The new lease accounting guidance in Accounting Standards Codification (ASC) Topic 842, “Leases,” is currently in effect for public business entities preparing financial statements for annual periods beginning after December 15, 2018 (including all interim periods within that year). All other entities (e.g., privately held) will have to comply with the new guidance for annual periods beginning after December 15, 2020 (including all interim periods within fiscal years beginning after December 15, 2021). The development of ASC Topic 842 is the product of several years of deliberations by FASB in concert with the IASB, informed by input from user groups. Consistent with its goal to reduce the cost and complexity of implementing this standard and others (i.e., its simplification project), FASB has endeavored to provide entities with several “practical expedients” within the standard itself, as well as in subsequent updates. Although the effective date for implementing the standard has passed for publicly held entities, private entities still have time to make changes. The purpose of this article is to summarize and discuss the expedients provided in the standard and its recent amendments.
Practical Expedients Provided in ASC Topic 842
In ASC Topic 842, FASB provides entities relief from the burden of having to determine whether leases are included in existing or expired contracts at the transition date. Most entities, such as a trucking company or airline with many leases existing at that date, would elect to avail themselves of this expedient given the significant cost of having to review all contracts to determine whether they do or do not contain a lease or a lease component.
Entities are also provided relief from having to reevaluate existing lease classifications. A capital lease under ASC Topic 840 would not be significantly affected under the new guidance if it met the criteria for classification as a finance lease (i.e., the existing lease asset and liability would be renamed during transition), but a reclassification of an operating lease under ASC Topic 840 (the previous leasing standard) deemed to meet the criteria of a finance lease would require the entity to make changes to a whole class of similar leases in the income statement. A reclassification of an operating lease under ASC Topic 840 to an operating lease under ASC Topic 842 would have no effect on the income statement. Both reclassifications (finance and operating) would require recognition on the balance sheet as right-ofuse assets and lease liabilities. In this regard, entities would be well advised to not elect to reclassify and reassess.
During the transition period, entities are also provided relief from having to reevaluate and exclude certain outlays classified as initial direct costs under ASC Topic 840. ASC Topic 842 defines initial direct costs as those that could have been avoided had the entity not entered into a lease agreement. Again, the entity can elect to avoid reassessing these costs during the transition period; however, the entity cannot elect only one or two of the practical expedients, but must elect all three of them as a single package.
In addition, entities may elect a practical expedient to use hindsight in determining the lease term and in assessing the impairment of the entity’s right-of-use assets. This is expected to save entities time during transition by not requiring them to determine the information available at the inception of the leases.
During the transition period, entities are also provided relief from having to reevaluate and exclude certain outlays classified as initial direct costs under ASC Topic 840.
Another practical expedient provided in the guidance is an election to avoid having to apply a provision of ASC Topic 842 that requires a lessee to break down consideration paid in connection with a contract into lease and nonlease components. Thus, the lessee is permitted to treat each lease component and its related nonlease components as a single lease component. If not elected, the lessee must apply other guidance with respect to its accounting treatment of nonlease components (e.g., application of ASC Topic 350, “Intangibles—Goodwill and Others”).
Lessees also have the ability to make an accounting policy election by class of underlying asset to not record a right-of-use asset and lease liability for short-term leases, which are defined as leases with a lease term of 12 months or less. Instead, those short-term leases would be recorded similarly to operating leases under ASC Topic 840, with the lease payments being recognized into profit or loss on a straight-line basis over the lease term. This election will help entities save the effort and time of maintaining lease schedules for leases of short duration.
A further expedient provided in ASC Topic 842 applies only to private entities. A privately held company can elect to use a risk-free rate (e.g., U.S. Treasury bill rate) to discount the lease payments and avoid the more complicated and problematic determination of a risk-adjusted discount rate (e.g., its incremental borrowing rate). The only downside would be that the entity would have to report a larger liability associated with the right-of-use asset.
Practical Expedient for Land Easements
A land easement confers rights of a particular entity to use, access, or cross another entity’s property for a particular purpose. Such rights may be permanent or limited and may be exclusive or shared with other entities. Prior to ASC Topic 842, the diversity of accounting practice with respect to such easements was such that some entities followed the guidance provided in ASC Topic 350 or ASC Topic 360, “Property, Plant, and Equipment,” while others treated such land easements as leases and applied the provisions of ASC Topic 840. If an entity such as an oil or natural gas distributor using land easements to construct pipelines traversing private or public property were required to classify such arrangements as leases under the new standard, it would constitute a significant burden. Indeed, implementation of the requirement for many entities with thousands of existing and expired land easements would prove nearly impossible given their volume and age. In this regard, the practical expedient in Accounting Standards Update (ASU) 2018-01, Leases (Topic 842)—Land Easement Practical Expedient for Transition to Topic 842, if so elected, provides entities with the option not to evaluate land easements that existed or expired before the entity’s adoption of ASC Topic 842. Such election, however, is not available to entities that followed the guidance provided in ASC Topic 840; thus, entities previously following that guidance must apply the provisions of ASC Topic 842 to land easements existing or expiring prior to its passage. Furthermore, this update provides clarity in its implementation guidance (e.g., Example 10, 350-30-55-30) that land easements first should be assessed under ASC Topic 842 to determine whether they meet the definition of a lease and that permanent easements do not meet the definition of a lease under ASC Topic 842. Finally, entities eligible for the election are not required to elect the package of practical expedients provided in ASC Topic 842 in order to avail themselves of this practical expedient. Eligible entities are expected to elect this practical expedient and thereby avoid the cost and complexity of having to evaluate thousands of existing and expired land easements at transition.
ASC Topic 842 provides lessees with an option to avoid separating nonlease components from their related lease components.
Practical Expedient for Cumulative Adjustment and Separating Components
Consistent with its simplification project, FASB issued ASU 2018-11, “Leases (Topic 842)—Targeted Improvements,” to further reduce the burden of implementing the new lease standard. The practical expedients in ASU 2018-11 provide for the following:
- Entities may record a cumulative adjustment to the opening balance of retained earnings in the year of adoption.
- Lessors may elect not to separate nonlease components from their related lease components.
Cumulative adjustment in period of adoption.
This practical expedient relieves the entity from having to apply the provisions of ASC Topic 842 at the beginning of the earliest period presented in the year of adoption, which would require it to restate the prior years in comparative financial statements. For example, this election allows publicly held entities with a calendar year-end to begin applying ASC Topic 842 on January 1, 2019, and privately held entities on January 1, 2021. As mentioned previously, this election significantly reduced the burden in transitioning to the new standard by allowing entities to avoid having to restate prior-year comparative financial statements and to make related disclosures.
In the initial transition, prior years included in the comparative financial statements can be prepared in accordance with ASC Topic 840. In this respect, this update has significantly reduced the complexity and cost of implementing the new lease standard for publicly held companies who must now follow the new guidance, and will similarly reduce the burden on privately held entities who will shortly have to comply with ASC Topic 842.
Option to avoid separating lease from nonlease components.
ASC Topic 842 provides lessees with an option to avoid separating nonlease components from their related lease components. In effect, the lessee is permitted to treat the lease and its related nonlease components as one component, thereby reducing the burden of having to account for lease components under the new guidance and nonlease components under other guidance. Similar relief was not originally provided to the lessor, however, thereby requiring the entity to evaluate lease arrangements to determine any lease and nonlease components requiring separation. Without this update, the lessor would have to apply the guidance provided in ASC Topic 842 with respect to any lease components while following the revenue recognition rules in ASC Topic 606, “Revenue from Contracts with Customers,” with respect to any nonlease components (or other applicable guidance). ASU 2018-10 grants this relief to lessors provided that both of the following conditions are met:
- The timing and pattern of transfer for the lease component and associated nonlease components are the same.
- The lease component, if accounted for separately, would be classified as an operating lease.
Furthermore, the guidance requires the lessor to follow the guidance related to the predominant component of the combined component. Thus, if most of the consideration is related to the lease component, the lessor would follow the guidance in ASC Topic 842. If most of the consideration received by the lessor is related to the nonlease component, the lessor would follow ASC Topic 606 or other applicable guidance. Of course, if so elected, the lessor would have to apply the same guidance to an entire class of underlying assets.
Codification Improvements to ASC Topic 842
Although ASU 2018-10, “Codification Improvements to Topic 842, Leases,” does not specifically address any additional practical expedients, it does provide several amendments that clarify existing guidance with respect to ASC Topic 842 and subsequent updates; this is consistent with FASB’s ongoing simplification. With respect to ASC Topic 842, this update provides amendments relating to 16 issues, addressing the concerns of various stakeholders in their comment letters. For example, issues regarding the reassessment of lease classifications addressed in several paragraphs throughout ASC Topic 842 have been consolidated into one paragraph, which provides guidance regarding how a lessee should perform the lease reassessment, as well as how to evaluate the facts and circumstances, changes in terms, and other pertinent matters as they relate to the reassessment. The codification improvements contained in this update, combined with the practical expedients discussed in this article, have and continue to provide valuable guidance to ease the transition for entities experiencing difficulty implementing the new lease standard.
Successful implementation requires a coordinated effort on the part of CEOs, CFOs, and other senior management. It is essential that companies understand the capabilities of their existing information systems, accounting, and administrative controls. Many entities continue to rely upon simple spreadsheets to accumulate information, which may be inadequate in documenting the volume and complexity of leases and evaluating the impact of changes in existing lease terms and escalation clauses. Legal staff must work with accounting and internal auditing staff in order to evaluate the nature of contractual obligations and determine the extent of leases embedded in contracts. It is important for lessee management in particular to understand and evaluate the impact of the new standard on existing debt covenants and other agreements that utilize financial ratios. Entities should work closely with their independent auditors in evaluating documentation requirements, as well as in evaluating the adequacy of their existing internal control systems.
It is important for lessee management in particular to understand and evaluate the impact of the new standard on existing debt covenants and other agreements that utilize financial ratios.
For many businesses, the challenges in meeting the new lease standard continue to be formidable, and those entities heavily engaged in leasing activities must develop a framework that will enable management to update critical accounting policies and financial reporting controls, and assess system capabilities. Project management teams must be established to facilitate coordination among the various functional areas of business: finance, accounting, marketing, information systems, procurement, and internal audit. Indeed, successful application of the new standard will require an ongoing, collaborative effort that will prove difficult and costly for many entities in the early years.