Understanding the ASC 842 Adoption Process
Dec 05, 2022 | By Stefan van Duyvendijk
With the Year-End Close right around the corner, private companies who have yet to adopt ASC 842, the new lease guidance for private company lessees, are scrambling to get their ducks in a row.
But before the panic sets in, remember that ASC 842 adoption doesn’t have to be a pain. We know how painful busy season is during a normal year, so for the last several weeks, the former accountants at FloQast have been working to develop resources for private companies looking to adopt ASC 842 before it's too late.
On Thursday, December 8, I co-hosted a webinar taking a deep dive into implementing ASC 842, now available on-demand, but as a primer, here are a few key points to consider as we come down to the wire.
Understanding ASC 842
Before we start worrying about the perceived lift around adopting ASC 842, it’s important to understand its purpose.
ASC 842 replaces the existing standard 840. Pretty simple, right? But here’s what that actually means. The primary difference between 840 and 842 is the capitalization of operating leases onto the balance sheet, along with Right-of-Use Assets (ROU).
This standard was created to give investors a better view of leases’ (if there is more than one) impact on a business. Though many businesses have relatively few leases to account for, at least one is generally real estate-related and could have a significant impact on the company’s balance sheet for both obligated payments to the value of the ROU asset.
Most of the inputs are very similar, as well as scope and classification. Consequently, there is enough difference that you will want to reassess leases and their recognition.
What To Consider When Adopting ASC 842
Now that we understand the purpose of ASC 842, it’s time to address the elephant(s) in the room: The myriad of important questions that need to be answered as part of the adoption process. For larger public filers ASC 842 may have some significant ramifications for business processes, reporting, and covenants down the road. However, for most private entities the standard may be significantly less impactful though it may appear daunting. Make sure to have the right mindset going into the adoption by knowing the extent of the standard and what needs to happen today. Take it step-by-step, and you’ll get through it with ease.
First is easy: review the new guidance, the changes in inputs, and the high-risk areas, which we will discuss further below (you can also join our webinar if you want to hear more). Most will find the high-risk areas are not applicable to their business. If that is the case, expedite the process by focusing solely on Day 1 accounting (if you are not familiar Day 1 accounting refers to adoption and initial recognition and NOT on maintenance or long-term recognition and remeasurement of standards). This will allow you to get what is required for your year-end financials and audit and save the rest for next year. This longer runway should give you ample time to plan the next steps.
The second is also easy: focus on practical expedients. These are available for a reason if you are pre-IPO and concerned with switching to a public entity in the future and having to remeasure and restate, don't. Going public generally requires accounting policies to be restated. Investors and underwriters are used to seeing this, and it generally has little to no impact on the IPO. Cross that bridge only if you have to.
Bridging ASC 840 to ASC 842
Now let us get into the meat of it. What are the differences between ASC 840 and ASC 842 for lease recognition and measurement? While not so different, there are enough changes that each input should be looked at again. Luckily most of this information should be readily available or easily obtained if you focus on a practical adoption.
Do you have an operating Lease or Finance Lease (note finance leases are a rename of capital leases in ASC 840)? The difference in operating versus finance leases (ASC 840 capital lease) is very similar to the old standard.
The critical change here is the removal of bright lines from the old standard. ASC 842 no longer sets bright lines such as 75% of assets remaining economic life, etc. Instead, broadens the guidance to “significant” remaining economic life, etc. Bright lines are still great practical expedients that are acceptable to use in your analysis. However, the high risk in this change in standard is when leases are close to thresholds. It is important to be consistent with the approach you choose to other leases in your portfolio.
Defined as “the date the lessor makes the underlying asset available to the lessee for its use and is the date on which a number of important determinations and measurements are made,” ASC 842 has all three (classification, recognition, and initial measurement) based on the commencement date.
“Date the lessor makes the underlying asset available to the lessee for its use” is an important distinction with significant implications. Pay close attention to this for individual leases.
As noted above the new standard has the recognition of a liability and offsetting right-of-use asset for both operating and finance leases. The discount rate is critical in this measurement. However, at the surface level, it looks a bit tricky. Luckily if we are ‘practical’ and rely on the allowed practical expedients, it is simplified. The risk-free rate is much simpler to obtain and use. The risk-free rate is the rate of a zero coupon U.S. Treasury instrument for the same period as the lease term. An easy adoption would rely on using this expedient.
The starting point is your non-cancellable lease period including any rent-free periods. However, there are several other factors to consider that are noted in the guidance. It is important not to get lost in the above factors. Instead, focus on what might be applicable and focus on those first. Get to your term and answer then go back and fill in the rest. Similar to lease classification, if the answer is not reach out to the appropriate business leader and get a response (pro-tip - simplify the wording for them and ask for a binary answer yes/no). However, the most critical step in the adoption is to be consistent with the analysis. Do not arbitrarily extend some and not others.
By definition purchase options provides the lessee the option to purchase the underlying asset(s), affecting accounting for the lease depending on how reasonably certain the lessee is to exercise the option.
There are several factors to consider per the guidance. As with lease classification and lease term do not get lost in the guidance. Focus on what is applicable and what is not based on the lease contract. For any other answers not readily available don’t be afraid to reach out (pro tip - send the appropriate business leader an easy questionnaire to fill out for ease and audit trail). The third time's the charm, be consistent with your application of the guidance, and you will avoid many issues.
Perhaps the most critical input as it has such a significant effect on the lease liability and ROU. Unfortunately, lease payments come in a lot of flavors.
|Factor||The indicator lessee is certain to exercise a purchase option|
|Historical conclusions about the likelihood of the lessee exercising the option under ASC 840||When exercising the option was historically deemed reasonably assured under ASC 840|
|History related to the lessee’s exercise of similar options||When similar purchase options have been exercised in the past|
|Option’s exercise price compared to the expected market value of the underlying asset on the option’s exercise date||When the exercise price is specified and fixed and also less than the expected market value of the underlying asset on the exercise date|
|Costs to enter a new lease compared to the option exercise price||When exercising the option would eliminate the lessee incurring costs to enter into a new lease, and those costs are significant relative to the option’s exercise price|
|Degree of specific design and customization of the underlying asset||When underlying asset requires a significant degree of design and customization|
|Importance of underlying asset to lessee’s operations||When the underlying asset is critical to the lessee’s operations|
Practical Expedients and Transition Methods
As noted above, there is a practical expedient for private companies struggling with IBR analysis. However, there are two more practical expedients to use:
- Package of Practical Expedients
- No reassessment of lease classification
- No re-evaluation of embedded leases
- No reassessment of initial direct costs
- Combining lease and non-lease components
- Eliminates the requirement to separate and allocate consideration in a lease contract between a lease and non-lease components
- Non-lease components transfer a good/service to the lessee that is separate from the right to use an underlying asset
For a practical and easy adoption of the guidance, it is highly recommended that you leverage these practical expedients. Utilizing these expedients will significantly reduce the lift and work necessary not only to recognize and measure leases but also reduce the lift to write up the corresponding memo.
In addition to practical expedients, there are also two transition methods allowed by the standard on the financials. The first method is to adjust the comparative periods in which ASC 842 is applied retrospectively to each prior reporting period presented in the financial statements with a cumulative-effect adjustment as of the beginning of the earliest period presented.
The second method is not to adjust comparative periods in which ASC 842 is applied retrospectively to the beginning of the period of adoption through a cumulative-effect adjustment recognized as of the beginning of that period. Most lessees will adopt this methodology for their financial statement presentation.
ASC 842 Disclosure Requirements
The new guidance has a few more disclosure requirements which are to be anticipated with the “capitalization” of operating leases and the creation of ROUs. So while the quantitative schedules have changed in substance so have the qualitative narrative of the disclosure. There are several examples on Edgars from public filers. Leverage these to give you insights.
In addition, a general description of leases is required, along with the basis on which measurement was applied. Many of these qualitative requirements are already disclosed depending on the classification and materiality of the lease or asset class. However, it is recommended to work directly with your auditor to proactively identify the disclosure lift early in the audit and gather the information early.