Welcome to the module on lease accounting.

We're going to be talking about a new leasing standard that was

issued recently by the FASB under ASC 842.

It's an entirely new leasing model that was issued in

response to perceived problems with the old leasing model.

What was the problem?

The major problem was off-balance sheet financing.

This came up as a result of some accounting scandals,

as a part of the Sarbanes-Oxley Act.

The SCC was asked to issue a report on off-balance sheet financing.

The FASB did start a project.

It took more than a decade to get a project up because

it still remains a very difficult and complex topic.

What do we mean by off-balance sheet financing?

Well, a lease is like that.

You owe money.

It's not cancellable.

You're going to have to make the payment.

Many of them are,

regardless of what happens,

even if the buildings destroyed or the equipment's destroyed,

you still have to make lease payments.

They're a form of ownership in a way.

They're a form of ownership of a right of use.

So after many, many years of trying to decide

exactly how to account for this liability that you have to make payments,

when you don't really have an asset,

the FASB and the IASB came up with the concept of a right of use asset,

and that's what we're going to be discussing.

Now, this was a joint project between the FASB and the IASB.

But at the end, after a decade of trying,

they did fail to converge.

The IASB opted for a single model.

That means that all leases are finance leases from the perspective of the lessee.

The FASB, however, retained a dual model,

where some leases are still classified as operating leases in order to

retain a straight-line lease expense for recognition.

On the lessor side,

both lessors made only minor changes to the lessor model.

In fact, that was a deliberate policy especially in the part of the IASB.

They proposed many changes,

but they weren't readily accepted in

the marketplace and the users of the financial statements

that commented pointed out that they

weren't really concerned about the lessor accounting model.

That wasn't an issue to them.

So not too many changes were proposed to the lessor model directly.

However, because there's another standard that was issued at

about the same time and this is ASC 606 and the IFRS world,

IFRS 15, that changed the way revenue recognition Is accounted for.

That had some impact on lessor accounting,

and you'll see some of that as we go through the lease model.

So let's start off with what is a lease?

Well, this was actually a very difficult question to answer,

and it was one of the last issues that was answered by

the boards when they wrote the standard.

A lease is a contract that conveys the right to use an underlying asset.

There has to be an underlying tangible asset for a period of time,

there has to be a lease term,

in exchange for consideration.

So a contract can contain a lease if

fulfillment depends on the use of an identified asset.

It can't be a right to use a group of assets at any time.

So if I have a membership in a gym,

and I have the right to use all of the equipment for a period of time,

the fact that it's not specifically identified which equipment

that I would be using and that multiple people

could be using the equipment at the same time,

that wouldn't be a lease because I wouldn't have the right to

control the use of the identified asset.

So it contains a lease if it's an identified asset,

and the contract conveys the right to control the use of the identified asset.

So why is this important?

Well, if it doesn't meet the definition of the lease,

it's going to be what's called an executory contract.

That's actually kind of an important term in accounting these days because

an executory contract means it's a contract where neither party has performed yet.

So if an arrangement,

if a contract is an executory contract,

such as like a service rather than a lease,

that obligation is going to remain off-balance sheet.

It won't be recorded.

So there's going to be an incentive to try and structure arrangements that are

perhaps near leases or could be a lease that

somehow they'll fall into this non-lease category and,

therefore, remain off-balance sheet.

So, again, what is a lease?

One of the issues that comes up is substitution.

Does the lessor have a substantive right to substitute another asset?

Well, what do we mean by substantive?

That means that if the supplier,

we're not sure if it 's a lease yet so we can't call them a lessor,

if the supplier can substitute alternative assets without the consent of the customer,

and there's no barriers,

economic or otherwise, it would prevent the supplier from doing that,

then maybe there's a substantive right to substitute,

and maybe the arrangement isn't a lease.

So if I lease a car,

that car is going to be mine.

The lessor wouldn't have a substantive right to come

in and sit there and take it out of my garage and say,

"Here, here's another one.

We're going to substitute for it,

and we're not talking about issues that arise if there's a warranty issue.

That's excluded from this."

The lessor would have to have a substantive right and

an interest in doing that without my consent.

This could happen, for example though,

if I was engaging a railroad to provide railway carts to take away goods from a factory.

I may not care which railway cart comes up to the door,

and they put the goods in,

and the railroad may have a substandard right to

substitute them for their benefit at any time.

That would not be an identified asset because it would

be a substantive right to substitute another asset.

What kind of barriers could there be that you could have

costs that create an economic disincentive to substitute assets?

This could be anything from the location of the assets.

It may be difficult for the lessor to do that,

or there could be operational barriers, such as availability.

What is the right to control use?

This is a sort of a new concept.

We've had control of an asset before that came up in the discussion of consolidations,

but this is a right to control use.

Again, a new concept.

So a contract conveys the right to control use if the customer

has the right to obtain substantially all of

the economic benefits from use and the right

to direct the use of the asset throughout the period of the lease, throughout the term.

So you have to be obtaining substantially all of

the economic benefits and the right to direct the use of it throughout the lease term.

That's why the gym isn't going to be a lease.

Economic benefits that can be obtained in order to

determine if I've got substantially all the benefits.

This would be the primary outputs and any by-products, too,

that are associated with that lease including

potential cash flows that could be derived from those items.

Benefits also include payments from

third parties that relate to the use of the identified asset,

so if I'm able to sublease part of it.

Economic benefits relating to the ownership of the asset are ignored.

This is the big but.

So you don't include tax credits or depreciation.

However, you can include certain energy credits, for example,

for solar arrays, this is also a major topic of discussion.

What's the right to direct use?

Well, when assessing the right to direct use of the identified asset,

the key question is which party can direct how

and for what purpose the asset is used throughout the period of use.

And that can be determined

either contractually where the contract says you can only use it for

this specific purpose without amending

the contract or the contract could give you the right to decide how you want to use it,

what hours you might want keep a restaurant open,

what type of food you would want to serve, et cetera.

So the decision-making rights,

the standard gives several examples of what would be

relevant: the right to change what type of output is produced,

the right to change when it's produced, where it's produced,

which wouldn't apply to real estate obviously if you're leasing it,

or the right to change how much of the output is produced.

So let's take an example of that and take a look at how that could work.

Let's use shipping as an example.

So, we have a customer that charters a specifically identified ship.

I get to use of this ship.

The supplier does not have substitution rights.

They can't bring in a rust bucket and replace it with

this nice beautiful ship I've just chartered.

The customer determines what cargo will be

transported and the timing and location of delivery throughout the contract.

The supplier, though, operates and maintains the ship.

They provide the crew,

they operate the ship,

and they are responsible for the cargo on board the ship.

They have risk of loss.

In fact, usually, most of these arrangements,

the customer cannot operate the ship,

and you cannot hire another operator.

Well, it's a lease. The arrangement is a lease because

the customer/lessee has the ability to direct the use of

the ship by making the decisions that most

significantly affect the cash flows to be derived from use,

where it's going, when it's going, what it's carrying.

Let's change that just a little bit and look at contract shipping.

So now, customer enters into a contract for all of the capacity of

a specified ship to transport cargo from point A to point B.

So this is the same thing,

we're still taking the entire ship and there's no right of substitution for it.

But now, I've contracted that it can only be used to carry goods from point A to point B.

It can only go from Singapore to San Francisco,

for example, and nowhere else.

The customer can determine the cargo to be transported and

the timing and location of the delivery at point B,

but I can't change the shipping instructions

without changing the terms and conditions of the contract.

The supplier operates and maintains

the ship and is responsible for the cargo on board the ship,

same as before. Is this a lease?

No, it's not a lease.

The contract, not the lessee,

not the customer, determines how and for

what purpose the ship will be used during the period of transportation.

So the customer does not have

any decision-making rights after the contract commences about the use of the ship.

In order to change the destination,

you have to change the contract.

So there can be a subtle difference

sometimes between what is a lease and what is not a lease.

And this is going to be a source of tension.

That's why we're spending so much time on that in this opening, in this lesson.

So as you go forward,

we're going to need to look at a lot of

service contracts and we're going to have to ask ourselves,

do they contain embedded leases?

Some contracts that are to use

underlying assets may not constitute the right to control the use.

Some contracts that today we never even would have

considered as having a lease can include in them,

may in fact have one.

And there could, again, be an incentive to structure the contracts to achieve

a particular result as the differences may be sort of inconsequential.

So here's a chart that sort of summarizes where we are here.

Is there an identified asset?

If no, it doesn't contain a lease.

Does the customer have the right to obtain largely all of the economic benefits from

the use of the asset throughout the duration of use, throughout the lease term?

If it's no, they don't have a lease.

Who has the right to determine?

How, and for what objective the asset is used?

Is it the supplier? There wouldn't be a lease.

Is it pre-determined, and the customer directs the asset?

If that's a no, it's not a lease.

So again, if it's contractually determined,

predetermined and can only be changed by amending the contract,

that would be effectively that the supplier has a right to do it.

And there's going to be questions about this,

how broad can that definition be,

that contractually definition be?

So expect a lot of judgment to be

required in many cases to determine whether or not a contract contains a lease.

There are some practical expedients that can help a little bit,

and these are exceptions to the lease model.

The first one is very important,

and that's leases with a term of 12 months or

less are going to be exempted from applying these lease requirements,

so they will just be treated as an executory contract,

the same way you recognize the expense is more or less as you go.

Now, when they originally proposed this exception,

the contracts could not be renewable at all and they amended it before it

was issued to say that they can be renewable but you can't structure it,

so that it's just a series of 12-month contracts that are definitely going to be renewed,

that it's reasonably certain they're going to be renewed and avoid the standard that way,

but there will be some potential for structuring within there.

Under IFRS and IFRS only,

small value leases were excluded,

and that is leases of less than about 5,000.

They didn't really want to put a dollar figure on there but when they finally did,

they said about $5,000,

so there are exceptions.

So definition of a lease is going to be

very important because lease accounting is changing,

it's becoming more complex,

it's going to put a lot more on the balance sheet.

And so, the definition of a lease is going to be

a very important issue as we go forward. Thank you.

Definition of a Lease

Accounting Analysis II: Measurement and Disclosure of Liabilities

Meet the Instructors