In the time since FASB passed the new accounting standard ASC 842 in 2016, the organization has issued periodic updates to the codification for generally accepted accounting principles (GAAP). These Accounting Standards Updates (ASUs) include practical expedients that have been created to simplify ASC 842 transition requirements.
As we mentioned in our blog on lease data collection tips, strategic accounting decisions need to be made early on, before data collection for FASB ASC 842 compliance begins. That includes choosing which practical expedients to use.
In this blog, we’ll take a closer look at ASC 842 practical expedients and their implications for the transition and your financial reporting.
What are Practical Expedients?
Practical expedients are considerations, or shortcuts companies can elect to lessen their burden in the adoption of ASC 842 and IFRS 16. They were designed to provide relief for companies during the transition to the new standards.
ASC 842 Transition Methods
Transition methods in ASC 842 are practical expedients designed to facilitate the transition from the previous lease accounting method to the new standard.
The discount package allows lessees to apply a single discount rate to a group of leases with reasonably similar characteristics. This simplifies the process and saves time during the transition.
The hindsight practical expedient permits lessees to use hindsight for lease renewals and purchase options when determining the lease term. However, this option is rarely chosen due to its complexity and potential accounting implications.
Package of 3:
The package of 3 expedient primarily benefits organizations during the transition phase. It allows lessees to avoid reassessing whether expired or existing contracts are or contain leases, reclassifying leases, and reevaluating initial direct costs for existing leases. This streamlines the transition process and reduces the burden of reassessing multiple lease aspects.
Three ASC 842 practical expedients in one package
Among the practical expedients created to ease the ASC 842 transition requirements is a package deal — three expedients that must be elected all together or not at all.
When you elect this package of practical expedients, it must be applied consistently to all leases. In addition, you need to disclose that the three expedients have been used.
Basically, these all-or-nothing practical expedients say that:
- You don’t need to reassess the lease classification for any expired or existing leases
- You don’t need to reevaluate whether any existing or expired contracts contain leases
- You don’t need to reassess previously recorded initial direct costs for any existing leases
What does the ASC 842 practical expedients package mean for lease accounting and compliance?
- No lease reclassification: Any lease that is classified as an operating lease under ASC 840 can remain an operating lease under ASC 842. Likewise, a lease classified as a capital lease under ASC 840 can remain a capital lease — though its name under ASC 842 is now “finance lease.” Keep in mind that this practical expedient only applies if there are no errors with the initial classification.
If you want to reassess the classification of a lease, you certainly can — BUT that means reassessing all your leases, because this expedient cannot be applied selectively to only some leases and not others.
- No reevaluation of embedded leases: As long as you have been correctly accounting for leases embedded in existing service and outsourcing contracts under ASC 840, you don’t have to reevaluate them. However, even if you elect the ASC 842 practical expedients package, you might want to look at your existing service and outsourcing agreements to be sure your embedded lease records are complete.
- No reassessment of initial direct costs: For any existing leases, the initial direct costs that are capitalized under ASC 840 also qualify to be capitalized under ASC 842. For instance, ASC 840 says you could allocate a portion of your internal expenses — such as salaries for internal real estate staff — to initial direct costs. But ASC 842 defines initial direct costs as costs you incurred only because you signed a lease, such as broker fees or external legal costs.
However, with this expedient, you don’t need to reassess those previously allocated internal costs according to the definition of initial direct costs under ASC 842. So, it saves you from reassessing initial direct costs and the resulting equity adjustments.
Why elect the ASC 842 practical expedients package?
This package of three expedients significantly reduces the time and effort you’ll need to spend going back to reevaluate lease accounting decisions made under the previous standards. It also helps to reduce the time and cost of preparing financial statements to meet ASC 842 transition requirements.
However, you might not want to elect the package if you will benefit from lease reassessments. For example, if most of your operating leases would qualify as finance leases under ASC 842 and that reclassification would have an impact on EBITDA, you might decide not to elect the practical expedients package.
Hindsight expedient applied to ASC 842 transition requirements
Another of the ASC 842 practical expedients — hindsight — can be used either with the package of expedients described above or alone.
The hindsight practical expedient says that when determining lease classifications, a company can consider the actual outcome of lease renewals, termination options, and purchase options that were previously evaluated. Specifically, for the periods that are being compared and restated, you can use hindsight to:
- Determine the lease term based on the likelihood of exercising lessee options to extend or terminate a lease or to purchase the underlying asset
- Assess any impairment of right-of-use assets
The hindsight expedient must be applied to all leases during the comparative period. For a company with a large lease portfolio, that could be labor intensive and should also be considered when deciding whether to apply this expedient.
Practical expedient combining lease and non-lease components
Under ASC 842, a company needs to identify its fixed consideration and allocate it across both lease and non-lease components. This requires performing an analysis to determine a method of allocation for every contract.
The problem is, it can be very difficult to determine the value of lease and non-lease components of a contract separately. In addition, the fixed consideration doesn’t include anything with variable costs, such as CAM, insurance, and taxes under most real estate leases.
In response, this practical expedient spares you from having to perform analyses to determine allocation methods. Instead, you can simply calculate the present value of the fixed payments without having to perform an allocation to the lease and non-lease components.
The advantage of this practical expedient is, once again, time savings. You don’t have to determine a method for allocating your fixed consideration, document that method for your auditors, and repeat the process for every lease.
In addition, there is some flexibility to apply the expedient according to class of asset. For instance, you might choose to apply it to all your real estate leases but not your equipment leases, where the fair values for lease and non-lease components (such as maintenance) are easier to determine.
However, keep in mind that if you elect this expedient, it must be applied consistently to all eligible non-lease components.
Practical expedient for restating prior year financials
Under ASC 842, lessees are required to recognize and measure their leases at the beginning of the earliest period presented in their financial statements. So, for example, a company adopting the new standard on January 1, 2020, would need to recognize and measure its leases as of January 1, 2018, in its comparative financial statements.
To remove the burden of going back so far, this practical expedient provides the option to apply the new guidance at its effective date (in the example above, January 1, 2020) without having to adjust the comparative financial statements (in the example, 2019 and 2018). Instead, in this example, the company would recognize a cumulative adjustment in equity as of January 1, 2020.
This practical expedient simplifies ASC 842 transition requirements, eliminating the need to record leases that expired prior to the effective date or consider the effects of lease modifications during the comparative periods.
Practical expedient for short-term leases
Under GAAP, a short-term lease is defined as a lease that is 12 months or less without a purchase option that the lessee is likely to exercise.
The short-term lease exemption says you don’t have to capitalize those short-term leases and record them on your balance sheet for ASC 842. You can simply continue to treat them as operating leases under ASC 840.
Electing this practical expedient will save you time in capitalizing your leases. However, while short-term leases may not be going on your balance sheet, you will still need to disclose them, and their value, in the notes of your financial statements.
Practical expedient for private company discount rates
This practical expedient offers a straightforward alternative to one of the more difficult components of the new standards: discount rates. The expedient says that private companies can use their risk-free interest rate in one of two circumstances:
- Instead of calculating their incremental borrowing rate (IBR)
- When there is no discount rate implicit in a lease contract
If you don’t already know what your IBR is, applying this expedient offers an alternative to performing the complex IBR calculation. The downside is that the risk-free interest rate is typically very low, resulting in a higher liability on your books.
Practical expedient for land easements
Some companies have multiple land easements going back many years and may have accounted for those easements as leases. Other companies may have accounted for land easements as intangible assets.
To simplify efforts to account for land easements, this practical expedient allows companies to choose to not apply the new leases guidance to land easements that existed before the effective date of the new standard.
However, this may be done only if the easements were not previously accounted for as leases. In addition, companies must apply the new leases guidance for easements entered into or modified on or after the effective date.
Accounting Standards Update (ASU) 2023-01, Leases (Topic 842): Common Control Arrangements
The Common Control Arrangements, was issued by the Financial Accounting Standards Board (FASB) on March 27, 2023. The ASU addresses how private companies and not-for-profit entities that are not conduit bond obligors should account for leases between entities under common control.
The ASU provides two main changes to the accounting for common control leases:
- A practical expedient that allows private companies to use the written terms of a lease, even if those terms are not legally enforceable, to determine the classification and accounting for the lease.
- A requirement that leasehold improvements between entities under common control be amortized over the useful life of the improvements, regardless of the lease term.
The practical expedient is intended to simplify the accounting for common control leases and reduce the cost of compliance. The requirement to amortize leasehold improvements over the useful life of the improvements is intended to better reflect the economics of these arrangements.
The ASU is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted.
Key provisions of ASU 2023-01:
- Practical expedient: Private companies and not-for-profit entities that are not conduit bond obligors may elect to use the written terms of a lease, even if those terms are not legally enforceable, to determine the classification and accounting for the lease. This practical expedient is intended to simplify the accounting for common control leases and reduce the cost of compliance.
- Leasehold improvements: Leasehold improvements between entities under common control must be amortized over the useful life of the improvements, regardless of the lease term. This requirement is intended to better reflect the economics of these arrangements.
- Effective date: The ASU is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted.
Practical expedient for related party leases
In the case of related party leases, a practical expedient allows private companies to use the written terms of a lease, even if those terms are not legally enforceable, to determine the classification and accounting for the lease.
This practical expedient was introduced in Accounting Standards Update (ASU) 2023-01, Leases (Topic 842): Common Control Arrangements. The ASU was issued in response to concerns from private company stakeholders that they would need to seek legal counsel or extensively analyze their lease contracts to determine the legally enforceable terms of the arrangement. The practical expedient allows these companies to avoid this costly analysis and instead rely on the written terms of the lease.
IFRS 16 Practical Expedients
Policy Election for Short-Term Leases:
Lessees can choose not to apply the lease standard to leases with a duration of 12 months or less. Instead, they can follow the previous lease accounting guidelines, recognizing lease payments as profit or loss on a straight-line basis over the lease term. This expedient can be applied on a lease-by-lease basis.
- Advantage: Time-saving for accounting short-term leases.
- Disadvantage: Different lease accounting procedures for short-term and long-term leases.
Policy Election for Low-Value Assets:
Lessees are not required to apply the new standard to leases of low-value assets. They can use the previous accounting guidelines and recognize lease payments on a straight-line basis.
- Advantage: Time-saving for accounting low-value asset leases.
- Disadvantage: Using two different lease accounting methods.
Policy Election for Non lease Components:
Lessees can combine lease and non lease components as a single, combined lease component. Non lease components are elements that transfer goods or services, such as parking expenses or annual maintenance.
Alternatively, lessees can allocate the consideration in the contract on a relative standalone price basis if they choose not to combine lease and non lease components. Estimations may be required if standalone prices are unavailable.
This policy election can be applied to all, some, or none of the underlying assets.
- Benefit: Time-saving in accounting for lease and nonlease components together.
- Impact: Larger liability and ROU asset, affecting debt ratios and bank covenants.
Policy Election for Footnote Disclosures:
By choosing this policy election, the lessee must present ROU assets separately from other assets and lease liabilities separately from other liabilities, either in the statement of financial position or footnotes.
- Advantage: Simpler footnote presentation in financial statements.
- Consideration: If leases are not significant, adding line items may dilute the reader’s understanding.
Policy Election for Hindsight:
Lessees can elect to apply the new lease standard to all or only the most recent reporting periods without restating prior periods. The cumulative impact should be reported in retained earnings.
- Advantage: No restatement of prior periods required.
- Disadvantage: Inconsistent reporting of leases for each period, as prior periods remain unchanged.
While a practical expedient might save you time, your decision must also consider its potential impact on your financial reporting. So, although FASB has extended the compliance deadline — giving private companies until 2021 to report their leased assets on balance sheets — it’s important to understand the implications and make your decisions about ASC 842 practical expedients as soon as possible.
If you are unsure what to do, speak with your accounting advisory partner, who can help to guide you through the ASC 842 transition requirements and your practical expedient decisions.
You can also visit the FASB website to see the latest practical expedients and other ASUs that have been issued.