The Leasing Industry will Change
In my last lease post, we saw that bright-line criteria (e.g., lease terms of 75% or more of economic life and minimum lease payments of 90% or more of fair market value) are eliminated in the new lease standard. Consequently, almost all leases—including operating leases—will create lease liabilities. This accounting change will alter the leasing industry.
Lessees are presently paying high lease interest rates to obtain operating lease treatment (no lease debt is recorded). Now—with the new lease standard—those same operating leases will generate lease liabilities. So why would the lessee pay the higher interest rate? There is nothing to be gained. Lessees will begin to borrow money from banks (at a lower rate). And they will buy the formerly leased asset, or they will demand lower interest rates from the lessor. Lessees, I think, will obtain better interest rates.
Scope of the Lease Standard
What does the lease standard apply to? It applies to leases of property, plant and equipment (identified asset) based on a contract that conveys control to the lessee for a period of time in exchange for consideration. The period may be described in relation to the amount of usage (e.g., units produced). Also, the identified asset must be physically distinct (e.g., a floor of a building).
Control over the use of the leased asset means the customer has both:
- The right to obtain substantially all of the economic benefits from the use of the identified asset
- The right to direct the use of the asset
What does the standard not apply to?
The lease standard does not apply to the following:
- Leases of intangible assets, including licenses of internal-use software
- Leases to explore for or use minerals, oil, natural gas, and similar resources
- Leases of biological assets
- Leases of inventory
- Leases of assets under construction
Operating or Finance Lease
Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. Under present lease standards, a finance lease is referred to as a capital lease.
So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
- The lease term is for the major part of the remaining economic life of the underlying asset (today we use the 75% rule)
- The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term
And what is an operating lease? It’s any lease that is not a financing lease.
Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases will be different (a topic we’ll cover in my next lease post).
Related Party Leases
Leases between related parties will be classified just as any other lease will be. Companies will look to the legally enforceable terms and conditions of the lease to determine the whether a lease contract exists. If a lease contract exists, the agreement will be treated as a lease with the lessor reflecting a sale and the lessee capitalizing the related lease liability and right-of-use asset.
Are there any leases that will not result in a right-of-use and lease liability. Yes, those with terms of twelve months or less.
Leases of Less Than 12 Months
Companies do have the option to not capitalize a lease of 12 months or less. To do so, the company must make an accounting policy election (by class of the underlying leased asset). Companies who use this election will recognize lease expenses on a straight-line basis, and no right of use asset or lease liability will be recorded. If, however, the terms of the short-term lease change, the agreement could become one in which the lease is capitalized, for example, the lessee can exercise a purchase option or the lease term extends to beyond twelve months. (Expect to see plenty of leases with lives of twelve months or less.)
More Lease Information Coming
We’ll continue this series of lease posts next week. So stay tuned. I invite your comments and questions.
To see my first lease post, click here.
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