Identifying a lease: Implementing the new leases accounting standard

With this article, we begin a series to explore the new requirements for lessee’s presented by Accounting Standards Codification (ASC) 842, Leases, issued by the Financial Accounting Standards Board (FASB) in February 2016. In broad terms, the headline of the new standard is that virtually all leases now must be brought onto the balance sheet of lessees in accordance with requirements of the standard. After initial recording, the leases are then accounted for as an operating lease or as a finance lease, with different requirements for reporting in the income statement.

Simple enough? The devil is in the details.

Determining if a contract contains a lease

The first step in applying ASC 842 is determining whether a contract, which is defined as an agreement between two parties which creates enforceable rights and obligations, contains a lease. Basically the contract contains a lease if it conveys the right to control the use of identified property or equipment for a period of time.

In order to determine whether a customer has the right to control the use of the specified asset, for a period of time, the customer determines that it has both:

• The right to obtain substantially all of the economic benefits from the use of the asset, and
• The right to direct the use of such asset.
• An asset is identified, usually by specific terms in the contract; however, absent description in the contract, an asset can be implicitly identified at the time the asset is made available to the customer. For example, a lease for a forklift could be worded in two different ways:

1. The contract could specify the type, make and serial number of a specific forklift which is then provided to the customer, or
2. The contract could specify that a forklift will be provided and at the time of delivery.

In both cases, the customer has a specifically identified asset.

Substantive substitution right

It is possible that the contract permits the supplier to substitute one asset for another. In this situation, the customer must determine whether this is a substantive substitution right. If so, then the contract does not contain a lease. The supplier has a substantive right if both of these conditions exist: