On July 18, 2018, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2018-10, Codification Improvements to Topic 842, Leases. The update provides clarification around certain guidance in the new lease accounting standard.
The ASU clarifies implementation questions brought to the FASB’s attention by stakeholders and makes other technical corrections. Some of the ASU’s more significant amendments are included below.
Rate Implicit in the Lease
Under FASB Accounting Standards Codification® (ASC) Topic 842, a lessor uses the rate implicit in the lease to measure its net investment in a sales-type or direct financing lease. For a lease with significant variable payments, the calculation of the rate implicit in the lease can sometimes result in a negative rate.
The amendments clarify the rate implicit in a lease can’t be less than zero. In such cases, entities should use a rate of zero rather than a negative rate.
As a result, some sales-type or direct financing leases with significant variable payments may require a lessor to recognize an initial day-one loss at lease commencement. This can occur when the calculation of a lessor’s initial net investment is lower than the carrying amount of the underlying asset being derecognized.
Lessor Reassessment of Lease Term and Purchase Option
The amendments clarify a lessor must account for a lessee exercising an option to extend or terminate a lease—or to purchase the underlying asset as a lease modification—unless the exercise of the option is consistent with assumptions made by the lessor on the later of these dates:
- Lease commencement
- Most recent modification
Variable Lease Payments that Depend on an Index or Rate
ASC Topic 842 requires lease payments to be remeasured when a contingency affecting variable lease payments is resolved.
The amendments clarify that changes in a reference index or other rate upon which variable lease payments are based don’t qualify as the resolution of a contingency. Accordingly, these types of changes don’t require a remeasurement of lease payments.
When ASC Topic 842 is initially applied, any previously unamortized initial direct costs that no longer meet the topic’s narrower definition of initial direct costs should be written off as an adjustment to equity.
The update clarifies that only those initial direct costs incurred before the beginning of the earliest period presented in the financial statements should be written off as an equity adjustment. Any initial direct costs incurred on or after the beginning of the earliest reporting period should be written off through earnings in the period they were incurred.
Impairment of Net Investment in the Lease
ASC Topic 842 requires a lessor to assess the net investment in a lease for impairment and record a loss allowance when necessary.
The ASU clarifies that when calculating the loss allowance, a lessor must account for any cash flows expected to be received during and after the end of the remaining lease term from the following:
- Lease receivable
- Unguaranteed residual asset
Failed Sale and Leaseback
When a sale and leaseback transaction doesn’t qualify as a sale under ASC Topic 842, the seller-lessee is required to adjust the interest rate on its financial liability to prevent negative amortization.
The update clarifies that the interest rate should be adjusted so interest on the financial liability doesn’t exceed total payments on the financial liability.
Transition and Effective Dates
For entities that early adopted ASC Topic 842, this ASU is effective upon issuance.
For entities that haven’t early adopted ASC Topic 842, the changes should be applied using the effective dates currently required under Topic 842. This means they’re effective for fiscal years beginning after December 15, 2018, including interim periods within those financial years, for any of the following:
- Public business entities
- Not-for-profit entities that have issued, or are a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or over-the-counter market
- Employee benefit plans that file financial statements with the US Securities and Exchange Commission
All other entities are required to adopt the new lease standard in fiscal years beginning after December 15, 2019, and interim periods in fiscal years beginning after December 15, 2020. Early adoption is permitted for all entities.
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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.