Implementation of ASC 842, Leases, can seem daunting due to the substantial analysis and related long hours that may be required. Thankfully, the Financial Accounting Standards Board (FASB) has provided some relief to adopters in the transition to the new standard including a series of available practical expedients.
However, there are stipulations which affect these expedients, and if not interpreted and applied correctly, potentially material financial misstatements could result. For example, one of the available practical expedients allows entities to simply carryforward each lease’s classification under the legacy leasing guidance prescribed within ASC 840. This expedient can save adopters countless hours if they don’t need to perform lease classification analysis for every single lease to which the company is a party at the transition date. The catch is that companies are not eligible to elect this practical expedient if they made any mistakes with the original classification.
To assist in the transition to and implementation of ASC 842, we have summarized the available practical expedients, key benefits, as well as some potential pitfalls.
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 re-evaluating 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 (ROU) 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 leases 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, allow 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 lease 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.
How Centri Can Help
Even though these practical expedients exist to make things easier on companies implementing ASC 842, they have the potential to exacerbate the issue if not interpreted and applied correctly.
Centri is comprised of seasoned professionals with extensive GAAP and SEC reporting experience including former international and Big 4 accounting firm partners, directors, and managers. Our technical expertise and extensive research into these practical expedients make Centri a valuable asset for any company adopting the new standard.
Centri helps clients to take advantage of the opportunities the practical expedients provide to reduce time and effort spent transitioning to ASC 842. Our firm has extensive experience with these analyses and can provide insight on the costs and benefits of each expedient to determine which of them would be advantageous to adopt, depending on each client’s needs. Additionally, Centri can ensure that each expedient is interpreted correctly due to experience gained from previous engagements as well as extensive technical research on the subject. Trust Centri to save your company countless hours trying to properly adopt the new standard and anxiety of not knowing if the standard was implemented correctly.
About Centri Business Consulting, LLC
Centri Business Consulting provides the highest quality finance and accounting consulting services to its clients by being reliable and responsive to their needs. Centri provides companies with the expertise they need to meet their reporting demands. Centri specializes in financial reporting, internal controls, valuation services, technical accounting research and CFO advisory services for companies of various sizes and industries. From complex technical accounting transactions to periodic financial reporting, our professionals can offer any organization the specialized expertise and multilayered skill sets to ensure the project is completed timely and accurately.
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