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Private company ASC 842 adoption: Key considerations

Jun 06, 2022

C.J. Finn
Private, Partner, PwC US
Brandon Campbell Jr.
Deals Partner, Leasing Accounting Solutions Leader, PwC US

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.

So what should I do right now?

Start asking scoping questions and mobilizing a team

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:

  1. How many leases do you have?
  2. How complex are your typical arrangements (mostly ordinary real estate leases or any complex structured financing arrangements?)?
  3. What processes, if any, are in place for identifying embedded leases?
  4. Where are all of your leases?
  5. Are your lease processes (tracking, accounting, document storage) centralized or decentralized?
  6. Do you have any sublease arrangements?
  7. How many functions or people are involved in your end-to-end leasing processes?
  8. How many resources does your transition plan require? Can you meet those needs with internal resources alone?
  9. How will the change impact potentially sensitive financial metrics, such as debt-to-equity ratio, other liquidity ratios, or non-GAAP metrics (e.g., EBITDA)?

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.

Bottom line

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.

Deeper dive into selected key areas to consider for successful transition

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:

1. Evaluate completeness of lease population

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:

  • Entity-wide workshops and diagnostic surveys
  • Reconciling various data sets (e.g., commitment footnote, lease inventory listings, etc.), and/or
  • Relevant general ledger data analytics
  • Sample contract reviews

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:

  • Group arrangements with similar asset classes, features, terms and pricing and consider selecting material / significant leases from each major group of leases;
  • Involve key stakeholders across the organization (e.g., real estate, procurement, internal audit, and legal, etc.) to help confirm no major group of arrangements were omitted from the consideration (including arrangements with potential embedded lease risks);
  • Consider selecting a handful of “day-2” leases or modifications post effective date so that companies have opportunities to simultaneously conduct a full application of ASC 842, focusing on key features that may involve accounting judgment;
  • Consider communicating with the independent auditor regarding the process and key judgments sooner rather than later.

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:

Service agreement

- Office consumables
- Outsourcing services
- Software services

Office equipment

- Water coolers
- Vending machines
- Postage meters
- Computers
- Printers, copiers, scanners

IT service arrangements

- Dedicated rack space
- Dedicated servers
- Data centers
- Data co-locations

Vehicles

- Tractors
- Vans
- Trailers
- Delivery services

Storage

- Warehouses
- 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.

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):

Modified-retrospective transition

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:

  • Adjust comparative periods: Apply the new standard to each lease that existed at the beginning of the earliest comparative period presented in the financial statements, as well as leases that commenced after that date. Under this method, prior comparative periods presented are adjusted. For leases that commenced prior to the beginning of the earliest comparative period presented, a cumulative effect adjustment is recognized at that date. The period from the beginning of the earliest comparative period up until immediately before the effective date is referred to as the “look-back period”.
  • Do not adjust comparative periods: Apply the guidance to each lease that had commenced as of the beginning of the reporting period in which the entity first applies the leases standard with a cumulative-effect adjustment as of that date. Prior comparative periods would not be adjusted under this method. An entity that applies this method must provide the required disclosures under ASC 840 for all periods to which ASC 840 is applied.
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.

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.

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