Scope

The standard applies to all entities: public, private, and not for-profit, whether large or small.

It applies to all leases, including subleases, other than the following:

• Leases of intangible assets
• Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources
• Leases of biological assets, including timber
• Leases of inventory
• Leases of assets under construction

Effective dates

The new leasing standard is effective as follows:

• Public business entities (which would include a not-for-profit entity that has issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market, and an employee benefit plan that files or furnishes financial statements with or to the SEC), are required to adopt the standard for reporting periods beginning after December 15, 2018. Meaning the standard is effective as of January 1, 2019 for public business entities with a December 31 year end.
• Nonpublic entities have an extra year to adopt, and therefore the standard is effective fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
• Early adoption is permitted for all entities.
• Special considerations are available for certain public business entities described in ASU No. 2017-13, which explains that the SEC staff would not object to a public business entity using the nonpublic entity’s effectives providing the public business entity would not otherwise meet the definition of a public business entity except for a requirement to include or the inclusion of its financial statements or financial information in another entity’s filing with the SEC.

Transition

Both lessees and lessors should adopt the leasing standard using one of the following two methods:

• • Retrospectively to each prior reporting period presented in the financial statements with the cumulative effect adjustment recognized at the beginning of the earliest comparative period presented, with the option to elect certain practical expedients to simplify transition. The date used by an entity to apply this transition method is the later of the beginning of the earliest period presented in the financial statements and the commencement date of the lease.
  • Retrospectively at the beginning of the period of adoption through a cumulative-effect adjustment, with the option to elect certain practical expedients to simplify transition. Under this transition method, an entity will apply the guidance at the beginning of the reporting period in which they adopt the standard.

• Both lessees and lessors may elect certain specified reliefs, which must be elected as a package and applied to all leases.
• Both lessees and lessors may use hindsight in evaluating whether payments for lease renewals and purchase options should be included in lease payments when accounting for existing leases. This practical expedient may be elected separately or in conjunction with the package of specified reliefs, and must be applied to all leases.
• Entities may elect a practical expedient to not assess whether existing or expired land easements that were not previously accounted for as leases.
• To assist in transtion, FASB has provided illustrative examples in FASB ASC 842-10-55-248 through 254.

Identified asset

As you can see in the flowchart, the first step in assessing whether a contract is a lease is to determine whether an asset has been identified. Similar to previous leasing standard, the determination of whether an asset has been identified within a contract can be made either explicitly or implicitly. In the former case, a particular asset may be identified within a contract. For example, a specific cargo ship for a transportation arrangement. However, the key point to note is that when assessing whether there is an identified asset, an entity does not necessarily have to be able to identify the particular asset in order to conclude that there is an identified asset. In other words, an entity simply needs to know whether an asset is needed to fulfill the contract from commencement to meet this first requirement.

Another significant consideration in determining whether an asset is specified within a contract relates to substitution rights. Simply put, an entity cannot conclude that it has the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use.² Two conditions must exist within the contract in order for a supplier’s substitution rights to be considered substantive:³

• 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.

The “practical ability” to substitute alternative assets mentioned in the first condition would be a situation in which a customer cannot prevent the supplier from substituting an asset. Additionally, these other assets that can be substituted in for the identified asset in the contract must be readily available. Said another way, though the supplier may have the ability to substitute an asset for the one specified in the contract, if that particular asset is so specialized or has a significant lead time for its construction, then the supplier does not have substantive substitution rights. The economic benefit mentioned in the second condition involves the supplier comparing the economic benefits of substituting the asset and determining whether these benefits would exceed the costs of actually performing the substitution.

The overall principle with respect to substitution rights is that they should be evaluated based on the facts and circumstances at the inception of the contract and should not take into account certain future events that are not likely to occur. FASB provides examples of these future events that should not be taken into account:⁴

• An agreement by a future customer to pay an above-market rate for use of the asset
• The introduction of new technology that is not substantially developed at inception of the contract
• A substantial difference between the customer’s use of the asset, or the performance of the asset and the use or performance considered likely at inception of the contract
• A substantial difference between the market price of the asset during the period of use and the market price considered likely at inception of the contract

An additional consideration of substitution rights is how easily substitution of the asset can actually be performed. Is the asset located at the customer’s premises or elsewhere? In general, the costs are higher when the asset is located at the customer’s premises than if it were located at the supplier’s premises and in turn, are more likely to exceed the benefits associated with substituting the asset.⁵

As you can likely note from the discussion of substitution rights, the determination of whether the rights are substantive requires professional judgment. Furthermore, there may be instances in which an entity is not able to make a determination of whether the supplier’s substitution rights are substantive.

As figure 5-1 shows, failing to meet the first requirement of identifying the asset automatically results in the conclusion that the contract does not contain a lease. However, if the asset is identified either explicitly or implicitly, an entity must then make a determination of whether the contract conveys the right to control the use of the identified asset.

Right to control the use of the asset

After concluding that a contract involves the use of an identified asset, the next step is to determine whether an entity has the right to control the use of that asset. In the new leasing standard, this assessment is twofold and comprises the consideration of both power and benefits regarding use of the asset. FASB noted that this twofold consideration is now consistent in many respects with the concept of control in FASB ASC 606, Revenue from Contracts with Customers, and FASB ASC 810, Consolidations.

In the previous leasing standard, the assessment of whether an entity had the right to control the use of the asset was based solely on the amount of the output an entity would receive from that asset. In other words, determining how much of the benefits of the asset an entity would receive was the primary consideration for determining control and whether the arrangement resulted in the determination that it was in fact a leasing arrangement. Contrasting this with the new leasing standard, an entity is now required to not only assess the benefits received from the asset, but to also assess whether the entity has the ability to direct the use of the asset. Said another way, an entity obtains control of the asset if it has both the power to direct the use and receives substantially all of the economic benefits from the use of the asset.

An entity obtaining substantially all of the economic benefits of the use of the asset can be accomplished in several ways. One way would be that an entity has exclusive use of the asset throughout the period, which provides an entity with a distinct competitive advantage. This determination will generally be readily apparent to an entity.

The right to use (that is, control) is the fundamental assessment that an entity is required to consider when determining whether a contract contains a lease. If an entity determines that it has the right to direct the use of the asset, the contract is a lease. Alternatively, if an entity makes the determination based on the facts and circumstances of the contract that the supplier has the right to direct the use of the asset, the contract is not a lease.

An entity has the right to direct the use of the asset throughout the period of use in either of the following situations:⁶

• The entity has the right to direct how and for what purpose the asset is used throughout the period of use.
• The decisions about how and for what purpose the asset will be used are predetermined and at least one of the following conditions exists:
  • The entity has the right to operate the asset (or direct others to operate) throughout the period of use without the supplier having the right to change those operating instructions.
  • The customer designed the asset (or specific aspects of it) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

Another important point to note here is that in assessing whether an entity has the right to direct the use of an asset, this assessment should take into account only the rights to make decisions about the use of the asset during the period of use (unless the customer designed the asset). As a result, an entity should not consider decisions that are predetermined before the period of use.

Decision-making rights is another term that is commonly used within the new leasing standard to describe power. In making the assessment of whether an entity can direct how and for what purpose an asset is used throughout the period specified in the contract, an entity should consider those decision-making rights that are most relevant.

The principle about decision-making rights is simple in terms of its assessment of power, but how does an entity make the determination that its decision-making rights are relevant? Decision-making rights are relevant when they affect the economic benefits to be derived from the use of the asset.⁷ The important point to note here is that decision-making rights are very likely to be different from contract to contract and industry to industry. See exhibit 5-2 for some practical examples from FASB of these decision-making rights that would suggest that an entity has the power to direct the use of an asset.

We have established a firm understanding of what a decision-making right is that supports the conclusion that an entity can direct the use of an asset. Now let’s contrast this with a decision-making right that does not result in an entity concluding it has the power to direct the use of the asset. Operating and maintaining an asset is an example of this type of situation. Although rights to operate or maintain an asset often are essential to the efficient use of an asset, they are not rights to direct how and for what purpose the asset is used and often are dependent on the decisions about how and for what purpose the asset is used.⁸

Illustrative examples — Does it contain a lease?

The following sections summarize and provide illustrative examples of application guidance prescribed within FASB ASC 842. These examples illustrate situations that do and do not contain a lease across various industries and different types of contracts, including the following:

• Rail cars
• Concession space
• Fiber-optic cable
• Retail unit
• Truck rental
• Ship
• Aircraft
• Contract for shirts
• Energy or power
• Network services

Though a comprehensive review of each of these examples is outside the scope of this course, we do offer examples of several of them to further solidify your understanding of applying the new lease accounting standard.

Now that you have had a chance to work through two of the examples of application of lease determination in FASB ASC 842, see case study 5-1.

Examples 5-3 and 5-4 help further address the lease determination process.

As you did with case study 5-1, refer to the following facts and circumstances and make a determination about whether the contract contains a lease.

As you can note from the previous sections of this chapter, the determination of whether an arrangement contains a lease is one of the more important areas of the new leasing standard. In later chapters of this course, we will address the accounting considerations for both lessees and lessors when the determination is made that a contract is, or part of it is, a lease.