ASC 842: Accounting for Leases
The new lease standard (ASC 842) has completely changed the way a lessee accounts for a lease. Under legacy U.S. GAAP (ASC 840), lessees were mostly concerned whether a lease was an operating or capital lease, as that determinant drove whether a lease was recognized on the balance sheet. In addition, there were no major differences in accounting between an operating lease and service contract that may have contained a lease because both were expensed in a similar fashion. As a result, lessees may not have historically focused on determining whether a service contract was a lease.
Under ASC 842, lessees must now recognize a right-of-use (“ROU”) asset and lease liability for each lease on its balance sheet, with exception of a short-term lease. With the adoption of ASC 842, companies will now have to focus on whether a service contract meets the definition of a lease (embedded lease), as that it will drive whether it is recognized on the balance sheet. ASC 842 defines a lease 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.
ASC 842 will have an impact on manufacturers who enter into contracts with suppliers to outsource some or all of their production. The contract may be structured in a way that allows the manufacturer to control the output (quantity and mix) manufactured during the use of a facility or a production line. As a result, these type of contracts will need to be evaluated to determine if they contain an embedded lease.
In order for a company to determine whether a service contract contains an embedded lease it must determine the following:
1) Is there an identified asset? To have an identified asset, a contract must either explicitly or implicitly specify the asset. Examples include a floor of a building, a production facility or a production line within a facility.
2) Does the supplier have a substantive right to substitute the identified asset throughout the period of use?
Some contracts give the supplier the right to fulfill its obligation using an alternative asset. If the supplier has a substantive right to substitute the identified asset for an alternative asset throughout the period of use, there is no identified asset. The supplier’s right to substitute an asset is substantive only if both of the following conditions exists:
- The supplier has the practical ability to substitute alternative assets throughout the period of use.
- The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
3) Does the company have the right to control the use of the identified asset?
Who has control over the right to use the asset and who has decision-making authority differentiates an embedded lease from a service arrangement. A company has the right to control the use of the identified asset when it has both of the following:
- The right to direct the use of the identified asset. To meet this condition, a company would have to have the right to change how and for what purpose the asset is used. In assessing whether it has that right, the company would consider the decision-making rights that affect the economic benefits to be derived from using the asset.
- The right to obtain substantially all of the economic benefits from the use of the asset. The economic benefits from using an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits that could be realized from a commercial transaction with a third party.
When adopting ASC 842, one of the most challenging aspects can be identifying whether a service contract contains an embedded lease. While it is possible that some of contracts may not meet the definition of a lease, it is critical that companies engage in a thoughtful analysis to identify contracts that may contain embedded leases as it can involve significant judgment.
M&D Intelligence - Q2 2019