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 Financial Accounting Standards Board (FASB) has provided several practical expedients entities may use for the transition.
The basic provisions are:
Leases previously classified as operating leases
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 Jan. 1, 2019. An entity entered into a five year lease for an asset on Jan. 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 Jan. 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 Jan. 1, 2017, the earliest comparative period, the entity calculates a lease liability, using its incremental borrowing rate of 6 percent, 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
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 Jan. 1, 2019. Lessee had entered into a seven year lease on Jan. 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 percent 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 Jan. 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:
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 practical expedients discussion
3 See practical expedients discussion
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 practical expedients discussion
7 See practical expedients discussion
8 ASC 842-10-55-244-247
9 ASC 842-10-65-1 (f)
10 ASC 842-10-65-1 (g)