Last Updated on August 30, 2022 by Neil Patel Accel
An estimated $3 Trillion dollars in lease liabilities is going onto the balance sheet with the ASC 842 standards. The most notable change is removing operating leases from the footnotes and instead recording those lease obligations on the balance sheet. That being said, preparing, understanding, and complying with the new standard is going to require a well-formulated ASC 842 transition roadmap. We are going to dive into your transition options and steps in this blog.
ASC 840 to ASC 842 Transition Options
Lessees must adopt ASC 842 using a modified retrospective transition approach. Reporting entities may elect to apply the transition approach either (a) as of the beginning of the earliest period presented in the financial statements – in which case it would adjust its comparative periods or (b) as of the beginning of the period of adoption – in which case it would not adjust its comparative periods as denoted below:
- Comparative Option: An entity can elect to apply the new lease standard at the beginning of the earliest period presented, and recognize a cumulative effect adjustment to the opening balance of equity in that period. This approach will result in any leases existing at, or entered into after, the beginning of the earliest period presented being reported in accordance with ASC 842.
- Effective Date Option: An entity can elect to apply the new lease standard at the effective date and recognize a cumulative effect adjustment to the opening balance of equity in the period of adoption. If an entity elects this option, the reporting for comparative periods presented in the financial statements will continue to be in accordance with legacy GAAP.
Underlying Assets Explained
While ASC 842 does not address what is meant by the phrase “class of underlying assets”, two views have emerged:
- View 1 — The class of underlying asset is determined on the basis of the physical nature and characteristics of the asset. For example, real estate, manufacturing equipment, and vehicles would all be reasonable classes of underlying assets given their differences in physical nature. Therefore, irrespective of whether there are different types of similar assets (e.g., within the real estate class, there may be retail stores, warehouses, and distribution centers), the class of underlying asset would be limited to the physical nature as described above.
- View 2 — The class of underlying asset is determined on the basis of the risks associated with the asset. While an asset’s physical nature may be similar to that of other assets (e.g., retail stores, warehouses, and distribution centers are all real estate, as discussed above), each has a different purpose and use to the lessee and would therefore have a separate risk profile. Therefore, for example, it could be appropriate for the lessee to disaggregate real estate assets into separate asset classes by “type” of real estate — to the extent that the different types are subject to different risks — when applying the practical expedients in ASC 842.
How to Identify Embedded Leases
Embedded leases are not explicitly defined by either ASC 842 or IFRS 16. But essentially, embedded leases are contracts that meet the accounting definition of a lease. A lease is a contract that gives the lessee the right to control the use of identified property, plant, or equipment, or PP&E.
As companies prepare their ASC 842 transition, identifying, collecting and organizing each and every contract across every department is the first step in identifying embedded leases. For instance, the marketing team can have a contract for an advertising billboard, the IT department may have a contract to use on-site servers, and a retail operations department may have a contract for space in a manufacturer’s facility for production.
There are 4 steps to identify a lease under ASC 842, and it starts with identifying the asset explicitly by serial number, VIN, or GPS coordinates etc. Or implicitly, based on whether a particular asset is required to fulfill a contract from commencement.
For finance and accounting teams, following the company expenses will give insights into who owns which contacts, then sitting down with those teams to better understand the contracts use case will prove helpful.
Implementation of Practical Expedients Under ASC 842
Practical expedients are relief efforts standardized to ease the transition to ASC 842 compliance. We’ll go over a few of the most common practical expedients to be aware of and consider during you lease accounting journey:
Hindsight Practical Expedient
When performing its hindsight assessment, an entity must consider events and circumstances that occurred up to the effective date of ASC 842. A company may elect to use hindsight when considering:
- Lessee options to extend or terminate the lease
- Lessee options to purchase the underlying asset
- Assessment of impairment of the entity’s right-of-use assets
This practical expedient may be elected separately or in conjunction with other practical expedients. However, most believe the“package of three” practical expedient has priority over the use-of hindsight practical expedient with respect to lease classification.
The Package of Practical Expedients
This trio of practical expedients outlines the steps in which an entity can elect and if they do so must then be adopted jointly and applied to all of it’s leases that commenced before the effective date.
- An entity does not need to reassess the lease classification for any expired or existing leases. For example, leases that were classified as operating leases under ASC 840 will be classified as operating leases under ASC 842. And leases that were classified as capital lease under ASC 842 will now be classified as finance lease under ASC 842.
- An entity does not need to reassess whether a contract contains a lease. This assumes that the lessee is accounting for leases accurately under ASC 840.
Initial Direct Costs
- An entity does not need to reassess any initial direct costs for any existing leases. With ASC 840, a lessee could apply the internal costs of acquiring a lease to initial direct costs. Yet, with ASC 842, the script is flipped and initial direct costs are costs that would not have incurred without the acquisition of the lease. In other words, external costs.
While practical expedients are helpful in relieving the stressors of transitioning to ASC 842, it does not leave any room for assessing if a lease that exists under ASC 840 can be carried forward. We have a post that delves deeper into the Implementation of Practical Expedients Under ASC 842.
Impact of ASC 842 on Debt Covenants
While the FASB has clearly articulated its view that lease liabilities resulting from operating leases under ASC 842 are intended to be characterized as operating liabilities outside of debt, the Board cannot dictate how banks and other lenders view such amounts. It is unclear whether banks and other lenders will take a consistent approach in evaluating liabilities for debt covenant purposes. Therefore, we encourage preparers and other stakeholders to communicate with these organizations to better understand the effects of ASC 842 on existing and future lending agreements.
FASB has considered potential issues related to debt covenants and noted the following factors significantly mitigate those potential issues:
- “Frozen GAAP” or “Semi-Frozen GAAP” clauses do not constitute a default and/or will require both parties to negotiate when a breach of loan covenant occurs as a result of new GAAP
- There have been banks who have stated that they are unlikely to dissolve a good customer relationship by “calling a loan” default due to the new GAAP accounting standards change
- ASC 842 defines operating lease liabilities as operating liabilities, not as debt
While many public companies are navigating the ASC 842 transition, only time will tell as to how banks respond to the addition of operating lease liabilities to the balance sheet. We have put together an outline of what we know now, called the impact of ASC 842 lease liabilities on debt covenants and bank capital requirements.
Navigating Disclosure Requirements
Under ASC 842, the disclosure requirements are more complex and intensive than with ASC 840. They offer a more in-depth analysis of how your business’s leasing activities from two major perspectives: one is qualitative and the other is quantitative.
Here are a few key disclosure requirements for lesses:
- Statement of financial position
- Statement of comprehensive income
- Maturity analysis of liabilities
- Significant assumptions and judgments disclosures
- Practical expedients disclosures
Learn more about why disclosure requirements were created and how they help financial statement readers gain a better understanding of an entity’s lease activities with our post disclosure requirements explained under ASC 842.
How to Start Your Transition Preparation
ASC 842 compliance is complicated, requiring a great deal of coordination to prepare for the likely hurdles ahead, so starting your transition to the new lease accounting standards early will be important. This transition not only affects the finance and accounting teams but it impacts nearly every department across the organization.
Designate a steering committee
As mentioned above, the ASC 842 transition touches numerous departments in an organization. So, the best first step is really to create a steering committee dedicated to helping your business gain ASC 842 compliance. Your steering committee should include finance and accounting team members, real estate teammates, as well as folks from Legal, IT & Security, as well as Audit. Each of these team members will bring a different perspective to your transition process. For instance, the legal requirements will differ from the real estate teams ASC 842 requirements as well as the finances teams transitioning requirements. Not to fear, there are tools and software solutions that help your entire team collaborate on the lease management process and meets each teams individual needs
Establish a timeline
Once your steering committee is in place, your ASC 842 team can start strategizing and planning a transition timeline. Careful planning will help you institute systems and processes that streamline the lease accounting transition under ASC 842. A few questions to help get your team started are:
- When shall we have all organizational contracts collected?
- Will we partner with a lease abstraction service provider?
- Do we have all our contracts in one single source of truth? Or does excel suffice?
- Do we want our real estate and lease accounting teams to collaborate within software?
- Do we understand the ASC 842 requirements?
- Do we understand the lease classification criteria under ASC 842?
- Which disclosure requirements apply to our lease contracts?
- Which practical expedients will we elect to use?
Collect all contract across your organization
This may seem like a no brainer, but many organizations that have started the ASC 842 transition cite this as the most underestimated and time consuming step. In fact, 50% of the attendees at Deloitte’s accounting and financial reporting symposium responded that collecting data on organization leases in a centralized inventory was their biggest challenge. Many departments do not even realize that the contract they have signed includes an embedded lease. It becomes a burden on the finance teams to track this information down, but once you have it all compiled and organized then your team can begin tackling the lease data abstraction. There are numerous softwares that can assist with the lease abstraction process.
Consider Implementation and Software Partners
Not all lease accounting solutions are created equally. Take time and consideration to find a software partner that brings all your organization’s teams together from finance, auditing, IT, facilities and real estate. Before investing in a platform, inquire about certain features that can streamline lease life cycle management, such as: SOC compliance, exportable reports, integrations, ease of use and real time updates amongst others.
If you are ready to take a tour of Occupier’s lease accounting solution, then request a demo with our team, and we’ll be happy to give you a product tour.