ASC 842, Leases, became effective for public business entities for annual periods beginning after December 15, 2018 and interim periods therein. For all other entities, including private companies, ASC 842 is effective for annual periods beginning after December 15, 2020. Successful implementation of ASC 842 demands considerable time, resources, and specialized expertise. As was the case with ASC 606, Revenue from Contracts with Customers, private company readiness for the new lease accounting guidance under ASC 842 is currently lagging and many private companies will be caught unprepared for the new leasing standard’s impact.
ASC 842 will impact all industries and substantially all companies will be materially affected. Over $2 trillion of additional lease liabilities (with corresponding right-of-use (ROU) assets) have been recorded to S&P 500 balance sheets alone as a result of the application of ASC 842. Companies that lease high dollar value equipment will see a significant increase in reported assets and liabilities. Other companies that have many low dollar value leases may find adoption of ASC 842 to be extremely time-consuming and costly as they identify all leases and related data needed to apply the new guidance.
Lessees are likely to be most significantly affected by the new leasing guidance. ASC 842 retains the two-model approach to classifying leases as operating or finance leases; however, most leases, regardless of classification type, will now be recorded on the balance sheet.
Although the changes to the lessor model are not as significant, lessors should not underestimate ASC 842’s potential impact. Most importantly, the profit recognition requirements under the lessor model are aligned with those under ASC 606, and the lease classification criteria have been amended to be consistent with those for a lessee. ASC 842 requires a lessor to classify a lease, at its commencement, as a sales-type lease, direct financing lease, or operating lease based on the classification criteria in the guidance.
The primary challenges companies face in the implementation of ASC 842 include ensuring completeness of lease population, data gathering and analysis, identifying and accounting for embedded leases, and system, process, and control changes and enhancements. The detail and volume of information required to complete the ASC 842 assessment and related disclosures is significantly greater than the lease information historically accumulated and maintained by most companies. Low quality lease documentation and decentralized lease processes are factors that will slow the process of capturing complete data required for the ASC 842 assessment.
The new lease accounting guidelines are often too complex for spreadsheets. There can be hundreds to thousands of lease contracts across the various operations of a large global company. These contracts must all be captured and analyzed. Then calculations must be run. The volume of data and calculations will be too much to manage in spreadsheets, and most general ledger systems are not designed to manage lease details or the corresponding calculations.
ASU 2016-02 prescribes that companies adopt the new leasing guidance using a modified retrospective transition method. Under this transition method, a company initially applies ASC 842 at the beginning of the earliest period presented in the financial statements, i.e., restating prior comparative periods. Lessees must also provide the new and enhanced disclosures for each period presented, including the comparative periods.
ASU 2018-11 provides an optional transition method allowing companies to initially apply the new leasing guidance at the adoption date. Under this transition option, companies can opt to continue to apply the legacy guidance in ASC 840, including its disclosure requirements, in the comparative periods presented in the year of adoption of ASC 842. This means companies that elect this option will make only annual disclosures for the comparative periods because ASC 840 does not require interim disclosures. Companies that elect the optional transition method still adopt the new leasing guidance using the modified retrospective transition method required by the guidance, but they recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption rather than in the earliest period presented. For convenience, it is expected that most companies will elect to adopt this optional transition method.
In order to assist companies with the implementation of ASC 842, the Financial Accounting Standards Board (FASB) has issued several practical expedients. Electing these expedients will save you time, but if you do not interpret them properly, you will end up with errors in your lease accounting. The available practical expedients include:
The Package of Practical Expedients
- Whether any expired or existing contracts are or contain leases,
- Lease classification for any expired or existing leases, and
- Initial direct costs for any expired or existing leases (i.e., whether those costs qualify for capitalization under ASC 842).
These three practical expedients must be elected as a package and must be consistently applied to all leases. A company cannot choose which of the individual practical expedients to apply or which leases to apply them to. The package of practical expedients is intended to greatly reduce the amount of time a company will be required to spend reevaluating its active leases. It is expected that most companies will elect the package to save time. However, it is important to note that election of the practical expedient package does not grandfather incorrect or missing assessments under prior GAAP.
The Hindsight Practical Expedient
ASC 842 also provides companies the option of electing the hindsight practical expedient which allows a company to use hindsight in determining the lease term and in assessing any impairment of right of use assets during the lookback period. (i.e., the comparative periods that are being restated). While the hindsight practical expedient can be elected separately or in conjunction with other practical expedients, it must be applied to all leases during the lookback period, including both when the company is a lessee and a lessor. Using the hindsight practical expedient might require a lot of effort if a company has a large number of leases. In some cases, applying this expedient may be more challenging than not applying it.
Land Easements Practical Expedient
Some companies may have numerous land easements going back many years. Historically, some companies have accounted for land easements as leases, while others have accounted for them as intangible assets. ASU 2018-01 provides an optional practical expedient that will permit a company to elect to not apply the new leasing guidance to land easements that existed before the effective date of the new guidance, but only if the land easements were not previously accounted for as leases. Companies that elect the land easement practical expedient will still need to evaluate whether land easements entered into or modified on or after the effective date meet the definition of a lease under ASC 842.
Short-term Lease Practical Expedient
ASC 842 states that as an accounting policy, a lessee may elect not to apply the recognition requirements to short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred. A short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less, including consideration of renewal options whose exercise is reasonably certain, and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. The accounting policy election for short-term leases is to be made by class of underlying asset.
Discount Rate Practical Expedient
ASC 842 allows a company to apply a single discount rate to a portfolio of leases if lessees and lessors can prove that the application will have the same material effects as the application to the individual leases in that portfolio. In addition, and because of the difficulty of determining the Incremental Borrowing Rate (IBR), ASC 842 provides a practical expedient to private companies by allowing those reporting companies to use a risk-free rate to determine lease classification. While the risk-free rate is certainly easier to determine than the IBR, the use of the risk-free rate could result in more leases qualifying as finance leases because the present value of the lease payments determined using the risk-free rate will be greater than the present value determined using the IBR. Accordingly, private company lessees will need to carefully consider the implications if they elect to use the risk-free rate.
Separation of Lease and Non-lease Components for both Lessee and Lessor
ASC 842, as an accounting policy election by class of underlying asset, allows both lessees and lessors to choose not to separate non-lease components from lease components. This expedient alleviates the costs and administrative burden of allocating consideration to separate lease and non-lease components that would more precisely reflect the ROU asset and lease liability.
Additional Issues Faced by Lessors
In December 2018, the FASB approved narrow scope improvements for lessors. Specifically, the FASB amended the new leasing guidance to allow lessors to make an accounting policy election not to evaluate whether sales taxes and similar taxes imposed by a governmental authority on a specific lease revenue-producing transaction are the primary obligation of the lessor as owner of the underlying leased asset. In addition, the amendments require a lessor to exclude lessor costs paid directly by a lessee to third parties on the lessor’s behalf from variable payments and include lessor costs that are paid by the lessor and reimbursed by the lessee in the measurement of variable lease revenue and the associated expense. Finally, the amendments clarify that when lessors allocate variable payments to lease and non-lease components, they are required to follow the recognition guidance in ASC 842 for the lease component and other applicable guidance, such as ASC 606, for the non-lease component.
In March 2019, the FASB reinstated the exception to determining the fair value of underlying assets by lessors that are not manufacturers or dealers. The amendment states that lessors, who are not manufacturers or dealers, will use their cost, reflecting any volume or trade discounts that may apply, as the fair value of the underlying assets. However, if significant time lapses between the lease commencement date and the acquisition of the underlying asset, the exception will no longer apply, and the lessors will be required to apply the definition of fair value (exit price) in ASC 820, Fair Value Measurements and Disclosures.
Capitalization Threshold Considerations
Many companies have accounting policies that establish a materiality threshold for capitalizing fixed assets. Under such policies, expenditures below the established threshold are expensed in the period incurred, as opposed to being capitalized on the balance sheet and depreciated over the life of the asset. While ASC 842 does not provide a specific exemption for low dollar assets, a company is not required to apply U.S. GAAP to immaterial items; therefore, materiality is always a consideration in the preparation of financial statements.
The financial statement impact of not identifying whether a contract is or contains a lease could be much more significant under ASC 842. As a result, many companies are sharpening their pencils on lease identification. Under ASC 842, 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. Control is considered to exist if the customer has both the right to obtain substantially all the economic benefits from the use of an identified asset and the right to direct the use of that asset.
Although the assessment of whether a contract is or contains a lease is often straightforward, the evaluation is more complicated when an arrangement involves both a service component and a leasing component or when both the customer and the supplier make decisions about the use of the underlying asset (i.e., an embedded lease). Companies in the banking, manufacturing, energy, oil and gas, healthcare, retail, restaurant, and logistics/transportation industries have a significant number of service contracts with embedded leases. Companies that use data centers have embedded leases as well.
The new rules regarding embedded leases are among the trickiest elements of ASC 842. Under ASC 840, service contracts that contain embedded leases were treated the same as service contracts that do not, i.e., they were amortized straight-line over the service term. Under ASC 842, companies must bifurcate the contract into the lease and non-lease components and record those embedded leases to avoid material misstatements. This is a practice that many companies may think they can skip, but it is critical to compliance with ASC 842, and misapplication will likely result in a required future restatement.
To identify embedded leases, the first thing you need to do is determine if there is an identified asset in the contract. Keep in mind, identified assets are tangible assets, i.e., they do not include intangible assets. Identification can be explicit or implicit. Explicit identification is when the asset is specifically identified in the service contract. Alternatively, an asset is implicitly identified when the only way the supplier can satisfy the obligation under the contract is to utilize that asset. The second thing to determine if you have an embedded lease is to evaluate if the lessee has the right to control the asset and obtain substantially all its economic benefits. If there is identification, control, and the company obtains substantially all the economic benefits, then you have an embedded lease that needs to be accounted for under the scope of ASC 842.
An additional area of significant judgment under ASC 842 is with the discount rate to be used. If you know the implicit rate in the lease, or if you can recalculate that rate, that is the discount rate to be used. Most leases do not specify the implicit interest rate, so lessees do not know it. Typically, you will be able to calculate that rate when you are leasing vehicles or certain types of equipment where you know the fair value of the asset at the beginning and end of the lease, and how much your payments are. You can use that data to determine the rate you would need to get from the initial fair value of the asset to the ending fair value based on your payments. However, this calculation is not possible when you do not know the fair value of the asset.
In these cases, ASC 842 prescribes that the discount rate to be used (Incremental Borrowing Rate) is the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. A common mistake when calculating discount rates is using the weighted average cost of capital to determine the discount rate. This is the wrong approach because the weighted average cost of capital includes an equity component and is not in conformity with ASC 842.
How Centri Can Help
Centri is comprised of seasoned professionals with extensive GAAP and SEC reporting experience including former international and Big 4 accounting firm partners, senior managers, and managers. Centri can offer technical accounting guidance and lead implementation projects by leveraging our accounting and reporting expertise and project management capabilities.
Areas where Centri can assist companies with their ASC 842 assessment and implementation include:
- Identifying a company’s full population of leases including any embedded leases that may exist within service contracts,
- Based upon the population identified, determining if the required change under ASC 842 is likely to have a material impact on a company’s current accounting,
- Developing a gap analysis to help companies understand where processes, systems, controls, and reporting need to be updated upon the adoption of ASC 842,
- Assisting in the company’s plan to address identified gaps as identified in the analysis,
- Assisting in the ASC 842 implementation including:
- Establishing a centralized repository for all lease agreements,
- Reviewing all lease agreements and inputting relevant information into the company’s lease accounting system, and
- Reviewing and testing the output of the lease accounting system for a sample of leases,
- Determining information required to comply with ASC 842 and drafting required disclosures, and
- Providing training on ASC 842 to company personnel.
Related Services: SEC Compliance and Financial Reporting; IPO Readiness; Technical Accounting And Position Papers; Audit Support; Risk Advisory Services; Outsourced Accounting Services; Mergers And Acquisitions.
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