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Suggested Small CPA firm approach to Lease type decisions.
The lease term is the original fixed period covered by the agreement plus any additional period included as an option (i.e., right to extend the term) that, at the inception of the lease, appears to be reasonably assured of being exercised. Generally, reasonably assured options are those that have penalties if not exercised, result in a lower rental payment if exercised, and/or may be exercised solely at the lessor’s discretion. Prior transactions are an indicator if they exist.
The estimated economic life is the estimated remaining period during which the leased asset is expected to be economically usable, with normal repairs and maintenance, at the inception of the lease. To determine the estimated economic life of an asset, use the past experience, intent of the lessee, or other equipment manufacturer input.
The discount rate to be used to compute the present value of the lease payments is the incremental borrowing rate. This is the estimated interest rate the lessee would pay in the lending market to purchase the asset using debt financing.
Fair value - The fair value of the leased asset at the inception of the lease is generally the estimated amount that would be paid to acquire the asset in the open market. The age of the asset, as well as appraisals of other similar facilities or equipment, are factors in determining the fair value.
Given a simple accumulation of projected lease payments (preferably by asset or equipment type), then using the estimated incremental borrowing rate, an asset and liability balance sheet value could be arrived at as the present value of the projected payments.
ASC 842 contemplates a portfolio approach and has a few paragraphs on the subject that provide very little detailed guidance. A mixture of both actual booking data and portfolio combined short cuts is probably what is being implemented by the public corporations. Four years after adoption, in my opinion, the standards board will be very lenient towards methods adopted by small CPA firms unless they can land on a preferred method that allows compliance at a reasonable cost. As of now, there is none I know of. Truleases has a portfolio dashboard with tools that provide for handing complex combined cash flows that can iteratively land on a present value given the discount rate(s) provided. Without these tools, the project can be arduous. See Tutorial 8 for further insight into handling portfolios.
All obligations for the right of use of an asset (ROU asset) no matter how classified must be capitalized if the term of the commitment is over 1 year.
ASC 842 is all about the balance sheet.
Getting all legal commitments on the balance sheet, no matter what the contract, was the primary goal.
Only three basic ways to go
There are 3 lease types defined by ASC 842 they are:
1) finance x x
2) operating x x
3) sales type x n/a
The decision comes down to who is left with the risks and rewards of ownership at the end of the lease. The sales type is specific to lessors only and contemplates a combined transaction of a sale financed by the lessor. On the lessee side it is a financing by virtue of it being sold to the lessee.
The risks and rewards of ownership are measured by 2 factors,the useful remaining life of the asset visa vie the lease term, and the amount of the remaining dollar value visa vie the original cost. Both of these measurements are estimated at about 90% for remaining life and 20% for remaining dollar value. In the final analysis, a decision is required based on accounting principals of revenue /cost matching, conservatism and specific stated requirements per ASC 842.
There is considerable leeway allowed in the estimates.
FASB Statement No.13 on lease accounting was issued in May 1980 or about 40 years ago and was 226 pages in length. Some large accounting firms have recently published hand books on leasing of various sizes. You are urged to research & download these publications as they are generally well done.
If the average small CPA has a need for detail because of a particularly involved contract, he or she can resort to these publications and others like them, for detailed assistance. In most cases both small and large CPA firms will probably not have a need for this detail in arriving at an accounting treatment for the vast majority of transaction.
A simplified decision tree with definitions is reproduced below. When combined with the principles set forth in the paragraphs above a decision as to lease type is reasonably attainable. Once done, Truleases will handle the accounting and record keeping.