Identifying Embedded Leases in Contracts Under ASC 842
We previously discussed how FASB had discussed changes in ASC 842: Lease Accounting in Rate Implicit in the lease as well as the determination of IBR. The board has also outlined the concern presented by some preparers about the identification of leases embedded within a contract. The main issue was that entities spent significant amounts of time trying to identify and account for leases already embedded into contracts. ASC 842 requires entities to recognize and report all operating leases – both assets and liabilities – as and when the lease commences.
The Problem ASC 842 suggests that if any contract includes a lease as identified under ASC 842 or simply gives a party the right to control property and reap the benefits and bear losses from the same in exchange for consideration (for a fixed amount of time), it needs to be recorded as a lease in the company’s balance sheets. Since there are a large number of potential lease contracts, the manual mode of recognition of these “embedded leases” is a costly venture for preparers. Entities often set a minimum threshold for the recognition of lease assets or liabilities – below which they are treated as immaterial, and therefore, just an expense in the Income Statement. This is an acceptable approach for FASB, since it makes the implementation of ASC 842 easier. Having said that, the minimum threshold remains a matter of entity preference and therefore, a source of inconsistencies.
Alternatives Proposed When exploring options about the need for a change in ASC 842 requirements for embedded leases, FASB proposed three alternatives:
- No change.
- Implementation of a “qualitative” minimum threshold. Here, if an embedded lease doesn’t represent the majority of a contract, it doesn’t have to be reported.
- Implementation of a “quantitative” minimum threshold. Here, if an embedded lease doesn’t exceed $5,000 when new.
When the alternatives were discussed among members, preparers, users and representatives, the following arguments came forward.
- Since the recognition of embedded leases isn’t new under ASC 842, most entities already have some process implemented to review and identify them. However, it’s when recognizing leases and liabilities as operating leases that the new processes will be needed, which is why the first alternative seemed viable to many. Furthermore, Update 2016-02 of ASC 842 on the materiality of a lease has already been discussed.
- The second and third alternatives, both gained some sympathy from participants – especially those representing non-public entities, but there was a concern that if a qualitative or quantitate threshold is used, it may give rise to the practice of shaping contracts in a way as to prevent it from falling under ASC 842.
The Decision All three alternatives were favored and not favored equally by those in the conference. The quantitative threshold implementation was most favored since it would improve convergence with IFRS 16: Lease Accounting. However, it was also determined that convergence doesn’t necessary mean easy implementation of said threshold. It would duplicate the thresholds already established under ASC 842. Implementing either the qualitative or quantitative threshold would demand an update over time. Right now, entities need to show why the current threshold is appropriate, something that would not be possible if a quantitative or qualitative threshold is specifically mentioned in ASC 842. At the end, the first alternative, i.e., making no change to the standard and the definition of a lease under US GAAP was agreed upon. If you’d like to learn more about other changes, we recommend you subscribe to our blog. We document any and all changes to ASC 842: Lease Accounting regularly to ensure our readers are always up to date!
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