Effective Dates Approaching
The FASB issued Accounting Standards Update (ASU) 2016-02 that introduced ASC Topic 842 into the FASB’s Codification in February 2016. In November 2019, the FASB recognized how the challenges encountered in implementing major standards are often magnified for smaller public business entities, nonpublic business entities, and not-for-profits.
As a result, the FASB introduced a two-bucket philosophy to stagger the effective dates of major standards between larger public companies and all other entities. Accordingly, in ASU 2019-10, the FASB deferred the effective date of three major new standards, including ASC Topic 842 by one year for certain entities, including private companies.
In June 2020, the FASB issued ASU 2020-05 to acknowledge how the challenges of adopting a major accounting standard were amplified by the COVID-19 pandemic and provided an additional one-year deferral for certain entities, including private companies.
Accordingly, the effective date for private companies is for fiscal years beginning after December 15, 2021, and interim periods in fiscal years beginning after December 15, 2022.
Although these effective dates are approaching, many private companies have yet to start preparing to adopt this accounting standard.
Factors to Consider When Adopting the Leasing Standard
The following seven factors generally will have the greatest impact on professional services organizations with respect to the new lease standard.
1. Finance Lease Classification
For finance leases, the triggering conditions for classification remain similar to those for capital leases under legacy GAAP.
In general, an arrangement should be classified as a finance lease if the arrangement effectively represents an installment purchase in which the lessee acquires substantially all the economic benefits of an asset and pays for this acquisition over time. However, the quantitative lease classification criteria under legacy GAAP were updated to be more qualitative in nature.
This change intended to remove the structuring of leases right up to a quantitative bright-line measurement criteria to achieve one lease classification when the nature of the arrangement indicates the alternate lease classification is more appropriate.
Under the new guidance, there’s an additional condition that could result in finance lease classification: The underlying asset is of such a specialized nature that it’s not expected to have an alternative use to the lessor at the end of the lease term.
For example, if a professional services firm’s landlord built a laboratory according to the firm’s specifications that can only be used by the firm to work on robotic device projects for a specific client, the landlord may expect to have no alternative use for the leased asset at the end of the lease without incurring significant losses to repurpose the laboratory.
In this case, the lessee would likely account for this leased asset as a finance lease. However, if the laboratory space could be used by other potential tenants performing similar robotics work or other uses, this aspect of the lease might not be determinative.
2. Portfolio Basis Adoption
Aside from the short-term lease practical expedient there aren’t scope exceptions for leases of assets that are individually relatively small in value such as copiers, printers, computers, or vehicles, which are common types of leases for professional services organizations.
To ease the adoption of ASC Topic 842 and subsequent accounting requirements, the FASB included a discussion of a portfolio approach in the Basis for Conclusion of ASU 2016-02 that may be used when “the entity reasonably expects that the application of the leases model to the portfolio would not differ materially from the application of the leases model to the individual leases in that portfolio.”
Accordingly, an organization may account for leases on a portfolio basis for lease contracts entered around the same time for similar assets with similar lease terms. This portfolio option requires management to calculate an appropriate weighted average lease term and discount rate as applicable.
An example may be the leasing of multiple laptops for consultants of an actuarial firm as part of a technology update when they are of the same make and model, entered into in the same month under a master leasing arrangement—or under individual agreements with the same terms and conditions.
3. Short-Term Leases
Often, professional services organizations rent storage or parking spaces on a month-to-month basis and many copier and printer leases may be for just one year. The new standard includes an accounting policy option that allows for short-term leases to be accounted for as an executory contract, similar to an operating lease under legacy GAAP.
A short-term lease is limited to those with a lease term of 12 months or fewer at commencement that doesn’t include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
However, a month-to-month lease with a legally enforceable extension option may not qualify as a short-term lease if it would be commercially disruptive or expensive to exit the lease. Such factors could cause the option to extend to be considered reasonably certain to be exercised such that the lease term could be determined to be more than 12 months.
4. Related-Party Leases
Under the new standard, lessees are required to account for related-party leases on the basis of the legally enforceable rights and obligations of the lease.
It’s recommended to take an inventory of leases that are both formally executed and informally agreed upon, which can be common among professional services organizations.
There’s additional judgment involved in determining lease terms, renewal options, and for how the lease is accounted for by both parties. While not required under the new standard, consider ensuring that all related-party lease agreements are appropriately documented in writing with sufficient specificity and are legally enforceable before implementation.
Not doing so will likely result in difficulties in adoption of the new standard and require further investigation of what legal rights and obligations have been created over time through past practices and informal communications, including oral arrangements and even emails.
Furthermore, you may need to involve legal counsel to provide guidance on what if any legally enforceable rights and obligations have been created in the absence of clearly written lease agreements that are fully executed.
5. Tenant Improvement Incentives
Professional services firms tend to spend significant amounts building out a leased space to accommodate the nature of their business and partial or full funding of such build-outs is often incorporated into the lease in the form of an improvement incentive from the lessor.
The first step is to evaluate whether the improvements are lessee or lessor assets, which is highly specific to facts and circumstances at hand. In general, if a lease doesn’t specifically require a lessee to make an improvement or requires the lessee to remove the improvement at the end of the lease, it will likely be considered a lessee asset.
However, if an improvement isn’t specialized and could be used by a subsequent tenant, is a major component of the leased asset’s electrical or mechanical systems, or is required to be left in place at the end of the lease and has remaining economic value, then it would likely be considered a lessor asset.
If a lessee incurs costs related to leasehold improvements that are determined to be lessee assets, they should generally be capitalized in accordance with ASC Topic 360, Property, Plant, and Equipment, and amortized over the shorter of their useful lives or the remaining lease term.
If the leasehold improvements are determined to be lessor assets, they should be capitalized and amortized by the lessor, and not the lessee.
Lessor payments to the lessee for leasehold improvements that are considered lessee assets should be accounted for as a lease incentive. The accounting for a lease incentive depends on whether the incentive is considered fixed and is paid or payable at lease commencement or is contingent on a future event or variable in some manner.
Lease incentives that are paid or payable by the lessor at lease commencement are deducted from lease payments, which will reduce the initial measurement of the lessee’s ROU asset. Lease incentives that are paid or payable at lease commencement will also reduce the initial measurement of the lease liability.
However, ASC Topic 842 doesn’t provide specific guidance on how to account for incentive payments that aren’t paid or payable at lease commencement, such as when the incentive provides for a maximum level of reimbursement to the lessee of qualifying construction costs related to the leasehold improvements and the total amount and timing is uncertain.
In this situation, one approach may be for the lessee to determine the amount of qualifying construction costs it’s reasonably certain to incur, consider that amount to be payable by the lessor at lease commencement, and include such amount in the determination of lease consideration for purposes of determining lease classification and the lease liability and ROU asset.
Any subsequent changes in that initial estimate would adjust the lease liability and ROU asset and be recognized prospectively over the remaining lease term. Alternatively, any changes in the initial estimate of qualifying construction costs to be reimbursed by the lessor could be accounted for as an adjustment to the lease liability and ROU asset and recognized as a cumulative catch-up adjustment to expense, as if the actual amount of reimbursed qualifying construction costs were known at lease commencement.
In contrast, lessor payments to the lessee for leasehold improvements that are considered lessor assets should be accounted for as a reimbursement of the lessor’s costs that were incurred by the lessee.
As the accounting for tenant improvement allowances and lease incentives is particularly complex under the new guidance, starting your evaluation early is recommended.
6. Lease Modifications
Professional services organizations often increase the amount of space leased in a building in the form of additional suites or floors to accommodate rapid growth in workforce.
The new standard defines a lease modification as a change to the terms and conditions of a contract that results in a change in the scope or the consideration for a lease. A modification such as the one described above should be treated as a separate contract when it grants the lessee an additional right of use not included in the original lease—additional suites or floors—and when the lease payments increase commensurate with the standalone price for the additional right of use.
In the event the additional consideration isn’t commensurate with the standalone price of the additional right of use at the date of the modification, including any additional lease incentives, the change should be accounted for as a modification of the existing lease which will require all the following:
- Reassessment of the lease classification
- Reallocation of the remaining consideration under the amended contract among lease and nonlease components
- Remeasurement of the lease liability using the appropriate discount rate as of the effective date of the modification
- Recognition of the remeasurement of the lease liability as an adjustment to the corresponding ROU asset
Conversely, a simple extension of a lease term or a reduction in space, as is commonplace due to COVID-19, doesn’t introduce an additional right of use and as such, wouldn’t be accounted for as a separate contract, but rather as a modification of the existing lease contract.
COVID-19 contributed to many organizations reducing the amount of leased space as employees working from home became increasingly popular and many organizations are considering, or already adopted, permanent work-from-home strategies that will require a smaller footprint.
Modifications of a lease that reduces the amount of leased space are accounted for as a lease modification which will require all the following:
- Reassessment of the lease classification
- Reallocation of the remaining consideration under the amended contract among lease and nonlease components
- Remeasurement of the lease liability using the appropriate discount rate as of the effective date of the modification
- Decrease the ROU asset proportionately to the reduction of the leased asset with any difference between the reduction of the lease liability and the reduced ROU asset being recognized as a gain or loss on lease modification at the effective date of the modification
Furthermore, COVID-19 resulted in a significant number of lease concessions for which the FASB staff issued some non-authoritative guidance in the form of a Q&A in April 2020.
Additional specific guidance applies when a finance lease modification doesn’t result in accounting for the modification as a separate contract and such modification results in the lease being classified as an operating lease.
Overall, it’s important for a professional services organization to closely analyze each in-scope lease contract to assess the proper accounting treatment and carefully assess changes made to those agreements.
7. Lease vs. Nonlease Components and Consideration of Land as a Separate Lease Component
ASC Topic 842 requires a lessee to identify the separate lease components and any nonlease components in a contract.
A lease component is considered separate from other lease components in the contract if both:
- The lessee can benefit from the right to use the asset on its own or with other resources readily available to the lessee
- The right to use the leased asset isn’t highly dependent upon nor highly interrelated with rights to use other assets in the contract
ASC Topic 842 provides for an accounting policy election, to be made by underlying class of asset, to account for a lease component and its related nonlease components as a single combined lease component.
A nonlease component includes goods and services provided to the lessee separate from the right to use the leased asset. Common examples include security, janitorial services, and common area maintenance.
Nonlease components exclude items that don’t provide a good or service to the lessee, such as administrative lease set up costs payable to the lessor or costs attributable to ownership of the leased asset such as property taxes and insurance.
Moreover, leases involving land must be evaluated as a separate lease component unless the accounting effect of not separately evaluating the land from the other assets in the lease is insignificant.
Under legacy GAAP, if the fair value of the land represents 25% or more of the total fair value of the real property subject to the lease, the land and building components required separate consideration. However, this 25% threshold is no longer applicable in ASC Topic 842.
As such, to determine whether the right to use the land is insignificant, the potential impact of separately assessing the land from the other assets must be evaluated.
In doing so, consideration should be given to the impact on matters including lease classification, value of the land in comparison to the value of the of the overall contract, timing and classification of expense or income recognition, classification of lease payments in the statement of cash flows, and financial statement disclosures.
Implementation Tips
For the professional services industry, here are some implementation tips to consider:
- Consider all lease contracts and service agreements for which a leased asset is embedded
- Formally document related party lease agreements before adoption
- Use the portfolio approach for small-ticket leases meeting the applicable criteria; it’s generally not meant for larger facility leases
- Remember that highly specialized leased assets will likely be classified as finance leases
- For entities with a large volume of leases, invest in a contract reading software that can help scan the lease agreement and extract certain relevant information
There are practical expedients to help ease transition. Organizations can elect not to perform the following upon transition:
- Reassess whether expired or existing contracts are or contain leases, reassess the lease classification for existing or expired leases, or reassess initial direct costs for existing leases—package of three expedients must all be elected and applied consistently to all leases
- Revisit estimates of lease terms—if elected, must be applied consistently to all leases
- Assess whether existing or expired land easements are or contain a lease
- Allocate consideration between lease and nonlease components if elected, must be applied consistently by class of underlying asset
- Recognize a ROU asset or lease liability for short-term leases—if elected, must be applied consistently by class of underlying asset
We’re Here to Help
For more information about the new lease standard, refer to our guide ASC Topic 842, Leases: The FASB’s New Guidance and Their Effect on Leasing Arrangements.
For additional questions or help understanding how the new standard may affect your business, contact your Moss Adams professional.
You can also learn more about our Professional Services Practice and additional topics affecting the industry.
