an identified asset. An arrangement that does not explicitly identify an asset may do so implicitly. This may be the case when only one asset can be used to fulfill a contract.
A physically distinct asset may be an entire asset, or a portion of an asset. For example, a building is generally physically distinct. One floor within the building may be physically distinct if it can be used independent of other floors. A portion of an asset that is not physically distinct is not an identified asset-- unless it substantially represents all of the capacity of the asset, and thereby provides the customer with the right to substantially obtain all of the economic benefits from the use of the asset. When assessing whether an asset is physically distinct, consideration may need to be given to the nature of the asset and how the asset was designed to be used, including the functionality the asset will provide to various parties.
The existence of a substitution right may result in the conclusion that a specific asset has not been identified. If an asset is explicitly specified in a contract but the supplier has the right to substitute the asset, then an evaluation of whether the substitution right is substantive is necessary. A substitution right is substantive when both of the following criteria are met: (a) the supplier has the practical ability to substitute alternative assets throughout the period of use (i.e., the total period of time that an asset is used to fulfill a contract with a customer, including the sum of any nonconsecutive periods of time) and (b) the supplier would benefit economically from the exercise of its right to substitute the asset. For example, a supplier that owns a fleet of commercial trucks could enter into a contract with a customer to transport the customers’ goods via truck for a specified period of time. If the supplier, at the inception of the contract, has the practical ability to substitute certain trucks for others (alternative trucks are available and the supplier does not require the customer’s permission to substitute them) and the would benefit economically from exercising its substitution right (for example, using a truck that is located closed to the customer’s pick up location), then the contract would not be a lease because it lacks an identified asset. An entity’s evaluation of whether a supplier’s substitution right is substantive is based on facts, and circumstances at the inception of the contract. The supplier’s substitution right is not substantive if the supplier has a right, or obligation, to substitute the asset only on, or after, either a particular date or the occurrence of a specified event. If a customer cannot readily determine whether a supplier substitution right is substantive, it should presume that the substitution right is not substantive.
Right to control the use of an asset
An entity must consider whether it has both the rights to (a) obtain substantially all of the economic benefits from using the identified asset and (b) direct the use of the identified asset. An entity must be able to direct how, and for what purpose, the asset is used throughout the period of use. If the “how” and “for what purpose is used” are predetermined, then the entity must have either the right to operate or direct others to operate the asset. Plus, the entity must have designed the asset or specific aspects of the asset that predetermines how, and for what purpose, the asset will be used throughout the period.
Utilizing all of an asset’s output may indicate that the customer is obtaining substantially all of the economic benefit; however, this alone is not sufficient enough to demonstrate control of the asset. The customer must also have the right to direct the use of the asset to meet the qualifications for lease accounting.
The right to control the use of an asset may not necessarily be documented as a lease agreement. The right to use an identified asset can often be embedded in an arrangement that may appear to be a supply arrangement, or a service contract. For example, an entity may enter into an arrangement with an information technology company to host its data on a dedicated service. Embedded within this hosting arrangement may be the entity’s right to direct the use of a specific server, which may meet the definition of a lease. Accordingly, entities will need to consider the terms of all arrangements to determine if there is a lease component embedded in the arrangement.
Identifying the population
- Once you understand which arrangements qualify as a lease, the challenge is identifying all arrangements that meet the definition, then locating and organizing all relevant documents, including the original lease document, all amendments, exhibits, supplements, etc. This step in the implementation of the Standard is crucial, however, it has proven to be quite challenging, particularly when an entity has multiple locations, subsidiaries and geographically disperse operations. It’s important to develop a process to canvas the organization for existing lease arrangements and identify all arrangements and contracts that could potentially contain an embedded lease to ensure the population is complete. The following are steps that can be taken to identify the lease population:
- Obtain a list of all recurring payments across the business and review for vendors and payments that might be leases. For example, rent payments tend to recur monthly, quarterly, semi-annually or annually.
- Survey business units, departments, and functional area employees with insight into contractual arrangements involving the entity such as: personnel in supply chain, revenue teams, contract teams, IT, and corporate accounting. Think about different asset categories such as: real estate, transportation, IT and data center equipment, and office equipment when determining where in the organization to request feedback.
- Perform a physical inspection by walking through offices, or manufacturing locations, to identify leased assets that might not appear on an asset listing.
- Examine contracts while maintaining documentation of contacts evaluated.
Going forward, entities will need to consider the processes, controls, and systems necessary to enter contractual arrangements, maintain documentation, and monitor for changes to ensure completeness of population, accurate accounting and compliance with the new standard.