Authored by: Phil Santarelli
As we have seen so far, the adoption of ASC 842 makes accounting much more complex for traditional operating leases. This inherent complexity makes the transition guidance equally complex. To address this complexity, the FASB has provided several practical expedients entities may use for the transition.
- Public business entities, not for profit entities with conduit debt, and certain employee benefit plans that file with the Securities and Exchange Commission: Apply ASC 842 for fiscal years beginning after December 15, 2018 and the interim periods within that year.
- For all other entities: Apply ASC 842 for fiscal years beginning after December 15, 2019, and interim periods for years beginning after December 15, 2020.
- Early application if permitted for both groups of entities.
The basic provisions are:
- Entities shall apply the provisions of ASC 842 to the earliest comparative period presented in the financial statements of the year of adoption (the methodology is discussed below).
- The entity will adjust opening equity for the earliest comparative period presented in the financial statements of the year of adoption: a cumulative effect change to retained earnings or comparable account.
- The entity will adjust disclosures to reflect the adoption for the earliest periods presented in the financial statements of the year of adoption.
Leases previously classified as operating leases
- For each lease an entity must calculate a lease liability and a related right to use asset as of the earlier of the beginning of the comparative period presented in the financial statements or as of the inception of the lease. Therefore covering leases existing before the start of the comparative period and those entered into during the comparative period.
- The lease liability shall be measured as the present value, using a discount rate for the lease1, of the sum of the remaining lease payments and any residual value guarantees that are probable of being paid.
- For leases classified as an operating lease in accordance with ASC 8422, the right to use asset is measured as the amount of the lease liability plus or minus, any prepaid or accrued lease payments, remaining balance of unamortized lease incentives, unamortized direct initial lease cost; and the amount of any recognized liability related to exit or disposal cost obligations recorded in accordance with ASC 420.
- For leases classified as a finance lease in accordance with ASC 842,3 a lessee shall measure the right of use asset, as the applicable portion of the lease liability determined by the remaining lease term relative to the initial total lease term, plus or minus any prepaid or accrued lease payments and the amount of any recognized liability related to exit or disposal cost obligations recorded in accordance with ASC 420.
- Any unamortized initial direct costs that do not meet the definition in ASC 8424 shall be written off as a direct charge to equity.
An example derived from ASC 842 illustrates the transition for an operating lease:5
The effective date for the entity to adopt ASC 842 is January 1, 2019. An entity entered into a five year lease for an asset on January 1, 2016 requiring annual payments at the end of the year; the entity incurred $500 in initial direct costs to be amortized over the lease term. At January 1, 2017, the entity had recognized $1,200 of accrued rent and four remaining lease payments; one of $31,000 and three of $33,000. The unamortized direct costs balance was $400.
As of January 1, 2017, the earliest comparative period, the entity calculates a lease liability, using its incremental borrowing rate of 6%, as the present value of the above remaining lease payments, $112,462.
The corresponding right of use asset is calculated as $111,662 ($112,462-$1,200+$400).
For subsequent measurements through the transition periods, 2017 and 2018, the entity will measure its lease liability and right of use asset in accordance with ASC 842 and, as it is an operating lease, will recognize rent expense.
Leases previously classified as capital leases
- For leases classified as a finance lease in accordance with ASC 842, an entity shall6:
- Recognize a right to use asset and a lease liability at the beginning of the earliest period presented or the commencement date of the lease in accordance with extant GAAP in ASC 840.
- Include any unamortized initial direct costs that meet the definition in ASC 842 in the right to use asset.
Write off as a direct charge to equity any unamortized initial direct costs that do not meet the definition in ASC 842.
- For leases classified as operating leases in accordance with ASC 842, an entity shall7:
- Derecognize the carrying amount of any capital lease asset and liability as of the earlier of the beginning of the earliest period presented or the inception of the lease. Any difference shall be accounted for in the same manner as prepaid or accrued rent.
- Recognize a right of use asset and lease liability in the manner required by ASC 842, at the earlier of the beginning of the comparative period or the commencement date of the lease.
- Write off as a direct charge to equity of any unamortized initial direct costs that do not meet the definition in ASC 842.
An example derived from ASC 842 illustrates, the transition for a capital lease:8
The effective date for the entity to adopt ASC 842 is January 1, 2019. Lessee had entered into a seven year lease on January 1, 2016 requiring annual payments of $25,000 at the end of each year. The lease included a residual value guarantee of $8,190. At the inception of the lease the entity determined it should be classified as a capital lease, and using its incremental borrowing rate at the time of 6% calculated a capital lease obligation and recorded a capital lease asset. Additionally, the lessee capitalized direct costs of $2,800.
At the transition date, the earliest period presented is January 1, 2017. As of that date, the entity has a lease liability of $128,707, a lease asset of $124,434, and unamortized direct costs of $2,400. Therefore, at transition the entity continues to recognize a lease liability in the amount of $128,707 and recognizes a right of use asset of $126,834, which is the asset balance plus the unamortized direct costs.
For subsequent measurements through the transition periods, 2017 and 2018, the entity will measure its lease liability and right of use asset in accordance with ASC 842 and continue to recognize in the statement of comprehensive income, interest expense and amortization of the right to use asset in a manner similar to what was previously recognized under extant GAAP.
In general for both scenarios discussed above, the subsequent measurement will be in accordance with ASC 842 as applied to operating leases or finance type leases.
While the transition requirements are fairly complex, the Board fortunately has provided some practical expedients for transition. The practical expedients apply to all leases in place at the time of transition. However, the practical expedients must be applied as a package; no cherry picking.
The practical expedients are:
- An entity need not reassess whether any expired or existing contracts are or contain leases.
- An entity need not reassess the lease classification for any expired or existing leases (that is, all existing leases that were classified as operating leases in accordance with Topic 840 will be classified as operating leases, and all existing leases that were classified as capital leases in accordance with Topic 840 will be classified as finance leases).
- An entity need not reassess initial direct costs for any existing leases.9
In addition, the standard provides this practical expedient which may be elected separately from the above:
An entity also may elect a practical expedient, which must be applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor) to use hindsight in determining the lease term (that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing impairment of the entity’s right-of-use assets. This practical expedient may be elected separately or in conjunction with the practical expedients in (f).10
For entities that rely extensively on leases for operating assets, the transition is likely to be labor intensive even when applying the practical expedients. All lease contracts will need to be inventoried and an analysis of each will need to be undertaken to determine relevant information to calculate the beginning lease liability and the related right of use asset. It may be possible for some companies to apply a portfolio approach if they have groups of similar assets entered into at the same time with similar lease terms, etc. Although the portfolio approach is permitted, the entity will need to support the assertion that applying such an approach is not materially different from analyzing each contract individually.
Entities will need to provide support for their auditors that the transition process was adequately controlled and the risk of material misstatement was appropriately managed. All of which should be documented.
For more information about the transition to the new leasing standard, or to learn how Baker Tilly’s specialists can help, contact our team.
1 This is the rate implicit in the lease, or if not determinable the lessees incremental borrowing rate. Non-public entities may substitute the risk free rate for the comparable period. The rate is established as the earlier of the beginning of the comparative period or the inception date of the lease, as in the first bullet.
2 See discussion below for practical expedients
3 See discussion below for practical expedients
4 Per the Glossary: Incremental costs of a lease that would not have been incurred if the lease had not been obtained.
5 ASC 842-10-55-249-254
6 See discussion below for practical expedients
7 See discussion below for practical expedients
8 ASC 842-10-55-244-247
9 ASC 842-10-65-1 (f)
10 ASC 842-10-65-1 (g)