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A Tale of Two Standards: An Adventure in Leases
In February, 2016, the Financial Accounting Standards Boards (FASB) issued an Accounting Standards Update (ASU) 2016-02 to significantly change how operating leases were to be recorded to comply with accounting principles generally accepted in the United State of America (US GAAP). This new guidance typically results in a lessee recording a right-of-use (ROU) asset and related lease liability on the balance sheet for operating leases, in addition to capital leases. Previous lease guidance under Accounting Standards Codification (ASC) 840 did not contain this requirement for operating leases.
Like many other CPAs, I’ve been to several classes prior to the implementation of FASB ASC Topic 842, Leases (ASC 842). I’ve also completed a self-study course and prepared an in-house training session for my firm. We also partnered with a lease accounting software company to assist with the implementation, and I was selected to be one of the administrators to help teach our staff how to use the software. All in all, I felt comfortable with my knowledge base as we hit the implementation deadline for private companies on January 1, 2022.
Transition year leases were straight-forward, and most of my clients had nothing out of the ordinary – only operating or financing leases, in some cases both, no additional costs to add to my lease payments. Once I added the lease terms to the software we used and answered a few questions, I had journal entries, amortization schedules, and footnote disclosures to share with my clients. Clients seemed to understand what the standard was trying to accomplish, even though the details of creating new accounts for what they deemed rent expense was still a little foreign.
For the transition year, various practical expedients could be adopted to help ease the transition to ASC 842. The net result for most transition leases was a right-of-use asset equal to the lease liability recorded. That set the stage for year two when the practical expedients were gone and new leases were executed. And here’s where our story begins.
We obtained a new client in mid-2023 for a year-end audit and tax engagement. The Director of Finance noted that the company was expanding its manufacturing capability during the year by leasing a facility for two years, and the lease contained two two-year renewal options. The lease began in June 2023, and the client planned to add in excess of $100,000 in production equipment in late 2023 to meets its production needs. There are several issues we discussed when evaluating the lease, and others we uncovered as we verified lease calculations and disclosures.
First, our client prepared the initial calculation of the present value of the lease liability using the lease terms, the company’s incremental borrowing rate, and the initial two-year term of the lease. Under ASC 842-10-30-1, only renewal or termination options that are reasonably certain of exercise by the lessee should be included in the lease term. Per my client, at the time of the calculation, the company was not certain either option would be exercised. When sending me a copy of the lease and the calculation, my client said he’d send a copy of the capital budget and additions for the year to include the new manufacturing facility. Upon receipt, we reviewed the document, noting significant additions for the new manufacturing facility and significant additions on order yet to be placed into service. As most of the cost was related to a significant fixture that would be expensive to move in two years, we reopened the discussion with the client, using the above argument in asking the client to reevaluate the lease term. After further reflection, the client agreed that based on the capital plans for the facility, the renewal options were reasonably certain to be exercised at lease commencement. The client calculation was updated to reflect the lease term and exercised options as the term of the lease.
Once that issue was resolved, we reviewed the discount rate used by the client. ASC 842-20-30-3 specifically states “lessee should use the rate implicit in the lease whenever that rate is readily determinable.” The implicit rate is defined as the rate of interest that at any given date causes the aggregate present value the lease payments and the amount the lessor expects to derive from the underlying asset as of the end of the lease term to equal the sum of both the fair value of the underlying asset minus any related investment tax credits retained and expected to be realized by the lessor and any deferred initial direct costs of the lessor. Implicit rates are rates earned by the lessor, and generally are not stated in a lease agreement. In the absence of the implicit rate of the lease, the lessee could elect to use the lessee’s incremental borrowing rate or elect the risk-free rate if no debt is held by the company or the incremental borrowing rate is not readily determinable. In this instance, our client used the incremental borrowing rate as the discount rate.
Lease payments per the calculation agreed to the lease agreement, so we had no issues there.
Our next set of issues didn’t arise until we went to test the client calculation using our lease software. We input the lease into the software using the date of the lease, the lease term, the payments, and the discount rate. Once the data were input and saved, we ran the journal entries, amortization schedules, and disclosures worksheet. Whereas in transition leases, the ROU asset nearly always agreed to the lease liability. But, for new leases, these amounts are more likely to not agree – they were different by the first payment made at the inception of the lease in this case. That sounded fine, but what bothered me was the following disclosure item: “ROU assets obtained in exchange for new operating lease liabilities.” This is the preferred wording from ASC 842. Our issue was that the amount disclosed from the software didn’t agree to the ROU asset – it was the amount of the lease liability incurred. But the disclosure line above clearly focuses on the ROU asset, not the lease liability. We set about to investigate and unravel this mystery.
After additional research, the answer became clear – the focus has always been on the liability, not the ROU asset in the disclosure. It even says so in ASC 842-20-50-4-g.2: Supplemental noncash information on lease liabilities arising from obtaining right-of-use assets. I went back to the standards and found the disclosure example in 842-20-55-53:
From one paragraph to another, the disclosure requirement in the new standard seems to change from the lease liability to the ROU asset. I remembered using this template when preparing our internal training, but at the time didn’t notice the differences from the narrative to the disclosure. Since this is the example from the standard, this is what was followed in the software company template. The example seems inconsistent with what’s required in the narrative. What do we do?
Here’s how we resolved our situation: For transition leases, the ROU asset agrees to the lease liability, so the disclosure example as shown above is fine. For the lease in question, which was a new lease after the implementation date, we followed the narrative literature in ASC 842-20-50-4-g.2 and disclosed the amount of the lease liability incurred in obtaining the ROU asset. To promote consistency with the narrative in the standard, we modified the wording in the footnote disclosure to read that we incurred operating lease liabilities in obtaining right-of-use assets.
What’s the moral of our story? To use a baseball analogy, keep your glove on the ground and be ready for a bad hop. When it comes, you can adjust and still make a play. Implementing new standards is sometimes tricky, so be sure to ask questions if something doesn’t sound right or if it’s not as you remember. Be ready to delve back into the details of the standard. You never know when you’ll learn something new.