Question

Lake Manufacturing Co. is considering alternative financing arrangements for equipment used in its warehouses. Besides purchasing the equipment outright, Lake is also considering a lease. Accounting for the outright purchase is fairly straightforward, but because Lake has not used equipment leases in the past, the accounting staff is less informed about specific accounting rules for leases. The staff is aware of some general lease rules related to “right-of-use”, but they are unsure how the accounting rules apply to their situation. Lake has asked you to conduct some research on these items related to lease capitalization criteria.   

Access the FASB Accounting Standards Codification System using the information provided in the Announcements pages and prepare responses for the following using the new Leases standard (ASC 842), providing appropriate codification references in your report.

a) What is included in the measure of the (1) lease liability and (2) right-of-use asset?

b) Besides the non-cancelable term of the lease, what other considerations determine the “lease term”?

c) When should a lessee account for a lease modification? What procedures are followed?

Answer 1

ASC 842, Leases, was added by ASU 2016-02 on February 25, 2016. It is effective for public business entities for annual periods beginning after December 15, 2018 (i.e., calendar periods beginning on January 1, 2019), and interim periods therein. For all other entities, ASC 842 will be effective for annual periods beginning after December 15, 2019 (i.e., calendar periods beginning on January 1, 2020), and interim periods thereafter. Early adoption will be permitted for all entities.

A lease conveys the right to use an underlying asset for a period of time in exchange for consideration. At the inception of an arrangement, the parties should determine whether the contract contains a lease by assessing both of the following: ? Whether there is an identified asset ? Whether the contract conveys the right to control the use of the identified asset in exchange for consideration for a period of time

On the lease commencement date, a lessee is required to measure and record a lease liability equal to the present value of the remaining lease payments, discounted using the rate implicit in the lease (or if that rate cannot be readily determined, the lessee’s incremental borrowing rate). Lease payments used in measuring the lease liability are amounts due to the lessor excluding any payments that a lessee makes before lease commencement. As discussed in LG 3.3.4, there are six components that should be factored into measuring lease payments. Lease arrangements should be thoroughly reviewed to ensure that all applicable payments are being considered. With some exceptions, the lease payments used to measure the lease liability should be the same as those used to determine lease classification. Two of these exceptions are: ? To classify a lease, a lessee should use all lease payments (i.e., including payments made before the commencement date), whereas only the remaining payments due should be used to measure the lease liability ? For lease classification purposes, the entire potential payment under a residual value guarantee should be included in the lease payments. The lease liability Accounting for leases PwC 4-3 recorded at lease commencement should only include amounts probable of being owed by the lessee under residual value guarantees

At the commencement date, the cost of the right-of-use asset shall consist of all of the following: a. The amount of the initial measurement of the lease liability b. Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received c. Any initial direct costs incurred by the lessee

An entity shall determine the lease term as the noncancelable period of the lease, together with all of the following: a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option b. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option c. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.  

The assessment of whether it is reasonably certain that a lessee will exercise an option should be based on the facts and circumstances at lease commencement. The assessment should not be based solely on the lessee’s intentions, past practices, or estimates. It should focus on the factors that create an economic incentive for the lessee, including contract-, asset-, entity-, or market-based factors.

A lease modification is a change to the contractual terms and conditions of a lease that was not part of the original lease and which results in a change in scope or consideration. A modification that grants the lessee an additional right of use priced at market is a separate lease that is then classified at the lease modification date.

Depending on the facts and circumstances, a lease modification may be accounted for by the lessee and lessor as (1) two leases – the original lease and a separate new lease, or (2) one modified lease. When a lease modification is accounted for as one modified lease, the lessee and lessor must reconsider the lease classification and remeasure the lease. ASC 842 also describes other circumstances in which a lessee must reconsider certain assumptions made at the lease commencement date (e.g., whether exercise of a renewal or purchase option is reasonably certain) and remeasure the lease liability and adjust the related right-of-use asset. In some of those cases, ASC 842 requires a lessee to reassess the classification of a lease. A lessee is required to remeasure its lease liability and adjust the related right-of-use asset upon the occurrence of the following: ? A triggering event that changes the certainty of a lessee exercising an option to renew or terminate the lease, or purchase the underlying asset ? A change to the amount probable of being owed by the lessee under a residual value guarantee ? The resolution of a contingency upon which variable lease payments are based such that those payments become fixed A lessor is not required to remeasure a lease unless the lease contract is modified.

lessee’s accounting treatment of a lease modification depends on the type of modification made to the lease. A lease modification can result in either a separate new lease that is accounted for separate from the original lease or a single modified lease

The following are examples of lease modifications that may be negotiated after the lease commencement date: ? A lease extension ? Early termination of the lease ? A change in the timing of lease payments ? Leasing additional space in the same building

An entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present: a. The modification grants the lessee an additional right-of-use not included in the original lease (for example, the right to use an additional asset). b. The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee. An additional right-of-use is granted when the lease contract is modified to give the lessee a right to use an additional underlying asset that was not included in the original lease. For example, when the floor space under lease is increased or a lessee receives the right to use a new standalone asset. A modification to increase the lease term is not considered an additional right-of-use.