What exactly is a lease?December 06, 2017
Michael Young, CPA, MBA
Last February, the Financial Accounting Standards Board (FASB) issued a set of new guidance for the accounting of leasing arrangements. The document, entitled Accounting Standards Codification (ASC) 842 Leases, will bring with it a host of changes to accounting and financial reporting processes across several industries going forward.
We’ll get into several of those changes in future articles, but—first—we want to answer a seemingly simple question: What exactly is a lease?
Under the new guidance, a lease is defined as “an arrangement that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.” This definition has two key points: control and identified asset.
In a lease agreement, the identified asset is the piece of property—for example, an automobile, a floor of an office building, or a bulldozer—that is included in the lease. The control—also known as right to use—is what is being conveyed in the arrangement. For example, the lessor of a new BMW conveys to the lessee the right to drive said BMW over the course of the lease term as part of the agreement.
The importance of control
The aspect of control of the asset being transferred in a lease agreement will be a significant factor to consider under the new standard. Once the new standard becomes effective, two conditions will need to be met for control to have been conveyed during the lease period:
- The right to obtain substantially all the economic benefits from use of the identified asset.
- The right to direct the use of the identified asset.
Maintaining or operating an asset do NOT qualify as stand alone rights to control an asset.
If one party does not obtain both of these conditions, control of the asset has not been conveyed. And, under the new standard, if control is not conveyed, the arrangement will not be considered a lease – and lease accounting, or ASC 842, will no longer apply.
Explicitly stated vs. implicitly stated
Under the new standards, the asset in question must be either explicitly stated or implicitly stated in the language of the arrangement in order for the arrangement to be considered a lease. For example, if a lease agreement lists a new BMW’s VIN number—making it explicitly clear that the lessee is gaining control over one specific BMW—that BMW is considered an explicitly stated identified asset.
On the other hand, if a lessor who owns a number of bulldozers agrees to lease “a bulldozer” to a construction firm, that bulldozer is considered an implicitly stated identified asset. The agreement doesn’t list the exact model number of the bulldozer in question, but it is implied that the lessee receives the asset by entering into the agreement.
Whether the asset is implicitly or explicitly stated, as long as the agreement contains an identified asset and there are no substantive substitution rights present (more on this below), it can still meet the new definition of a lease.
Substantive substitution rights
We mentioned substantive substitution rights earlier. Under the new guidance, this term represents a significant factor in determining whether an agreement is a lease, because if an agreement contains substantive substitution rights, that agreement is not a lease.
So, what are we talking about?
To identify substantive substitution rights, two conditions must be met:
- The agreement must grant the supplier the ability to substitute similar or alternative assets (in regard to the underlying asset in the agreement) over the lease term.
- The supplier must benefit economically from the exercise of the substitution right and be expected to do this during the lease term.
Consider the example of the bulldozer we listed above. In the first example, a construction company struck an agreement with a supplier to gain control of one bulldozer (the identified asset) over an agreed-upon period of time for an agreed-upon monthly price. This agreement would be considered a lease.
However, let’s say the supplier has a provision in the agreement in which they can exchange the bulldozer in question for another bulldozer during the lease term as they see fit. Let’s also assume that the supplier can and would want to exchange the bulldozer as it would decrease the wear and tear on the asset and benefit the supplier. If the agreement had these rights, it would not be a lease under ASC 842 as the company never truly got an identified asset as part of the agreement. Rather, this type of agreement would be considered a supply agreement as the supplier is really just providing the use of an asset for a period of time but over which the company had no real control.
With so much focus on the aspects of control and identified asset under the new leasing standards, it will be very important for companies to review all existing lease agreements to make sure they understand the specifics of each lease. By doing this, some old agreements that were considered leases under the old standards may no longer be leases under ASC 842.
Now that we’ve outlined the definition of a lease, our next article will address into the impact the new accounting standards will have on companies’ year-end balance sheets.
If you have further questions regarding accounting for leases under Section 842 of U.S. Generally Accepted Accounting Principles, please contact Michael Young, Audit Director, at 401-330-2706 or email@example.com.
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