New FASB Rules on Accounting for Leases: A Sarbanes-Oxley Promise Delivered

New FASB Rules on Accounting for Leases:

A Sarbanes-Oxley Promise Delivered

By Donald J. Weidner*

Congress responded to the ﬁrst ﬁnancial accounting scandals of the new millennium by

enacting the Sarbanes-Oxley Act of 2002, which required the Securities and Exchange

Commission (“SEC”) to study issuers’ ﬁlings and report on whether their ﬁnancial state-

ments reﬂect the economics of off-balance sheet arrangements to investors in a transparent

fashion. In 2005, the SEC reported that there “may be approximately $1.25 trillion in non-

cancellable future cash obligations committed under operating leases that are not recog-

nized on issuer balance sheets, but are instead disclosed in the notes to the ﬁnancial state-

ments.” Accordingly, the SEC requested that the Financial Accounting Standards Board

(“FASB”) craft new rules to record more lessee liabilities on the balance sheet.

In 2016, the FASB issued sweeping new rules that affect virtually every ﬁrm that leases

assets “such as real estate, airplanes, and manufacturing equipment.” In a dramatic change

in approach, every lease extending more than twelve months will be capitalized and re-

corded on the lessee’s balance sheet as reﬂecting both a “right-of-use asset” and a corre-

sponding liability. The new rules move away from the formalism of bright-line rules and

toward an afﬁrmative obligation to record economic substance. This article provides an

overview of the history, policy, and mechanics of the new rules, which are likely to have

a signiﬁcant economic impact on many companies.

I. INTRODUCTION

A lease can be deﬁned as a contractual obligation that allows an asset owned

by one person to be used by another over a period of time in exchange for con-

sideration. Leases can be long or short, for one payment or multiple payments,

and for ﬁxed or varying payments. They can cover any type of tangible asset,

from computers and airplanes to land and buildings. They can cover only a

small portion of the useful life of the underlying asset, or they can cover most

or all of it. They can be entered into for various objectives, including economies

of scale, ﬂexibility, the reduction of exposure to the risk of full ownership of the

underlying asset, the obtainment of greater access to capital, or tax objectives and

accounting advantages.

* Dean Emeritus and Alumni Centennial Professor, Florida State University College of Law. The

author would like to thank Steve Johnson, Thomas Linsmeier, Mary McCormick, Kevin McGavock,

and Marcia Sampson. Special thanks to Jeffrey Rubin and Dean Vail for their meticulous and extra-

ordinarily generous suggestions over multiple drafts.

367

The ﬁnancial accounting scandals that came to light in the early 2000s made

clear that to a widespread and systemically signiﬁcant extent, lessees that were

the substantive owners of heavily leveraged properties were keeping both the

asset and the liability off their balance sheets.

Companies took advantage of the

applicable ﬁnancial accounting standards then in place to keep more than one tril-

lion dollars of liabilities off their balance sheets. The ﬁnancial accounting standards

were more reﬂective of form than of substance: they treated users as mere tenants

with no obligation to record their long-term lease obligations on the balance sheet.

In this respect, lease obligations were treated in a similar fashion to other operating

expenses, except in those few situations in which leases were required to be cap-

italized. Current and prior ﬁnancial accounting standards permitted companies to

ﬂunk fairly mechanical tests to disqualify themselves from ownership status. If they

were not the substantive owners, their long-term lease obligations needed not be

recorded as assets or liabilities on the balance sheet. Accordingly, many very signif-

icant, long-term lease obligations were excluded because the leases did not r epre-

sent substantive ownership. For example, a ﬁrm that leases a new building for ﬁf-

teen years has made a signiﬁcant long-term commitment but has not been required

to record that commitment on its balance sheet.

Part II of this article explains the still-applicable “old” FASB rules that have

permitted public companies to keep far in excess of one trillion dollars of

long-term lease liabilities off their balance sheets. Part III discusses the SEC re-

port ordered by the Sarbanes-Oxley Act of 2002 to address the phenomenon of

off-balance sheet ﬁnancing. The SEC report found fundamental faults with the

old rules and recommended that the FASB craft new rules to record more lessee

liabilities on the balance sheet.

Part IV is the core of this article. It analyzes Accounting Standards Update No.

2016-02,

which the FA SB issued in February 2016 in response to the SEC re-

port and other calls for reform. These new rules on lease accounting are exten-

1. Over the centuries, the form of a lease has been used to mask the substance of a ﬁnancing ar-

rangement. Purported tenants were often the substantive owners of the underlying asset. For exam-

ple, sale leasebacks were used to avoid various religious proscriptions against charging either interest

or excessive interest. Rather than lending money to an owner of an asset and charging a prohibited

interest, the provider of funds or credit would avoid the label “lender” and instead purchase the asset

from the owner seeking ﬁnancing and contemporaneously lease it back to that person. The “rent”

would provide the “landlord” with a return of investment plus proﬁt and leave the tenant in posses-

sion. Alternatively, a seller on credit would simply lease an asset to the would-be purchaser. See gen-

erally Donald J. Weidner, Synthetic Leases: Structured Finance, Financial Accounting and Tax Ownership,

25 J. C

ORP. L. 445 (2000) [hereinafter Weidner].

2. Many of these same ﬁrms successfully claimed they were the substantive owners and borrowers for

purposes of the federal income tax law. It is common and perfectly appropriate for companies to have

two very different sets of books: one for ﬁnancial accounting purposes and another for federal income

tax purposes. Taxpayers are permitted to take tax reporting positions that differ from their ﬁnancial ac-

counting positions. See Frank Lyon Co. v. United States, 435 U.S. 561, 577 (1978) (“[T]he characteri-

zation of a transaction for ﬁnancial accounting purposes, on the one hand, and for tax purposes, on the

other, need not necessarily be the same.”); see also Thor Power Tool Co. v. Comm’r, 439 U.S. 522, 542

(1971) (referring to “the vastly different objectives that ﬁnancial and tax accounting have”).

3. Fin. Accounting Standards Bd., Accounting Standards Update No. 2016-02, Leases (Topic 842)

(Feb. 2016) [hereinafter ASU 2016-02], adding Accounting Standards Codiﬁcation 842 [hereinafter

ASC 842].

368 The Business Lawyer; Vol. 72, Spring 2017

sive and represent a major change in approach. They will have widespread im-

plications throughout the economy. The purpose of this article is to analyze the

core concepts in the new rules and explain how they differ from the old rules. In

short, the new rules require most business leases for more than a year to be re-

corded on the lessee’s balance sheet as reﬂecting both an asset and a liability. For

income statement purposes, the rules continue a modiﬁed version of the distinc-

tion between operating leases and ﬁnance leases. Part IV concludes by consider-

ing the effective date, transition rules, and major impacts of ASU 2016-02. Part V

offers a few ﬁnal conclusions.

II. THE “OLD” FASB APPROACH TO BALANCE SHEET RECORDING

The still-applicable old rule that has allowed many lease obligations to be kept

off balance sheets is Statement of Financial Accounting Standards No. 13, which

was ﬁrst issued in 1976.

It says that unless a lease is a “capital” lease, it need not

appear on the lessee’s balance sheet. It is a capital lease only if, under very spe-

ciﬁc rules, it transfers substantially all the beneﬁts and burdens of ownership to

the lessee. It deﬁnes a “lease” as “an agreement conveying the right to use prop-

erty, plant or equipment . . . usually for a stated period of time.”

Thus, SFAS 13

applies to agreements that may not even be “nominally identiﬁed as leases.”

The

old approach of SFAS 13 continues in effect until the new rules are effective, ei-

ther in 2019 or 2020, depending on the nature of the ﬁrm.

A. FOUR TESTS TO DISTINGUISH A “CAPITAL” FROM AN “OPERATING”

EASE

To be an off-balance sheet arrangement under SFAS 13, the lease must be clas-

siﬁed as an operating lease rather than as a capital lease.

SFAS 13 states that a

lease is a capital lease if it meets any one of four criteria. If none of those criteria

is met, the lease is treated as an operating lease.

A lease is classiﬁed as a capital lease if it meets one or more of the following

criteria:

(a) the lease transfers ownership of the property to the lessee by the end of

the lease term;

(b) the lease contains a bargain purchase option to purchase the leased

property;

4. See Fin. Accounting Standards Bd., Statement of Financial Accounting Standards No. 13, Ac-

counting for Leases (Nov. 1976) [hereinafter SFAS 13].

5. Id. at para. 1.

6. Fin. Accounting Standards Bd., Emerging Issues Task Force Issue No. 01-8: Determining

Whether an Arrangement Contains a Lease at para. 7 (May 2003).

7. The precise effective date of the new rules depends on whether the company is public or pri-

vate. See infra Part IV.

8. See SFAS 13, supra note 4, at para. 7.

9. Id.

New FASB Rules on Accounting for Leases 369

life of the leased property; or

(d) the present value, at the beginning of the lease term, of the minimum

lease payments equals or exceeds 90 percent of the fair value of the

leased property to the lessor at the inception of the lease.

Stated differently, if a lease passes any one of these four tests, the lessee will be

required to record it as a capital lease on its balance sheet.

B. CONSEQUENCES OF A CAPITAL LEASE

Treating the lease as a capital lease means several things. First, the lessee re-

cords the capital lease as an asset and as an obligation at an amount equal to the

present value, at the beginning of the lease term, of the minimum payments over

the lease term.

If both land and buildings are involved, they must be separately

capitalized in proportion to their fair values at the inception of the lease.

Sec-

ond, any capitalized building asset must be amortized.

Third, each minimum

lease payment must be allocated between a reduction of obligation and interest

payment.

Finally, “a termination of a capita l lease must be accounted for by

removing the asset and obligation” and recognizing gain or loss for the differ-

ence.

However, if a lease has none of the four characteristics of a capital

lease, it is treated as an operating lease.

C. CONSEQUENCES OF AN OPERATING LEASE

If a lease is an operating lease, the asse t is not recorded on the lessor’s balance

sheet,

and the lessee ordinarily records rent expense over the lease term only as

it becomes payable. The lessee is not required to record either an asset or a long-

term liability on the balance sheet proper. However, the lessee must disclose, at

least in a note to the ﬁnancial statements, certain minimum future lease pay-

ments.

In addition, if the lessee is a public company, it may be required to

make disclosures regarding both capital and operating lease obligations in man-

agement disclosures.

10. Id.

11. Id. at para. 10.

12. Id. at para. 26.

13. Id. at para. 11.

14. Id. at para. 12.

15. Id. at para. 14(c).

16. If the lease is from a special purpose entity (“SPE”) afﬁliated with the lessee, the lessee and the

SPE may be required to prepare a consolidated ﬁnancial statement, thus indirectly recording the lease

on the lessee’s balance sheet. See Weidner, supra note 1, at 458–62.

17. SFAS 13, supra note 4, at para. 19(a).

18. Id. at para. 16(b).

19. U.S. S

EC.&EXCH.COMM’N,REPORT AND RECOMMENDATIONS PURSUANT TO SECTION 401(C) OF THE

SARBANES-OXLEY ACT OF 2002 ON ARRANGEMENTS WITH OFF-BALANCE SHEET IMPLICATIONS,SPECIAL PURPOSE EN-

TITIES

, AND TRANSPARENCY OF FILINGS BY ISSUERS 62 (July 2003) [hereinafter SEC REPORT], https://www.sec.

gov/news/studies/soxoffbalancerpt.pdf.

370 The Business Lawyer; Vol. 72, Spring 2017

D. CORE CONCEPT:CAPITALIZE ONLY IF YOU OWN UNDERLYING

ASSET

At its core, SFAS 13 requires balance sheet recognition only if an “ownership”

model is satisﬁed. The four criteria of SFAS 13 are said to be derived from the

concept that a lease must be capitalized only if it transfers substantially all the

beneﬁts and risks of ownership to the tenant, even if it is not equivalent in sub-

stance to a purchase:

[A] lease that transfers substantially all of the beneﬁts and risks incident to the own-

ership of property should be accounted for as the acquisition of an asset and the

incurrence of an obligation by the lessee and as a sale or ﬁnancing by the lessor.

All other leases should be accounted for as operating leases. In a lease that transfers

substantially all of the beneﬁts and risks of ownership, the economic effect on the

parties is similar, in many respects, to that of an installment purchase. This is not

to say, however, that such transactions are necessarily “in substance purchases” as

that term is used in previous authoritative literature.

The drafters of SFAS 13 thought that its principal contribution was to extend the

“substantially all of the beneﬁts an d risks” analysis to lessees and thereby require

certain lessees to report according to the same principles that are applied to

lessors.

The drafters probably never anticipated the extent to which companies would

structure lease obligations speciﬁcally to ﬂunk all four of the SFAS 13 tests for

lease capitalization and thereby avoid recording lease liabilities on the balance

sheet. Companies wanted lease obligations to be treated more like ordinary op-

erating expenses, which are not included on the obligor’s balance sheet. For ex-

ample, obligations to compensate employees are generally not on the balance

sheet, even if the employees are under long-term contracts. As the SEC would

report decades later, “lease structuring to meet various accounting, tax, and

other goals” became “an industry unto itself in the last 30 years.”

20. SFAS 13, supra note 4, at para. 60.

21. Id. at para. 61 (“The transfer of substantially all the beneﬁts and risks of ownership is the con-

cept embodied in previous practice in lessors’ accounting. . . . However, a different concept has ex-

isted in the authoritative literature for lessees’ accounting. . . . [Earlier authority] required capitaliza-

tion of those leases that are ‘clearly in substance installment purchases of property,’ which it

essentially deﬁned as those leases whose terms ‘result in the creation of a material equity in the prop-

erty.’ Because of this divergence in both concept and criteria, a particular leasing transaction might be

recorded as a sale or as a ﬁnancing by the lessor and as an operating lease by the lessee.”). The FASB

explained its reason for rejecting the argument that the only leases that should be capitalized are

those that are in substance installment purchases: “Taken literally, the concept would apply only

to those leases that automatically transfer ownership. All other leases contain characteristics not

found in installment purchases, such as the reversion of the property to the lessor at the termination

of the lease.” Id. at para. 69.

22. SEC R

EPORT, supra note 19, at 63.

New FASB Rules on Accounting for Leases 371

III. SARBANES-OXLEY AND THE SEC R EPORT

A. THE SARBANES-OXLEY ACT

A number of ﬁnancial accounting scandals boiled to the surface in 2001 and

2002, including those involving Enron and WorldCom. Reﬂecting a sentiment

that the rules relating to ﬁnancial reporting and the entire audit function needed

to be improved, Congress responded by enacting the Sarbanes-Oxley Act of

2002 (“SOX”).

Also referred to as the Public Company Accounting Reform

and Investor Protection Act in the Senate and as the Corporate and Auditing Ac-

countability and Responsibility Act in the House, SOX introduced a broad array

of reforms to the ﬁnancial reporting system in the United States. Among other

things, SOX created the Public Company Accounting Oversight Board to in-

crease the oversight of auditors of public companies.

It also required key cor-

porate ofﬁcers to provide periodic certiﬁcations regarding a company’s disclo-

sure controls and procedures, internal control over ﬁnancial reporting, and

certain other matters.

Section 401(c)(1) of SOX required the SEC to conduct a study of ﬁlings by

issuers and to issue a report addressing two primary questions: (1) the extent

of off-balance sheet arrangements, including leases and the use of SPEs; and

(2) whether generally accepted accounting rules result in ﬁnancial statements

that reﬂect “the economics of such off-balance sheet transactions to investors

in a transparent fashion.”

B. THE SEC REPORT

1. Magnitude of the Problem and Call for Reform

The SEC Report, released on June 15, 2005, is the result of an empirical study

of ﬁlings by 200 issuers and a qualitative review of generally accepted ﬁnancial

accounting standards in the United States. The SEC Report concluded that there

“may be approximately $1.25 trillion in non-cancellable future cash obligations

committed under operating leases that are not recognized on issuer balance

sheets, but are instead disclosed in the notes to the ﬁnancial statements.”

Ac-

cordingly, the SEC Report recommended that the accounting guidance for leases

be reconsidered.

23. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codiﬁed as amended in scat-

tered sections of the U.S.C.).

24. Id. § 201, 15 U.S.C. § 78j (2012) (directing the SEC to establish rules prohibiting auditors

from providing certain nonaudit services to audit clients).

25. Id. §§ 901–906, 18 U.S.C. §§ 1341, 1343, 1349, 1350, & 29 U.S.C. § 1131 (2012).

26. Id. § 401(c)(1)(B).

27. SEC R

EPORT, supra note 19, at 4. The $1.25 trillion does not include amounts attributed to

non-SEC registrants.

28. Id.

372 The Business Lawyer; Vol. 72, Spring 2017

2. Critique of SFAS 13

The SEC Report’s basic critique of SFAS 13 related to its all-or-nothing treat-

ment of leases. Despite the tremendous diversity in leasing arrangements, “all

leases receive one of two opposing accounting treatments; either the lease is

treated as if it were a sale or as if it were a rental.”

If most of the risks and re-

wards of ownership are transferred to a lessee, the lease is treated as a sale of the

entire asset by the lessor and as a purchase of an asset ﬁnanced with debt by the

tenant. Stated differently, if the lease is a capital lease, the whole of the asset is

treated as sold.

The lessee records on its balance sheet both the asset and the

related liability at the present value of the required lease payments.

If instead

the lease does not meet any of the four SFAS 13 tests to be a capital lease, it is

classiﬁed as an operating lease and treated as a rental contract. The lessee does

not record either an asset or a related liability on its balance sheet, “but records

leasing expense in its income statement, also on a period-by-period basis.”

The SEC Report was not precisely correct when it stated that the “intention” of

SFAS 13 “is to treat those leases that are economically equivalent to sales as sales,

and to treat other leases similar to service contracts.” As explained above, the

stated intention was slightly different. The core concept of SFAS 13 is to treat

a trans fer of “substantially all” of the beneﬁts and burdens of ownership as a

sale, even if it does not rise to the level of a true sale.

Nevertheless, the basic

point of the SEC Report is correct: the current approach “does not allow the bal-

ance sheet to show the fact that, in just about every lease, both parties have some

interest in the asset, as well as some interest in one or more ﬁnancial receivables or

payables.”

The SEC Report correctly concluded that the all-or-nothing result of passing

or failing the bright-line tests of SFAS 13 means that “economically similar ar-

rangements” may receive different accounting treatment—if they are just to

one side or the other of the bright line.

It is easy to see that a lease that commits

a lessee to pay 89 percent of an asset’s value is not very different from a lease that

commits a lessee to pay 90 percent of the asset’s value. Nevertheless, the treat-

29. Id. at 60.

30. Id.

31. Id. Conversely, the lessor removes the cost of the asset from its balance sheet and reports its

sale for an amount “equal to the present value of the required lease payments, plus the expected re-

maining value of the leased asset at the end of the term.” Id.

32. Id. at 61. The lessor keeps the asset on its balance sheet and records rental income in its in-

come statements as well as depreciation.

33. See SFAS 13, supra note 4, at paras. 61, 69. Indeed, at the time SFAS 13 was promulgated,

some members of the FASB held

the view that, regardless of whether substantially all the beneﬁts and risks of ownership are

transferred, a lease, in transferring for its term the right to use property, gives rise to the acqui-

sition of an asset and the incurrence of an obligation by the lessee which should be reﬂected in

his ﬁnancial statements.

Id. at para. 63. This is, of course, the view that ultimately carried the day in ASU 2016-02.

34. SEC R

EPORT, supra note 19, at 62.

35. Id.

New FASB Rules on Accounting for Leases 373

ment of the two is dramatically different because only the latter lease passes one

of the four SFAS 13 tests for a capital lease, and so only the latter lessee must

record the long-term liability and the corresponding asset on its balance sheet.

Conversely, the SEC Report was also concerned that under SFAS 13, “econom-

ically different transactions may be treated similarly.”

It noted that despite the

“different economic signiﬁcance,” both a one-month lease and a ten-year lease of

a building have “little to no balance sheet impact” if they are both classiﬁed as

operating leases. It acknowledged, however, that the “extensive disclosures for

leases do provide some information about the rights and obligations inherent

in operating leases.”

Finally, the SEC Report noted that although SFAS 13 may have been an effec-

tive innovation when it was ﬁrst introduced,

its bright-line rules have been

gamed to a startling degree:

[M]any issuers involved in leases, taking advantage of the bright-line nature of the

lease classiﬁcation guidance, structure their lease arrangements to achieve whatever

accounting (sales-type/capital or operating) is desired. These issuers have been aided

in these endeavors by a large number of attorneys, lenders, investment banks, ac-

countants, insurers, industry advocates, and other advisors. Indeed, lease structur-

ing to meet various accounting, tax, and other goals has become an industry unto

itself in the last 30 years.

3. Recommendation of New Rules on Leases

The focus of the SEC Report “is on the standards themselves and recommen-

dations tend to focus on what changes the FASB, as the accounting standard-

setter in the U.S., should consider.”

Most fundamentally, the SEC Report rec-

ommended that the FASB reconsider the “all or nothing” approach of SFAS 13:

The current “all or nothing” lease accounting guidance is not designed to reﬂect the

wide continuum of lease arrangements that are used, and therefore, it cannot transpar-

ently and consistently reﬂect the varying economics of the underlying arrangements.

In addition, the SEC Report cautioned against bright-line rules that invite

gaming to treat similar arrangements quite differently.

Finally, the SEC Report

recommended that the FASB reconsider lease accounting rules that focus on con-

tractual cash inﬂows and outﬂows to determine the amount of assets and liabil-

ities to record on balance sheets.

Lease accounting based on cash ﬂows “would

36. Id. at 63.

37. Id.

38. Id. (“Indeed, the current accounting guidance, which is criticized by many, would likely be

held in much higher regard were it being applied to the lease arrangements that existed when it

was debated and created.”).

39. Id.

40. Id. at 3.

41. Id. at 105–06.

42. Id. at 106.

43. Id.

374 The Business Lawyer; Vol. 72, Spring 2017

generally require both parties in lease agreements to report their economic inter-

ests in the leased assets as well as assets and/or liabilities related to payments

mandated by the lease agreement.”

The SEC Report acknowledged that it was sending the FASB a project that was

highly complex, extremely controversial, and internationally signiﬁcant. It was

complex because of the tremendous variety of leases and lease mechanisms, “in-

cluding contingent rents, optional extensions, penalty clauses, purchase options

and others that each will require consideration.”

It was controversial because

of the widespread practice of lease structuring:

The fact that lease structuring based on the accounting guidance has become so

prevalent will likely mean that there will be strong resistance to signiﬁcant changes

to the leasing guidance, both from preparers who have become accustomed to de-

signing leases that achieve various reporting goals, and from other parties that assist

those preparers.

The project was signiﬁcant internationally both because many foreign investors

and creditors rely on the ﬁnancial statements of U.S. ﬁrms and because many for-

eign ﬁrms prepare their ﬁnancial statements in accordance with FASB standards.

The leasing project was also signiﬁcant because of the interest, here and

abroad, in greater convergence between the U.S. Generally Accepted Accounting

Principles (“GAAP”) of the FASB and the International Financial Reporting Stan-

dards (“IFRS”) adopted by the International Accounting Standards Board

(“IASB”). The SEC Report noted that the “FASB, as part of a group of standard

setters known as the G4+1, has considered, in depth,” lease accounting reform

measures.

Perhaps most broadly, the SEC Report encouraged expanded use of

the IASB’s “objectives-oriented” or “principles-based” accounting rather than the

FASB’s more rules-based accounting.

Stated differently, the SEC Report en-

couraged the FASB to move away from the formal structure of transactions

and toward judgments about their economic substance. Accordingly, the SEC

44. Id. at 106. The SEC Report also noted that “sophisticated users, such as credit-rating agencies,

often adjust balance sheets in their work so they can analyze companies as if all leases were reﬂected

on the balance sheet.” Id.

45. Id.

46. Id. at 63.

47. Id. at 106. Members of the G4+1 included the Australian Accounting Standards Board, the Ca-

nadian Accounting Standards Board, the International Accounting Standards Committee, the New

Zealand Accounting Standards Review Board, the New Zealand Financial Reporting Standards

Board, the United Kingdom Accounting Standards Board, and the FASB.

48. Id. at 3 (recommending an expanded “use of objectives-oriented standards, which would have

the desirable effect of reducing complexity in accounting methods”). Not everyone has been in favor

of the direction the move has taken. See, e.g., Letter of Sen. Carl Levin to Russell G. Golden, Chair-

man, Fin. Accounting Standards Bd. 4 (Oct. 14, 2014) (“U.S. GAAP has been the gold standard for

ﬁnancial reporting requirements and has contributed to this success [at attracting and fostering for-

eign investment]. In contrast, the IFRS rely more on principles than requirements, invite multiple

interpretations, have been more difﬁcult to enforce, and have been subjected to abusive practices

to circumvent effective accounting disclosures. In many instances, IFRS permit less transparency

and greater variations in ﬁnancial reporting than GAAP.”).

New FASB Rules on Accounting for Leases 375

Report recommended that the FASB proceed jointly with the IASB on the leasing

project.

IV. THE NEW FASB RULES: ASU 2016-02

A. O

VERVIEW OF THE JOINT PROJECT OF THE FASB AND THE IASB

Encouraged by the SEC Report and by other critics of the old leasing rules, the

FASB and the IASB in 2006 together undertook to formally revise the ﬁnancial

accounting standards for leases. Each group hoped that its new rules would re-

ﬂect the true economic position an entity enters into when it obtains access to

capital in the form of a lease. They sought “to improve and converge” their ex-

isting standards to record lease obligations on a ﬁrm’s balance sheet.

As the

SEC Report had predicted, the project was both complicated and controversial.

The two groups issued a 2009 discussion paper,

which was followed by a ﬁrst

exposure draft in 2010. Reactions to the ﬁrst exposure draft were intense.

As the SEC Report had predicted, there was strong resistance to the signiﬁcant

changes embodied in the ﬁrst exposure draft. The U.S. Chamber of Commerce

(“Chamber”), together with a variety of other private groups primarily from the

real estate industry, commissioned a study of the economic impact of the FASB/

IASB exposure draft. The study, which was prepared by Chang & Adams Con-

sulting and released in February 2012, predicted dire economic consequences if

the exposure draft were adopted:

The capitalization of operating leases would impact a broad number of ﬁnancial

metrics that are used by investors, causing a number of ﬁrms to violate their lending

covenants and retarding their ability to acquire new credit. It would force ﬁrms to

cut their spending. And it would generate losses in real estate value.

49. Id. at 106. The FASB and the IASB had already signed the Norwalk Agreement of 2002, in

which they committed to develop “high-quality, compatible accounting standards that could be

used for both domestic and cross-border ﬁnancial reporting.” See Fin. Accounting Standards Bd.

& Int’l Accounting Standards Bd., Memorandum of Understanding: The Norwalk Agreement 1

(2002), http://www.fasb.org/news/memorandum.pdf; see also Denise Lugo & Stephen Bouvier,

FASB, IASB Revised Proposals Would Cause Signiﬁcant Lease Accounting Changes,A

CCT.POL’Y &PRAC.

EP. (BNA), May 24, 2013, at 420. For a 2008 progress report, see Fin. Accounting Standards

Bd., Completing the February 2006 Memorandum of Understanding: A Progress Report and Time-

table for Completion (Sept. 2008), http://www.fasb.org/intl/MOU_09-11-08.pdf; see also Convergence

with the International Accounting Standards Board (IASB),F

IN.ACCT.STANDARDS BOARD, http://www.fasb.

org/intl/convergence_iasb.shtml (last visited Jan. 28, 2017).

50. Accounting and Auditing Oversight: Pending Proposals and Emerging Issues Confronting Regulators,

Standard Setters, and the Economy: Hearing Before the Subcomm. on Capital Mkts. & Gov’t Sponsored En-

ters. of the H. Comm. on Fin. Servs., 112th Cong. 12–13 (2012) (statement of FASB Chair Leslie F.

Seidman).

51. Fin. Accounting Standards Bd., Fin. Accounting Series Discussion Paper No. 1680-100,

Leases: Preliminary Views (2009), http://www.fasb.org/draft/DP_Leases.pdf.

52. Fin. Accounting Standards Bd., Proposed Accounting Standards Update: Leases (Topic 840),

Exposure Draft (2010) , http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=

1176162613656&acceptedDisclaimer=true.

53. C

HANG &ADAMS CONSULTING,THE E CONOMIC IMPACT OF THE CURRENT IASB AND FASB EXPOSURE

DRAFT ON LEASES 5(2012)[hereinafterCHAMBER STUDY], http://www.centerforcapitalmarkets.com/wp-

content/uploads/2010/04/2012-0 2-08-IASB-FASB-CA-Report-FINAL-v-3-_2_.pdf. In addition to the U.S.

376 The Business Lawyer; Vol. 72, Spring 2017

The Chamber Study purported to measure three effects: reduced spending ne-

cessitated by deleveraging to deal with “apparent increases in liabilities,” in-

creased borrowing costs “for lessees with higher debt ratios,”

and the reduced

valuation in real estate caused by the resulting contraction of the economy.

concluded that the new standard would increase “the apparent liabilities of U.S.

publicly traded companies by $1.5 trillion,”

with more than two-thirds of that

increase attributable to balance sheet recognition of real estate operating leases.

Under the Chamber Study’s “best case” scenario, the new standard “would de-

stroy approximately 190,000 U.S. jobs” and reduce U.S. gross domestic product

(“GDP”) by $27.5 billion annually.

In addition, “U.S. public companies would

face $10.2 billion in annual costs from the increased interest on borrowing” and

commercial real estate would lose $0.6 billion in value because of economic

contraction.

The FASB’s parent organization, the Financial Accounting Foundation (“FAF”),

commissioned Professor Robert C. Lipe to review the Chamber Study. In April

2015, he released Review of the Chang and Adams Leasing Study: Are the Predicted

Economic Effects Likely to Occur?

The Lipe Review faulted the assumptions and

methodology of the Chamber Study and surveyed academic and business sources

to provide “compelling evidence that many lenders and their analysts already in-

clude adjustments for the impact of off-balance sheet leases in their lending deci-

sions.”

These sources also indicated that lenders and other creditors distinguish

a change in the balance sheet mandated by new accounting rules from a change in

Chamber of Commerce and the Real Estate Roundtable, the other organizations that joined in com-

missioning the Chamber Study are listed at its beginning.

54. The most basic measure of a ﬁrm’s leverage is probably its debt-to-equity ratio. As more debt is

recorded on the balance sheet, the ratio increases, indicating greater leverage. This is true even if a

corresponding right-of-use asset is recorded in the same amount as the new lease liability. An increase

in the debt/equity or other leverage or debt coverage ratios could be an occasion for a lender to in-

crease interest rates when a loan is negotiated or reﬁnanced. It also may trigger a regulatory response

or internal control.

55. C

HAMBER STUDY, supra note 53, at 6. The Chamber Study did not consider any reduction in real

estate values that might be caused by shorter leases, nor did it consider increased accounting or ad-

ministrative costs.

56. Id. at 2.

57. Id.

58. Id.

59. Id. In the Chamber Study’s “worst case” scenario, “there would be a loss of 3.3 million jobs”

and GDP would be lowered by $478.6 billion annually. Id. There was an almost immediate and

sharply negative response to the Chamber Study from the other side of the debate: “These doomsday

predictions border not only on the ridiculous, but also the whimsical.” See, e.g., Anthony H. Cata-

nach, Jr. & J. Edward Ketz, Op/Ed, The Economic Impact of Capitalizing Leases: The Chamber of Com-

merce Study,S

MARTPROS LEGAL (Mar. 2012), http://accounting.smartpros.com/x73475.xml.

60. R

OBERT C. LIPE,REVIEW OF THE CHANG AND ADAMS LEASING STUDY:ARE THE PREDICTED ECONOMIC EFFECTS

LIKELY TO OCCUR? (Apr. 2015) [hereinafter LIPE REVIEW]. The Lipe Review has a low publication proﬁle. It

is most readily available as an attachment to the July 1, 2015, letter in response to it by Andrew Chang,

the coauthor of the Chamber Study. Letter from Andrew Chang to Fin. Accounting Standards Bd.,

Comment Letter 18: Leases (July 1, 2015), http://www.fasb.org/js p/FASB/CommentLetter_C/

CommentLetterPage&cid=1218220137090&project_id=LEASES-14 [hereinafter Chang Letter].

61. L

IPE REVIEW, supra note 60, at 1.

New FASB Rules on Accounting for Leases 377

the balance sheet resulting from a modiﬁcation in “the fundamental economics of a

company.”

As a result:

Moving information about leases from the ﬁnancial statement footnotes to the bal-

ance sheet is unlikely to cause a large change in the lessees’ cost of borrowing,

and, in the numerical model in the [Chamber Study], if borrowing costs do not in-

crease, then jobs and GDP are unaffected.

The Lipe Review concluded that because the Chamber Study incorrectly predicts

both a widespread increase in lessee borrowing costs and a redirection of funds

by lessees seeking to deleverage, it “substantially overstates the loss of jobs and

GDP reduction associated with the FASB’s proposed lease accounting.”

Al-

though it acknowledged that the new rules “will undoubtedly affect some com-

panies,” the Lipe Review also concluded that “the net effect on jobs and GDP will

likely be a tiny blip.”

Commentators at many stages of the leasing project observed that sophisti-

cated investors, lenders, creditors, and rating agencies already recognize the

ﬂaw in lessee-constructed balance sheets and respond by reconstructing them

to includ e capitalized leases.

Indeed, the SEC Report’s empirical study had

said as much.

The essence of the exposure draft was that lease capitalization

and recording should be readily available to all, not just the few.

For some, a matter of fundamental principle was at stake. A comment by the

Financial Accounting Standards Committee of the American Accounting Associ-

ation (“Committee”) stated that the “current accounting for leases (based on an

ownership model) is probably the clearest example of a dysfunctional accounting

standard because the rules-based approach of that standard has led to wide-

spread non-compliance with the intent of standard setters to have lease contracts

62. Id. “Financial statement users do not respond to mandated accounting changes as if the

changes reﬂect shifts in the fundamental economics of the reporting entity.” Id. at 9.

63. Id. at 1.

64. Id. at executive summary.

65. Id. at 1. Just as in the case of the Chamber Study, there was immediate and sharply negative

feedback to the Lipe Review. Congressman Brad Sherman wrote that it deserves “widespread exco-

riation.” Letter of Congressman Brad Sherman to Mr. Russell Golden, Chair, Fin. Standards Account-

ing Bd., Comment Letter 19: Leases (July 15, 2015), http://www.fasb.org/jsp/FASB/CommentLetter_

C/CommentLetterPage&cid=1218220137090&project_id=LEASES-14. Among other things, the

Chang Letter summarizes industry concerns about the negative effects of the proposed rules on ﬁnan-

cial ratios and debt covenants, including the concern expressed by one industry participant that they

will “result in a de facto increase in the regulatory capital requirements of ﬁnancial institutions.”

Chang Letter, supra note 60, at 2.

66. See Anthony H. Catanach, Jr. & J. Edward Ketz, Economic Impacts of Capitalizing Leases: The

ELF Study,G

RUMPY OLD ACCTS.BLOG (Jan. 2012), http://www19.homepage.villanova.edu/anthony.

catanach/GOA%202012%20Archive%20Page.htm [hereinafter Economic Impacts] (“sophisticated ﬁ-

nancial analysts have been estimating lease obligations for at least two decades” and “rating agencies

have been estimating lease obligations for several years”).

67. The SEC had previously made the same basic point: “Sophisticated users, such as credit-rating

agencies, often adjust balance sheets in their work so they can analyze companies as if all leases were

reﬂected on the balance sheet.” SEC R

EPORT, supra note 19, at 106.

378 The Business Lawyer; Vol. 72, Spring 2017

reported on the balance sheet.”

It decried the knife-edged accounting practices

that had developed to allow ﬁrms to carve themselves out of the SFAS 13 deﬁ-

nition of ownership and, hence, out of recording on the balance sheet.

The

Committee considered the goal of recording all lease contracts on the balance

sheet to be “important for a well-functioning accounting system.”

Despite the predictions of dire economic consequences caused by increased

borrowing costs,

and despite the relative absence of data on increased compli-

ance costs, the joint project continued on the path of requiring all leases to be

recorded on the balance sheet.

Although there was an eleventh-hour effort

by the Chamber and others to exclude private companies from the scope of

the new rules,

early in 2016 the FASB and the IASB separately issued ﬁnal

rules requiring that virtually all leases be recorded on the balance sheet.

B. THE FASB’S END RESULT: ASU 2016-02

On February 25, 2016, the FASB formally updated its Accounting Standards

Codiﬁcation by issuing ASU 2016-02, a massive set of new rules on accounting

for leases that update GAAP.

The FASB, like the IASB,

now requires almost

all leases, both capital and operating, to be recorded on the lessee’s balance

sheet. According to FASB Chair Russell G. Golden, the guidance in the new

rules “ends what the U.S. Securities and Exchange Commission and other stake-

holders have identiﬁed as one of the largest forms of off-balance sheet account-

ing,” the accounting for leases.

ASU 2016-02 has extremely widespread implications because it affects “all

companies and other organizations that lease assets such as real estate, airplanes,

and manufacturing equipment.”

Although the FASB and the IASB agreed

throughout the project that operating lease liabilities should be put on the bal-

68. Yuri Biondi et al., A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases,

25 A

CCT.HORIZONS 861, 862 (2011) [hereinafter Perspective]. Perspective integrates earlier studies sug-

gesting the need for reform.

69. Id. at 863.

70. Id. at 862.

71. See E

QUIP.LEASING &FIN.FOUND., ECONOMIC IMPACTS OF THE PROPOSED CHANGES TO LEASE ACCOUNT-

ING

STANDARD (Dec. 2011). The ELF Study estimated an additional $2 trillion in reported debt as well

as decreases to net income because of the front-loading effect in capitalized leases. In response, see

Economic Impacts, supra note 66.

72. The FASB and the IASB issued three documents for public comment: a 2009 discussion paper,

a 2010 exposure draft, and a 2013 exposure draft. See Accounting Standards Update No. 2016-02,

Leases (Topic 842), FASB

IN FOCUS, Feb. 25, 2016, at 2 [hereinafter FASB IN FOCUS]. Together, the

three documents generated more than 1,700 comment letters. The FASB also held more than 200

meetings with preparers and users, ﬁfteen roundtables with more than 180 companies, and ﬁfteen

preparer workshops with representatives from more than ninety organizations. Id.

73. See Chamber of Commerce Asks for Private Company Exemption to Planned Leases Standard,A

CCT.

OMPLIANCE ALERT (WG&L) (Feb. 11, 2016).

74. ASU 2016-02, supra note 3.

75. Int’l Accounting Standards Bd., IFRS 16, Leases (Jan. 2016) [hereinafter IFRS 16], http://eifrs.

ifrs.org/eifrs/bnstandards/en/2016/ifrs16.pdf.

76. FASB

IN FOCUS, supra note 72, at 1.

77. Id. at 3.

New FASB Rules on Accounting for Leases 379

ance sheet, they ultimately diverged with regard to how operating leases should

be represented on income and cash ﬂow statements. The remainder of Part IV

analyzes the ﬁnal FASB rules, noting only the most important way they diverge

from the ﬁnal IFRS promulgated by the IASB.

C. THE THRESHOLD QUESTION:IS ITALEASE?

1. The Scope of ASC 842 and Basic Deﬁnition of “Lease”

The threshold question about the applica tion of ASC 842 is whether a contract

is or contains a “lease.” As we shall see in more detail, the deﬁnition of lease has

changed. In short, the test is whether a contract transfers the right to control the

use of an asset that is explicitly or implicitly identiﬁed. More speciﬁcally, a lease

is “a contract, or part of a contract, that 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.”

Although ASC 842 applies to all con-

tracts that are leases of land and depreciable assets, it has a short-term exemption

for leases of twelve months or less.

Despite the change in deﬁnition, most con-

tracts that have in the past been classiﬁed as leases, such as those for ofﬁce

spaces or the use of equipment, will continue to be classiﬁed as leases. The con-

sequences are now different because they all must be capitalized and recorded

on the balance sheet. However, a new test for “control” and other nuances

means that some contracts previously classiﬁed as leases may avoid lease classi-

ﬁcation and the resulting capitalization.

In deciding whether a lease exists, the label of the contract is not determina-

tive.

What matters is whether the substance of the contract is within the def-

inition of a lease. Form does not control substance. ASC 842 clearly applies to

many arrangements even though they are not all labeled as leases. Indeed,

ASC 842 can apply to arrangements that, on their face, disavow any intent to

78. The IASB’s ﬁnal rules were promulgated as IFRS 16, supra note 75 (“The FASB and the IASB

have reached the same conclusions in many areas of lease accounting, including requiring leases to be

reported on the balance sheet, how to deﬁne a lease, and how lease liabilities are initially measured.”).

FASB

IN FOCUS, supra note 72, at 3.

79. A period of time may be described “in terms of the amount of use of an identiﬁed asset (for

example, the number of production units that an item of equipment will be used to produce).” ASC

842-10-15-3.

80. ASC 842-1-15-3.

81. ASU 2016-02, supra note 3, at 29 (giving lessees under leases with lease terms of twelve

months or less an election not to capitalize those leases). However, no lease that contains a purchase

option is eligible for this exemption. Id. There is no exception for leases of very small dollar amounts,

such as rent paid for computers. Id. at 8. By contrast, the IASB included a lessee recognition and mea-

surement exemption for leases of assets with values of less than $5,000. Id. However, ASU 2016-02

permits lessees to report leases with similar characteristics at the portfolio level. Fin. Accounting Stan-

dards Bd., Project Update: Lease—Joint Project of the FASB and the IASB (Nov. 19, 2015), http://www.

fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=900000011123.

82. The same is true for federal income tax purposes. See Sun Oil Co. v. Comm’r, 562 F.2d 258,

262 (3d Cir. 1977) (“Regardless of whether the parties honestly believe the transaction to be a lease,

where the documents they have executed fully embody the elements of their bargain, it is the doc-

uments themselves, not the parties’ conception of them, which must govern the legal characterization

of the transaction.”), cert. denied, 436 U.S. 944 (1978).

380 The Business Lawyer; Vol. 72, Spring 2017

create a lease. Conversely, ASC 842 does not apply to some arrangements that

are labeled leases. In part this is a matter of the scope of the project. Certain

major asset classes are excluded from the new leasing standard. For example,

ASC 842 does not apply to leases of intangible assets; leases to explore for or

use minerals; leases of biological assets, including timber; leases of inventory;

or leases of assets under construction.

A ﬁrm must determine whether a contract is or contains a lease at the incep-

tion of the contract.

There are two basic questions to determine whether there

is a lease: (1) Does the contract involve the use of an identiﬁed asset? (2) Does

the contract transfer the right to control the use of that asset? If a single contract

contains both a lease component and a non-lease component, the two should be

separated.

2. First Test for Lease: Is There Use of an “Identiﬁed Asset”?

The ﬁrst question under the new lease deﬁnition is whether a contract in-

volves the use of an “identiﬁed asset.” An asset can be “identiﬁed” either because

it is “explicitly speciﬁed” in the contract or “implicitly speciﬁed” at the time it is

made available for use.

An asset can be implicitly identiﬁed if, for example, the

supplier has only one asset that can satisfy the arrangement. An asset can be a

“physically distinct” portion of a larger asset, such as two speciﬁc ﬂoors in a

four-story ofﬁce building. On the other hand, a portion of the capacity of an

asset or other portion of an asset that is not physically distinct “is not an iden-

tiﬁed asset, unless it represents substantially all of the capacity of the asset and

thereby provides the customer with the right to obtain substantially all of the

83. ASC 842-10-15-1(a)–(e). The Committee reacted negatively to the appearance of these large ex-

ceptions in the ﬁrst exposure draft: “The proposed scope exceptions (e.g., oil and gas, regenerative as-

sets) involve large and material assets and create loopholes that managers know how to exploit.” Per-

spective, supra note 68, at 7 (citations omitted). Leases of inventory and leases of assets under

construction were originally included in the scope of the project but were ultimately removed. Bring

It On—Discussing the FASB’s New Leases Standard,D

ELOITTE DBRIEFS WEBCAST (Mar. 15, 2016, 2:00

PM EST), http://www2.deloitte.com/us/en/pages/dbriefs-webcasts/events/march/2016/dbriefs-bring-it-

on-discussing-the-fasbs-new-leases-standard.html [hereinafter New Leases Standard].

84. ASC 842-10-15-2. There is no need to reassess whether a contract is or contains a lease unless

the terms and conditions of the contract are changed. ASC 842-10-15-6.

85. Contracts with lease components often also involve a contract for goods or services. Thus, a

contract may contain both a lease of a car and an arrangement for servicing the car over a period of

use. Similarly, a lease of real estate may also include a maintenance contract. See New Lease Standard,

supra note 83; Joseph Sebik, A Paradigm Shift in Lessee Accounting: An Explanation of the New U.S. Leas-

ing Guidance,A

CCT.POL’Y &PRAC.REP., Mar. 11, 2016, at 3 [hereinafter Paradigm Shift]. It may be

difﬁcult to distinguish a lease when a contract is not in the form of a conventional lease. Id. at 6–7

(“For instance, a contract may be called a service agreement or a long-term product supply contract,

as is the case of a multiple-element arrangement wherein an asset is supplied ‘without cost’ as long

as the entity using the asset agrees to purchase a deﬁned quantity of the consumables that are used

by that asset. For example, if a supplier provides a customer a diagnostic machine and the customer

agrees to purchase a given quantity of blood or urine test kits that include a testing reagent over a pre-

determined period of time. These types of contracts are referred to as supply agreements but essentially

have a lease of an asset embedded within the contract.”).

86. ASC 842-10-15-9.

New FASB Rules on Accounting for Leases 381

economic beneﬁts of the use of the asset.”

Thus, the use of a natural gas pipe-

line or ﬁber-optic cable on a shared basis with other users does not involve an

identiﬁed asset.

The idea is that although there is a transfer of a right to use an

asset, there is no transfer of a right to use any discrete part of it. However, the

economics of the two might appear to be the same, and it is unclear why one

should be considered an “identiﬁed asset” and the other not. As we shall see,

however, even if a capacity contract involves an identiﬁed asset, it may fall out-

side lease classiﬁcation if the transferee lacks sufﬁcient control over the use of

the asset.

A further question is whether an asset is disqualiﬁed from being “identiﬁed”

because the supplier has the right to substitute a different asset. Even if an

asset is speciﬁed, the transferee does not have the right to use an identiﬁed

asset “if the supplier has the substantive right to substitute the asset throughout

the period of use.”

The supplier’s right is considered “substantive” only if it has

the practical ability to substitute and if it would beneﬁt from exercising its right

to substitute.

If the supplier’s substitution rights are substantive, the contract is

a service contract rather than a lease. It is “characterized by the acquiring of out-

put or utility from the asset rather than the use of the asset.”

The requirement

that the supplier beneﬁt from the substitution is a new rule that makes it more

difﬁcult to avoid lease classiﬁcation by a simple contractual right to substitute.

The formal right to substitute must be economically meaningful. The contractual

right is not economically meaningful if, for example, the costs of physical sub-

stitution are too great to give the supplier a net economic beneﬁt.

3. Second Test for Lease: Is There a Transfer of Control of the

Use of the Identiﬁed Asset?

The second question under the new lease deﬁnition is whether the contract

transfers the right to “control the use” of the identiﬁed asset. Indeed, the core

change in the lease deﬁnition is its new emphasis on the concept of control.

The new control concept itself has two components: a beneﬁts test and a

power test. To determine whether a contract transfers the right to control the

87. ASC 842-10-15-16.

88. Id.; see also New Leases Standard, supra note 83.

89. ASC 842-10-55-1 (containing a ﬂowchart that depicts the decision process for identifying

whether a contract is or contains a lease).

90. ASC 842-10-15-10.

91. Id. It would beneﬁt economically if “the economic beneﬁts associated with substituting the asset

are expected to exceed the costs associated with substituting the asset.” ASC 842-10-15-10(b). An en-

tity’s evaluation of whether a supplier’s right to substitute is meaningful must be based on the circum-

stances at the inception of the contract and “shall exclude consideration of future events that, at incep-

tion, are not considered likely to occur.” ASC 842-10-15-11.

92. Paradigm Shift, supra note 85, at 8.

93. ASC 842-10-15-12. For a tax case probing the economic signiﬁcance of a purported lessee’s

substitution rights, See Sun Oil Co. v. Comm’r, 562 F.2d 258 (3d Cir. 1977), cert. denied, 436 U.S.

944 (1978). Neither a supplier’s right nor obligation to substitute in the event of repair, operational

failure, or upgrade disqualiﬁes the asset from being “identiﬁed.” ASC 842-10-15-14.

94. This is similar to the new revenue standard and the new consolidation standard.

382 The Business Lawyer; Vol. 72, Spring 2017

use of an identiﬁed asset for a period of time, a ﬁrm must assess whether,

throughout the period of use, it has both (a) the right to obtain substantially

all of the economic beneﬁts from the use of the identiﬁed asset and (b) the

right to direct the use of the identiﬁed asset.

This “right to direct the use”

(or “power”) component is what is new about the deﬁnition of control. In

short, for a lease to exist, the transferee must get both substantially all the eco-

nomic beneﬁts from the use of an identiﬁed asset and decision-making authority

over the use of that asset.

(i). The “Beneﬁt” Requirement: The Right to Obtain Substantially All the Economic

Beneﬁts. The ﬁrst necessary element of the control test is the right to obtain sub-

stantially all the economic beneﬁts from an identiﬁed asset. The deﬁnition of

“economic beneﬁts” is extremely broad. Economic beneﬁts from the use of an

asset “include its primary output and by-products (includ ing potential cash

ﬂows derived from these items) and other economic beneﬁts from using the

asset that could be realized from a commercial transaction with a third

party.”

Consider, for example, a solar facility that generates electricity and re-

ceives “renewable energy credits” for generating that electricity. Those credits can

be sold to a third party and hence have value. The rule of thumb is that any piece

of output that can be monetized should be considered a by-product for the pur-

poses of this test.

Tax attributes that cannot be sold are not included.

The customer is not required to receive every economic beneﬁt from all pos-

sible uses of the identiﬁed asset to meet this test. The focus is on the economic

beneﬁts “that result from use of the asset within the deﬁned scope of the custom-

er’s right to use the asset in the contract.”

For example, a contract may merely

provide a right to use a motor vehicle only within a particular territory and yet

remain a lease. Similarly, if a contract require s payment of a portion of the cash

ﬂows from the use of an asset as consideration, “those cash ﬂows paid as consid-

eration shall be considered to be part of the economic beneﬁts that the customer

obtains from the use of the asset.”

Consider, for example, shopping center

leases, which frequently require ﬁxed rent plus a payment of a percentage of a

retailer’s gross receipts. The requirement to pay “a percentage of sales from

use of retail space as consideration for that use . . . does not prevent the [tenant]

from having the right to obtain substantially all of the economic beneﬁts from

use of the retail space.”

100

Even the portion of cash ﬂow from sales the tenant

must pay as rent is considere d economic beneﬁt to the tenant.

(ii). The “Power” Requirement: The Right to Direct the Use. The second necessary

element of the control test is the “right to direct the use” of the asset. This is the

new “power” element of the control test. To have the right to direct the use of the

95. ASC 842-10-15-4.

96. ASC 842-10-15-17. The economic beneﬁts of the use of an asset can be obtained in many

ways, such as by using, subleasing, or holding the asset.

97. New Leases Standard, supra note 83.

98. ASC 842-10-15-18.

99. ASC 842-10-15-19.

100. Id.

New FASB Rules on Accounting for Leases 383

asset, the customer must have the right to direct both “how and for what pur-

pose” the asset is used throughout the term. This right to direct “how and for

what purpose” concept is both new and fundamental. This language refers to

the big decisions with respect to an asse t. If the supplier makes them, there is

no lease because the customer does not have the right to direct the use of the

asset and hence does not control it. If the customer makes the fundamental de-

cisions, the control test is satisﬁed. A customer can have the requisite right to

direct the use of an asset in either one of two basic situations.

First, a customer has the requisite right to direct the use if it “has the right to

direct how and for what purposes the asset is used throughout the period of

use.”

101

It has the requisite right to direct the use “if, within the scope of its

right of use deﬁned in the contract, it can change how and for what purposes

the asset is used.”

102

Decision-making rights are relevant “when they affect the

economic beneﬁts to be derived from use.”

103

Thus, a customer has the right

to direct how and for what purpose an asset is used if it can change the type

of output that is produced, including the mix of products sold from a retail

unit, or when, where, or how much output is produced.

104

Second, a customer can have the requisite right to direct the use even in some

situations in which the relevant decisions about “how and for what purpose” the

asset is used are predetermined. Consider, for example, situations in which

the use is predetermined either by contractual restrictions or by the design of

the asset.

105

Despite the predetermination, the customer can have th e requisite

“right to direct the use” if one or both of the following conditions exists: (a)

the customer has the right to operate the asset without the supplier having the

right to change the operating instructions, or (b) the customer designed the

asset in a way that predetermines “how and for what purpose” the asset will

be used.

106

Return to the example of a shopping center lease of a deﬁned space,

107

which

typically limits the tenant’s use in many ways. For example, it may require the

tenant to operate a particular type of outlet, such as a pharmacy; it may limit

the categories of products that may be sold; it may require that the outlet remain

open for deﬁned business hours; and it may require the tenant to contribute ﬁ-

nancially to shopping center-wide advertisement and maintenance that is cen-

trally managed. Even though the use is circumscribed, the contract gives the cus-

tomer sufﬁcient control to classify the arrangement as a lease. Most basically, a

typical shopping center tenant falls within the ﬁrst basic situation because it

has the right to direct “how and for what purpose” the space is used “within

101. ASC 842-10-15-20(a).

102. ASC 842-10-15-24.

103. Id.

104. ASC 842-10-15-25. Rights that are limited to operating or managing the asset are not sufﬁ-

cient. ASC 842-10-15-26.

105. ASC 842-10-15-21.

106. ASC 842-10-15-20.

107. Contrast a contract for concession space that gives the provider the right to change the loca-

tion of the space allocated to the customer. ASC 842-10-55-52.

384 The Business Lawyer; Vol. 72, Spring 2017

the scope of its contractual right,” which is limited only by the contractual con-

ﬁnes of its membership within the broader community of economically interde-

pendent businesses. More speciﬁcally, it has decision-making rights over “the

mix of products sold.”

108

It gets to decide both the mix of products that will

be sold and their price.

109

In addition, control over the use is not taken away

because the supplier of the space is exercising protective rights. A “protective

right” is a contractual provision either to protect parties other than the user or

to ensure legal compliance. For example, a contract “may include terms and con-

ditions designed to protect the supplier’s interest in the asset or other assets, to

protect its personnel, or to ensure the supplier’s compliance with law or regula-

tions.”

110

Contractual provisions might, for example, specify the time or place

for use of an asset or may require particular operating practices or requirements

to contribute to common expenses. Although protective provisions limit the

scope of the customer’s use, they do not, in isolation, defeat the custome r’s req-

uisite right to direct the use. Finally, even if the decisions on “how and for what

purpose” were somehow considered to be predetermined, the customer would

appear to have the right to direct the use because it has the right to operate

the asset without the supplier’s having the right to change the operating instruc-

tions. Indeed, if the shopping center lease had been for space to operate a movie

theater, the tenant may have designed the theater in a way that predetermined

“how and for what purpose” the asset would be used.

There are some arrangements previously classiﬁed as leases that the new

“power” element—the “right to direct the use” requirement—may cause to fall

outside the deﬁnition of lease. Output arrangements in particular have been

identiﬁed as contracts that might fall outside the deﬁnition of lease because of

its new control component.

111

For example, consider a contract to purchase

all the output generated by a particular power plant for a period of years.

Even if the purchaser has the right to substantially all the beneﬁts from the op-

eration of the power plant, it may not have the right to direct “how and for what

purpose” the plant operates.

112

However, the result may differ if the customer

designed the power plant and “there are no decisions to be made about whether,

when, or how much electricity will be produced because the design of the asset

has predetermined these decisions.”

113

4. The Lease Term and the Effect of Options

Deciding the length of the lease term is critical. The longer the period of the

rental commitment, the greater the lease liability and related right-of-use asset

that must be recorded on the balance sheet. Here, again, the lessee must deter-

108. ASC 842-10-55-70(b).

109. Id.

110. ASC 842-10-15-24.

111. New Leases Standard, supra note 83.

112. ASC 842-10-55-116.

113. ASC 842-10-55-108; see also ASC 842-10-55-109—123; New Lease Standard, supra note 83.

New FASB Rules on Accounting for Leases 385

mine the term as of the commencement date. The lessee cannot simply report

whatever base lease term is speciﬁed in the contract. Rather, the lessee must de-

termine

114

a lease term that includes both the noncancelable period of the lease

and any periods that are:

(a) covered by an option to extend that the lessee is reasonably certain to

exercise;

(b) covered by an option to terminate that the lessee is reasonably certain

not to exercise; or

the option is controlled by the lessor.

115

In making its determination of reasonable certainty, the lessee must consider “all

relevant factors that create an economic incentive for the lessee (that is, contract-

based, asset-based, entity-based and market-based factors).”

116

For example, a

lessee should consider whether there are leasehold improvements that are ex-

pected to have signiﬁcant economic value when an option is exercisable.

117

Lessees are required to reassess the lease term or a lessee option to purchase

the underlying asset only if any of the following occurs:

(a) There is a signiﬁcant event or change in circumstances that is in the

control of the lessee that directly affects whether it is reasonably certain

to exercise or not to exercise an option to extend or terminate the lease.

114. The Committee indicated a preference for including all lease renewal periods in the initial

measurement of the leas e to block opportunistic behavior by management. Perspective, supra note

68, at 5–6 (“Using convoluted tests like ‘term that is more likely than not to occur’ . . . creates a

loophole which management can exploit. Management can argue that certain renewal options

will not meet the ‘more likely than not’ te st. Experimental evidence suggest that auditors are likely

to go along with these managerial judgments thus defeating the intent of the standard.” (citations

omitted)).

115. ASC 842-10-30-1.

116. ASC 842-10-30-2. ASC 842-10-55-26 reiterates the importance of all economic factors rel-

evant to the assessment of reasonable certainty. The federal income tax law also considers all relevant

factors to determine whether an option is likely to be exercised. See, e.g., Sun Oil Co. v. Comm’r, 562

F.2d 258, 267–68 (1977), cert. denied, 436 U.S. 944 (1978). The court concluded that, in economic

reality, a lessor’s right to reject an offer was illusory. Id. at 265 (“The limitations of time, distance, and

subject matter also erode whatever substance may have existed in the lessor’s rights to reject an

offer.”). In Hilton v. Commissioner, the court reviewed conﬂicting expert testimony on the likelihood

lease options would be exercised and considered among other things the expected useful life of the

neighborhood for purposes of the tenant. 74 T.C. 305, 354 (1980), aff’d per curiam, 671 F.2d 316

(9th Cir. 1982). Courts have reached different conclusions on whether lease options are likely to

be exercised. See, e.g., Frank Lyon Co. v. United States, 435 U.S. 561, 560–70 (1978) (discussing

the conﬂicting opinions in the lower courts). Analogous recent authority also indicates that a broader

pattern of behavior may inﬂuence a court’s decision on the likelihood of option exercise. Cf. Sun Cap-

ital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, 172 F. Supp. 3d 447

(D. Mass. 2016) (ﬁnding a partnership between two private equity ﬁrms that were formally separate).

The “smooth coordination” of the two was “indicative” of a shared control. Id. at 464.

117. ASC 842-10-55-26(b). The same principles apply to assess an option to purchase the under-

lying asset. ASC 842-10-30-3.

386 The Business Lawyer; Vol. 72, Spring 2017

(b) There is an event written into the contract

118

that obliges the lessee to

exercise or not to exercise an option to extend or terminate the lease.

termined that it was not reasonably certain to do so.

(d) The lessee elects not to exercise an option even though it had previ-

ously determined it was reasonably certain to do so.

119

Thus, lessees must monitor for the occurrence of any of these events and reassess

the lease term if such an event occurs. For example, a lessee must reassess the lease

term if it makes such signiﬁcant leasehold improvements that it becomes reason-

ably certain to exercise an option to renew.

120

The key factor in this example is

that the lessee controlled the change in circumstances. A change in market-

based factors alone would not require a lessee to reassess the lease term.

121

For

example, the lessee does not control an increase in value stemming from improved

transportation access effected by a third party. A reassessment of the lease term

may lead to a remeasurement of the lease liability and the corresponding right-

of-use asset for balance sheet purposes. It may also lead to a reclassiﬁcation of

the lease for income statement purposes.

122

D. THE LESSEE’S BALANCE SHEET:THE CRUX OF THE MATTER

1. The Theoretical Change from Ownership to Use

The most important change in the new rules is that lessees are required to re-

cord most lease liabilities on their balance sheets.

123

Lessees under leases for

more than twelve months must now record the lease liability on their balance

sheets and also record a cor responding right-of-use asset. Both the liability

and the asset must include the present value of the future lease payments.

This dramatic result reﬂects a major theoretical shift with respect to balance

sheet recording. The new rules abandon the ownership model and replace it

with a right-of-use model.

118. See ASC 842-10-30-5 for initial measurement of the lease payments on the commencement

date.

119. ASC 842-10-35-1.

120. ASC 842-10-55-28.

121. ASC 842-10-55-29.

122. See P

RICEWATERHOUSECOOPERS,THE OVERHAUL OF LEASE ACCOUNTING:CATALYST FOR CHANGE IN COR-

PORATE

REAL ESTATE 3(2016)[hereinafterCATALYST], http://www.pwc. com/us/en/asset-management/

real-estate/publications/assets/pwc-overhaul-of-lease-accounting.pdf.

123. The new rules also affect lessors, but to a much more minor extent. Because accounting for

leases by lessees rather than lessors was the main focus of ASC 842, there is no fundamental change

to accounting by lessors. Accounting for lessors is largely unchanged from current Topic 840 in the

Accounting Standards Codiﬁcation. FASB

IN FOCUS, supra note 72, at 1. However, the new rules con-

tain “some targeted improvements that are intended to align lessor accounting with the lessee ac-

counting model and with the updated revenue recognition guidance issued in 2014.” Press Release,

Fin. Accounting Standards Bd., FASB Issues New Guidance of Lease Accounting (Feb. 25, 2016),

http://www.fasb.org/jsp/FASB/FASBContent_C/NewsPage&cid=1176167901466.

New FASB Rules on Accounting for Leases 387

a. The Underinclusive “Ownership” Model. Recall that the core concept of the old

rules was the “ownership” model. More speciﬁcally, the focus had been on own-

ership of the underlying asset. A lessee was not required to record a lease on its

balance sheet unless it was a capital lease that gave the lessee substantially all of

the beneﬁts and risks incident to ownership of the underlying asset. If a lessee

could ﬂunk each of the four ownership tests of SFAS 13, the lease was an oper-

ating lease that was not recorded on the balance sheet.

124

The ownership tests

were easy to ﬂunk because they were mechanical and involved bright lines

that were often easy to draft around. Knife-edged accounting developed that al-

lowed ﬁrms to carve themselves just outside the line and hence avoid recording

the lease obligation on the balance sheet.

The ownership model kept an extremely wide range of leases off balance

sheets. At one extreme were leases that did indeed effectively transfer substantive

ownership of the underlying asset but were structured to ﬂunk the SFAS 13

ownership tests.

125

In the middle were leases that represented a signiﬁcant ﬁnan-

cial obligation and transferred many of the risks and beneﬁts of the underlying

asset but did not approach full ownership. At the other extreme were leases that

represented fairly minor ﬁnancial obligations and transferred a relatively small

portion of the beneﬁts and burdens of the underlying asset.

b. The Extremely Inclusive Right-of-Use Model. The right-of-use theory in the

new rules requires that a wide range of operating leases be capitalized and re-

corded on the balance sheet. As we have seen, the new rules deﬁne a lease as

a contract that conveys the right to control the use of identiﬁed property for a

period of time in exchange for consideration. The new rules provide that the

contractual right of use is itself an asset that must be recorded on the balance

sheet. Ownership of the beneﬁts and burdens of the underlying asset is now ir-

relevant for the purposes of requiring the lease to be recorded on the balance

sheet.

126

Similarly, the total contractual lease obligation should be recorded

on the balance sheet as a liability. The starting point for both is the present

value of the required lease payments.

c. Right to Use Is a Redirected Ownership Model. The right-of-use model is, in

effect, an ownership model with a different focus than the ownership model

of SFAS 13. SFAS 13 focuses on ownership of the underlying asset. It asks the

lessee to record on the balance sheet only if it has substantially all the beneﬁts

and burdens associated with the underlying asset. The new rules in ASC 842

focus on the beneﬁts and burdens associated with the lessee’s leasehold interest

itself. The new rules simply ask the lessee to record the beneﬁts and burdens

it has under the lease, ignoring the beneﬁts and burdens that may lie elsewhere.

124. If the lease was from an SPE, the lessee might have been indirectly required to record the

lease liability if it had been required to prepare consolidated ﬁnancial statements with the SPE.

125. Many leases that were treated as operating leases under SFAS 13 were treated as mortgages

for federal income tax purposes. See Weidner, supra note 1, at 487.

126. As we shall see, ownership of the beneﬁts and burdens of the underlying asset remains rel-

evant for purposes of classifying the lease as a ﬁnance lease as opposed to an operating lease for other

ﬁnancial statement purposes.

388 The Business Lawyer; Vol. 72, Spring 2017

Although accounting rules and legal rules are designed for different purposes,

it may be useful to point out that the legal system has long considered the rights

and liabilities associated with ownership of leasehold interests. The leasehold es-

tate is one of a handful of basic estates in land,

127

the most complete of which is

the fee simple. When the owner of a fee simple estate in an asset transfers a right

to use the asset for a ﬁxed term, the fee owner becomes a specialized grantor

called a lessor, and the recipient becomes a specialized grantee called a lessee.

For the duration of the term, the lessee receives the present possessory interest

with respect to the underlying asset, which is the right to occupy and control it.

During that term, the landlord has a future interest called a “reversion.” It is a

future interest because although it exists throughout the lease term , it will not

become possessory until the term ends.

The conveyance of a leasehold estate differs from the conveyance of other es-

tates in land because the lease typically contains many continuing promises of

both parties. Shopping center leases and ﬁnancing leases are examples of situa-

tions in which both the landlord and the lessee make many continuing promises.

Bankruptcy law in particular closely examines the multiplicity of covenants. Sec-

tion 365 of the Bankruptcy Code empowe rs the trustee in bankruptcy to assume

or reject a debtor’s executory contracts.

128

A lease is an executory contract for

this purpose because both the landlord and the lessee have material obligations

yet to be performed. Accordingly, the lessee’s lease agreement represents both an

asset (the landlord’s unperformed promises) and a liability (the lessee’s unper-

formed promises, not the least of which is the promise to pay rent). Once the

asset and liability are identiﬁed, however, a subsidiary question in bankruptcy

is whether the lease is in substance a ﬁnancing transaction. If the lease is a ﬁ-

nance lease—that is, if it is in substance a mortgage—then the lessee may be

able to remain in possession and have the mortgage obligation restructured as

part of a bankruptcy reorganization plan.

129

The new ASC 842 rules adopt an

analogous two-tier analysis. First, they ask whether there is a lease for more

than twelve months. If there is, it must be capitalized and recorded on the bal-

ance sheet as representing both an asset and a liability. Second, they ask whether

it is a ﬁnance lease. If so, it must be treated as a mortgage on the income state-

ment and recorded separately on the balance sheet.

130

2. Determining the Lease Liability and Right-of-Use Asset

The basic rule implementing the right-of-use model is that on the lease com-

mencement date, a lessee shall recognize both a lease liability and a correspond-

ing right-of-use asset.

131

127. Others are the fee simple absolute (the highest quantum of ownership), the defeasible fees,

and the life estate. These interests can be held in personal property.

128. 11 U.S.C. § 365 (2012).

129. See G

RANT NELSON &DALE WHITMAN,REAL ESTATE FINANCE LAW 73 (5th ed. 2007).

130. ASC 842-20-25-5.

131. A lessee may elect not to apply this recognition requirement to a short-term lease, which is

one that at the commencement date “has a lease term of 12 months or less and does not include an

New FASB Rules on Accounting for Leases 389

a. Determining the Lease Liability. Lease liability is the term used to describe the

obligation to make payments under a lease as opposed to other debt. The starting

point to determine the lease liability is to identify the lease payments that have

not yet been made. The next step is to reduce these future lease payments to their

present value by applying an appropriate discount rate.

The total lease payments the lessee must capita lize include a variety of

components:

(a) ﬁxed payments, including in substance ﬁxed payments;

(b) variable lease payments that depend on an index or a rate;

lessee is reasonably certain to exercise the option;

(d) payments for penalties for terminating the lease if the lease term reﬂects

the lessee’s exercising an option to terminate the lease; and

(e) amounts the lessee will probably owe under residual value guarantees.

132

The ﬁrst two items require more explanation than the last three. Fixed pay-

ments are speciﬁ ed in the lease and ﬁxed over the lease term. “In substance”

ﬁxed payments are variable payments that include a ﬂoor or minimum amount.

Variable payments need not be included as lease payments unless they are based

on an index or a rate.

133

Payments based on usage of the asset or performance

are not included. Consider, for example, a shopping-center tenant that contracts

to pay a ﬁxed rent plus 2 percent of gross sales. The amount generated by the

2 percent is a variable payment that is not included in the lease liability because

it does not depend on an index or a rate.

134

With regard to the third item, lessees

must exercise judgment to decide whether they are reasonably certain to exercise

an option to purchase. Similarly, they must exercise judgment to determine how

much they will probably owe under a residual value guarantee.

Once the future lease payments are identiﬁed, the question becomes what dis-

count rate should be applied to reduce them to their present value. Theoretically,

there are three basic discount rates that might be used: (1) a risk-free rate (such

as the rate on a Treasury obligation of the same term), (2) a lessee-speciﬁc bor-

rowing rate that will reﬂect the strength of the lessee’s credit, or (3) a lease-

speciﬁc interest rate (implicit in the terms of the lease). Under ASC 842, the

choice of discount rate depends on both available ﬁnancial information and

whether the lessee is a public business entity.

option to purchase the underlying asset that the lessee is reasonably certain to exercise.” ASC 842-20-

25-2.

132. ASC 842-10-30-5 also requires the lessee to include in lease payments any fees it pays to the

owners of an SPE to structure the transaction.

133. A lessee will reassess variable lease payments that depend on an index only if the lease lia-

bility is remeasured for another reason independent of a change in the reference index.

134. ASC 842-10-55-233.

390 The Business Lawyer; Vol. 72, Spring 2017

A lessee should apply the discount rate for the lease at lease commence-

ment.

135

It should use the “rate implicit in the lease,”

136

that is, the rate the les-

sor charges in the lease whenever that rate is readily determinable.

137

If, as is

often the case, the rate implicit in the lease is not readily determinable, a lessee

is to use its incremental borrowing rate. A public business entity may use a port-

folio approach, which applies a single discount rate to the portfolio of new

leases, if the leases are similar.

138

If the lessee is not a public business entity,

it may use a risk-free discount rate determined by using a period comparable

to the lease term.

139

The price to pay for making this simple choice is that

both the lease liability and the right-of-use asset will appear on the balance

sheet at higher amounts.

140

The irony in the overall approach is that the re-

corded liability on a similar lease will be smaller for a more risky ﬁrm than it

would be for a ﬁrm that is less risky. The riskier the ﬁrm, the higher the discount

rate; and the higher the discount rate, the lower the present value of the future

rent stream.

141

(ii). Determining the Right-of-Use Asset. Right-of-use asset is the term used to

enable readers of ﬁnancial statements to readily distinguish assets that are leased

from those that are directly owned. Right-of-use assets are those offset by lease

liabilities. In the simplest situation, a right-of-use asset will be recorded on the

balance sheet at the same amount as the lease liability, that is, at the present

value of the future rent payments. However, the lease asset must also include

any lease payments made to the lessor prior to the commencement date as

well as any initial direct lessee costs.

142

135. ASC 842-20-30-1(a).

136. ASU 2016-02, supra note 3, at 99 (deﬁning “rate implicit in the lease” as follows: “The rate of

interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the

amount that a lessor expects to derive from the underlying asset following the end of the lease term to

equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit

retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the

lessor.”).

137. ASC 842-20-30-3.

138. ASC 842-20-55-20.

139. ASC 842-20-30-3.

140. In general, there is no requirement to reassess the discount rate unless there is a modiﬁcation

of the lease that does not result in a separate contract.

141. See C

ATALYST, supra note 122 at 7–8 (“Although counter-intuitive, under the new standard,

companies with a better credit proﬁle and lower borrowing costs will record a larger lease liability

as a result of discounting the associated lease payments based on a lower incremental borrowing

rate when compared to a company with a lesser credit and higher borrowing costs, relative to the

same lease.”).

142. ASC 842-20-30-5. A more complete statement of the amount for the right-of-use asset is

lease liability + unamortized initial direct costs + prepaid rents − any accrued rents − the remaining

balance of any lease incentives received.

New FASB Rules on Accounting for Leases 391

E. THE INCOME STATEMENT

1. Distinguishing a Finance Lease from an Operating Lease

Because all leases must now be recorded on the balance sheet, the old distinc-

tion between capital leases and operating leases no longer exists for the purposes

of balance sheet inclusion. However, the old distinction, modiﬁed slightly, con-

tinues for other ﬁnancial statement purposes. The new rules replace “capital”

lease with “ﬁnance” lease.

143

Finance leases and operating leases continue to

be reported differently on the income statement. In the language of accounting,

there is a different expense proﬁle or expense recognition for each type of lease.

The expense proﬁle, in turn, affects some key ﬁnancial ratios.

When a lease begins, a lessee must classify it either as a ﬁnance lease or an

operating lease.

144

A lessee is required to classify a lease as a ﬁnance lease

(and a lessor is required to classify it as a sales-type lease) whenever the lease

meets any of the following ﬁve criteria:

(a) The lease transfers ownership of the underlying asset to the lessee by

the end of the lease term.

(b) The lease grants the lessee an option to purchase the underlying asset

that the lessee is reasonably certain to exercise.

the underlying asset.

145

(d) The present value of the lease payments and any residual value guaran-

teed by the lessee that is not already reﬂected in the lease payments

equals or exceeds substantially all of the fair value of the underlying

asset.

(e) The underlying asset is so specialized that it is expected to have no al-

ternative use to the lessor at the end of the lease term.

146

When none of these factors is present, the lessee is required to classify the lease

as an operating lease.

147

The ﬁrst four of these factors are, to differing extents, very much like the SFAS

13 tests for a capital lease. The ﬁrst factor, concerning transfer of asset ownership

to the lessee, is identical. The second factor, concerning a lessee purchase option,

replaces the concept of “bargain purchase option” with the concept of a purchase

143. ASC 842-10-25-2.

144. Id. An entity shall not later reassess lease classiﬁcation unless the contract is modiﬁed and the

modiﬁcation is not accounted for as a separate contract. A lessee shall also reassess the lease classi-

ﬁcation “if there is a change in the lease term or the assessment of whether the lessee is reasonably

certain to exercise an option to purchase the underlying asset.” ASC 842-10-25-1.

145. This criterion shall not be used if the commencement date is at or near the end of the asset’s

economic useful life.

146. ASC 842-10-25-2.

147. ASC 842-10-25-3. Using a related but different test, a lessor shall classify the lease as either a

direct ﬁnancing lease or an operating lease. ASC 842-10-25-3(b).

392 The Business Lawyer; Vol. 72, Spring 2017

option “that the lessee is reasonably likely to exercise,” presumably for reasons

beyond a bargain price. The third factor, addressing the portion of the economic

life of the asset transferred by the lease, eliminates the 75 percent bright-line rule

and asks simply whether the lease is for the major part of the remaining eco-

nomic life of the asset. No longer may lessees ﬂunk the test by claiming that

their leases fall just outside the 75 percent line. Simil arly, the fourth factor,

which looks at whe ther the lessee has paid most of the asset’s value, eliminates

the 90 percent test and asks simply whether the lease payments equal substan-

tially all of the asset’s fair value. Here again, lessees may no longer claim that they

ﬂunk the test because they fall just outside the 90 percent bright line.

148

The

ﬁfth factor is new and asks whether the asset is so specialized that it is not ex-

pected to have any alternative use to the lessor at the end of the term.

149

This

factor is related to the others. For example, a lessor that will have no use for

the asset at the end of the term will presumably charge rent that equals or ex-

ceeds the asset’s value.

The new tests for a ﬁnance lease shift from bright-line rules to broader prin-

ciples that require an exercise of judgment.

150

The underlying accounting prin-

ciple remains ownership

151

of the underlying asset: a lease is a ﬁnance lease if

the lessee has substantially all the beneﬁts and burdens of the underlying

asset. Because the new ﬁnance lease deﬁnition is so similar to the old capital

lease deﬁnition, most agreements that were capital leases under the old rules

are likely to be ﬁnance leases under the new rules. For example, a lease of a

piece of equipment for most of its useful life will continue to be a ﬁnance

lease. Similarly, most operating leases under the old rule will continue to be op-

erating leases under the new rule. For example, most leases of ofﬁce space are

likely to continue to be operating leases, although they now must be capitalized

148. However, a lessee is permitted some limited use of bright-line guidance. For example, it may

assume that 75 percent or more of the remaining life of the asset is “the major part” of the remaining

economic life of the asset. ASC 842-10-55-2. Similarly, it may assume that 90 percent or more of the

fair value of the underlying asset amounts to substantially all of its fair value.

149. ASC 842-10-25-2(e).

150. Lessee Accounting Under the New Leasing Standard,P

RICEWATERHOUSECOOPERS (July 14, 2016),

http://www.pwc.com/us/en/ cfodirect/multimedia/videos/lessee-accounting-fasb-leasing-standard.

html.

151. The federal income tax law has long recognized that in the case of complex commercial leas-

ing arrangements, more than one person can plausibly be seen as the owner. The U.S. Supreme Court

has allowed taxpayers great ﬂexibility in deciding whether the landlord or the tenant is considered

the owner. In the leading case on the subject, Frank Lyon Co. v. United States, 435 U.S. 561, 560–

570 (1978), the Court made two statements of the test. In what is referred to as the “long form”

of the test, the Court stated, “where . . . there is a genuine multiple-party transaction with economic

substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-

independent considerations, and is not shaped solely by tax avoidance features that have meaningless

labels attached, the Government should honor the allocation of rights and duties effectuated by the

parties.” Id. at 584. It followed that statement with what is referred to as the “short form” of the same

test: “Expressed another way, so long as the lessor retains signiﬁcant and genuine attributes of the

traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.”

Id.; see also Comm’r v. Bollinger, 485 U.S. 340, 344 (1988) (in a case involving the use of single-

purpose ﬁnancing entities, the court said, “[t]he problem we face here is that two different taxpayers

can plausibly be regarded as the owner”).

New FASB Rules on Accounting for Leases 393

and recorded on balance sheets. However, some leases that were operating leases

under the old rules because they were structured to fall just outside the old

bright lines will be ﬁnance leases under the new rules. Because both now

must be capitalized, the basic impact of the distinction is on the lessee’s expense

proﬁle.

152

2. The Two Different Expense Proﬁles

Over the life of the lease, the ﬁnancial statements must characterize the pay-

ments on the lease, reduce the lease liability each year as the rent is paid, and

reduce the right-of-use asset as its life expires. The characterization differs de-

pending on whether the lease is a ﬁnance lease or an operating lease.

a. The Finance Lease. If a lease is a ﬁnance lease, it will be treated similarly to a

capital lease today. The annual lease expense must be broken down into two

components to be recognized on the income statement. The income statement

must reﬂect both “amortization of the right of use asset” and “interest on the

lease liability.”

153

Recall that the right-of-use asset appears on the balance

sheet at an amount equal to the present value of the lease payments.

154

This cap-

italized right-of-use asset must be written down, or amortized, on a straight-line

basis over the life of the lease.

155

Amortization of the right-of-use asset is treated

like straight-line depreciation of a tangible asset purchased with a mortgage. The

interest on the lease liability is deemed to be the total lease liability multiplied by

the discount rate that was used to value the lease liability.

156

Because the amor-

tization of the right-of-use asset is deemed to be constant and the interest ex-

pense will be measured on the declining balance, this approach will tend to

front load the total lease expense in the early years.

157

b. The Operating Lease. If a lease is an operating lease, it will be treated similarly

to the way it is treated today. The income statement will reﬂect an annual lease

expense as part of the lessee’s computation of income from continuing opera-

tions.

158

The annual expense is to be recognized on a straight-line basis. Annual

lease expense is computed by calculating the total lease expense for the entire

lease term and deducting it on a straight-line basis over the remaining lease

152. See CATALYST, supra note 122, at 3 (“While bright lines no longer exist, we believe that a rea-

sonable approach may be to consider the previous percentages when determining lease classiﬁcation

[i.e., 75% of the economic life of the underlying asset and 90% or more of the fair value of the un-

derlying asset].”).

153. ASC 842-20-25-5. The income statement must also reﬂect any variable lease payments not

included in the lease liability in the period in which the obligation for those payments is incurred

as well as any impairment of the right-of-use asset. Id.

154. This ignores, for the sake of simplicity, any additional pre-commencement or initial costs.

155. ASC 842-20-35-7.

156. This is referred to as the effective interest rate method.

157. At the end of the lease term, the sum of each of these two amounts for the prior years—the

total amortization expenses plus the total interest expenses—should equal the total rent paid in cash

over the years.

158. ASC 842-20-45-4(b) (“For operating leases, lease expense shall be included in the lessee’s

income from continuing operations.”).

394 The Business Lawyer; Vol. 72, Spring 2017

term.

159

Because lease expense often increases over time, the straight-line method

of reporting lease expense may overstate lease expense in the early years.

160

c. The Distinction on the Balance Sheet. Because ﬁnance leases and operating

leases are treated differently on the income statement, it is not surprising that

the distinction between the two still has some residual impact on the balance

sheet. Either on the balance sheet or in the notes, lessees must present ﬁnance

lease right-of-use assets and operating lease right-of-use assets “separately from

each other and from other assets.”

161

Similarly, ﬁnance lease liabilities and op-

erating lease liabilities must be presented “separately from each other and from

other liabilities.”

162

3. Why Retain the Category of Operating Lease?

Because all leases must now be recorded on the balance sheet, it has not been

clear whether there would be any need for a continuing distinction between a

ﬁnance lease and an operating lease. Even though the IASB and the FASB

were in substantial agreement throughout their reconsideration of lease account-

ing, the two diverged on this issue in their ﬁnal reforms. The IASB’s ﬁnal stan-

dard for leases abandoned the ﬁnance versus operating lease distinction. Under

IFRS, all leases must now be treated as ﬁnance leases for both balance sheet pur-

poses and income statement purposes.

163

By contrast, we have seen that ASC

842 continues to treat operating leases differently from ﬁnance leases on the in-

come statement.

164

The result of retaining a distinction between ﬁnance leases

and operating leases is that “the effect of leases in the statement of comprehen-

sive income and the statement of cash ﬂows is largely unchanged from previous

GAAP.”

165

Operating lessees will report a single combined lease expense as part

159. ASC 842-20-25-6(a) (“unless another systematic and rational basis is more representative of

the pattern in which beneﬁt is expected to be derived from the right to use the underlying asset”).

160. What is new with respect to operating leases is that the reduction in the newly recorded lease

asset must be accounted for. Recall that, for the ﬁrst time, an operating lease will be recorded as an

asset on the balance sheet. An entry must be made that will reduce that asset over time. ASC 842 does

not use the term “amortization” to refer to the reduction in the right-of-use asset in the case of an

operating lease—that term is used only in connection with ﬁnance leases. Compare ASC 842-20-

35-1(b), -2 (ﬁnance lease), with ASC 842-20-35-3(b) (operating lease). Instead, a reduction in the

right-of-use asset is computed by deriving a deemed interest expense and deducting it from the

straight-line lease expense. The deemed interest expense for the period is computed by multiplying

the total current outstanding lease liability by the discount rate. In sum, the reduction of the right-of-

use asset is what is left over after deducting the deemed interest expense from the rent expense. As

one commentator put it, “the amortization expense is basically ‘backed into.’” Paradigm Shift, supra

note 85, at 4. Similarly, a lease liability has been capitalized and recorded as a liability on the balance

sheet. An annual entry must be made that will reduce the lease liability to the present value of the

remaining lease payments. ASC 842-20-35-3(a).

161. ASC 842-20-45-1(a).

162. ASC 842-20-45-1(b).

163. IFRS 16, supra note 75, at para. IN8.

164. “This divergence will cause complications for multi-national companies dealing with the dif-

ferent models in different jurisdictions.” C

ATALYST, supra note 122, at 1.

165. ASU 2016-02, supra note 3, at 2.

New FASB Rules on Accounting for Leases 395

of continuing operations. Unlike the case of a ﬁnance lease, none of the lease ex-

pense must be classiﬁed as part of the expense of ﬁnancing a business.

The basic criticism of single lease expense treatment for operating leases is that

it ignores the twofold economic reality behind that expense. Speciﬁcally, it fails

to clarify the fact that there is implicit interest being paid with respect to the lease

liability. As one study commented, it results in “obscuring the amount of effec-

tive interest expense related to the lease liability and limiting the amount of am-

ortization reported in any given period.”

166

The question then is why did the

FASB pull back from the IFRS requirement that operating lessees separate the

two components of lease expense on the income statement?

Most fundamentally, the FASB treated operating leases differently from ﬁ-

nance leases because it viewed the two as substantively different. It stated that

“the economics of leases can vary for a lessee and that those economics should

be reﬂected in the ﬁnancial statements.”

167

A ﬁnance lease is in economic sub-

stance the purchase of the underlying asset. The lessee receives substantially all

the economic beneﬁts and burdens associated with the underlying asset. Those

beneﬁts and burdens can ﬂuctuate in value over time, either up or down, and the

lessee can depreciate the asset at a different rate than it reduces the liability. By

contrast, an operating lease does not represent an acquisition of the underlying

asset. Rather, an operating lease represents an acquisition of an equal right to ac-

cess the underlying asset over the lease term. Generally, payment for that access

is also equal over time. Therefore, the right and the liability ought to decline at

the same rate over time.

168

166. Angela Wheeler Spencer & Thomas Z. Webb, Leases: A Review of Contemporary Academic Lit-

erature Relating to Lessees,29A

CCT.HORIZONS 997, 1016 (2015) [hereinafter Academic Literature].

167. ASU 2016-02, supra note 3, at 2. Another argument made to the FASB in favor of retaining

the distinction was that the accounting for leases should reﬂect the legal deﬁnition of an asset and a

liability in bankruptcy. Recall that leases in bankruptcy will be evaluated to see whether they are, in

substance, mortgages as opposed to more limited contracts for the use of assets. See text accompany-

ing supra note 129. The theory was that the accounting for leases should make the same basic dis-

tinction, given that the two kinds of leases have very different substantive economic impacts in bank-

ruptcy. Mere operating leases “may be assets and liabilities to a going concern but not in most

bankruptcy scenarios.” Letter from William Bosco, to Russell Golden, Chairman, Fin. Accounting

Standards Bd. & Hans Hoogervorst, Chairman, Int’l Accounting Standards Bd. 2 (July 23, 2013),

http://www.leasing-101.com/c5/03BoscoCommentLetter07.23.2013.pdf (commenting on 2013 sec-

ond exposure draft). Retention of the distinction between ﬁnance leases and operating leases

would “provide debt analysts and lenders information about the assets available in bankruptcy

and the debt that will survive bankruptcy.” Id.

168. For some FASB members, the fundamental premise of the lessee accounting model in ASU

2016-02 is that

operating leases are economically different from ﬁnance leases and that recognition of a generally

straight-line single lease cost for operating leases appropriately reﬂects the fact that, in an oper-

ating lease, the lessee solely obtains a generally equal right to use the underlying asset through-

out the lease term and is not exposed to, nor does it beneﬁt from, changes in the value of the

underlying asset in a way an owner of a similar asset is exposed to (or beneﬁts from) such

changes.

ASU 2016-02, supra note 3, at para. BC68. The “carrying value of the right-of-use asset, which reﬂects

the remaining economic beneﬁts of equal access to the underlying asset during the remainder of the

lease term, is directly correlated to the generally equal lease payments the lessee makes for those ben-

eﬁts.” Id.

396 The Business Lawyer; Vol. 72, Spring 2017

Because the right-of-use asset and the lease liability are initially recorded at the

present value of the rent obligation, the operating lease right-of-use asset and its

corresponding lease liability are reduced each year to the present value of the

remaining lease payments. For FASB members “viewing accurate measurement

of the lease liability as paramount,” the decision to measure the right-of-use

asset by reference to the lease liability throughout the lease term “is principally

one of cost beneﬁt”

169

In their view, measuring the right-of-use asset by reference to the lease liability rep-

resents the most cost-effective way to enact what they view as the primary improve-

ment resulting from [ASU 2016-02] (that is, the recognition of the lease assets and

lease liabilities that arise from operating leases) while still reﬂecting what they view

as the economic substance of those leases in the income statement and the statement

of cash ﬂows and reasonably representing the future economic beneﬁts to the lessee

in the lease.

170

The FASB partially addressed the issue of interest not being reported separately

for operating leases by requiring lessees to disclose the weighted average dis-

count rate for operating leases.

171

This disclosure enables readers of ﬁnancial

statements to calculate what interest expense would be if recognized for operat-

ing leases each period.

When the split from IFRS was ﬁnally announced, it was explained that retain-

ing “the presentation of expenses and cash ﬂows consistent with current GAAP”

was “in direct response to U.S. stakeholder feedback to reduce costs associated

with implementing” the new rules.

172

Retaining the distinction between ﬁnance

leases and operating leases, along with other simpliﬁcations, would “allow many

lessees to leverage their existing systems and processes to apply the require -

ments”

173

of the new rules:

Companies . . . will be able to leverage many of their existing ﬁnancial reporting pro-

cesses, reducing costs associated with implementing [ASU 2016-02]. This is because

the core guidance to determine ﬁnance and operating leases will be applied to [the

new] guidance, and most of the underlying data needed to record the liability al-

ready is captured by companies to create the required footnote disclosure.

174

The announcement concluded that beca use of the continuity, the costs to imple-

ment ASU 2016-02 “are not expected to be signiﬁcant.”

175

However, it acknowledged that som e organizations will incur increased addi-

tional costs, depending on the nature and volume of their leasing activity. In gen-

eral, organizations will incur “initial costs to educate employees about how to

169. ASU 2016-02, supra note 3, at para. BC67.

170. Id.

171. ASC 842-20-50-4(g)(4); see also ASU 2016-02, supra note 3, at para. BC281(a).

172. Fin. Accounting Standards Bd., Understanding Costs and Beneﬁts, ASU: Leases (Topic 842)

2 (Feb. 25, 2016) [hereinafter Costs and Beneﬁts].

173. Id. at 3.

174. Id. at 1.

175. Id.

New FASB Rules on Accounting for Leases 397

apply the new requirements” and to explain to users the effect of the changes in

accounting for leases on their ﬁnancial statements.

176

In addition, many organi-

zations “may need to consider supplementary processes and controls to ensure

that they capture leasing activity on the balance sheet.”

177

Others have noted a dearth of empirical studies demonstrating that signiﬁcant

beneﬁts would be obtained by reporting separate interest and amortization com-

ponents for operating leases.

178

To some, the cost/beneﬁt conversation may have

been framed in terms of the broader question of “the price that domestic com-

panies and auditors would have to pay for changing their reporting language

from GAAP to IFRS.”

179

The business community is not of one mind on this

issue. Multinational companies are already familiar with IFRS and are used to

reporting under them.

180

However, at many smaller, domestically centered com-

panies, the concept of converging GAAP with IFRS “has always been synon-

ymous with lost time, red tape and compliance costs.”

181

F. EFFECTIVE DATE,TRANSITION RULES, AND MAJOR IMPACTS

ASU 2016-02 provides different effective dates depending on whether a com-

pany is a public company. For public companies,

182

ASU 2016-02 is effective for

ﬁscal years and for interim periods within those ﬁscal year s, beginning after De-

cember 15, 2018.

183

Therefore, for a calendar-year public company, ASU 2016-

022 is effective January 1, 2019.

184

In addition, upon adoption, there must be

some retrospective application of the new principles, primarily with respect to

the balance sheet. Prior comparative years will need to be restated because

GAAP “requires the presentation of comparative balance sheets for the current

and prior year as well as three years of comparative income statements.”

185

For public companies on the calendar year, 2017 and 2018 must be restated

to reﬂect the impact of ASU 2016-02. For all other organizations, the new

rules are effective for ﬁscal years beginning after December 15, 2019, and for

interim periods within ﬁscal years beginning after December 15, 2020.

186

There-

176. Id. at 3.

177. Id.

178. Academic Literature, supra note 166, at 1016.

179. David M. Katz, The Split Over Convergence, CFO M

AG. (Oct. 17, 2014), http://ww2.cfo.com/

gaap-ifrs/2014/10/split-convergence/.

180. “[T]he beneﬁts of a full-scale move to IFRS always stood to be narrowly dispersed among big

multinationals.” Id.

181. Id. The Governmental Accounting Standards Board has not yet ﬁnalized its new lease ac-

counting standard, but it is expected to follow the IASB rather than the FASB and treat all leases

as ﬁnancing leases. See Joseph Sebik, The New Lease Accounting Standard: Transition Methodologies

and Considerations,A

CCT.POL’Y &PRAC.REP. (BNA), May 20, 2016, at 2 [hereinafter Transition

Methodologies].

182. A public company is any organization that is either a public business organization, a not-for-

proﬁt organization that has issued certain securities, or an employee beneﬁt plan that furnishes ﬁnan-

cial statements to the SEC. FASB

IN FOCUS, supra note 72, at 3.

183. ASC 842-10-65-1(a).

184. FASB

IN FOCUS, supra note 72, at 3.

185. Transition Methodologies, supra note 181, at 1.

186. ASC 842-10-65-1(b); see FASB

IN FOCUS, supra note 72, at 3.

398 The Business Lawyer; Vol. 72, Spring 2017

fore, for a calendar-year nonpublic company, the new rules are effective January 1,

2020.

187

The new rules will generally apply to all contracts in place on the effective

date, not merely to those that are entered into after the new rules take effect.

Therefore, unless a ﬁrm avails itself of the transition relief discussed below,

the new rules will apply to all of a ﬁrm’s contracts. This means, ﬁrst, that a

ﬁrm will be required to evaluate all of its contracts to determine whether they

are or contain leases. Depending on the ﬁrm, the magnitude of this task could

be staggering: “The list of agreements might include but not be limited to certain

product purchase or supply agreements, power purchase agreements, certain

concession agreements, dedicated contract manufacturing agreements and

even possible utility agreements.”

188

Second, contracts that are or contain leases

must be reassessed to determine whether they are to be classiﬁed as ﬁnance or

operating. Third, initial dir ect costs would need to be reassessed.

To avoid what could be the crushing administrative burden of making these

reassessments, the new rules permit ﬁrms to elect a liberal transition relief pack-

age, which ASU 2016-02 calls a “practical expedient.”

189

Those that elect the

transition relief package are not required to reassess whether existing contracts

are or contain leases.

190

A ﬁrm will not need to reassess whether old contracts

that were classiﬁed as leases are still leases. Similarly, contracts that were not

leases under the old model can simply be carried forward as representing some-

thing other than leases. In addition, companies that elect the package are not re-

quired to reassess the classiﬁcation of existing leases as ﬁnance versus operat-

ing.

191

Consider, for example, a lease that has been classiﬁed as an operating

lease because it ﬂunked by the thinnest of margins the SFAS 13 bright-line

tests for capitalization. That lease can contin ue to be classiﬁed as an operating

lease even if it would be clearly classiﬁed as a ﬁnance lease under the new

rules. In addition, companies that elect the transition relief package are not re-

quired to reassess initial direct costs for existing leases under the new and

more stringent direct cost standards.

192

This relief package is likely to save sig-

niﬁcant costs, particularly for ﬁrms with many contracts that are or might con-

tain leases.

193

Even assuming that most businesses will opt into the transition relief package,

major accounting and legal ﬁrms, in-house accountants and attorneys, and other

187. Earlier adoption is permitted. A “modiﬁed retrospective” transition would be required. To

make things easier, the lessee can use hindsight to determine whether, for example, it exercises re-

newal or purchase options.

188. Transition Methodologies, supra note 181, at 7.

189. ASC 842-10-65-1(f). The same practical expedient is available to lessors.

190. ASC 842-10-65-1(f)(1).

191. ASC 842-10-65-1(f)(2).

192. ASC 842-10-65-1(f)(3).

193. There is also a second practical expedient that allows ﬁrms to use hindsight to determine the

lease term when, for example, considering whether options to extend or purchase have been exer-

cised or declined. ASC 842-10-65-1(g). This second practical expedient may be adopted or not in-

dependent of the transition relief package.

New FASB Rules on Accounting for Leases 399

experts are encouraging businesses to begin immediately considering what it will

take to transition to the new rules.

194

The transition rules are lengthy and com-

plex, with potentially signiﬁcant costs attached, and are beyond the scope of this

article.

195

Because almost all leases must now be recorded on the balance sheet, many

ﬁrms may need to report signiﬁcantly more data, particularly with respect to op-

erating leases.

196

In the past, operating lease data may have been obtained only

for business purposes and not for ﬁnancial accounting purposes.

197

Many ﬁrms

will need new processes to support the classiﬁcation and measurement of lease

assets and liabilities.

198

For some, new software and systems may be required to

capture, store, retrieve, manipulate, and report data for ﬁnancial accounting pur-

poses.

199

For example, new software may be necessary to perform present value

and amortization calculations for virtually all leases.

In addition to the need for new software and systems, the new standard will

have governance implications for public companies. Because of the signiﬁcance

of the new leasing standard and its potential effect on many companies with sub-

stantial lease obligations, it will be important that senior management assure that

the company is properly applying it. For example, the standard will require the

review and modiﬁcation of a company’s policies concerning internal control

over ﬁnancial reporting (“ICFR”) to assure that the proper assessments are being

made, recorded, and reviewed. In addition, the periodic certiﬁcations made re-

garding ICFR by the company’s principal executive and ﬁnancial and accounting

ofﬁcers will need to reﬂect the ICFR as so modiﬁed. Further, if the company has

an audit committee ﬁnancial expert, consideration should be given to whether the

expert is familiar with the new leasing standard and its effect on the company.

Another reason to begin early is to assess any possible increase in the cost of

credit for ﬁrms whose balance sheets make the extent of their leverage more ap-

parent. Hopefully, the massive increase in borrowing costs and the resulting

dire economic consequences predicted by the Chamber Study will not materialize.

Although it appears that well over $1 trillion of fresh obligations will be recorded

194. See New Leases Standard, supra note 83.

195. Transition Methodologies, supra note 181 passim, is an extensive and excellent article on the

transition rules.

196. See ASC 842-20-50-1—842-20-50-9 (other lessee qualitative and quantitative disclosure

requirements).

197. “Few lessees maintain a sophisticated lease accounting system designed to handle capitalized

leases and the offsetting liability treatment. Lessors may offer their support in the interim to keep the

leasing volume up but, ultimately, lessees will need their own systems to better manage and account

for their leases.” Paradigm Shift, supra note 85, at 6.

198. “For some companies, the new lease accounting standard . . . is likely to entail signiﬁcant cost

and complexity. The cost of adoption is likely to include the education of all key stakeholders, robust

systems upgrades, new processes, and implementation of new controls.” Perspective, supra note 68, at 3.

199. New Leases Standard, supra note 83 (slide 38) (addressing the need for technology to support

efﬁcient data gathering for large volumes of leases, store lease documents and related data, and per-

form necessary calculations while creating required disclosures, as well as other operational consid-

erations). Compare Economic Impacts, supra note 66 (“[T]he necessary data should already be collected

if these ﬁrms have good internal control systems, particularly in light of developing fair value disclo-

sure requirements.”).

400 The Business Lawyer; Vol. 72, Spring 2017

on balance sheets, the existence of those obligations is neither new nor a surprise,

especially in the case of public companies. As the SEC Report and others

200

have

noted, many sophisticated investors, creditors, and rating agencies had already re-

constructed the balance sheets of public ﬁrms to add long-term lease obligations as

liabilities. Furthermore, many lending decisions and loan covenants have been

made more on the basis of the income statement than on the basis of the balance

sheet. There is empirical evidence that creditors and lenders rely less on the bal-

ance sheet and more on the income statement when it comes to ﬁrms with signif-

icant amounts of operating leases.

201

To the extent that is true, recording operating

leases on the balance sheet may have a less signiﬁcant or even minimal impact on

the cost of funds. Similarly, given the FASB’s continuation of the operating lease

classiﬁcation for expense purposes, ratios based on the income statement of com-

panies with multiple operating leases may be largely unaffected, whether the ratios

are being used for credit decisions, to determine compliance with existing cove-

nants, or to provide for executive compensation.

It remains to be seen whether the new leasing standard will affect the cost or

availability of credit for nonpublic companies. Many credit decisions relating to

nonpublic companies will still be made on the basis of income statement analysis.

The important question is often whether the company’s cash ﬂow is sufﬁcient to

enable it to service its debt and other obligations. Nonpublic companies may be

required to provide lenders with much more ﬁnancial information than is set

forth in the ﬁnancial statements, including proposed budgets; projected ﬁnancials,

including a comparison of actuals versus budget; more information about receiv-

ables; and so forth. Very small or less ﬁnancially sound ﬁrms may continue to

ﬁnd ﬁnancing based on secured debt, guarantees, or other credit support.

Companies may look for ways to minimize the new lease liabilities that are re-

corded on the balance sheet. Some may claim that arrangements that previously

might have been leases are no longer leases because the new control-the-use re-

quirement is not met. Others may rely on the provision that contracts transferring

an undivided interest in the use of assets, such as pipelines or ﬁber-optic cables,

are not leases because they do not involve an identiﬁed asset.

202

Still others may

ﬁnd new incentive to disaggregate their package agreements into lease components

versus non-lease components to avoid capitalizing payments for signiﬁcant items,

such as maintenance or other services, rather than for the use of an asset.

203

Some

ﬁrms may consider altering their standard form contracts. For example, retailers

200. See also Academic Literature, supra note 166, at 997 (“In general, the research reports that

lenders, credit rating agencies, and other capital market participants sufﬁciently understand off-

balance sheet leases and consider them in their decision making.”).

201. Daniel Gyung H. Paik et al., The Relation Between Accounting Information in Debt Covenants and

Operating Leases,29A

CCT.HORIZONS 969 (2015).

202. See ASC 842-10-55-60.

203. Paradigm Shift, supra note 85, at 6 (“Previously bundled elements will be broken out into sep-

arate components or those elements may be billed separately. Lessees may now request that certain

items that were previously included in the cost of an asset, such as a long-term warranty or mainte-

nance agreement, be billed on an as-incurred basis rather than included upfront so as to minimize the

capitalized value.”).

New FASB Rules on Accounting for Leases 401

with many operating leases, or even professional service ﬁrms with many loca-

tions, may consider whether to rent for shorter periods

204

or opt for more variable

rent and less ﬁxed rent to reduce the amount of rent that must be capitalized.

205

Perhaps the venerable long-term, triple-net lease will itself be reconsidered in

some situations. The loss of favorable balance sheet treatment for operating leases

may cause some ﬁrms to consider whether the scale has been tipped so far that

yesterday’s lease should be tomorrow’s purchase. Each of these possible contract

changes will have to be evaluated from both an operational and a ﬁnancial stand-

point to consider potential beneﬁts and costs.

All ﬁrms should consider the impact of the new rules on their operating re-

sults, their performance and debt coverage metrics,

206

and their debt covenants.

Throughout the project, there has been particular concern about the impact on

debt covenants.

207

Indeed, the FASB has said that the long lead time between

issuance and implementation was intended to “mitigate concerns raised about

potential debt covenant violations.”

208

Most of the concern about debt covenants seems to have been about covenants

based on the balance sheet rather than on the income statement. Many borrow-

ers have covenants providing that it is an event of a default, or an event that re-

quires additional steps to be taken, if debt recorded on the balance sheet exceeds

a certain amount or ratio. The speciﬁc language of a debt covenant can be crit-

ical. Perhaps the most basic question about existing covenants is, “Which GAAP

controls?” If a debt covenant is explicitly based on GAAP as it existed at the time

the covenant was entered into, the fresh liability from operating leases may not

breach or trigger the covenant. If, however, a covenant does not refer to GAAP as

of a particular point in time, it may be subject to interpretation or require rene-

gotiation. For example, should liabilities attributable to operating leases be con-

sidered debt within the meaning of an existing covenant?

209

Many indentures

204. If a shorter term is accompanied by renewal options, periods covered by options the lessee is

reasonably certain to exercise must be added to the lease term. ASC 842-10-30-1(a); see also Paradigm

Shift, supra note 85, at 5 (“Lessors may seek residual value guarantees from lessees to compensate for

additional lessor risk associated with shorter lease terms, but lessees will have to include any portion

of the guaranteed amounts that are probable of being paid in lease payments (and thus capitalize that

portion).”).

205. Variable lease payments that do not depend on an index or rate are not lease payments that

must be capitalized. ASC 842-10-30-6(a).

206. See C

ATALYST, supra note 122, at 4 (“While the dual model may often limit the impact on

income-based performance metrics, it may impact other ﬁnancial metrics that utilize balance sheet

elements, for example, debt-to-equity ratios or return on assets metrics. Further, there may be indi-

rect impacts caused by these changes. For example, recording signiﬁcant additional assets may affect

state tax payments, while changes to key metrics may alter incentive compensation payments or earn-

outs and perhaps even impact legal or regulatory capital.”).

207. Firms may also opt to apply the new standard early. ASC 842-10-65-1(b).

208. See Costs and Beneﬁts, supra note 172, at 3; see also Clifford W. Smith, Jr., A Perspective on

Accounting-Based Debt Covenant Violations,68A

CCT.REV. 289, 292 (1993) (“The longer the time

from an initial discussion memorandum to ﬁnal implementation, the more time ﬁrms will have to

adjust and the less likely the changes will result in technical default.”). The author notes that lenders

have incentive to renegotiate contracts: “For the lender, maintaining a reputation for eschewing op-

portunistic behavior is important in attracting future borrowers . . . .” Id.

209. Some covenants treat off-balance sheet leases as debt. L

IPE REVIEW, supra note 60, at 5.

402 The Business Lawyer; Vol. 72, Spring 2017

and credit agreements make clear that indebtedness relates to money borrowed

and not to lease obligations. However, even if the distinction was not explicit,

lease obligations may not have been intended to be included at the time the cov-

enant was made. The different nature of operating lease liabilities is underscored

by their separate treatment under the new standard. They must be stated sepa-

rately on the balance sheet and treated differently on the income statement. Similar

issues can arise with respect to executive compensation agreements.

V. CONCLUSIONS

ASU 2016-02 clearly advances the purpose of SOX to address off-balance

sheet ﬁnancing. It does so by requiring that most leases, including operating

leases, be reported on the balance sheet. The new rules on balance sheet inclu-

sion no longer focus on whether a lessee has substantially all the beneﬁts and

burdens of the underlying asset. Rather, the focus is on the leasehold interest it-

self. Any contract that is in substance a lease for more than twelve months must

be capitalized and recorded on the balance sheet as both an asset and a liability.

The asset is called a right-of-use asset, and the lease liability is the obligation to

pay rent for the entire term. Both the asset and the liability must be recorded on

the balance sheet at an amount equal to the present value of the future rent pay-

ments. However, the distinction between a ﬁnance lease and an operating lease

continues for purposes of the income statement. The two also must be presented

separately on the balance sheet.

The Chamber Study predicted that the greater apparent leverage will increase

borrowing and credit costs for many ﬁrms and cause them to divert monies away

from productive use and toward deleveraging. However, the SEC Report, the

Lipe Review, and others have made the point that sophisticated creditors, inves-

tors, and rating agencies had already used ﬁnancial models that effectively recon-

structed the balance sheets of public ﬁrms to reﬂect lease liabilities. There also is

empirical evidence that investors and creditors often evaluated ﬁrms with many

leases more on the basis of the income statement than on the basis of the balance

sheet. Moreover, it has been clear for years that the ﬁnal res ult was going to be

lease capitalization on the balance sheet. Depending on the ﬁrm, there are two or

three additional years before the rules take effect. Most sophisticated ﬁrms

should have had ample time to adjust to any new balance sheet presentation.

Time and empirical study will tell the extent to which some ﬁrms will indeed

incur increased lender, creditor, or investor demands because the extent of

their leverage is now more readily apparent. The biggest increase in the cost

of funds may be felt by smaller ﬁrms whose creditors or investors previously

made decisions on the basis of unreconstructed balance sheets.

The new rules may impose other signiﬁcant costs on ﬁrms. Even ﬁrms that opt

into the transition relief package should begin immediately to assess the extent to

which operating systems may have to be redesigned and new technology de-

ployed to collect, assess, and manipulate data, including the calculation of the

present value of every lease. There may also be other signiﬁcant economic or

New FASB Rules on Accounting for Leases 403

legal consequences. The impact is likely to be felt more by some ﬁrms than oth-

ers, particularly by those with many operating leases. Depending on the indus-

try, ﬁrms may consider whether to structure their contracts differently to avoid

lease classiﬁcation or to minimize the amount that must be capitalized and re-

ported on the balance sheet. Some real estate leases, for example, may become

shorter or may be based more on contingent rent than on ﬁxed rent. All ﬁrms

should consider the impact of the new rules on their performance and debt cov-

erage metrics, including the extent to which they affect their ability to obtain ﬁ-

nancing, their debt covenants, and their executive compensation agreements.

Some also may need to address internal or regulatory controls.

Costs aside, the new rules reﬂect and reinforce the trend away from formalism

and toward economic substance. Despite the divergence on expense treatment

for operating leases, the new rules reﬂect a further shift away from a rules-

based approach and toward the IASB’s principles-based approach.

210

The for-

malistic tests of SFAS 13 enabled gaming the rules to the knife’s edge. The

new rules are written without bright lines and are intended to discourage a for-

malistic approach. They ask companies to use judgment

211

to prepare ﬁnancial

statements based on economic reality. Throughout, they apply a totality-of-the-

circumstances approach that considers the full range of economic realities. Re-

peatedly, ﬁrms are asked to assess “all economic factors,” including those that

are “contract-based, asset-based, market-based and entity-based.”

212

The shift

away from formalism and toward practical economic reality is intended to en-

courage more meaningful reportin g in basic ﬁnancial statements and beyond.

210. Cf. U.S. SEC.&EXCH.COMM’N,STUDY PURSUANT TO SECTION 108(D) OF THE SARBANES-OXLEY ACT OF

2002 ON THE ADOPTION BY THE UNITED STATES FINANCIAL REPORTING SYSTEM OF A PRINCIPLES-BASED ACCOUNT-

ING

SYSTEM (2003), https://www.sec.gov/news/studies/principlesbasedstand.htm#1a.

211. Not everyone is pleased about converging with standards that rely more on judgment. See Let-

ter of Sen. Carl Levin to Russell G. Golden, Chairman, Fin. Accounting Standards Bd. 2 (Oct. 14, 2014)

(“Finance executives and corporate accountants will have to, and will be encouraged to, use their judg-

ment much more than they’ve ever had to before. Given competitive pressures and the history of ac-

counting abuses over the last two decades, greater reliance on management judgment to ensure proper

accounting disclosures does not build conﬁdence.”). Senator Levin was discussing the newly converged

revenue recognition standards in Fin. Accounting Standards Bd., Accounting Standards Update No.

2014-09, Revenue from Contracts with Customers (Topic 606) (May 28, 2014), which ASU 2016-

02 reﬂected. But see Adoria Lim & Chi Cheng, How Principles-Based Accounting Standards Impact Litiga-

tion,L

AW360.COM (Feb. 22, 2016), https://www.law360.com/articles/760089/how-principles-based-

accounting-standards-impact-litigation (“With regard to leasing speciﬁcally, research has generally

found that a move from rules-based standards toward principles-based standards results in less aggres-

sive reporting, perhaps for fear of litigation.”). The authors also report, however, that research outside

the area of lease accounting is mixed. Id. at 3. They also report some evidence that “mock juries return

fewer verdicts against auditors in a principles-based regime,” while noting a dearth of research regard-

ing hypothetical verdicts against companies or their directors and ofﬁcers. Id. at 4.

212. See ASC 842-10-55-26.

404 The Business Lawyer; Vol. 72, Spring 2017