ASC 842 Practical Expedients: Navigating Lease Accounting with Ease

Practical expedients under ASC 842. With the introduction of ASC 842, the Financial Accounting Standards Board (FASB) significantly changed how you must account for leasing transactions on financial statements. This new standard aims to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. Understanding the details of ASC 842 can help ensure your financial reporting meets the current compliance standards.

One of the complexities in implementing ASC 842 is the assessment and classification of leases under the new guidance. To ease this transition, ASC 842 introduces several practical expedients that you may elect to use. These practical expedients are designed to relieve the burden of re-evaluating all existing contracts by allowing you to carry forward previous lease classifications. However, it’s important to consider the implications of each decision as they affect how leases are reported on your financial statements.

Your choice to utilize these practical expedients will influence the effort required to implement the new leasing standard. For instance, making use of the package of practical expedients permits you to forego reassessing whether expired or existing contracts are or contain leases, among other things. Keep in mind that disclosures regarding the use of any practical expedients are required, ensuring transparency in the reporting of your leasing activities. As you navigate through ASC 842, you’ll want to be well-versed in these practical expedients to streamline the adoption process and maintain compliance with reporting requirements.

Overview of ASC 842

ASC 842 introduces a significant shift in accounting for leases, impacting your financial statements. It requires you to recognize right-of-use assets and lease liabilities for leases that were previously off-balance sheet.

Key Definitions and Concepts

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 for a period of time in exchange for consideration. As a lessee, you must recognize a right-of-use asset and a lease liability on your balance sheet for most leases. This includes both operating leases and finance leases.

The right-of-use asset represents your right to use the underlying asset for the lease term, while the lease liability represents your obligation to make lease payments.

  • Operating Lease: A lease where you gain control over the use of the property, plant, or equipment, but do not assume the risks and rewards of ownership.
  • Finance Lease: A lease that effectively transfers the risks and rewards of ownership of the property, plant, or equipment to you.

Scope of ASC 842

ASC 842 applies to both lessors and lessees, with the primary changes affecting lessee accounting. As a lessor, the standard impacts the classification of leases and how you recognize lease income and assets.

  • Lessee Accounting: You must recognize a right-of-use asset and corresponding lease liability on your balance sheet for almost all leases.
  • Lessor Accounting: You must classify leases as operating, direct financing, or sales-type leases.

Your balance sheet will now show the rights and obligations arising from leases, providing a clearer picture of your financial commitments.

Transition to ASC 842 and Practical Expedients

The adoption of ASC 842 requires you to choose a transition method and assess the viability of various practical expedients that can significantly impact lease accounting and reporting.

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Transition Methods

With the introduction of ASC 842, you can apply the modified retrospective method as your transition method. This approach does not require restating prior period financial statements but does mandate the application of the new lease standard as if it had been in effect since the commencement date of each lease. Starting on the effective date, typically for fiscal years beginning after December 15, 2018, ASC 842 becomes applicable for public companies, while for private companies, it’s for fiscal years beginning after December 15, 2021.

  • ASC 840: Under the previous standard, ASC 840, certain guidance differs significantly. You don’t have to reassess the lease classification for existing leases unless the lease is modified.
  • Hindsight: The modified retrospective method incorporates the hindsight expedient, allowing you to use hindsight in determining lease term and in assessing impairment of right-of-use assets.

Practical Expedients and Elections

Practical expedients under ASC 842 are designed to simplify your transition. You have the option to elect them as a package and apply them consistently to all of your leases.

  • Election Package: The package generally includes not reassessing whether expired or existing contracts contain leases, lease classification, or initial direct costs.
  • Risk-Free Rate: Lessees can elect to use a risk-free rate to discount lease payments, which can alleviate the complexity of determining the incremental borrowing rate.
  • Land Easements: The treatment of land easements that existed under ASC 840 as not containing a lease can continue under ASC 842 if you elect this practical expedient.

By understanding the ramifications of each of these choices on your lease accounting and disclosures, you can more confidently navigate your transition to ASC 842.

Accounting Treatment for Leases Under ASC 842

Under the ASC 842 standard, you must re-evaluate your lease accounting practices, ensuring that all leases are correctly classified, measured, and disclosed in financial statements.

Lease Classification

Under ASC 842, you classify leases as either finance leases or operating leases. To determine the classification, you assess factors such as the transfer of ownership at the end of the lease term, the lease term length in relation to the asset’s economic life, and whether the present value of lease payments amounts to substantially all of the fair value of the leased asset. This classification affects how you record and report your leases.

Measurement and Recognition

For both finance and operating leases, you must recognize lease liabilities and corresponding right-of-use (ROU) assets at the lease commencement date based on the present value of lease payments. The discount rate you apply should be the rate implicit in the lease, if readily determinable, or your incremental borrowing rate. Initial direct costs are included in the measurement of the ROU asset.

  • Finance Leases: Lease payments are split into interest expense and principal reduction, similar to a financed purchase.
  • Operating Leases: Lease payments are recognized as a single lease expense on a straight-line basis over the lease term.

Presentation and Disclosure

Your financial statements need to have clear disclosure of both operating and finance leases.

  • Finance Leases: On the balance sheet, present the ROU asset and lease liability separately from other assets and liabilities. The lease liability will decrease, and amortization will be recorded for the ROU asset.
  • Operating Leases: Operating lease liabilities and ROU assets are also presented separately on the balance sheet.

For both lease types, the interest on the lease liability and the amortization of the ROU asset should be presented in the income statement. Disclosures must include information about the nature of your leasing activities, including the lease term, the amount of lease and nonlease components, and significant judgements made in classifying and measuring leases.

Frequently Asked Questions

The transition to ASC 842 brings up several common questions regarding the practical expedients designed to ease the adoption process. Here’s what you need to know to navigate them with confidence.

What are the options available for lessees to apply the risk-free rate election under ASC 842?

Under ASC 842, you can apply a risk-free rate to all leases or by class of underlying asset, rather than determining the rate implicit in each lease. This practical expedient simplifies lease measurement for lessees, especially those without readily determinable implicit rates.

How does the short-term lease recognition exemption operate within ASC 842?

You can elect not to recognize lease assets and liabilities for leases with a term of 12 months or less. If you choose the short-term lease recognition exemption, lease payments are recognized as expenses on a straight-line basis over the lease term.

In what situations might an entity use a practical expedient during the ASC 842 adoption process?

Entities may use practical expedients to ease transition burdens. For instance, the package of practical expedients under ASC 842 permits you not to reassess lease classification, lease whether expired or existing contracts contain leases, and initial direct costs for leases that commenced before the effective date.

What are the key differences between the modified retrospective and full retrospective transition methods under ASC 842?

The modified retrospective method does not require restatement of prior periods but involves applying the new lease rules to the cumulative-effect adjustment to retained earnings in the year of adoption. The full retrospective method requires restating all financial statements presented as if ASC 842 has always been applied.

Can you explain the modification of lease terms under ASC 842-10-65-1(f) and its impact?

Under ASC 842-10-65-1(f), if there’s a modification of lease terms while adopting the new standard, you should not reassess lease classification for those modified leases. This exemption simplifies the transition as you only apply the new requirements prospectively from the adoption date.

How does the portfolio approach practical expedient simplify lease accounting under ASC 842?

The portfolio approach allows you to apply the lease accounting standards to a portfolio of leases with similar characteristics instead of individually. This practical expedient can significantly reduce the time and effort required to account for leases with a large volume of similar agreements.

Greg Kautz
Greg Kautz

Greg Kautz, CPA, CMA

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