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Key Decisions and Considerations When Implementing ASC Topic 842, Leases

By The Bonadio Group, on August 23rd, 2021

In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), which provides new guidelines that change the accounting for leasing arrangements.

Compared with legacy lease accounting, Topic 842 primarily changes the accounting for lessees, requiring lessees to record Right of Use (ROU) assets and lease liabilities on the balance sheet for almost every lease. This significantly differs from legacy accounting for operating leases, under which they were viewed as executory contracts not recognized for accounting purposes—in other words, they were off balance sheet.

To properly implement Topic 842, there are many considerations and several key decisions to be made. This article outlines the most significant of those key decisions and considerations.

Lease inventory

One of the first considerations is how to identify your lease inventory. Not every contract subject to the new standard is going to say “Lease Agreement” at the top. You may have service or supply agreements that involve the right to control the use of an asset that would be subject to Topic 842. Keep in mind that the new standard applies to property, plant, and equipment only. It does not pertain to the following, which are covered under other standards:

  • intangible assets
  • exploration for or use of minerals, oil, gas, and similar resources
  • biological assets (i.e., timber)
  • inventory
  • assets under construction

Check with your auditors or a reputable CPA firm for a lease inventory completeness checklist to help you identify the complete population of lease agreements.

Process for determining accounting entries

Determining the accounting entries can be daunting. Consider whether you have the capabilities internally, using either purchased software or a spreadsheet application to generate the entries or if you need to engage a CPA firm to help with the task. Either way, there are a number of variables to consider in calculating the accounting entries, which are discussed next.

Policy elections and practical expedients

The new standard has several policy elections and practical expedients to consider, some of which need to be disclosed if elected. The key ones to consider include:

The package of practical expedients (“the package”)

The package consists of three practical expedients which must be elected together or not at all. When electing the package, there is no need to reassess lease definition, lease classification, or initial direct costs, which can be a significant time saver. The package must be consistently applied to all leases, and must be disclosed, if elected.

Combining lease and non-lease components

Topic 840 (the previous lease standard) required separation of lease components (physical assets) and non-lease components (goods or services related to the use of a physical asset, such as maintenance or operation). Topic 842 allows new leases on or after the effective date of Topic 842 to combine lease and non-lease components and to account for together as a single lease component. The ability to combine lease and non-lease components is another significant time saver, but will result in a greater ROU asset and lease liability on the balance sheet. This accounting policy practical expedient can be applied by class of underlying asset, and must be disclosed, if elected.

Excluding short-term leases

A short-term lease is “A lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.” A lessee can elect, by class of underlying asset, not to apply the recognition requirements of Topic 842 to short-term leases and instead to recognize the lease payments as lease cost on a straight-line basis over the lease term. This accounting policy practical expedient can be applied by class of underlying asset, and must be disclosed, if elected.

Discount rate

Another significant consideration is the discount rate used to present value your remaining lease payments at the adoption date. The standard says to use the inherent lease rate if the rate is known or can be determined (no estimation allowed). Given that the inherent lease rate is generally not know and cannot be determined, the FASB provided a second option: the incremental borrowing rate (IBR).

The IBR is a collateralized loan rate for an asset of the same value and lease term. Probably the easiest way to determine the IBR is to contact your bank for a rate quote. The rate used may be based on the original lease term or the remaining lease term at transition.

Another option available to non-public companies only is the risk-free rate. While the FASB is currently evaluating whether to make this option available by class of underlying asset, at the time of publication of this article, it must be consistently applied to all leases at the application date. Although the risk free rate is easy to look up from the U.S. Department of the Treasury website (www.treasury.gov), it will result in higher ROU Asset and lease liability.

Balance sheet sensitivity

As noted above, there are several policy elections and practical expedients that make implementation easier, but have the tradeoff of a greater ROU asset and lease liability. Consider whether you have any debt agreements with covenant requirements. Bank loans often require compliance with covenants that do not contemplate the new lease standard. Potential effects, if covenants are violated, may be reduced access to credit and increased borrowing rates. Considering the impact on covenants may be a key factor in determining whether to elect certain of the policy elections and practical expedients, such as combining lease and non-lease components or using a risk-free discount rate.

Adoption method

The modified retrospective method must be applied, which means that certain transitional requirements must be followed. However, the FASB has provided the option to either restate or not restate comparable prior periods. Not restating is certainly the easier way to go, but restating will have the advantage of greater comparability.

Implementation timing

While adoption will result in accounting entries recorded to beginning of fiscal year accounts, there is some flexibility in when those entries are actually recorded. That said, the effort needed to determine those entries will be significant. Additionally, once the ROU asset and lease liability are recorded, they need to be amortized and paid down, respectively. Given the ongoing accounting needed, the key decision is whether to put in the implementation effort early and record the entries at the beginning of the fiscal year or defer the implementation effort and record the entries at the end of the fiscal year.

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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The Bonadio Group

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