Lease Accounting Transition Guide from ASC 840 to ASC 842

A detailed guide of how to transition from ASC 840 to ASC 842 with examples.

The process of adopting the new lease accounting standard ASC 842 is no easy task. Not only does ASC 842 require significantly more effort than ASC 840, given all leases are captured on the balance sheet and require complex present value calculations. In addition, a company is then needed to migrate its entire lease portfolio from ASC 840 to ASC 842 in one effort. 

Before getting into the detail on how to transition to ASC 842, a sound knowledge of how to calculate the lease liability and the right of use asset lease under ASC 842 is recommended. Refer to the below articles for further information:

• How to calculate an operating lease under ASC 842
• How to calculate a finance lease under ASC 842

With the knowledge of how to calculate a lease liability and right of use asset, we’re ready to tackle how to go about your transition from ASC 840 to ASC 842 and the necessary steps to take.

Scope

To understand the required work of transition, an entity will need to identify what contracts are in the scope of ASC 842. The first place to start is how many leases are in the scope of ASC 840. This will prompt questions such as: 

• How many operating and capital leases are you currently accounting for?
• Do these include all leased assets such as computers, cell phones, and photocopiers? 
• Have you identified embedded leases?

You can leverage a practical expedient under the new lease accounting standard that allows you to carry forward previous assessments if the contract contains a lease under ASC 840 - we'll cover more on that later in the guide. However, bear in mind that the auditors may have paid less attention if the lease were classified as an operating lease. This is because the accounting under ASC 840 is consistent with a general expense item. This drastically changes under ASC 842. 

Unlike the IASB with IFRS 16, there is no low-value scope exemption under ASC 842. However, your auditors still need to apply the concept of materiality. For example, suppose you are deliberating not to account for specific contracts that meet the definition of a lease under either ASC 840 or 842 based on the concept of materiality. In that case, you will want to initiate this conversation with your auditors ASAP.

Definition of a lease

When determining the scope it’s important to consider the definition of a lease. Under ASC 842-10-15-2 a lease is defined as: 

A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. 

Control over the use of the identified asset means that the customer has both 

(1) the right to obtain substantially all of the economic benefits from the use of the asset and 

(2) the right to direct the use of the asset.

Under ASC 840-10-15-6 a lease is defined as:

An arrangement conveys the right to use property, plant, or equipment if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying property, plant, or equipment. The right to control the use of the underlying property, plant, or equipment is conveyed if any of the following conditions is met: 

1. The purchaser has the ability or right to operate the property, plant, or equipment or direct others to operate the property, plant, or equipment in a manner it determines while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment. The purchaser's ability to operate the property, plant, or equipment may be evidenced by (but is not limited to) the purchaser's ability to hire, fire, or replace the property's operator or the purchaser's ability to specify significant operating policies and procedures in the arrangement with the owner-seller having no ability to change such policies and procedures.A requirement to follow prudent operating practices (or other similar requirements) generally does not convey the right to control the underlying property, plant, or Equipment. Similarly, a contractual requirement designed to enable the purchaser to monitor or ensure the seller's compliance with performance, safety, pollution control, or other general standards generally does not establish control over the underlying property, plant, or equipment. 
2. The purchaser has the ability or right to control physical access to the underlying property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment.
3. Facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than a minor amount of the output or other utility that will be produced or generated by the property, plant, or equipment during the term of the arrangement, and the price that the purchaser (lessee) will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output.

A couple of points to note here:

• The lease definition of ASC 840 is still applicable if an entity decides to apply the package of practical expedients. Essentially you will transition using ASC 840's definition and only apply the definition on ASC 842 for new leases post-transition. See below for more details
• Don't forget there are a number of exemptions for certain contracts e.g. Leases of intangible assets subject to ASC 350

Once you’ve had your discussion with your auditors, it’s time to transition all those leases to ASC 842. With the extra scrutiny, you might discover several leases in the scope of the standard.

Effective date

The effective date is the date you apply the new lease accounting standard. Public companies worldwide have already applied the new lease accounting standards ASC 842 and IFRS 16. If you’re a U.S. private company, the latest date you can adopt the standard is for fiscal years beginning after December 15, 2021. For more information, refer here. 

A company can adopt the standard earlier if wanted. This could be applicable given the standard was pushed back a year because of COVID-19, and a company may already be in the process of transition to the new standard. For most private companies in the U.S., the transition date will be January 1, 2022, assuming you have a year-end of December 31.

Practical expedients

To simplify the transition, the standard setters have made several concessions to reduce the workload in transitioning to the new lease accounting standard. The majority of public companies, when transitioning to ASC 842, leveraged these practical expedients available. 

Package of practical expedients

A lessee has the option to utilize a package of practical expedients as described in paragraph ASC 842-10-65-1, which are: 

• An entity does not have to reassess whether any expired or existing contracts are or contain leases.
• An entity does not have to reassess the lease classification under ASC 840. For capital leases, there are now referred to as finance lease under ASC 842.
• No need to reassess initial direct costs

These concessions must be applied to your entire lease portfolio consistently, no picking and choosing!

Hindsight practical expedient

As per ASC 842-10-65-1(g) an entity can use hindsight in determining the lease term (that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing impairment of the entity’s right-of-use assets. This practical expedient is only applicable to the comparative method and must be applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor)

Transition method

The next step is to determine what transition method you are going to apply. This must be applied to your entire lease portfolio. You have two options:

Comparative method

This method will result in adjusting the comparative periods in your financial statements. 

This method of adoption is by far the most time-consuming. The comparative method also referred to as the modified retrospective approach, requires a company to apply the standard as if it was always in place for those comparative periods. In other words, you need to change prior periods in your financial statements. Modification accounting during the comparative period is not explicitly dealt with by ASC 842, so it's best to speak to your auditors on that topic. As a result, this is not a simple task. The standard-setters understand this and, as a result, made available the effective date method.

Effective date method

An entity does not have to adjust the comparative periods in a set of financial statements. However, you may require a cumulative adjustment depending on the circumstances. This method is extremely straightforward compared to the comparative method, applying ASC 842 prospectively from the transition date. Another way of looking at is all your leases start at the transition date.

What about the scope exemption of leases shorter than 12 months? 

A short-term lease is defined by the lease term at the commencement date of the lease. Therefore, if the lease has a lease term at the commencement date that is greater than 12 months, it is not eligible for the short-term leases policy election even if the remaining lease term at the transition date is 12 months or less.

Select the transition method

From here, the entity must select a transition method. Before choosing the transition method, you might want further detail on the nuances required, so feel free to read the guidance on the comparative and effective date method. If you've already decided on a transition method, jump straight to that guidance.

Operating leases in the scope of both ASC 840 and ASC 842

Regardless of the transition method, it is possible with an operating lease for balances to be carried over when transitioning from ASC 840 to ASC 842.

A lessee should measure the operating lease right-of-use asset at an amount equal to the lease liability, adjusted for the following:

• Prepaid or accrued rent: For example, the lessee pays $1,000 each month in advance. The transition date is January 1, 2022; on December 1, 2021, a month before the transition, the lessee pays the usual $1,000 and pre-pays the month of January, as a result, pays $2,000 in total. When transitioning to ASC 842 on January 1, 2022, $1,000 should be added to the value of the right of use asset. This treatment is prescribed by ASC 842-20-30-5(d). 
• The remaining balance of any lease incentives: This amount will be subtracted from the right of use asset as per ASC 842-10-30-5(a).
• Unamortized initial direct costs will be added to the right of use asset value per ASC 842-20-30-5(c). If you haven't applied the practical expedients package, this amount should be written off at transition, with the offsetting entry going to equity. 
• Any impairment will be deduced from the right of use asset value. 
• The carrying amount of any liability related to the lease recognized in accordance with ASC 420, Exit or Disposal Cost Obligations which will be added to the value of the right of use asset, it's Dr side to the liability akin to the lease liability.

Transition under the Comparative method

With the comparative method, an entity must account for the current period to reflect the accounting requirements of ASC 842 and the comparative periods in a set of financial statements (also referred to as the "lookback" period). As the accounting for capital leases under ASC 840 closely reflects that under ASC 842, the primary focus will be on operating leases transition to ASC 842, given those are the leases that will need to come on the balance sheet for both current and comparative periods. 

Because of this, a company is required to restate its financial statements to the earliest comparative period presented in the financial statements. For example, if the transition date is January 1, 2022, that adjustment will occur on January 1, 2020.

In other words, the lessee will be transitioning all their leases to their earliest date of application. This diagram illustrates this principle:

In the above diagram, let's assume:

• Lease A commenced on October 1, 2019
• Lease B commenced on March 1, 2020

For lease A, the accounting under ASC 842 will start on January 1, 2020. This treatment results in a portion of the lease to be accounted for under ASC 840 and the remainder under ASC 842. As a result, lease A will come on the balance sheet based on the known feature lease payments on January 1, 2020. While with Lease B, under the comparative method, the entire lease period will be captured under ASC 842.

If an entity decides to transition with the comparative method, a general outline of steps to follow are: 

1. Identify all the leases in scope. This is not just current leases but leases that were active in the comparative period
2. Account for the leases as per ASC 842 
3. Retrospectively update the financial statements

Operating lease transition example

We’ll now dive into an example to help illustrate the comparative transition method:

Company A 

The transition date is January 1, 2022. That date of initial application/earliest comparative period is January 1, 2020. The company has two leases:

Office lease:

• The office lease is classified as an operating lease. 
• The commencement of this lease was January 1, 2007
• The expiry of the lease is December 31, 2027
• The lease payments are $1,000 per month at the start of each month
• This discount rate used is 6%

Motor Vehicle:

• Classified as an operating lease. 
• The commencement of this lease was June 1, 2009
• The lease payments are $1,000 per month at the start of each month
• This discount rate used is 6%
• The lease expires on January 2, 2022

Solution:

The transition date is 1 January 2020. As a result, the balance sheet for company A at year-end would like like this: