CHAPTER 3: LEASE AUDIT HOW-TO + CHECKLIST
A critical part of implementing the new lease standard is reviewing existing contracts, determining what does and doesn’t qualify as a lease, and creating initial journal entries to apply the standard to the balance sheet.
This article examines what you need to know about what does and doesn’t qualify as a lease, separating lease components, making policy elections, and auditing leases.
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Understand what qualifies as a lease
Before reviewing your portfolio of contracts, it’s important to understand exactly what qualifies as a lease under the new lease standard. Under the new lease standard, all leases must be recognized as both an asset and offsetting liability for future lease payments. This is a big difference from the previous standard, where operating leases were not reflected on the balance sheet. There are a few considerations that help determine if a particular contract is a lease:
One key to knowing that you have a lease rather than another type of contract is whether you have the right to control or use an asset. Additionally, the asset itself must be explicitly or implicitly identified, as well as be physically distinct. Also keep in mind that some leases are actually being leased as part of that vendor contract. The criteria to qualify as an embedded lease is the same criteria explained above.
With any rule, there are always exceptions. For example, the leasing standard does not require lessees to apply the guidance to leases with a term of 12 months or less. Additionally, there are certain leasing scenarios that exempt the lease from consideration, including:
- Leases of intangible assets (e.g., goodwill, etc)
- Leases to explore or use non-renewable resources (e.g., oil, natural gas, etc)
- Leases of biological assets (e.g., timber, livestock, etc)
- Leases of inventory or assets under construction
- If you comply with the IFRS standards, you may elect to not apply the new lease standard if the underlying asset is of low value.
Separating lease and nonlease components
Not all costs related to a lease are included in the leased asset and liability. For example, a lessor may lease a truck and also include a provision to operate the truck on behalf of the lessee. Providing a driver, maintenance, and gas are not related to securing the use of the truck and these costs would be considered nonlease components.
On the other hand, costs attributable to securing the asset itself should be included in the lease payments for both classifying and measuring the lease. For example, a non-refundable upfront deposit would be considered a lease component.
A hallmark of ASC 842 is that it requires quite a bit of judgment. This means you need to think about the intent of a particular payment to determine whether it should be included or excluded. This is a good starting place when considering how to classify lease-related payments.
Likely to be
Likely to be Nonlease Components
Not Likely to be Lease or Nonlease Components
Help clients make the right policy elections
A critical part of implementing the new lease standard, including auditing leases, is making the required policy elections, summarized below.
Lessees may make a policy election not to apply the standard (that is, not recognize a right of use asset or lease liability) to short-term leases of 12 months or less for all classes of underlying assets. If this election is made, the lessee would recognize the lease payments as operating expenses straight-line over the lease term. This election saves time in accounting for these leases, but the disadvantage is that different accounting policies and processes need to be in place for short-term and long-term leases.
A lessee may choose, as a practical expedient by class of underlying asset, to account for the lease and nonlease components as a single combined lease component. If this election is not made, the lease payments are allocated to the separate lease and nonlease components, using relative standalone prices (estimated if not readily available). While this expedient saves time, the lessee will have a larger liability (and ROU asset) by treating nonlease components as lease components.
At the lease commencement date, lessees determine the present value of the lease payments to calculate the ROU asset and lease liability using the rate implicit in the lease. If the rate implicit in the lease is not readily available, nonpublic business entities can make a policy election to use the risk-free rate in lieu of determining an incremental borrowing rate. This election saves time and reduces audit risk; however, the risk-free rate will likely be a lower rate than the incremental borrowing rate, creating a larger lease liability.
If any of the five criteria in ASC 842-10-25-2 were met, a lessee would classify the lease as a finance lease. One of these evaluation criteria is whether the lease term is for a major part of the economic life of the underlying asset. Lessees can make a policy election, by class of asset, to define what percentage constitutes a major part. Although the FASB did not include a bright-line percentage in ASC 842 as in prior guidance, it has indicated that 75% of the asset’s remaining economic life is a reasonable approach.
Another of the five evaluation criteria is to determine whether the present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the underlying asset. Lessees can make a policy election, by class of asset, to define what percentage substantially constitutes “all”. Although the FASB did not include a bright-line percentage in ASC 842 as in prior guidance, it has indicated that 90% of the fair value of the underlying asset is a reasonable approach. The advantage of defining the major part and substantially all using 75% and 90% respectively, is consistent accounting application across the lease portfolio.
Presentation of ROU assets and lease liabilities
Lessees can make a policy election on how to present their finance and operating lease ROU assets and lease liabilities in their statements of financial position and related footnotes. They can elect to present a separate statement of financial position line items for finance lease ROU assets, operating lease ROU assets, finance lease liabilities, and operating lease liabilities. Or they can disclose in the footnotes, where each of these types of assets and liabilities has been included in the financial statement line items. If leases are not significant, clients may find disclosure in the footnotes to be a better election.
A number of practical expedients are available for lessees to apply to leases that commenced before the standard’s effective date. Each practical expedient must be elected as a package and applied to all leases. Lessees can elect not to assess whether expired or existing contracts are or contain leases, lease classification for any existing or expired leases, and whether initial direct costs would have qualified for capitalization for any existing leases.
Another expedient that can be elected for existing leases at transition is to use hindsight regarding lease renewals and purchase options when determining the lease term and in assessing impairment of the ROU asset. This relief can be elected independently of the previous practical expedient, but it must be applied consistently to all leases.
Lessees may apply a single discount rate to a portfolio of leases with reasonably similar characteristics (such as a similar lease term for a similar class of asset). A single discount rate cannot be applied to the entire lease portfolio.
In July 2018, the FASB issued an additional transition relief option for lessees, allowing entities to use the effective date of the new lease standard as their date of initial application. (For example, the initial application date for most privately held companies with a calendar year-end is January 1, 2020 if this transition relief is elected.) With this transition method, comparative prior years on the financial statements do not have to be restated.
Lease review checklist
Once it’s time to conduct an actual review of each lease, you’ll want to walk through a number of questions. Download free Office Space and Vehicle lease review checklists here to simplify the process.
- Determine if it is a lease for accounting purposes under the new lease standard, taking into consideration asset control and identification.
- Note general information about the lease, including name, description, lessor, lease terms, termination clauses, renewal options, discount rate, etc.
- Outline lease payment terms, including payment frequency, amount, start date, and other relevant details.
- Classify the lease correctly based on ownership, economic life, and fair value of the leased asset.
- Calculate variable and nonlease payments.