The Financial Accounting Standards Board held a public roundtable Sept. 18 on implementation of the new lease accounting standard. The purpose was to discuss technical issues that are challenging for practitioners and where additional or amended guidance might be needed from FASB.
Participants in the roundtable included financial statement preparers and users, auditors, and representatives from industry. A full discussion of the roundtable topics, along with the list of participants, is available on FASB’s Website.
In June, FASB deferred the effective date of Topic 842 (Leases) for one year for entities other than public business entities and not-for-profit entities to fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022.
Here are highlights of the five topics discussed at the roundtable.
Lessee application of rate implicit in the lease. The discount rate applied by a lessee has a direct effect on the lease classification and the measurement of the lease liability and related right-of-use asset.
Topic 842 indicates lessees should use the rate implicit in the lease (the rate the lessor is charging the lessee) when it is “readily determinable.” If it is not, the lessee must use its incremental borrowing rate (the interest rate the lessee would have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term). Because “readily determinable” is open to interpretation, there is diversity in practice.
The implicit rate includes assumptions specific to the lessor, like the lessor’s expected residual value of the leased asset and initial direct costs, that are not known to the lessee unless the lessor provides the rate and inputs used. The lessee may also be able to determine them from publicly available information.
Topic 840—the standard on leases set to be replaced by Topic 842—calls for lessees to use the implicit rate unless it is “practicable” to learn the lessor’s implicit rate and the implicit rate computed by the lessor is less than the lessee’s incremental borrowing rate. The criteria about the rate being lower was removed from Topic 842, but FASB did not intend for practice to change. Under Topic 840, lessees historically defaulted to using their incremental borrowing rate. The implicit rate is often significantly higher than the incremental borrowing rate, so its use results in a higher lease liability.
Three alternatives were discussed at the roundtable: no change; eliminate the lessee requirement to consider the implicit rate and require use of the incremental borrowing rate; or provide lessees the option to use the implicit rate under certain conditions.
Lessee application of incremental borrowing rate. As discussed above, a lessee may need to determine its incremental borrowing rate to calculate the present value of lease payments to classify leases as operating or finance leases at commencement. Discount rates are also used at subsequent dates for lease modifications and remeasurement events. Since Topic 842 requires lessees to recognize operating lease liabilities on their balance sheets at discounted amounts, the definition and calculation of incremental borrowing rates has gotten more attention.
Public business entities already applied this guidance and usually use the incremental borrowing rate as the discount rate. Determining the rate can be a complex process. Topic 842 allows non-public lessees to make an accounting election to use a risk-free discount rate for a period comparable to the lease term for all leases.
Some non-public companies have expressed concern that because the risk-free rate is lower than other rates, discounting will result in a higher lease liability—although the lease economics have not changed. Non-public companies that do not make the election to use a risk-free rate must incur time and costs of determining their incremental borrowing rates. They may not have treasury functions or have readily available information they need to develop the rates, and they may have to hire third-party valuation experts.
Other GAAP topics, including Topic 944 on long-duration insurance contracts and Topic 715 on retirement benefit compensation, include specific rates to use to discount liabilities, while Topic 842 does not.
Two alternatives were discussed at the roundtable: no change, or give all lessees—including public business entities—an option to make an accounting policy election to use a specific rate (like an A or AA rating) instead of the incremental borrowing rate.
Embedded leases. Leases embedded in non-lease contracts must be identified and recognized under Topic 842. Examples include contracts for services, supplies, manufacturing, transportation, and construction. Concerns have been raised about the costs and complexities of this identification process and related controls.
Although the embedded lease concept existed under Topic 840, more emphasis is placed on identification under Topic 842 because operating lease assets and liabilities are on balance sheet. Topic 842 permits companies to adopt reasonable capitalization thresholds for recognizing lease assets and liabilities, consistent with their other asset capitalization policies. Immaterial lease components not accounted for as leases under Topic 842, like a service contract, would be accounted for under other GAAP.
Three alternatives were discussed at the roundtable: no change; provide an option to not apply Topic 842 to embedded leases based on a qualitative threshold; and provide an option to not apply Topic 842 on the basis of a quantitative threshold.
The qualitative thresholds consider whether the non-lease component is “significant” or “predominant,” and whether the embedded lease component is “immaterial in the context of the contract.” The criteria would have to be further developed, but if this option were applied, the entire contract would be accounted for based on the relevant GAAP for the non-lease component.
The quantitative thresholds would determine whether to apply Topic 842 based on whether the value of the underlying asset in the lease is less than a specific dollar amount. IFRS 16 has a $5,000 threshold for exempting “small assets” from the lease accounting guidance.
Lease modifications. Accounting for modifications under Topic 842 is quite different and much more complex than it was under Topic 840. Modifications can result in the existing lease being treated as a new lease and require a reassessment of lease classification and remeasurement of the existing lease asset and liability at the modification date.
In April, FASB addressed modification issues in its Q&A on relief for lease concessions due to COVID-19. In July, the rulemaker added a project to its agenda to amend lease modification accounting for certain reductions within the scope of lease contracts.
In June, FASB asked for feedback on modification accounting from the large accounting firms as part of its ongoing post-implementation activities. All the firms believed the modification framework in Topic 842 is an improvement over Topic 840 and cautioned FASB against making broad changes to the modification model because public business entities have already adopted it. The firms were supportive of certain revisions being considered during the roundtable that could be an improvement for both lessees and lessors.
FASB also incorporated 2019 feedback from a large preparer group, including specific implementation issues they encountered when applying modification accounting.
As part of the roundtable, FASB is considering whether the lease modification model overall can be improved, along with the specific issues of minor modifications, termination penalties, modifications that do not create a separate contract, and reductions included within the scope of a master lease contract.
Lessee allocation of fixed and variable payments. Under Topic 842, lessees must identify the separate lease and non-lease components of a contract and allocate the contract consideration to them. FASB has received feedback from lessees applying this guidance that allocation requirements are complex, challenging, and costly to apply.
Stakeholders also shared feedback that when there are both fixed and variable lease payments, the allocation results may not reflect the economics of their lease transactions. Lessees may elect an expedient to combine lease and non-lease components, by asset class, and account for them as a single lease component. If elected, both fixed and variable payments are treated as lease payments, which results in a larger lease liability than if some of the fixed payments were allocated to the non-lease component, and the variable payments are accounted for as lease expense when the lease obligation payment is made.
Two alternatives were discussed at the roundtable: no change, or amend the lessee allocation guidance.
FASB staff will use input from the roundtable to work on developing a plan for the board. This path forward may include education, clarifying Q&A’s, potential standard setting, additional outreach, or no action on certain of the issues.