With an effective date of December 15, 2021, ASC 842 is right around the corner.
Different areas of ASC 842 have given entities trouble during implementation. Part one of this ASC 842 summary explored three of these: the definition of a lease, what counts as an embedded lease and how to identify the term of a lease.
Part two explores the six practical expedients and policy elections that can make the transition easier.
What practical expedients and policy elections are available to make transition easier?
Six primary expedients and elections are available to nonpublic business entities that may help simplify the accounting for leases under ASC 842. Of course, an entity should carefully consider which expedients, if any, it would like to elect. Thoughtful decision making, including weighing the pros and cons, should be employed in determine whether to elect each expedient.
The first three expedients discussed below are transitional expedients. That is, the entity may elect to apply the expedient at transition from ASC 840 to ASC 842, and the expedient primarily concerns the process of implementation and adoption. While the remaining three elections are also effective during the transition, they represent ongoing policies and accounting beyond the initial year of transition as well.
1. Package of three expedients: The package of three expedients is exactly what it sounds like: three expedients that have been combined into a “package” that can be adopted upon transition.
It’s described as a package because that is how the three expedients are treated — they are all or nothing. That is, an entity may elect to apply all three or will not apply any; an entity cannot pick and choose from the three.
The first of three expedients is that an entity does not need to reassess existing or expired contracts for lease classification (i.e., a lease that was classified as an operating lease under ASC 840 does not need to be reassessed for classification under ASC 842 and can carryforward the operating classification under the new standard).
The second is that an entity does not need to reassess existing or expired contracts for the existence of embedded leases.
The third is that initial direct costs under existing leases do not need to be reassessed under the new definition. Most entities are expected to elect this expedient.
It’s important to note that the expedients to not reassess existing or expired leases does not apply to errors. In other words, an entity cannot carryforward or grandfather in an improper lease classification or an embedded lease for which the accounting was improper.
For example, a lease that was accounted for as an operating lease under ASC 840 but should have been accounted for as a capital lease (but the correction was never made, perhaps because it was immaterial), cannot simply be carried forward as an operating lease. It must be reassessed under the classification requirements of the new standard.
Similarly, if an embedded lease existed under ASC 840 but the entity elected not to account for it as a lease (presumably because the effects were immaterial; no balance sheet impact and expensed as incurred), the entity must still reassess the contract because the embedded lease was following improper accounting treatment that cannot be carried forward under the guise of an expedient.
2. Hindsight expedient: This expedient allows an entity to use hindsight in assessing the lease term and other contract conditions upon transition. This may be beneficial, for example, if an entity intends to adopt the new standard using the full retrospective method (that is, applying the principles to both periods in comparative financial statements). In that scenario, a lease that the entity was reasonably certain to renew as of the end of YR1 would have included the renewal period in the lease term for purposes of calculating a lease liability and right-of-use asset on the YR1 balance sheet.
If, however, during YR2, the entity determined it was no longer reasonably certain to exercise the renewal option, the entity could use the hindsight expedient to report the YR1 impact using the information it knows now — that no renewal will take place.
This expedient has not been adopted frequently in practice, partly because not many private companies will adopt using a full retrospective method. Most entities are expected to adopt under the modified retrospective method, which does not require comparative reporting. Under the modified retrospective method, presentation and disclosure of the YR1 financial information would remain under ASC 840, and YR2 would apply the presentation and disclosure requirements under ASC 842.
3. Land easements expedient: The land easements expedient allows an entity to not reassess existing or expired land easements or right-of-ways for embedded leases. Historically, land easements may have been accounted for as a lease under ASC 840. However, indefinite easements may have been accounted for as intangible assets, and easements with a definite term may have been paid up front, resulting in a prepaid asset.
This expedient allows an entity to effectively carryforward that prior treatment. It is noted, however, that easements that were treated as leases under ASC 840 are not eligible for this election. In other words, they would still need to be reassessed under the principles of the new standard for proper measurement and accounting.
4. Short-term lease exemption expedient: One of the expedients that is exciting for many entities is the short-term lease exemption, which allows entities to not apply the recognition requirements in the new standard to leases with a term of 12 months or less. Therefore, leases qualifying for this exemption would not need to have a lease liability and right-of-use asset recorded on the balance sheet.
This expedient can be elected by class of underlying asset. For example, an entity could elect to apply this expedient to building leases but not to equipment leases.
There are a few additional important things to note regarding this expedient. First, if a lease contains a renewal option that is reasonably certain to be exercised, resulting in a lease term greater than 12 months, the lease will not qualify for this treatment.
Second, the standards are specific in stating that the lease must be 12 months or less; a lease that extends past 12 months (including renewal terms) does not qualify. This means that a lease agreement that states the lease begins on January 1, 2022, and ends on January 1, 2023, would not qualify, as the lease term would be 12 months and one day.
Third, the term of the lease is to be determined based on the lease commencement date. A five-year lease that started on November 1, 2017, would only have 10 months left upon adoption of the new standard on January 1, 2022. While the entity would measure the lease liability and right-of-use asset based on the remaining term of 10 months, the entity must still use the original lease term at commencement (60 months) for evaluation of whether the short-term lease exemption applies. In this example, the exemption would not apply to this lease.
5. Lease and nonlease components expedient: Many leases, especially leases embedded in other executory agreements, include other services besides the leased asset. Those other services are called nonlease components while the identified asset represents a lease component of the contract.
Under ASC 842, an entity would identify the lease and nonlease components within a contract, determine the value of each component, and account for each component under the respective applicable GAAP.
For example, a maintenance agreement with a printing company might include the lease of a copier and ongoing maintenance services related to the copier. The copier would represent a lease component of the contract, and the maintenance would represent a nonlease component. The entity would bifurcate the total contract price between the components based on the relative standalone value of each of the components (the copier and the maintenance) as if they were purchased separately. The copier (lease component) would be accounted for under the principles of ASC 842, and the maintenance (nonlease component) would be accounted for under other applicable GAAP, in this case accounting for expenses under a service agreement.
This expedient would allow an entity to not separate the lease and nonlease components when evaluating lease payments. Like the short-term lease exemption, this expedient can be made by class of underlying asset. For example, and entity may elect to apply the expedient (that is, not separate components) to equipment leases but not apply the expedient (that is, continue to separate lease and nonlease components) for building leases. This may be particularly relevant for building leases as common area maintenance (CAM) charges are considered a nonlease component. However, real estate taxes and insurance are not considered a lease component or a nonlease component — they are a noncomponents or reimbursements under the definitions of the standard.
The benefits of this expedient are that an entity would have cost savings associated with not performing the analysis — no breakdown of the contract price, no determination of standalone price for each component, no allocation of the price to the various components, and no separate accounting for each component.
However, the potential downside of electing the expedient is that the nonlease component must be accounted for together with the lease component as a single lease component. Therefore, the whole contract would be considered a lease, resulting in a larger lease liability and right-of-use asset on the balance sheet.
6. Risk-free rate expedient: Another common expedient that many nonpublic entities are expected to elect is the risk-free rate expedient. The standard requires that the rate implicit in the lease is to be used as the discount rate in calculating the lease liability. If the rate implicit in the lease is not known, an entity should use its incremental borrowing rate for a comparable period.
However, many nonpublic entities don’t know their incremental borrowing rate. If they do, they either only know one — such as a 12-month line of credit rate already in place — or they only know it at one point in time. Since the rate must relate to a comparable period (i.e., a three-year lease would need a rate to borrow for three years, and a 10-year lease would need a rate to borrow for 10 years) and must be determined at the commencement date of each new lease, determining the incremental borrowing rate can become difficult and burdensome.
Therefore, the risk-free rate expedient may be used. This allows a nonpublic entity to use the risk-free rate (for example, U.S. Treasury rates) for the discount rate when computing the lease liability. The rate used must still be for a comparable period, but the U.S. Treasury publishes rates daily for various terms (one-month, six-month, one-year, five-year, 10-year, etc.). Unlike the last two expedients, the risk-free rate expedient is currently applied on an all-or-nothing basis. However, the FASB has issued a draft update that would allow entities to elect this expedient by class of underlying asset.
This expedient is expected to make the determination of the appropriate discount rate easier, since risk-free rates are readily available. However, because risk-free rates are so low, entities may see slightly larger lease liabilities and right-of-use assets on the balance sheet if they elect to use the risk-free rate, since a lower discount rate will result in a higher present value calculation.
Entities should carefully vet and evaluate these expedients to determine which expedients will be elected and, where applicable, for which classes of underlying assets.
Wipfli can help with your ASC 842 lease accounting implementation
While the new standard was published five years ago, there are still many areas of uncertainty, confusion and judgment that will be encountered during the implementation process. The FASB has issued several clarifications, corrections and updates over the past few years, and other organizations have provided interpretations and other materials that entities may find helpful as they evaluate the accounting impact and necessary changes to processes, controls and accounting systems to accommodate the new standard.
Entities should not take lightly the implementation of ASC 842 and the amount of work and time that will be incurred ensuring they are in compliance with the standard and all of its requirements. If you have questions about implementation of the new standard, its impact on your organization, potential software solutions to assist in tracking and maintaining your organization’s lease information, please contact your Wipfli representative.
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