Non-public business entities have enjoyed deferred adoption dates related to the new accounting model. However, the required adoption date is fast approaching, bringing with it changes to the definition of a lease and how leases are accounted for.
ASC 842 became effective for all public business entities for fiscal years beginning after December 15, 2018. Multiple ASUs have since been issued to modify certain aspects of ASC 842 following its initial issuance, including ASU 2020-05 - Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842), which was issued in June 2020 to defer the adoption date due to adverse impacts and disruption caused by the COVID-19 pandemic. As a result, ASC 842 is now effective for non-public business entities in the fiscal year beginning after December 15, 2021, and interim periods in the subsequent year.
For lessees under ASC 840, the costs associated with contracts meeting the definition of a lease and classified as an operating lease were only required to be presented on an entity’s income statement as the services were incurred. ASC 842 now requires the present value of the lease payments, as defined, be presented on an entity’s balance sheet as both a lease liability and right-of-use asset.
ASC 842 now requires the present value of the lease payments, as defined, be presented on an entity’s balance sheet as both a lease liability and right-of-use asset.
However, the presentation on an entity’s income and cash flow statements remains largely unchanged.
While a lessor’s adoption will not have as dramatic of a shift as a lessee’s, the FASB did revise certain aspects of a lessor’s accounting. The revisions include changes to certain definitions, such as those impacting the criteria for lease classification and alignment of certain control concepts with those within ASC 606 – Revenue from Contracts with Customers. While generally narrow, these revisions may impact lessors throughout the energy industry, including power providers and field service companies. (The impacts of lessors’ accounting, as well as any income tax and tax-related accounting and financial reporting ramifications of ASC 842, are beyond the scope of this article).
Some of the entities most heavily impacted by ASC 842 are those with capital-intensive business models, which is prevalent throughout the energy industry. While most entities have “common” leases such as office space, office equipment, and vehicles that would be subject to ASC 842, as entities with a capital-intensive business model generally utilize a significant number of service providers to execute their operational and development plans, those service agreements may also contain a lease as they often result in the service provider utilizing property, plant, and equipment to carry out their service. These arrangements are often determined to contain an “embedded lease.” For example, a drill rig contract; a well completion agreement; or a contract mining arrangement all may include provisions that meet the definition of a lease. Additionally, other common transactions throughout the energy industry, including power purchase agreements; easements for roads or pipelines; and contracts for natural gas transportation and processing, could all meet the definition of a lease depending on the specific terms and conditions of the agreement.
Some of the entities most heavily impacted by ASC 842 are those with capital-intensive business models, which is prevalent throughout the energy industry.
While many of these agreements, including those with an embedded lease, may have met the definition of a lease and generally been classified as an operating lease under ASC 840, they would not have been required to be accounted for on an entity’s balance sheet. Additionally, the expense recognition pattern of these arrangements was largely not impacted if accounted for under ASC 840 or as an executory contract as costs were generally accounted for when incurred, which in total resulted in a minimal impact if one of these agreements was “missed” and not accounted as a lease. However, as the ASC 842 accounting model now generally requires recognition on the balance sheet, the impact of “missing” accounting for a lease will have a much more significant impact on an entity’s financial statements.
What is a lease?
ASC 842 defines a lease as, “a contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration” (emphasis added). While this definition may seem simplistic, it is broad, and the application and analysis of each part may be complex and require significant judgment.
For an agreement to be considered a lease or to contain a lease, the assets listed within the agreement must be identified. This identification may be explicit, such as a specific drill rig or pipeline connection, or implicit, such as field equipment like a compressor with certain specified characteristics or a power plant within a power purchase agreement. However, an asset is not considered to be identified if the supplier has substantive substitution rights, which allows them to switch out that asset for another at-will, and the customer cannot prevent such substitution from occurring. If multiple assets are included within the agreement, each should be analyzed individually, as the right to use each may be considered a separate lease component. Further, sub-divisions of an asset, such as a floor of a building or a section of pipe in a gathering system, may also qualify as an identified asset.
ASC 842 provides certain scope exceptions, including those related to leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources; the intangible right to explore for those resources; and the right to use the land in which those resources are contained, such as certain rights-of-way and/or easements. However, the use of equipment to explore for those resources is not a part of the scope exception. Thus, leases meeting this scope exception will follow other applicable GAAP.
Right to control
The right to control centers around who provides direction during use of the asset, and who receives substantially all the benefits of the use of that asset.
To meet the definition of right to control, lessees must be able to direct how and for what purpose the asset is to be used without interference from an outside party including the supplier, other than reasonable restrictions considered protective rights, such as those required by law, regulatory requirements, or proper and safe use of the asset.
To meet the definition of right to control, lessees must be able to direct how and for what purpose the asset is to be used.
The lessee must also receive substantially all the economic benefits of the asset, directly or indirectly. This is often exhibited through the customer obtaining the primary outputs of the asset, such as the related drilling or completion services, or secondary outputs such as renewable energy credits. Judgment may be required when determining “substantially all.” For example, if a customer secures firm capacity on an interstate pipeline, the overall economic benefits of capacity received must be analyzed relative to the overall capacity of the segment of pipeline to determine if substantially all benefits are received by the customer. This analysis should be performed on lateral gathering lines as well because, while the “substantially all” threshold may not be met for a larger pipeline segment, it may be met for smaller segments.
Under certain arrangements in the energy industry, such as joint arrangements for oil and gas development and operations, multiple parties may work together to contract with a supplier, such as securing a drill rig. As these arrangements between the joint operating parties may take many forms, analysis should be performed to determine which party(ies) has the contractual arrangement with the supplier and which has the right to control the direction of the use of the identified asset. Consideration should also be given to the arrangement between the joint arrangement parties to determine if it is in substance a sublease requiring additional accounting considerations.
Period of time
The period of time refers to the noncancelable period of use of an asset that the supplier must provide to a customer. Generally, this is based around an amount of time that the asset is available to the customer, which may be expressed in units of time or in units of production. For example, a drill rig agreement may have an initial noncancelable period of a certain number of feet drilled, a certain number of wells drilled, or a certain number of months — each of which could be considered a term for a lease.
Agreements with extremely long or loosely defined terms — commonplace in easements — may still meet the definition of a period of time. For example, a 100-year easement still has an end date, an easement that is effective for as long as the well produces still has an expected finite life, and an evergreen easement that requires periodic payments still has an end date as the periodic payments are optional.
Many agreements contain both components that meet the definition of a lease as well as those that do not, such as maintenance services or crew time to operate the underlying asset. Unless a practical expedient is selected to combine lease and non-lease components, the overall lease cost should be allocated to the lease and non-lease components on a relative standalone sales price basis. As the cost of the lease is necessary for determination of the lease liability and right-of-use asset, determination as to whether the practical expedient is used or if allocation of the lease cost should be performed may have a significant impact on an entity’s balance sheet.
Lessees are provided an optional accounting policy election, by underlying asset class, to not recognize a lease liability or right-of-use asset for leases that, as of their commencement date, have a lease term of twelve months or less and do not include an option to purchase the asset that is reasonably certain to be exercised by the lessee. However, the lease term does include periods covered by an option to extend the lease that are reasonably certain to be exercised, which may require significant judgment.
The “right to control” concept is often present in a common easement or rights-of-way agreements within the energy industry. In many ways, easements may appear to meet the definition of a lease, as there is often a defined term, an identified asset, and a right to control that asset. However, depending on the purpose and use of the asset subject to the easement, the easement may not be in scope of ASC 842 as certain exceptions cover assets used to explore for oil and gas. However, for midstream entities and power providers, or upstream entities with gathering and transportation assets and operations, the scope exception may not apply if the easement is used as part of the gathering and transportation process and further analysis regarding the right to control should be performed, especially regarding whether the customer has the right to control some or all of the property subject to the easement. For example, if a midstream entity has an easement to lay and maintain an above-ground pipeline, or a power provider has an easement to run powerlines to its end users, the agreements could meet the definition of a lease if there is a restricted area, such as a fence, around the pipeline or poles holding the powerlines, as it would restrict the use of the property. However, if the pipeline or powerlines are buried underground and there are no restrictions on the use of the surface, it might not be considered a lease as the land can still be used for other productive activities, such as farming, grazing, or recreation.
Accounting for a lease
After a lease has been identified, the lease classification needs to be determined as it will drive the ultimate accounting method utilized. Two categories exist for lessees within the new standard: Finance and Operating. Finance leases are defined as having at least one of the following characteristics:
- The lease contains a transfer of ownership provision
- The lease contains an option to purchase the asset that is reasonably certain to be exercised
- The term of the lease is for the major part of the remaining economic life of the asset
- The present value of lease payments is greater than or equal to substantially all of the fair value of the asset
- No alternative use exists for the asset after the end of the lease.
The first four characteristics are generally consistent with the provisions within ASC 840 for determining if the lease was a capital lease; however, these characteristics under ASC 842 contain fewer “bright-lines” than those under ASC 840. While many of these terms have precise definitions, judgment is still necessary upon application. However, the fifth item is new and attempts to identify situations where a custom property, plant, or equipment was built and substantively financed through a lease rather than other financing sources. All leases not meeting any of the five characteristics are considered operating leases.
For finance and operating leases, the initial accounting for a lease liability and right-of-use asset is identical. The initial lease liability is the present value of the sum of the lease payments over the lease term. To determine this amount, the lease term, lease payments, and discount rate must be determined:
- Lease term: The lease term is the noncancelable period for which the lessee has the right to use the underlying asset, including periods covered by an option to extend the lease that the lessee is reasonably certain to exercise, and options to terminate the lease that the lessee is reasonably certain not to exercise. The determination of “reasonably certain” requires judgment and estimates and may take into consideration all relevant factors related to the agreement and renewal terms, including additional costs during the renewal periods, past practice, and availability of alternative assets and their cost.
- Lease payments: The lease payments include fixed payments, less any incentives received by the lessee from the lessor payable at the commencement date, plus variable payments based on a rate or index. Variable payments not based on a rate or index, such as those based on throughput or usage, are not included in determination of the initial lease liability and will be recognized as incurred.
- Discount rate: The discount rate used should be the discount rate implicit in the lease, unless that rate cannot be readily determined by the lessee, which is often the case. If so, the lessee should use the incremental borrowing rate (on a collateralized basis over a similar term and economic environment). If an entity is not a public business entity, a risk-free rate may be utilized. As the use of a risk-free rate may have a significant impact on the amount of the day-one lease liability, and a related impact on the prospective amount of associated interest, other factors should be considered before a risk-free rate is elected.
The right-of-use asset is computed as the sum of the initial lease liability, any lease prepayments, and any initial direct costs.
For operating leases, the income statement recognition generally mirrors that of ASC 840. The amount recognized is generally the average of the total lease payments, resulting in a straight-line recognition amount, unless another systematic allocation is deemed more appropriate based on the asset’s usage.
The lease liability is accreted each period based on the initial discount rate and is reduced based on each payment made. The sum of the interest expense associated with the lease liability’s accretion and the amortization of the right-of-use asset is equal to the straight-line single lease cost. Due to the straight-line nature of the single lease cost and higher interest expense associated with the lease liability accretion, the amortization associated with the right-of-use asset is less in the earlier years of the lease than it is in the latter years of the lease, resulting in a higher net book value in those earlier years as compared to finance leases. As a result, the right-of-use asset may be more susceptible to impairments early in the lease term, which follows the same impairment accounting model as most other long-lived assets.
The classification of this single lease cost should be based on the nature of the underlying asset. For example, while an office lease would generally be classified within operations, costs associated with the lease of a drill rig could be capitalized if the nature of the cost was associated with capitalizable activities, pursuant to other applicable GAAP.
For finance leases, the amount and timing of lease cost recognition is nearly unchanged from that of capital leases within ASC 840. This differs from operating lease classification and recognition as there is not a concept of a straight-line single lease cost for finance leases. The interest expense associated with the lease liability is presented as a financing charge and the amortization associated with the right- of -use asset is presented with other similar amortization, unless other applicable GAAP dictates otherwise as in the earlier example of costs associated with a drill rig and potential capitalization. The result of this classification for finance leases is that higher total lease costs are generally recognized earlier in the life of the lease due to interest expense on a larger lease liability combined with a consistent, straight- line amortization associated with the right-of-use asset.
There are also numerous additional financial statement footnote disclosures required by ASC 842, which are generally lengthier and more detailed than those of ASC 840.
There are also numerous additional financial statement footnote disclosures required by ASC 842, which are generally lengthier and more detailed than those of ASC 840.
If a lease is modified through a change to the terms and conditions of the related contract, then reassessment of whether the contract contains a lease is necessary, including whether the modification resulted in a separate new lease, or a change in the current lease, including remeasurement of the lease liability and adjustment of the right-of-use asset.
As there are complexities throughout ASC 842 — including determining which agreements are within the scope of the guidance, classification, and calculation of the initial and ongoing lease liability and right-of-use asset — adoption of this standard may involve numerous stakeholders within an entity and overall implementation may be a significant, time-consuming endeavor.
Adoption can be done via two methods: retrospectively applied to the earliest period presented in the financial statements, or retrospectively applied to the beginning of the period in which the standard was adopted. While only adopting for the most recent period may be the least complex option, this option requires all prior periods to continue to be presented under prior guidance. As such, if significant leases exist, this method may make the financial statements much less comparable pre- and post-adoption.
The FASB provided certain practical expedients to allow for smoother transitions, regardless of the adoption method selected:
- Hindsight: When a lease commences, all estimates must be made at that time. This practical expedient allows an entity to consider all facts and circumstances known at the time of adoption in assessing the lease term and impairment considerations.
- Package of three: If selected, the assessment of whether a contract contained a lease, classification of the lease, and initial direct costs treatment of all leases existing prior to adoption need not be reassessed upon adoption. All three of these items must be selected together, and all existing leases must be accounted for as such. However, this practical expedient does not allow for grandfathering of the incorrect classification of leases under prior guidance, and as such, entities electing this should consider the completeness of their lease population and prior accounting and classification conclusions upon adoption as well as any potential embedded leases.
- Existing land easements: If selected, all existing land easements at the adoption date may continue to be accounted for as they were previously. All easements entered into during the adoption year, and subsequently, must be assessed using the ASC 842 model.
- Non-lease components: An entity can make an accounting policy election, by underlying asset class, to not separate the non-lease components from the lease components, resulting in those amounts being included with the lease-related consideration. While this expedient may simplify the initial calculation of the lease liability and ease the administrative burden of separating and allocating costs to lease and non-lease components, it will result in a higher value for the initial lease liability and right-of-use asset.
This new standard will have wide-reaching impacts across many industries, including the wide range of entities that operate throughout the energy industry given the capital-intensive nature of the industry and reliance on service providers for performance of many activities. Initial determination of a complete listing of potential contracts that meet the definition of a lease — including identification of embedded leases, as well as the initial calculation of the lease liabilities and right-of-use assets — can be complex and may require significant judgment. Many public entities that have already adopted ASC 842 have identified determining the complete listing of leases as one of the biggest challenges they face primarily due to the significant impact that embedded leases have under ASC 842.
Many public entities that have already adopted ASC 842 have identified determining the complete listing of leases as one of the biggest challenges.
Given the breath of this standard, its adoption may also have significant impacts to an entity’s internal control processes, information and software systems, bank covenants, and other key metrics and stakeholder considerations.
While many entities have enjoyed the ability to defer the adoption for several years, if an entity has not begun planning for its implementation, the time is now.
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