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What Qualifies as a Lease under the New Lease Standard?

Under ASC 842, a lease is defined as a contract that conveys the lessee the right to control the use of a physically distinct, explicitly or implicitly identified asset by having both the right to substantially all economic benefits and the right to direct the use of that asset, requiring recognition of a corresponding asset and liability on the balance sheet, while arrangements allowing substantive substitutions or lacking control do not qualify as leases.

What is Considered a Lease Under ASC 842?

Not all arrangements qualify as a lease under the new standard’s definition of a lease. Sometimes it’s easy to determine if your arrangement is a lease; for example, renting office space, copier, and vehicle leases are clearly leases.

However, there are situations where payments for the use of an asset may not be considered a lease. Understanding the definitions is important to ensure proper accounting. There are also exceptions to these rules, which are discussed below.

What is the Accounting Definition of a Lease?

Under the new leasing standard, all leases must be recognized as both an asset and an offsetting liability for future lease payments. This is a significant change from the previous standard, where operating leases were not reflected on the balance sheet.

A key factor in determining whether you have a lease is whether the contract gives you the right to control or use an asset. Additionally, the asset must be explicitly or implicitly identified and be physically distinct.

Who Controls the Asset?

To meet the new definition of a lease, the lessee must control the asset. If the lessee does not control the asset, there is no lease, even if the asset is explicitly identified in the contract. Both of the following requirements must be met to qualify as a lease:

  1. 1.The lessee has the right to substantially all of the economic benefits through the period of time.
  2. 2.The lessee has the right to direct the use of the identified asset.

Explicitly Identified Assets

In most cases, an asset is explicitly identified—such as office space or equipment installed and used onsite. However, if an agreement allows for substantive substitutions, the contract may not be a lease.

For example, if a manufacturer specifies a particular model but the actual equipment used is interchangeable and still satisfies the contract, this arrangement does not fall under the definition of a lease. Similarly, a supplier who outsources their obligation to unspecified and interchangeable third parties may not meet the lease definition.

Lease substitution terms are not automatically considered substantive. For example, a contract that allows the lessor to replace an asset for a defect or requires a lessor to substitute other assets at specified dates may still be considered a lease.

Two factors must be true for a substantive substitution right to exist and not result in a lease:

  1. 1.The supplier must have the practical ability to substitute the asset throughout the period of use.
  2. 2.The supplier benefits economically by substituting the asset.

Implicitly Identified Assets

There are situations where an asset isn’t explicitly identified, yet the contract is a lease. For example, a healthcare company may pay a data center to store patient-related information. While the supplier may use any portion of their data center, a privacy and security provision in the contract may require the data center to use a specific asset to comply with the contract terms.

Identified Assets are Physically Distinct

An identified asset must be physically distinct, which could be the entire asset or just a portion of an asset. Examples include a building or a floor within a building. Another example is a billboard in a stadium; if the contract specifies the use of a specific billboard for advertising, it is physically distinct. A pipeline with a specific capacity could also be physically distinct if the contract includes the use of substantially all of the pipeline capacity.

Exceptions to the Rules

There are exceptions to the lease standard. For example, the standard does not require lessees to apply the guidance to leases with a term of 12 months or less.

Certain leasing scenarios are exempt from consideration under the new definition of a lease, including:

  • Leases of intangible assets (e.g., goodwill)
  • Leases to explore for or use non-renewable resources (e.g., oil, natural gas)
  • Leases of biological assets (e.g., timber, livestock)
  • Leases of inventory or assets under construction
  • Under IFRS standards, you may elect not to apply the new lease standard if the underlying asset is of low value.

Have Questions?

Lease accounting can be complex under the new standards. If you have questions, consider reaching out to a lease accounting professional or using lease accounting software to help ensure compliance and accuracy.