The FASB published accounting standards updated (ASU) 2016-02, Leases (Topic 842) in February 2016, which created accounting standards codification (ASC) Topic 842, Leases. Since issuing ASU 2016-02, the FASB has deferred the effective dates of ASC Topic 842 for certain entities.
Most recently, the FASB acknowledged that entities could face limited resources due to the COVID-19 pandemic and provided an additional one-year deferral of the effective date for certain entities.
ASC 842 is effective for private companies for fiscal years beginning after December 15, 2021. Although this effective date is forthcoming, many agribusiness companies have yet to start preparing to adopt this new accounting standard.
Three-Phased Approach to Implementation
As your agribusiness organizes its adoption approach, explore a step-by-step process broken into three phases.
3 Adoption Challenges for Agribusiness
1. Variable Consideration
ASC Topic 842 requires that most leases be recorded on the balance sheet and are represented by both an asset and a liability. The lease liability recorded on the lease commencement date should be equal to the present value of the remaining lease payments discounted using the appropriate discount rate.
The right-of-use (ROU) asset recorded on the lease commencement date should be the sum of the lease liability and any lease payments made to the lessor at or before the commencement date, minus any lease incentives received by the lessee, and any initial direct costs incurred by the lessee.
When calculating the lease liability and ROU asset, the lease payments for a lessee should consist of the following:
- Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee
- Variable lease payments that depend on an index or a rate
- Payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease
- Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction
- Amounts probable of being owed by the lessee under residual value guarantees
Leases are often structured so that a lessee is required to pay the lessor both a fixed amount of consideration and variable amount of consideration. Variable payments that aren’t tied directly to a rate or index aren’t considered lease payments, and as such, are excluded from the lease liability and ROU asset calculations.
Variable consideration can often be found in agribusiness leases to allow for both the lessor and lessee to share the risk and reward of the commodity’s value, such as a crop-share arrangement. Under a crop-share arrangement, the lessee pays the lessor a percentage of the value received from the sale of the crop grown on the leased property.
In agribusiness, it’s common practice for companies to lease orchard property from third parties for the purpose of farming and producing a marketable crop.
In this example, the lessee agrees to farm the orchard and is required to remit 30% of the orchard’s net proceeds to the lessor each year as a form of variable consideration. In addition to the variable component, the lessee will pay the lessor $300,000 in fixed consideration for each of the next five years.
The lessee must determine the lease liability and ROU asset that should be recorded on the balance sheet at the lease commencement date. This would be calculated by discounting the lease payments, which consist of the five fixed payments of $300,000 each—totaling $1.5 million to the lease commencement date.
The lessee’s discount rate should be that which is implicit in the lease whenever such rate is readily determinable. However, when the implicit rate isn’t readily determinable—likely often—the lessee should use its incremental borrowing rate for debt collateralized by the underlying leased asset for a term the same as the lease term.
Nonpublic business entities are permitted to make an accounting policy election by class of underlying leased asset. When the rate implicit in a lease isn’t readily determinable, the entity would use a risk-free rate of a comparable period to the lease term.
The amounts expected to be paid to the lessor for the 30% of the crop proceeds wouldn’t be included in the lease liability or ROU asset as these variable payments don’t depend on a rate or index. They instead would be expensed when the variable nature of the consideration is resolved, which is when the crop is sold and net proceeds are determinable.
2. Leases that Contain Land
Another consideration under ASC Topic 842 relates to leases containing land. The new standard requires a separate evaluation of the lease of land whether the lease explicitly includes land or it’s merely implied.
For orchard leases, even if the lease agreement is silent on land, it would be assumed a portion of the consideration would be for the underlying land.
The right to use the land is to be accounted for as a separate lease component, unless there’s no effect on lease classification of any lease component or the amount recognized for the land lease component would be insignificant.
3. Biological Assets
ASC Topic 842 doesn’t apply to leases of biological assets. While US GAAP doesn’t specifically define biological assets, paragraph BC110 in the basis for conclusion to ASU 2016-02 refers to plants and living animals as biological assets. Our interpretation of this guidance leads us to believe that bearer plants, such as fruit and nut trees, would be considered biological assets and as such, would be excluded from the scope of ASC Topic 842.
At first glance, this scope exception appears to simplify the accounting treatment for agribusiness companies that lease property containing biological assets, but upon further consideration it may create additional accounting challenges as the biological assets would need to be accounted for as a nonlease component.
Nonlease components aren’t within the scope of the updated lease guidance, and ASC Topic 842 requires lease components to be accounted for separately from nonlease components—unless the accounting policy to not separate nonlease components from lease components is elected.
A typical orchard lease includes the rights to use the trees, the land, and all the improvements associated with the production and maintenance of the trees—such as trellis and irrigation equipment.
- The trellis equipment and the irrigation system typically would be considered one lease component as the rights to use the trellis equipment and the irrigation system are highly dependent as they’re designed to work together to ensure the trees grow and produce fruit or nuts.
- The right to use land typically wouldn’t be accounted for as a separate lease component as the effect of accounting for the right to use the land as a separate lease component would generally be insignificant because the agribusiness company’s right to use the trellis equipment and irrigation system is coterminous and separating the right to use the land from the right to use the trellis equipment and irrigation system wouldn’t affect the lease classification of the trellis equipment and irrigation system component.
- The right to use the trees would be considered a nonlease component as they’re considered biological assets and are excluded from the scope of ASC Topic 842.
This conclusion produces the practical dilemma of how to allocate consideration to the lease and nonlease components. Generally, lease agreements don’t explicitly allocate the consideration of the lease to the specific lease and nonlease components.
Additionally, lease agreements typically aren’t structured to lease the trees without the land and interrelated components of trellis equipment and irrigation systems. This can make it challenging to determine the standalone prices of the various components.
Two accounting options for handling lease and nonlease components are discussed below, and in these examples, the land isn’t considered a separate lease component from the trellis equipment and irrigation system.
Accounting Option One
Follow the guidance in paragraph 842-10-15-33 and allocate the consideration in the contract on a relative standalone price basis to the following lease and nonlease components.
The portion of the payments allocated to the trees would be excluded from lease payments and determination of the ROU asset and lease liability under ASC Topic 842.
This method may be challenging as the agribusiness company will need to determine an amount to allocate to the lease component consisting of the land, trellis equipment, and irrigation system and the nonlease component consisting of the trees.
The company would need to document and defend its allocation method. When recognized, the variable payments excluded from consideration would also need to be allocated between the lease and nonlease components on the same basis.
Accounting Option Two
Elect the nonseparation practical expedient under paragraph 842-10-15-37 to not separate the lease and nonlease components. In doing so, a company would make an accounting policy election to not separate the trees from the land, irrigation system, and trellis equipment, and instead account for the lease and nonlease components as a single lease component.
While this method typically leads to a larger ROU asset and lease liability, as compared to the accounting under option one above, it may also be less complex to apply as the company wouldn’t need to allocate the consideration between the lease and nonlease components.
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 agribusiness company, contact your Moss Adams professional.