Early in 2020 the Financial Accounting Standards Board announced their intention to hold a leases roundtable meeting with stakeholders to have open discussion of matters related to Topic 842, Leases. In the FASB’s press release the FASB Chairman stated the purpose of the roundtable would be to:
. . . provide select stakeholders, many of whom have already implemented the leases standard, a forum to share feedback about their challenges and successes. What we learn at the roundtable will help the FASB understand and address ongoing implementation issues, which we hope will facilitate a smoother transition to the standard for private companies.
The roundtable was originally scheduled for the start of the second quarter, but it was delayed by the COVID-19 related business disruptions. The session was ultimately rescheduled to Sept. 18. Participants included the large accounting firms, users of financial statements, companies and trade associations.
This column will review the topics to be discussed at the roundtable. Future columns will provide an update on the meeting and the impact of the discussions on the Leases standard in the coming months.
As the FASB’s press release indicates, this discussion of ASC 842 is more than a rearview mirror look at the standard. With the recent issuance of ASU 2020-05, the mandatory adoption date of Leases by many private companies is now pushed back to 2022. As a result, it is possible that any simplifications discussed during the meeting might make their way into a new Accounting Standards Update. It is also possible comments or suggestions raised during the meeting will impact companies who have already adopted ASC 842.
What’s on the Agenda?
The topics up for discussion in the roundtable have been announced and the FASB Staff have posted the related papers to the FASB’s website. The issues in the papers will be introduced by the FASB Staff and we expect there will be an open discussion of the issues surrounding each topic. The topics reflect the major challenges companies, primarily lessees, have faced as they adopted the Leases standard, and they include:
- Lessee application of the rate implicit in the lease,
- Lessee application of the incremental borrowing rate,
- Embedded leases,
- Lease modifications, and
- Lessee allocation of fixed and variable payments.
Lessee application of the rate implicit in the lease
Under ASC 842 a lessee needs to classify and measure it lease obligations using a discount rate. The discount rate guidance in the standard requires lessees to use the rate implicit in the lease, if it is readily determinable. If the lessor implicit rate is not readily determinable the lessee defaults to their incremental borrowing rate as defined in the standard. The question in this topic partially revolves around the circumstances when and if the lessor’s implicit rate is readily determinable by the lessee. A lessee may know the asset’s fair value—and the payments they are making under the lease—but they probably do not know for certain what the lessor’s residual assumption is. Absent that knowledge, some lessees wish to estimate the residual based on public information and use this estimate residual to determine the lessor’s implicit rate. To date, the general view is that this approach would not meet the readily determinable threshold in the standard.
The Staff paper suggest three possible approaches to resolving this issue:
- Leave the standard as is,
- Eliminate the requirement in the standard for the lessee to consider the implicit rate, or
- Provide lessee’s the option of using the implicit rate.
The definition of the incremental borrowing rate or IBR proved to be challenging for many lessees during the adoption. The rate has to be imputed and there were approaches that were turning the development of the IBR into what one Board member termed “a science project.”
The Staff paper suggests two alternatives approaches to the IBR question:
- Leaving the standard as is, or
- Provide lessees with the option of using a specific rate rather than an entity specific rate.
Embedded leases
The question of when to separate a lease embedded in a service contract from the service itself is one of the most difficult questions in lease accounting. The need for this accounting judgement often arises in power generation, transportation arrangements, logistics contracts, contract manufacturing and IT services. If there is a simplification that could be made here it would greatly reduce the compliance burden of the standard, as both the process of identifying embedded leases and the accounting for the arrangement are time consuming.
The Staff paper proposes three alternative approaches to the topic:
- Leave the standard as is,
- Establish an option to not separate leases embedded in service arrangements on the basis of a qualitative threshold, or
- Establish an option to not separate leases embedded in service arrangements on the basis of a quantitative threshold.
- The lease component is “immaterial in the context of the contract” or not “more than insignificant,” or
- The nonlease component is “significant”, “predominant” or is “substantially all” of the contract.
Lease modifications
The question of what changes to a lease result in an accounting modification is not always straight forward and the accounting for the change may be time intensive and not readily subject to automation. The paper discusses some questions that have arisen and then asks the participants to discuss issues related to:
- Certain reductions within the scope of the lease contract, including the master lease agreement,
- Reassessment of lease classification on modification, including the updating of assumptions on fair value, economic life and discount rate,
- The accounting for termination penalties, and
- Minor modification.
Lessee allocation of fixed and variable payments
The Leases standard requires a lessee to separate payments under the lease into lease and nonlease components and the allocate the payments between the two buckets. This allocation becomes more difficult if the contract is a service contract containing an embedded lease and the payments are both fixed and variable. The allocation is not only difficult, but the Staff have heard the results of the allocation may not reflect the economics of the arrangement.
The Staff paper lists two alternatives for discussion:
- Leave the standard as is, or
- Amend the lessee allocation guidance to require the allocation of fixed and variable payments solely to the lease or nonlease component under certain circumstances.
The Financial Watch column will provide an update on the meeting and the impact of the discussions on the Leases standard in the coming months.
