Last Updated on May 25, 2023 by Morgan Beard
Accounting for leases under ASC 842, the new standard as laid out by the Financial Accounting Standards Board (FASB), has brought many changes in lease accounting practices. With the deadline for adoption of ASC 842 having passed for private companies on December 15, 2021, most finance teams operating under the United States’ Generally Accepted Accounting Principles (GAAP) are well into their transition to the new guidance.
The most significant change that comes with ASC 842 and its international counterpart, IFRS 16, is the requirement for all leases—finance and operating leases—to be recorded on the company’s balance sheet. The only real exception is a short-term lease exemption for contracts of exactly 12 months or less. This is all part of FASB’s efforts to create more transparency into an organization’s lease portfolio and the larger lease liabilities on their financial statements.
Beyond a few accounting policy elections, ASC 842’s guidance is primarily the same for all public business entities and private U.S. companies. However, there are several practical expedients that finance teams can choose to ease the transition to ASC 842. Here’s a look at some of them and what they mean for your company.
What are practical expedients?
Under the ASC 842 guidelines, all new leases must be accounted for under the new standards upon the company’s transition date. However, FASB outlines transition relief for entities from the Accounting Standards Update. Practical expedients act as an exception to the new lease accounting rules that, when implemented, add a shortcut acting as common sense relief methods.
Practical expedients can help companies save time, money, and overall effort during the ASC 842 transition. But some of these methods can also make things more complicated in the long run. In the following sections, you’ll learn about the pros and cons of choosing practical expedients. As well as how they impact your internal controls for financial statement users.
How to use the practical expedients when implementing ASC 842
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 a lease
- Lessee purchase options for an underlying asset
- Reassessment after impairment of an entity’s right-of-use assets
These practical expedients may be elected separately or in conjunction with other practical expedients. However, most believe the “package of three” practical expedients has priority over the use-of-hindsight practical expedient for lease classification or determining the outcome of actioning lease renewals or termination options.
The Package of Practical Expedients
This trio of practical expedients outlines the steps to election. If a company chooses this option, it must be adopted throughout the business and applied to all of its leases with commencement dates prior to the business’s effective date of transition to ASC 842.
- Lease Classification: An entity does not need to reassess the lease classification for any expired or existing leases. For example, leases classified as operating leases under ASC 840 are still classified as operating leases under ASC 842. Leases classified as capital leases under ASC 840 are now classified as finance leases under ASC 842.
- Embedded Leases: An entity does not need to reassess whether a contract contains a lease, assuming the lessee has accounted 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. The script is flipped with ASC 842, and initial direct costs are any costs that would not have been incurred without the acquisition of the lease.
While this “package of three” is a solid option for businesses, it doesn’t cover every type of scenario companies may encounter during the ASC 842 transition. Below are some additional practical expedients offered for the new guidance.
Land Easement Practical Expedient
With the land easement practical expedient, entities are allowed to elect not to assess whether those land easements contain a lease in accordance with ASC 842. Many land leases are prepaid and, as such, are already on the balance sheet. If an amendment is introduced or a new land lease contract is signed after the entity’s effective ASC 842 transition date, then the lease must be assessed under ASC 842.
Please note: the transition practical expedient for existing land easements can be elected alone or with any other transition practical expedients.
Separate Lease & Non-Lease Components Practical Expedient (By Class of Underlying Asset)
Once a contract is deemed to be or contain a lease, the lessee is permitted to account for each separate lease component and its non-lease components as one single lease component. Only the components that are integral to the right to use an underlying asset are considered lease components. In this case, a component constitutes the transfer of a good or service.
An example of when a business might choose this practical expedient would be for equipment leases. Say you lease a truck as a distributor, and as a part of your lease agreement, you’re afforded a truck operator who provides driving services for the leased truck on your behalf. The truck is one component of the lease, and the truck operator is a non-lease service provision or non-lease component. Conversely, multiple lease components cannot be combined into one singular lease component.
Risk-Free Rate Policy Practical Expedient (Private Companies Only)
Private companies are permitted the risk-free rate practical expedient as the discount rate for their leases. This essentially allows lessees to avoid having to calculate an incremental borrowing rate, which could create unnecessary cost and complexity, and instead use a discount rate that is anything higher than zero. If this election is made, then you must apply it to all existing leases, all new contracts, and any lease modifications after the ASC 842 effective date.
Short-Term Lease Practical Expedient
Under ASC 842, the short-term lease practical expedient allows any lease with a lease term of 12 months or less to be excluded from the balance sheet. In other words, lessees do not need to recognize an ROU asset or the lease liability for any leases with terms less than 12 months at the lease commencement date.
Adapting to the New Lease Accounting Standards
With ASC 842, your organization’s financial reporting better reflects its lease obligations. Under previous standards, some leases may not have been reflected on the balance sheet, effectively hidden in notes and disclosures. And rather than simply recording lease payments and allocations on the books, the new standard captures lease assets and liabilities for a more holistic view of a company’s financial standing. The only hurdle is completing your transition as easily as possible.
Using practical expedients can help reduce the time spent on modifications and calculations, the cost analysis, and the complexities endured when transitioning and applying ASC 842’s guidance. When electing to use these practical expedients, the organization must be positive that the lease or contract meets the expedient’s requirements to avoid issues with financial audits down the road.
In the era of ASC 842, comprehensive lease accounting software is the best way to reap the benefits of the new standard and remain compliant. Occupier is the only lease management and accounting software that enables commercial tenants, CPAs, and real estate teams to collaborate. To see for yourself, schedule a demo today.
Accounting Guidance Reference:
- ASC 842-10-65-1
- Deloitte A Roadmap to Applying the New Leasing Standard (2020) 16.5.1, 16.5.2, 16.5.3
- Check out our Lease Accounting Compliance Hub for all things ASC 842.
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