Update On The Current State of Lease Accounting For Financial Reporting Purposes
By William Redpath
March 23, 2021
The portion of United States financial accounting standards that involves lease accounting has recently undergone major changes. Right-of-use leases, including IRUs (Indefeasible Rights of Use), are important assets to telecommunications companies, including those involved with submarine cables as lessors or lessees.
This post is addressed to non-accountants (although accountants are welcome consumers of this article), so I will address lease accounting standards and these changes at a rather high level.
Financial accounting rules in the United States are set by the Financial Accounting Standards Board (FASB), based in Norwalk, CT, which is empowered by the Securities and Exchange Commission (SEC) to set accounting standards for all companies that file their financial results with the SEC. The FASB does this through its issuance of Generally Accepted Accounting Principles (GAAP), which also usually must be adhered to by private companies in their audited, reviewed or compiled financial statements.
As an aside, accounting standards for most other nations are issued by the International Accounting Standards Board (IASB). Although there has long been discussion of a “convergence” of GAAP and the IASB’s International Financial Reporting Standards (IFRS), that has not yet happened, and that is not in the foreseeable future.
I also want to note that this post addresses only financial accounting, not tax accounting, for leases. Tax accounting for leases is not within the purview of the Financial Accounting Standards Board (FASB), but is a matter of tax law in the United States and was not affected by the issuance of ASB 842.
Before I get to the lease accounting changes brought about by ASC 842, a predicate issue must be addressed: What qualifies as a lease? The rules by which an agreement qualifies as a lease have been tightened in ASC 842.
A lease agreement involves at least two parties, a lessor and a lessee, and an asset that is to be leased. A lease involves Property, Plant or Equipment (PPE). Assets to which ASC 842 does not apply include intangible assets, natural assets (such as timber or coal), inventory, assets under construction, and financial assets.
The lessor is the party that agrees to provide the lessee with a right to use an asset for a specified period of time in return for consideration.
Leases can be structured in many different ways, and that leads to the accounting complexity with leases. The structure of a lease can include allocation of income tax benefits between lessor and lessee. Leases can be used to transfer ownership or control of the leased asset.
From an accounting perspective, what truly matters with leases is the substance, not the form, of a lease transaction. If the essence of a lease transaction is to effectively transfer ownership or control of an asset to the lessee, then the substance of the transaction is that of a sale, and it is recognized as such for accounting purposes even though the transaction is, in form, structured as a lease.
Specific PPE must be identified in the lease. An example might be three strands of a dark fiber optic cable. The three strands would have to be specifically identified, and the lessor would have to have no practical ability to, at any time, substitute some other strands for the identified strands and would not benefit from doing so. If a lessor makes available to a lessee any three available strands, at the lessor’s choosing, at any time, the agreement does not qualify as a lease. It would then be a service contract, which has different accounting rules than leases.