If you’re a US public company or international company, you’re required to follow ASC 842 and IFRS 16 for lease accounting. ASC 842, which went into effect in 2018 for US public companies and 2019 for international companies, requires nearly all leases to be recognized as assets and liabilities. One of the main differences between the old lease guidance (ASC 840) and the new guidance is how a lease is defined. In this blog post, we’ll review the definition of a lease under ASC 842 and provide guidance to help you determine if you have a lease.
Previous vs New Definition of a Lease
Under the previous lease guidance (FASB ASC 840), a lease is defined as a contractual agreement between a lessor (owner of an asset) and a lessee (user of an asset) that allows the lessee to use the asset for a period of time in exchange for consideration. The contract specifies the terms and conditions under which the lessor grants the lessee the right to use the asset.
Under FASB ASC 842, a lease is defined as a contract or part of a contract that conveys the right to control the use of an identified property, plant or equipment for a period of time. In a lease contract, the lessee continues to benefit from the asset throughout the lease term, while in a service contract, the customer obtains economic benefit only as the lessor performs the service prescribed within the contract. ASC 842 provides guidance to help companies determine if a contract or a portion of a contract contains a lease, and the new definition will result in more contracts being considered a lease.
Key Factors to Consider
To determine whether a contract contains a lease under ASC 842, companies must consider several factors, including the identification of an asset, the right to economic benefit from the asset, the right to direct use of the asset, the right to operate the asset, and whether the asset was designed by the customer.
1. How to Identify an Asset
Under the previous accounting standards, certain leases were treated as operating leases, and the leased assets did not appear on the balance sheet of lessees. The new lease accounting standards require companies to recognize most leases on their balance sheet as assets and liabilities, which means that identifying the underlying asset that is subject to the lease is a crucial step in determining the appropriate accounting treatment.
In order to identify an asset in a lease contract, we can refer to FASB Concept Statement No. 6, which defines an asset as something that will likely provide future economic benefits to an entity as a result of a past transaction or event. In a lease, the criteria for meeting the definition of the right to use the asset include the lessee’s ability to derive significant benefits from the asset’s use throughout the lease term and having control over granting access to the asset to others. This control is demonstrated through the lessee’s ability to decide how and when to use the asset and obtain future economic benefits from its use. The past event that gives the lessee control of the asset is the lessor’s making the asset available for use at the start of the lease. Other factors that can help identify an asset include the lessee’s ability to substitute alternative assets during the lease and whether the lessee would benefit economically from doing so. It’s important to note that certain future events that are unlikely to occur should not be taken into consideration when identifying the asset, according to ASC 842 guidance.
2. Right to Economic Benefit from the Asset
For a contract to be classified as a lease, it needs to have clauses that guarantee that the customer gets all the financial advantage from the specified asset for the entire duration of the agreement.
3. Right to Direct Use of the Asset?
It’s important to consider how and why the identified asset is used during the entire period. Who has the authority to direct the use of the asset and make decisions about it? This includes the right to modify the output type, production schedule, location and quantity. If a party has the power to control the use of the asset for only a portion of the contract term, then that portion of the contract may be considered a lease.
4. Right to Operate Asset
Under ASC 842, for a lease to exist, the customer should have the right to operate the identified asset or direct others to operate the asset in a manner that it determines, throughout the period of use.
5. Designed by Customer
Another consideration is the design of the asset. Was the asset designed based on the specification provided by the customer?
Service Contract vs Lease
Service contracts and lease contracts have different rights and responsibilities. In a lease, the lessor provides the asset to the lessee, who benefits from it throughout the lease term. In a service contract, the customer receives economic benefit from the service provided by the lessor. The main difference is that the lessee does not continue to benefit from a service contract, while they do continue to benefit from a lease contract throughout the term. Unlike lease contracts, service contracts do not require an asset or liability recognition on the balance sheet.
Wrap Up
ASC 842 provides guidance to help companies determine if a contract contains a lease. To qualify as a lease, a company must answer “yes” to all of the following questions:
- Is there an identified asset?
- Does the lessee have the right to economic benefit from the asset?
- Does the lessee have the right to direct the use of the asset?
- Does the lessee have the right to operate the asset or was the identified asset designed by the customer?
We believe the new lease definition may result in more contracts being classified as leases.
Understanding the difference between a service contract and a lease contract is important for companies to properly account for their financial statements and comply with ASC 842 regulations. Identifying whether a contract contains a lease can be complex, but answering the four questions listed in ASC 842 can help determine if a lease exists. With the new lease definition, more contracts are likely to be considered a lease, and companies should prepare accordingly to ensure compliance.
ASC 842 provides guidance to help companies determine if a contract contains a lease. To qualify as a lease, a company must answer “yes” to all of the following questions:
- Is there an identified asset?
- Does the lessee have the right to economic benefit from the asset?
- Does the lessee have the right to direct the use of the asset?
- Does the lessee have the right to operate the asset or was the identified asset designed by the customer?
We believe the new lease definition may result in more contracts being classified as leases.
Understanding the difference between a service contract and a lease contract is important for companies to properly account for their financial statements and comply with ASC 842 regulations. Identifying whether a contract contains a lease can be complex, but answering the four questions listed in ASC 842 can help determine if a lease exists. With the new lease definition, more contracts are likely to be considered a lease, and companies should prepare accordingly to ensure compliance.
