Private company ASC 842 adoption: Key considerations

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.

2. Evaluate adequacy of existing lease data

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?

3. Make appropriate transition elections and policy choices

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):

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.

4. Don’t forget about potential day-2 impact

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.

• Determining commencement date - The new standard defines commencement date as the date on which a lessor makes an underlying asset available for use by a lessee. This date is fact specific and may not be the same as the commencement date as defined in the contract. In arrangements with many assets, it’s possible there may be multiple commencement dates when assets are delivered at different times. Commencement date matters because it’s the date that the lease is classified and balance sheet and income statement recognition begin.
• Determining lease term - Lease term directly impacts the classification, measurement and recognition of a lease. The lease term is never shorter than the noncancellable term to which the lessee is subject. However, leases often include optional periods that permit a lessee to extend its use of an asset. Contracts may also include termination options that can impact the lease term used for classification and measurement.
• Determining lease payment - Lease payments are an important factor in lease classification and measurement. Under ASC 842 fixed payments allocated to a lease component(s) are discounted and compared to the fair value of the asset to determine whether the lease is an operating lease or a finance lease. Regardless of classification, the discounted payments are recorded as a lease liability and are the starting point for measuring the right-of-use asset. The right-of-use asset may be subject to further adjustment for items such as prepaid rent.

We look forward to discussing how we can help you navigate effectively adopting ASC 842.