In the final installment of our series on leases, we offer lessees insights into the process of transitioning from ASC 840 to ASC 842 — focusing on available transition methods, practical expedients and policy elections.
As the January 1, 2022, effective date for calendar year private companies to implement the new leases standard draws near, a key consideration is how you will transition from the old leases standard, ASC 840, to the new one, ASC 842 — and how can you do so efficiently and effectively. Below lays out options to consider ahead of your implementation.
2 Ways to Apply the Modified Retrospective Transition Approach
The new standard requires a modified retrospective transition approach but has two options for how you apply it, which are referred to as the effective date method and the comparative method.
Companies electing the effective date method record any cumulative adjustment needed related to the implementation of ASC 842 as of the date of implementation, with no adjustment to any prior year information presented in the financial statements. For calendar year companies adopting as of January 1, 2022, this means 2022 will be presented under ASC 842 and any prior years presented in the financial statements will be presented under ASC 840. For this reason, this approach is often referred to as the “non-comparative” approach.
Companies electing the comparative method record any cumulative adjustment needed related to the implementation of ASC 842 as of the opening date of the earliest comparative period presented in the financial statements. For calendar year companies with comparative statements adopting as of January 1, 2022, this means both 2022 and 2021 (assuming a dual year presentation) will be presented under ASC 842.
Which method is best? The short answer is, it depends. However, there are some factors you should consider when weighing which method is the best fit for your company.
1. Effective Date Method
The effective date method is generally the simpler, less time consuming and less expensive transition method of the two, due to the fact that it does not require the restatement of any prior periods presented in the financial statements.
On the flip side, this method may not be the best choice for companies with comparative financial statements, as prior periods included in the financial statements are not restated. This reduces comparability between periods, which could cause confusion for some financial statement users. In addition, comparative financial statements would need to include two sets of lease disclosures: ASC 842 disclosures for the period of implementation and ASC 840 disclosures for any prior periods presented. One option to not have to include both disclosures is to only present a single year statement in the year of implementation. However, be sure to consult your financial statement users before deciding to present single year financial statements, including your bank as your loan documents may not permit this presentation.
2. Comparative Method
The comparative method is generally the more complex transition method of the two, since it requires the restatement of any prior periods presented in the financial statements. For this reason, it generally requires more time and expense to implement.
On the positive side, this method allows for the greatest comparability in the financial statements when presenting more than one period.
3 Transition Practical Expedients
Practical expedients are options companies can adopt that are meant to ease the process of implementing a new accounting standard. Those implementing ASC 842 have three such expedients available to them: the package of three, hindsight and land easements.
1. Package of Three
The package of three allows the conclusions made under ASC 840 to be maintained until the lease is modified or replaced with a new lease, at which time reassessment under ASC 842 would occur. So, if this option is adopted, management does not have to reassess:
- Whether any expired or existing contract is or contains a lease,
- The lease classification of any expired or existing lease and
- Initial direct costs for any existing lease.
However, this does not grandfather in errors made under ASC 840, as errors must be corrected prior to implementing ASC 842. This practical expedient is an all or nothing “package” deal — these three options must all be adopted or none, and, if adopted, they must be applied to all leases.
>> Impact: Adopting this package of practical expedients can reduce the time and expense involved in implementing ASC 842 as electing this package reduces much of the need to reassess expired or existing lease contracts, lease classifications, and initial direct costs. It is widely accepted that this will be a popular practical expedient. However, not adopting may be a better fit if management has the time and feels reassessment may lead to more favorable lease outcomes, such as more leases having a preferred classification or the booking of additional right-of-use assets related to initial direct costs.
If this option is adopted, management may use hindsight when evaluating the lease term and impairment of right-of-use assets. This simply means management should consider all changes in facts and circumstances through adoption of ASC 842 when assessing lease terms and right-of-use asset impairment. Similar to the package of three, this must be adopted for all or none of the leases at your company.
>> Impact: Adopting this practical expedient can lead to more accurate lease accounting as it requires management to consider a greater range of information when implementing ASC 842. This is especially true if facts and circumstances have changed significantly since lease commencement. However, adoption of this practical expedient generally requires additional time and expense to implement. That is, not adopting this practical expedient allows management to carry over the remaining lease term as determined under ASC 840 when implementing ASC 842.
3. Land Easement
A land easement consists of a right to use and/or enter land owned by another party. If a company adopts the land easement practical expedient, management does not have to reassess whether or not any existing or expired land easements at the time of implementation of ASC 842 meet the definition of a lease. This practical expedient was offered since companies may not have previously accounted for certain agreements as leases under ASC 840.
>> Impact: Adopting this practical expedient can reduce the time and expense involved in implementing ASC 842, as land easements would not have to be reassessed for possible lease accounting. However, your lease accounting may be more accurate if you do not adopt this expedient, as reassessing land easements under ASC 842 could lead to different, and more on point, lease accounting conclusions.
4 Additional Practical Expedients and Accounting Policy Elections
The practical expedients we’ve discussed so far specifically relate to the implementation of ASC 842. However, there are additional ASC 842 practical expedients and accounting policy elections that apply after implementation, including:
- Short-term leases,
- Lease and non-lease components,
- Discount rate and
- Portfolio approach.
1. Short-Term Leases
Under this accounting policy election, management may elect not to apply the usual recognition requirements of ASC 842 to leases deemed short-term. In other words, management would not record a right-of-use asset or lease liability. This election applies to short-term leases only, which are leases that at their commencement date, which includes periods before implementation of ASC 842:
- Have lease terms of 12 months or less, and
- Do not include options to purchase the underlying asset or extend the lease beyond 12 months, that the lessee is reasonably certain to exercise.
This policy election is elected by class of underlying asset, such as office equipment and vehicles.
>> Impact: Adopting this accounting policy election can reduce the time and expense involved in implementing ASC 842, as short-term leases would not require the calculation and recognition of a right-of-use asset or lease liability. However, this exemption should not be used as a means to structure long-term leases as short-term leases to avoid ASC 842 consideration. Attempting to structure long-term leases as short-term leases could lead to unintended consequences, including having to write off related long-lived leasehold improvements over that short period, increased legal costs to write frequent lease agreements, and concerns from lenders regarding the viability of short-term leases.
2. Lease and Non-Lease Components
A lease agreement may include both lease and non-lease components. Non-lease components consist of other goods or services offered to the lessee. Common examples of non-lease components include providing supplies for leased equipment or common area maintenance for a building. Under this practical expedient, management may elect not to separate payments made for non-lease components from those made for the related lease components. That is, these components would all be accounted for together as a single lease component. This expedient is elected by class of underlying asset and can be applied regardless of the dollar value of the non-lease components.
>> Impact: Adopting this practical expedient can reduce the time and expense involved in implementing ASC 842, as management would not be required to evaluate all the lease and non-lease components in every agreement. This is particularly helpful when the lease agreements do not clearly define the stand alone selling prices of the non-lease components. However, adopting this expedient may not be beneficial for companies with leases that contain material non-lease components, as it could lead to higher valued lease liabilities and could impact the classification of leases (i.e., leases are more likely to be classified as finance leases if non-lease components are material and included in the valuation).
3. Discount Rate
The calculation of right-of-use assets and lease liabilities under ASC 842 requires the use of a discount rate. ASC 842 requires management to use the rate implicit in the lease; if not specified in the lease, then the incremental borrowing rate must be used. Under this accounting policy election, management may elect to instead use a risk-free discount rate, such as the U.S. Treasury rate. This accounting policy election is only available for private companies. While this currently must be elected for all assets, pending tentative guidance (if passed) would permit this to be elected by class of underlying asset.
>> Impact: Adopting this accounting policy election can reduce the time and expense involved in implementing ASC 842, as many lease agreements do not include an implicit rate and the incremental borrowing rate may be difficult to determine (i.e., the incremental borrowing rate needs to be for borrowings collateralized by similar assets as those being leased and for a similar term as the lease). However, the risk-free rate is historically very low compared to the one implicit in the lease or the incremental borrowing rate. As a result, using a risk-free rate generally results in the recognition of larger right-of-use assets and lease liabilities, and can also lead to more leases being considered finance leases (i.e., due to the present value of lease payments being more likely to meet or exceed the fair value of the underlying asset).
4. Portfolio Approach
ASC 842 requires the calculation of right-of-use assets and lease liabilities for all lease components. For companies with many leases, this may lead to significant calculations, and the tracking of a large number of right-of-use assets and lease liabilities. Under this accounting policy election, management may elect to apply the usual recognition requirements of ASC 842 to leases at a portfolio (or combined) level. For example, the lessee may combine several similar vehicle leases into one right-of-use asset and lease liability. This election is permitted if the leases being recognized together have similar characteristics, such as length, extension provisions, purchase options, etc., and the portfolio level accounting is not expected to differ materially from accounting for these leases at the individual level.
>> Impact: Adopting this accounting policy election can reduce the time and expense involved in implementing ASC 842, as similar leases would not require the calculation and tracking of separate right-of-use assets and lease liabilities. Instead, these similar leases could be combined in a single portfolio with one related right-of-use asset and lease liability. This election would be most beneficial when a company has low-dollar, high-volume leasing arrangements often seen with copiers, vehicles or phone systems. However, adopting this accounting policy election may not be feasible if there is variation in the leases, and may not be beneficial for companies that want greater visibility into their business operations provided by accounting for leases individually.
The implementation of ASC 842 requires the management of your company to review and choose between various transition methods, practical expedients and accounting policy elections. Each of these have unique advantages and disadvantages you must carefully consider. As a result, discuss the factors noted in this article with your financial statement users. Now is the time to consider these and decide which fit best with your specific circumstances and reporting requirements.
Contact Jami Blake at firstname.lastname@example.org, Scott Wilms at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.