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Considering the Transitional Practical Expedients Allowed Under ASC 842

June 27th, 2022

This article was written by Mark Perez, CPA.

After two deferrals, the time for ASC 842 implementation is finally here. For fiscal years beginning after December 15, 2021, organizations, besides public companies and public not for profits (both required to implement earlier) will need to evaluate their various lease commitments and determine if they will need to record a right of use asset and a lease liability on their balance sheet. Depending on the number of leases involved, a significant effort may be required to assemble the complete lease portfolio and evaluate each lease to determine how ASC 842 applies. Luckily, the standard includes several practical expedients that can make such a process more efficient. The application of the practical expedients can save time but must be interpreted appropriately to avoid the risk of errors in lease accounting. There are three transitional practical expedients.

The first is the Package of Practical Expedients, also known as the “Package of Three”, and, if elected, must be applied consistently to all leases. Under ASC 842-10-65-1(f), organizations that decide to elect this expedient are not required to reassess:

  • Whether expired or existing contracts contain leases under the new definition.
    • For example, if the accounting for leases within outsourcing and service agreements were appropriately evaluated under the old standard, it is not necessary to re-evaluate those contracts under the new standard.
  • The lease classification of expired or existing leases.
    • The lease tests under ASC 840 of 75% of the lease term and 90% of the present value of lease payments are gone under ASC 842. However, the previous classification of leases as operating versus capital (now finance leases) will carry forward under ASC 842. Keep in mind that the accounting under ASC 840 must be correct. There is no “grandfather clause” for errors under ASC 840.
  • Whether previously capitalized initial direct costs should be accounted for differently under ASC 842.
    • Under ASC 840, some internal expenses could be capitalized as initial direct costs. Under ASC 842, the definition of initial direct costs has narrowed (now typically external costs only), but a reassessment under the new definition is not needed.

Organizations must decide whether or not to utilize the package of three for their implementation of ASC 842. Doing so can reduce costs and the amount of effort from personnel by not requiring a reassessment of expired and existing leases, lease classification, and unamortized initial direct costs upon adoption. However, the practical expedient may increase the impact that implementation may have on the balance sheet as assets currently classified as leases under ASC 840 may not be leases under ASC 842.

The second practical expedient is known as the hindsight practical expedient and must also be applied by organizations, if elected, to all of their leases. Under ASC 842-10-65-1(g), organizations may use hindsight in developing assumptions to reassess lease terms and any impairment of the right of use asset. This expedient may be used alone or in conjunction with other practical expedients allowed under ASC 842. The advantage of this expedient is that it provides a clearer expectation regarding the amount of the right of use asset and lease liability to be recorded to the balance sheet. However, this practical expedient is most efficient when the lease portfolio only includes a small number of agreements. Larger lease portfolios still require an assessment of each agreement, which can take significant effort.

The final practical expedient is related to existing land easements. A land easement represents an agreement between two parties that allows the use by one party of land that is owned by the other party. Organizations may elect to not assess whether existing or expired land easements, that were not accounted for as leases under ASC 840, contain a lease. In such cases, the accounting can be maintained as it has been historically. However, land easements that were accounted for as leases under ASC 840 or did not exist before the adoption of ASC 842 are specifically not eligible for this practical expedient. This practical expedient can be applied alone or in conjunction with other practical expedients.

In the end, each organization will need to assemble its entire lease portfolio and develop a plan to properly implement ASC 842. Each of the practical expedients described above should be considered in developing the most efficient strategy for the transition. Hopefully organizations will be able to benefit from a combination of any of the practical expedients available under the guidance to assist in the process.

If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.

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