When ASC 842 – Leases (“ASC 842”) was first published in 2016, the effective date for non-public entities was scheduled for 2020. The date seemed so far away that most people took the, “we will cross that bridge when we come to it” approach. To be fair, most people were too concerned about the new revenue recognition standard (ASC 606) to worry about anything else.
But here we are in 2019. If you are a public company, ASC 842 is already in effect. And for all non-public companies, the bridge is here and we are going to need to think about crossing it.
Right off the bat, the biggest change ASC 842 made is that most leases are now required to be recorded on the balance sheet as “Right of Use” assets with corresponding lease liabilities. Similarly to how the new revenue recognition standard redefined a 5-step process of when and how you recognize revenue, ASC 842 not only changed how we treat leases, it actually redefined on a conceptual level, what actually constitutes a leasing arrangement. Under ASC 842, a lease is a contract, or part of a contract, that conveys the right to control the use of an explicitly or implicitly identified asset for a period of time in exchange for consideration.
First of all, we should determine if there is an identified asset. Because no identified asset = no lease. Now, in order for there to be an identified asset, the supplier must not have substantive substitution rights. ASC 842 defines substitution rights to be substantive only if the supplier has 1) the practical ability to substitute alternative assets throughout the period of use and 2) would benefit economically from the substitution.
Once an identified asset is, well, identified, we move on to determine if the arrangement conveys the right to control the use of this asset. ASC 842 defines this as having both 1) the right to obtain substantially all the economic benefits from the use of the asset and 2) the right to direct the use of the asset. To put it simply, think of this in terms of having both economic and physical control of the asset.
Okay, that was a lot of definitions, but why is that important? Because of this change, one of the biggest challenges in applying ASC 842 is determining whether an arrangement or portion of an arrangement is a lease. Contracts that previously were not considered to be a lease, might fall under this definition. Let’s take a common colocation arrangement for example. Historically, a colocation arrangement is a monthly service contract that is expensed as incurred. However, under ASC 842, the details of the arrangement must be closely evaluated to determine if there is a right to control the use of the identified asset. Does the arrangement call for a specific dedicated area of the data center for use? Can the servers and equipment easily be replaced by the supplier without interruption? Would the supplier have any economic incentive in this equipment change? Are you using substantially all of the entire capacity of the data center? These are but a few questions you must ask when reevaluating your arrangements under the new lease guidance.
Once you have determined that you have a lease, the next step will be determining the components of the lease, which will ultimately impact the Right of Use asset and Lease liability. Come back next time, we will go a little further across that bridge.