Most nonpublic companies will be required to adopt ASC 842 (or the “new standard”) in 2022. The biggest change is that, upon adoption, lessees will be required to reflect virtually all leases on the balance sheet. In preparation for this change, companies should review their contracts to understand which arrangements are impacted, and to assess the impact of adopting the new standard. This publication provides insights into properly planning an effective transition approach, as well as some key accounting considerations associated with ASC 842 adoption for nonpublic companies to consider.
There is a lot to do and you want to start by asking yourself some, or all of, the following questions, scope out the estimate level of effort, and begin to sketch out an adoption timeline:
Based on insights drawn from the preliminary scoping questions, companies can start assessing resource needs, skill or data gaps, and begin to estimate the financial impact of transition. Ideally, after you conduct this exercise you will have a realistic timeline and roadmap for an overall implementation project.
Start now - There will be challenges that you didn’t anticipate. Starting now will allow time for your organization to adjust. It will also help you assess whether and how to better structure contracts and address any downstream implications, such as new process and system needs, tax implications, and debt covenants.
Get mobilized / Learn from others - Adoption will take time and careful planning. Fortunately for private companies, there are many valuable lessons learned from public companies who adopted ASC 842 in 2019 and have been applying it since. Of all the lessons learned, the most common recommendation is to build a cross-functional team that could help develop a robust implementation roadmap early in the process.
Get help - Don’t go it alone. Be realistic about your resources, competing priorities, and the timeline. Involve your auditors upfront and often.
Lease accounting adoption will take time and careful planning. Building a robust implementation roadmap early in the process is critical to an efficient and successful adoption of the new standard, and it may save you time and money. As companies plan for the adoption, there are four critical areas that management teams should address:
Prior to the adoption of ASC 842, many companies used fairly simple tools to account for their leases. Often less emphasis was placed on identifying and accounting for leases that were clearly operating leases as the accounting model differed little from executory contracts. However, ASC 842 requires lessees to record virtually all leases on the balance sheet. Performing a completeness review typically involves a number of activities, such as:
Contract reviews are an important complement to preliminary scoping activities. Reviews of a representative sample of material leases (e.g., headquarter lease, key operational locations, lease with significant amount of remaining commitments, etc.) would also provide valuable insight on (i) key contract features impacting the accounting analysis and outcome, (ii) identifying directional financial statements implications of adopting the new standard, and (iii) relevant data that could allow management to make more informed decisions around expedients and policies.
Ultimately, there will be judgment involved in “right-sizing” the number of contracts to review. Some industry leading practices may include:
Validating completeness of your lease population — including making certain that embedded leases were properly identified — has become a critical step in transition. Identifying embedded leases requires judgment, and often involves detailed contract reviews and obtaining a deep understanding of the terms and economics of an arrangement. This assessment is vital to help ensure lessees do not underestimate the balance sheet impact of the new standard. Leases can be found in many different kinds of service contracts including some of the common examples below:
- Office consumables
- Outsourcing services
- Software services
- Water coolers
- Vending machines
- Postage meters
- Printers, copiers, scanners
- Dedicated rack space
- Dedicated servers
- Data centers
- Data co-locations
- Delivery services
- Supply storage
Establishing a systematic, scalable, and collaborative process involving the right team with a deep understanding of the company’s overall procurement function is critical to pinpoint and mitigate potential high-risk areas of unrecorded embedded leases from an accounting perspective.
Additionally, depending on the size of companies’ lease portfolio and level of complexity, management may need to evaluate whether a more robust leasing system or other additional resources would be needed to handle the ongoing reporting and control around its leasing activities. Please refer to this previously issued blog, Decisions, decisions: Deciding on your go-forward path for lease accounting, for further insights specifically around systems and processes.
One of the key challenges of adopting the new standard is that the data requirements are extensive. The obvious change is the impact leases will have on the balance sheet and other financial metrics. It will also impact disclosures related to the company’s leasing activities, which are more significant than those required previously. Accordingly, adoption is likely to require new or different data and a reconsideration of internal controls associated with the data. It’s important to create a robust papertrail to clearly document judgements and accounting elections both at transition and for ongoing changes, decisions, and interpretations. Companies often find that existing financial reporting systems and controls are not sufficient to meet the requirements of the new standard.
To efficiently identify potential data gaps, it is important to first understand and leverage the company’s existing data sets. Many companies start with existing support used for their 5-year commitment footnote disclosure. They also look to real estate / equipment lease management tools or contract repositories, if any. From there, a thorough understanding of the new standard would be necessary to identify which additional data fields must be captured to comply with the new standard. For purposes of the transition, some of the key data points include, but are not limited to, the following:
Lease term / dates - key dates (e.g., inception, commencement, possession / handover dates), base term and remaining term as of the adoption date, existence and details around various options (e.g., renewals, purchase, early termination, etc.)
Payment details - timing of payments (advance or arrears), fixed vs. variable payments, identification of residual value guarantee or other types of guarantees, any incentives / tenant allowances (i.e., payments from the landlord), etc.
Executory / non-lease goods or services - existence and nature of executory-type costs (e.g., gross, modified gross, triple net, etc.)
Other existing accounts that may impact the transition balances - prepaid / deferred rent balances, incentives / tenant improvement allowances, initial direct costs, favorable / unfavorable intangibles, cease-use liabilities, etc.
Discount rate - the new standard requires a lessee to measure the lease liability and corresponding right-of-use asset by discounting the remaining lease payments using the rate implicit in the lease, or if not known, an incremental borrowing rate. In practice, a rate implicit in the lease is not readily determinable for a lessee as it is an internal measure specific to a lessor. Accordingly, lessees need to go through a separate set of procedures to determine appropriate incremental borrowing rates as of the date of adoption to be able to measure their balance sheet impact. Acknowledging the time and efforts needed to adopt the new standard in general, the guidance provides a policy election for a nonpublic business entity to utilize a risk-free rate (e.g., US Treasury rate) to measure the lease liability and right-of-use asset. Since the election of the practical expedient may be easier to apply, companies should consider implications for lease classification and its balance sheet as such election may result in higher lease liabilities. If the practical expedient is not selected, additional considerations include:
How many rates the company needs (which is dependent upon whether the entity can assert they have a centralized treasury function.)
Does the company have existing secured and collateralized borrowings to leverage?
Would the company be able to use a portfolio approach to determine the discount rate for a group of leases with similar characteristics such as similar lease terms and economic environments?
What processes will be implemented to determine and update the discount rate not only at transition but also at post-transition?
The new standard provides various transition-related expedients and policy elections that can ease the level of effort required to adopt the new standard. The following table summarizes some of the more significant expedients and ongoing policy elections that should be considered as part of a company’s transition effort (not an exhaustive list):
Upon adoption of the new standard, entities are required to apply a modified retrospective transition approach. Reporting entities are permitted to choose one of two methods:
|Package of three expedients||If elected, companies will not reassess prior ASC 840 conclusions with respect to (i) whether an arrangement is or contains a lease, (ii) lease classification and (iii) initial direct costs for leases that commence prior to the adoption date of the new standard.|
|Hindsight expedient||Companies may elect to use hindsight with respect to determining the lease term. They may consider the actual outcome or updated expectations of lease renewals, termination options, and purchase options and in assessing any impairment of right-of-use assets for existing leases.|
|Short-term lease election||If elected, leases that (a) have a ‘lease term’ of 12 months or less and (b) do not contain a ‘reasonably certain’ purchase option will not be recognized on the balance sheet (i.e., lower liability balance).|
|Election to combine lease and non lease components (lessee)||If elected, lessees can combine non-lease components into the related lease components. This is an accounting policy election made by the class of underlying assets. Note that a lessee can only combine non-lease components into the lease, not vice-versa.|
|Portfolio approach||If elected, lessees and lessor can combine multiple individual assets as a single unit of account provided application does not create a material difference when compared to accounting for leases at the individual asset level. An entity applying this approach would combine leases that commence around the same time and have comparable terms such as lease term, extensions, purchase options, etc.|
While these expedients and elections may ease the level of implementation effort and simplify the information needs, certain expedients and elections may also affect the amounts reported under the new standard (e.g., value of lease liability, amount of lease expense). For instance, making a component election to not separate non-lease components of the contract from the lease component would simplify the data gathering process and alleviate potential judgment related to allocating contract consideration based on their standalone selling prices. However, treating payments as lease payment alone increases the likelihood that a lease will be classified as a finance lease as it would put more pressure on the lease payment test criterion. That is, by electing to combine the non-lease components into the lease component, all fixed payments get included in the numerator for the lease payment test, while the denominator (fair value of the leased asset) is not impacted by the election.
Accordingly, you want to consider potential pros and cons, and seek input from key stakeholders — particularly if the population of finance leases could rise.
It is important to emphasize that the new standard requires private companies to adopt ASC 842 effective as of January 1, 2022. We are halfway through 2022, and companies will need to think not only about transition, but also the leases they signed in 2022. Transition guidance delays the interim reporting requirements imposed by ASC 842 until the following year, but 2022 annual statements for periods beginning after January 1, 2022 must reflect all lease activity in accordance with ASC 842. Specifically, leases that commence or are modified after the adoption date must be assessed under ASC 840 for interim periods and ASC 842 when preparing annual statements.
The following provides some examples of common features in the leases that may require significant judgment when applying ASC 842. This listing is not comprehensive and should not be used as a checklist. Depending on the nature and extent of your leases, other considerations may apply.
We look forward to discussing how we can help you navigate effectively adopting ASC 842.