Years ago there was a TV commercial for an antacid that claimed its name spelled relief.
Right now 45% of private companies with 100-499 leases report they’re somewhere in the implementation process. Another 40% admit they are only as far as assessing the impact of FASB ASC 842 on their business and financial reporting.
Both groups are looking for ways to alleviate the stress (with accompanying heartburn), cost and scope of the implementation process.
Fortunately, in terms of ASC 842, the board has periodically issued amendments to the guidance that can offer some much needed relief. These ASC 842 practical expedients are meant to ease the burden--both the financial aspects and complexity--of transitioning to the new lease accounting standards.
Of course, the publication of practical expedients after a new major regulatory change is nothing new. Revenue recognition had its own set not too long ago.
Without compromising the quality of a company’s financial reporting, the ASC 842 practical expedients can simplify the transition requirements for lessees and to a lesser extent, lessors.
(A bit of a pun intended.)
It’s important to grasp the substance of each practical expedient early in your transition process for two reasons:
- The election of any, or all, of the practical expedients greatly affects the amount and kinds of data you will need to collect for reporting.
- If you opt to upgrade or onboard a lease accounting solution, you’ll need to make sure the software you’re considering can be configured appropriately for the expedients you elect.
A Little Background is in Order
The new lease accounting standards have been in the making since the financial scandals of the early 2000s. Finally, Leases (Topic 842) was officially released on Feb. 25, 2016. During the new guidance development process, both the U.S. governing body (FASB) and the international governing body (IASB) tried to agree on the changes to lease accounting policies. But, as to completely agreeing, their attempts were unsuccessful.
However, the two boards did make targeted improvements to the proposed guidance.
While deliberating, the two boards met with financial statement users and preparers to elicit feedback on their needs with regards to enhancing financial statement comparability as well as the feasibility and impact of the proposed requirements.
Those meetings resulted in the FASB Topic 842 and IFRS 16 practical expedients.
Some of the accommodations apply only to the comparative transition period for both lessees and lessors. Others are actually new accounting policies which reporting entities can elect for the transition period as well as all following reporting periods.
FASB Topic 842 Practical Expedients for Transitioning
#1 The All-or-None Package
The first set of practical expedients is known as the package because it includes three components which must be elected together. This set applies only to the transition period and addresses the concerns that the new lease accounting standards placed an extreme demand on entities to review the details of each and every one of their contracts--including expired ones.
In addition, if elected, the package must be applied consistently to all your leases--you cannot pick and choose which leases you’d like to apply the expedients to.
- No need to re-evaluate embedded leases
This goes for expired and existing leases. As long as you were properly accounting for leases embedded in service agreements and outsourcing contracts under the old standard, then you’re good to go. However, because embedded leases are easily overlooked, reviewing your contracts for this type of “hidden” lease is recommended.
- No need to reassess classification of leases
If there were no errors made with the initial classification, then what was an operating lease under ASC 840 is still an operating lease. And a capital lease in effect remains a capital lease, although under ASC 842, it is now termed a finance lease.
Keep in mind, this component focuses only on the classification of leases. Under the new standards, operating leases move to the balance sheet.
- No need to reassess initial direct costs
The definition of initial direct costs differs between the old and the new standards. Under ASC 840, you could allocate some internal costs such as a portion of salaries to initial direct costs. But with FASB ASC 842, that is no longer the case. Initial direct costs are defined as only the costs that would otherwise not be incurred if a lease had not been entered into. This component of the package means entities don’t have to reassess those costs.
If elected, this package accomplishes exactly what it was meant to do--save companies the countless man hours required to review all their contracts and make determinations.
For many private companies, electing this package is the expedient thing to do. However, there are times when it could be advantageous to reclassify a lease, or if you know that you have classification errors or omissions in accounting for embedded leases, then you’ll have to pass on electing the package.
Key point to remember about the package: All three components must be elected together and applied consistently across all your leases.
Another practical expedient to be used only during the comparative transition period allows you to use hindsight in determining lease terms such as options to buy the underlying asset, options to terminate or extend a lease, and also to assess the impairment of an ROU asset.
- It can be elected in conjunction with or independently of the above 3-part package
- If elected, it must be applied consistently to all leases
- It is available to both lessees and lessors
- It applies to both expired and existing leases
# 3 Land Easements
This practical expedient addresses the historical inconsistencies in accounting for land easements. A significant number of companies have land easements or right of ways that go back many years and have been accounted for as either leases or intangible assets.
This provision means companies don’t have to apply the new lease accounting standards to land easements acquired before the effective date of the new guidance--as long as they were not previously accounted for as leases.
#4 Restatement of Financials
Under the new guidance, companies must recognize and measure their leases at the beginning of the earliest period reported in their financial statements. So if a company adopts the new standard on January 1, 2021, it must also present the same information for all leases, expired and existing, for the two-year comparative period.
To avoid having to go back and adjust financial statements during the lookback period, companies can elect this practical expedient and simply recognize a cumulative adjustment in equity on their adoption date.
FASB ASC 842 Practical Expedients as Accounting Policies
#5 Short-Term Leases
Short-term leases are exempt under both FASB ASC 842 and IFRS 16. So electing this practical expedient saves you from having to capitalize those leases. Their value does still have to be disclosed in the notes of your financial statements.
GAAP defines a short-term lease as one with terms of 12 months or less without a purchase option that the lessee is likely to exercise. IFRS defines a short-term lease as one of 12 months or less and no purchase option at all.
#6 Discount Rate
This practical expedient is only available to private companies. It simplifies the calculation of discount rates, one of the more complex challenges in the new lease accounting standards.
Under ASC 842, lessees must calculate a lease’s discount rate by using the rate implicit in the lease. As this measurement is often difficult to determine, lessees have another option: to use their incremental borrowing rate. But IBR is a complicated calculation where errors are likely to occur.
So the discount rate expedient allows companies to use a risk-free interest rate instead of either the implicit rate or IBR.
The catch is that the risk-free rate is usually low, so using it may mean you have a higher liability to report.
#7 Combining Lease and Non-Lease Components
Instead of the term executory costs used in ASC 840, the new lease accounting standards refer to expenses such as CAM and other variable payments as non-lease components. (Taxes and insurance are neither lease or non-lease components.)
Under ASC 842, lessees must identify fixed considerations and allocate them across lease and non-lease components. To do this requires performing an analysis to determine a methodology for the allocation on every single contract.
Not only are these analyses time consuming, it’s often difficult to determine the value of contract components separately. So if you elect this practical expedient, you avoid having to perform an analysis, determine an allocation methodology and document it for your auditors--for each lease.
You just calculate the present value of the fixed consideration.
And unlike most of the other practical expedients which must be applied to all related leases, this expedient permits you to apply it according to asset class. For example, many companies will choose to apply it to their real estate leases but not to equipment leases.
Conclusion: Shortcut to Compliance?
There are other practical expedients--those released by the IASB and some applicable only to lessors--but since lessees are the entities most affected by the new lease accounting standards, we’ve discussed only the FASB practical expedients beneficial to them.
Although these allowances can save much time and effort when it comes to re-evaluating and reassessing your leases as well as in the preparation of your financial statements, you should carefully consider whether to elect them or not. They can potentially impact EBITDA.
Nevertheless, accounting advisors expect that most companies will choose at least some of the practical expedients, especially those meant to bring relief during transition.
If you’re feeling stressed about the complicated process of compliance, the AMTdirect team is standing by with our own kind of relief. We’ll answer your questions and offer some tips based on our 20+ years in lease management and accounting solutions.