It is old news that accounting standards have changed and the Financial Accounting Standards Board (FASB) imposed new lease accounting standards. The FASB issued its guidance for new leasing standards, ASU 2016-02 (known as “ASC 842”), in February 2016, stating that its purpose is to “change the accounting requirements so that lessees would be required to recognize the rights and obligations resulting from leases as assets and liabilities.” (ASC 842, Summary; see also 842-10-10-2.) And while the FASB lease standards are not “new,” ASC 842 becomes effective on Dec. 15, 2019, for private companies.

“Accounting standards” and “legal advice” are phrases that are not typically thought about together. However, meeting the standards in ASC 842 will require significant legal analysis. To prepare for the lease accounting standards taking effect in December, private companies will need to review and evaluate their contracts, obligations, and even some deals they might not realize fall under the lease standards. The depth and breadth of this contract analysis necessitates that a company’s legal advisers should be included in the ASC 842 preparations. This is borne out by the significant hurdles, growing pains, and unexpected challenges public companies faced in implementing ASC 842 by December 2018 as referenced in a Feb. 16, 2019, CNBC article.

This article highlights some of the “sticky” legal questions that can arise during this process, and how calling in legal support is necessary to resolve the questions that arise in applying FASB ASC 842. Naturally, because these changes will impact a company’s reporting of its assets and liabilities, its accountants will also need to provide advice and analysis regarding compliance with ASC 842.

At its most basic, ASC 842 asks a single question: Is the lease a “financial lease” or an “operating lease”? The answer to this question determines how the lease obligation is recognized in the company’s financial statements. Unpacking whether an obligation falls into the financial lease or operating lease category requires several layers of analysis, including legal analysis. As the saying goes, “The devil is in the details.”

First Steps: Determining Whether A Lease Exists

The first steps in the ASC 842 analysis are determining whether a lease exists, and whether there are lease and non-lease obligations in a contract or agreement. These first steps are also where legal issues can arise. This problem is best illustrated through examples:

Company A rents airplanes. A customer signs a contract that allows them to take possession of the airplane, make monthly installment payments toward the total price, and have full control of the plane while making payments. Does Company A lease its planes?

A: It depends. Depending on the particular circumstance of each rental, it is possible that in some situations, Company A rents its planes, in some it leases its planes, and in others it even sells its planes. (See ASC 842-40-25-1.)

Company B rents airplanes. A customer does not sign an agreement, but agrees with Company B on a price, a time period for the return, and that they will return the plane when the rental period is finished. Does Company B lease its planes?

A: Yes. Even without a written agreement, so long as the elements of a lease exist, Company B is deemed to lease its planes. (ASC 842-40-25-1 (citing ASC 606-10-25-1 (listing the criteria for concluding a contract exists)).)

Determining if a lease exists requires analyzing whether an obligation relates to an “identified asset,” whether there is a contract that “conveys the right to use and control” of that identified asset (in exchange for consideration), and whether there is payment over a period of time. (ASC 842-10-15-3.) Once those requirements are satisfied, ASC 842 then looks to whether the contract conveys “the right to obtain substantially all of the economic benefits from use of the identified asset,” and “the right to direct the use of the identified asset.” (ASC 842-10-15-17 to 15-19; 842-10-15-20 to 15-26.) ASC 842 states that leases arise based on the rights and obligations, not any specific formalities or magic words. Since a contract can arise without any written deal or terms, complying with ASC 842 therefore requires reviewing contracts the company determines are leases, as well as those contracts and obligations not originally deemed leases, which potentially includes “handshake” agreements.

Next Complications: Separating Lease and Non-Lease Components

After determining that a lease exists, ASC 842 requires that the contract be separated into specific lease and non-lease components (ASC 842-10-15-3), which necessitates a detailed review of the contract and further legal analysis. ASC 842 does not allow non-lease components of a contract to be accounted for alongside lease components. (ASC 842-10-15-28.) It requires that the company separate lease components, allocate them, and determine the price of each. (ASC 842-10-15-33.) The company has to allocate the “relative standalone price” and “the consideration in the contract on a relative standalone price basis.” (ASC 842-10-15-33; 38.) As illustrated by this example, dividing consideration leads to some interesting results:

Company A, which makes auto parts, leases equipment from Company B for three years. For a single price, Company B provides the equipment, safety consulting during the installation of the equipment, and consultants to advise Company A on manufacturing the auto parts more efficiently. Does Company A have a lease, and if so, how does it account for this under ASC 842?

A: Yes, Company A has a lease, and there are both lease and non-lease components that must be separated. (ASC 842-10-15-33.) Company A has to break down the lease and separate it into its lowest separable lease/non-lease components, determining each component for which consideration passes between parties. (ASC 842-10-15-28.) Fortunately for Company A, this lease breaks into three constituent parts: the equipment lease, safety consulting, and efficiency consulting. Working with its accounting team, the company would have to allocate some portion of the purchase price to each component of this contract. (ASC 842-10-15-33.)

This problem compounds as agreements become more complex. When payment amounts are variable, if price is contingent on other factors, or when an agreement is loosely defined, both the legal and accounting teams will be working hard to sort out contract lease puzzles.

Further Complications: Forward and Backward Looking Standards

Next, when ASC 842 becomes effective in December, contracts under negotiation and closed deals are both subject to its requirements because it is a forward- and backward-looking standard. And its considerations are not static once a contract is assessed the first time. When a contract is changed, ASC 842 may require that the lease classification changes. Again, the problems that can arise are shown through an example:

Company A signs a contract with Company B. The contract provides that for a single price Company B will lease equipment to Company A for three years, provide safety consulting for installing the equipment, and provide consulting to promote efficient use of the equipment. Company A planned the contract to have a three-year lifespan because it believed that the auto manufacturer it supplies would change models after three years. However, the auto manufacturer decides to delay its model change one year, and Company A informs Company B that it will keep the equipment for an additional year. Company B offers that if Company A keeps the equipment for the additional year, Company A can also choose to purchase the equipment after the fourth year for a small, single payment. Does Company A have to reassess and account for this lease based on these changes?

A: Yes, Company A’s lease has been modified. On the new terms—even though no new contract was signed—the original lease must be remeasured and reassessed. (ASC 842-10-35-4.) The changes mean that Company A will have to remeasure the remaining consideration between lease components and any new consideration, lease components, and non-lease components added in this modification. (ASC 842-10-35-4.)

With ASC 842 poised to take effect in December 2019, private companies should now begin consulting with their legal and accounting advisers to prepare for the coming changes, make strategic decisions, and avoid some of the obvious challenges that may arise. Working together, company management, legal counsel, and an accounting team can review current agreements and determine how best to handle their future relationships and leases.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Kevin D. Oles is a lawyer in Thompson Hine LLP’s Business Litigation and Construction practice groups. He counsel clients in a number of areas, including corporate litigation, construction disputes, and international arbitration. Jim Balthaser leads the firm’s Private Company Counseling group; is a member of the firm’s Corporate Transactions & Securities practice; and handles numerous state and local tax matters. He counsels his clients on a broad spectrum of legal issues. His experience includes—but is not limited to—mergers and acquisitions, private equity infusions, equity and equity-based compensation, corporate governance, financing arrangements, strategic alliances, and restructuring and/or reorganization of businesses.