Last Updated on January 12, 2023 by Morgan Beard
Introduction to ASC 842 Implementation
Accounting for leases under ASC 842 is a new area that many finance teams are carefully navigating in order to meet the ASC 842 deadline coming up on December 15, 2021 for private companies with a reporting period beginning subsequent to December 15, 2021. It is worth noting that the ASC 842 effective date has been delayed from its original timeline of December 2019 to relieve COVID pressures on accounting teams.
In an oversimplification, ASC 842 is in essence bringing all leases finance and operating leases onto the balance sheet. This is FASB’s effort to create more transparency into the lease liabilities of organization’s. If interested, on getting started with ASC 842, read our blog on How to Transition to the ASC 842 Lease Accounting Standards.
What are practical expedients?
Under the ASC 842 guidelines, FASB outlines relief for entities from the burden of having to determine whether leases are included in existing or expired contracts at the transition date. FASB created practical expedients as a way to save finance and accounting teams time, cost and overall effort during the ASC 842 transition. In this post, we will summarize practical expedients and how to implement these relief measures during your ASC 842 transition process.
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 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.
- Lease Classification – 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.
- Embedded Leases – 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.
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 or new land lease contract is signed after the entity’s effective date of ASC 842 then the lease must be assessed under ASC 842.
Do note, the transition practical expedient for existing land easements may be elected alone or with any of the other transition practical expedients.
Separate Lease & Non-Lease Components Practical Expedient (By Class of Underlying Asset)
Once a contract is deemed 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 a service.
An example of when to use this practical expedient would be with equipment leases. Say you lease a truck as a distributor and as a part of your lease agreement, a truck operator provides driving services of the leased asset on behalf of a customer. The truck is one component of the lease and the truck operator is a non-lease service or non-lease component. On the flip side, 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 it must be applied to all existing leases as well as any new or modified leases after the ASC 842 effective date.
Short-Term Lease Practical Expedient
Under ASC 842, any lease in which the lease term is 12 month or less does not need to be accounted for on the balance sheet. In other words, lessees do not need to recognize an ROU asset or the lease liability for leases with a term under 12 months at the lease commencement date.
Practical expedients under ASC 842 are developed to provide relief of the new ASC 842 compliance standards. Using practical expedients should reduce the time spent, the cost analyzing and the complexity endured of applying ASC 842. When electing to use these practical expedients, the entity must be positive that the lease or contract in question meets the expedients requirements in order to save on an audit at a later date.
Accounting Guidances 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.