ASC 842 Lessee Practical Expedients

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businessman reading documents at meeting, business partner considering contract terms before signing checking legal contract law conditionsA practical expedient is an accounting policy election allowed by the Financial Accounting Standards Board (FASB) that provides relief from the burden on financial statement preparers to apply the requirements of an accounting standard.

The FASB provides several practical expedients in ASC 842, which entities may elect to use in implementing the new lease accounting standard to reduce the burden of adoption. Several practical expedients provide relief in the initial application of the new standard, while others simplify the ongoing compliance. These options are described below:

“Package of Three” Transition Relief

Election of this transition relief package, which must be elected as a package of three (“all or none”), allows an entity to not reassess the following:

  1. Whether any expired or existing contracts are, or contain, leases
    • Provided the prior lease accounting policies were consistent with the provisions of ASC 840. This expedient does not grandfather incorrect assessments, such as failing to identify a lease embedded in service or supply contract.
  2. The lease classification for any expired or existing leases
    • All existing leases that were classified as operating leases in accordance with ASC 840 will be classified as operating leases under ASC 842. Similarly, all existing leases that were classified as capital leases in accordance with ASC 840 will be classified as finance leases under ASC 842.
  3. Initial direct costs for any existing leases
    • If a reporting entity elects this package of practical expedients, it does not need to reassess whether initial direct costs meet the new definition upon the adoption of ASC 842.

If elected, the transition relief package should be applied to all leases consistently. If a lessee decides not to adopt the package of practical expedients, the entity should reassess lease classification as of the commencement date of the lease or the lease modification date.

Electing the package of three practical expedients saves time and effort in implementing the new lease standards by avoiding the need to reassess decisions that were already properly made under the prior guidance in ASC 840.

Hindsight Transition Relief

Entities can use hindsight in determining the lease term, including lease renewal, termination and purchase options, as well as in assessing any impairment of the right-of-use (ROU) asset. The lessee should take into consideration all available information prior to the effective date but not the events or circumstances after the effective date.

Adopting the hindsight practical expedient could increase the accuracy of the data used in the implementation of the new lease accounting standard and eliminate the need to determine the impact of remeasurements and impairments in initial calculations, when applicable. However, because this practical expedient must be applied to all leases, it is generally not considered beneficial for most entities, especially those choosing the transition method that forgoes comparative reporting.

Land Easements Transition Relief

A land easement, commonly referred to as right-of-way, is the right to use, cross or access another entity’s land for a specified purpose. Using this practical expedient, an entity can choose to continue to treat expired or existing land easements in other standards, such as ASC 350, Intangibles – Goodwill and Other or ASC 360 Property, Plant and Equipment, by not applying the new lease standard at transition.

However, this practical expedient cannot be used if:

  1. The land easement was previously accounted for under ASC 840;
  2. The ROU easement is ongoing on a perpetual basis (i.e., there is no time limit for access to the asset).

Individual land easement elections are also prohibited if an entity holds a portfolio of land easements to avoid similar land easements from being accounted for under two different standards.

Adopting this practical expedient will reduce the cost and complexity of implementing the new lease standard, especially for lessees with old or several land easement arrangements.

Short-Term Leases

As an accounting policy, entities may elect not to record “short-term” leases on the balance sheet. To qualify as a short-term lease, a lease must have an initial term of 12 months or less and not include renewal options or a purchase option that the lessee is reasonably certain to exercise. This accounting policy election is made by class of underlying asset.

Electing not to apply the new lease standard to short-term leases could simplify the process and save time accounting for short-term leases. However, appropriate disclosures related to short-term leases are required in the notes to financial statements.

Combining Lease and Nonlease Components

Lessees may choose not to separate nonlease components from their related lease components. Rather, the lessee would account for a lease component along with all its related nonlease components as a single lease component. This accounting policy election is made by class of underlying asset.

Lessees electing to combine lease and nonlease components would avoid the need to allocate contract consideration to various components based on their standalone prices, which would minimize effort and save time in applying the requirements of the new lease standard. However, combining lease and nonlease components will result in higher lease liability and related ROU asset balances.

Risk-Free Discount Rate

A lessee that is not a public business entity can elect by class of underlying asset to use a risk-free discount rate, determined using a period comparable to the lease term, as the discount rate for the lease.

Electing to use a risk-free rate would eliminate the need to determine incremental borrowing rates for leases. However, the risk-free discount rate would generally be lower than the incremental borrowing rate, resulting in higher lease liability and ROU asset balances.

The option to make the election by class of underlying asset gives lessees ability to control where the use of the risk-free rate has an impact. For example, lessees may elect to use the risk-free rate for higher volume and lower dollar asset classes, such as office equipment or vehicles. However, at the same time, the lessee may prefer to use the implicit rate or incremental borrowing rate for lower volume and higher dollar asset classes such as real estate.

Required Disclosure

A reporting entity is required to disclose the election of any of the practical expedients in the policy notes to financial statements.

If you have questions about practical expedients, please talk to our experts.

This publication contains general information only and Sikich is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or any other professional advice or services. This publication is not a substitute for such professional advice or services, nor should you use it as a basis for any decision, action or omission that may affect you or your business. Before making any decision, taking any action or omitting an action that may affect you or your business, you should consult a qualified professional advisor. You acknowledge that Sikich shall not be responsible for any loss sustained by you or any person who relies on this publication.

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