2021 LEASE Summit: Q/A, Main Takeaways for ASC 842 Transition

1. Transition accounting

2. Materiality

3. Software

4. Determining the lease term

5. Discount rate

6. Valuation

7. Leasehold improvements

8. Summary

As companies look in earnest to begin their transition for the effective date of January 1, 2022, specific questions may arise. Below are some of the questions we answered during our September LEASE summit. Make sure you’re registered for our LEASE Summit – The FASB Series in December or our LEASE summit – The GASB Series in January (more to come!) for a chance to ask your own questions regarding the complexities of the new lease accounting standards.

Transition accounting

When implementing ASC 842 for a lease that was entered into 3 years ago, do we calculate the NPV as of the date of the lease (3 years ago) or as of our implementation of ASC 842 (i.e. today)? What interest rate do we use? The incremental borrowing rate as of 3 years ago, or as of today?

If you elect to apply the package of practical expedients available for transition, you do not have to re-evaluate the contract to determine 1) whether or not it contains a lease, 2) whether the lease is finance or operating, or 3) whether any unamortized initial direct costs (IDC) qualify as such under ASC 842, all with the caveat they were properly accounted for under ASC 840.

Assuming the lease is classified as an operating lease directly prior to transition, you would calculate the present value of the remaining lease payments at transition using your incremental borrowing rate as of the effective date of transition to measure the initial lease liability.

If the lease is classified as a capital lease prior to transition, you would derecognize the capital lease liability, the capital lease asset, and the unamortized IDC balances directly prior to the transition. Then you would recognize a lease liability equal to the capital lease liability and a ROU asset equal to the capital lease asset plus the unamortized IDC. If any adjustments were made to the prior balances to arrive at the initial lease liability and ROU asset, any differences between the amounts are recorded to profit and loss.

When transitioning from ASC 840 to 842 for a private company, does deferred rent affect the initial measurement of the lease liability and ROU asset at transition? How does one properly transition a deferred lease liability balance under ASC 840 to the new standard?

At transition the initial lease liability is measured as the present value of the remaining lease payments. The initial ROU asset is measured to be:

• the initial lease liability
• + any unamortized IDC
• – any unamortized incentives received
• +/- any prepaid or deferred rent balances for that specific lease.

The mechanics of the journal entry at transition are to credit lease liability for the initial balance, reverse any amounts related to the lease from before transition (e.g. credit the prepaid rent amount, debit the deferred rent amount, etc), and debit the ROU asset for its initial balance.

We’ve been told by our external auditors that we don’t need to reassess existing leases or leases expiring before our transition; only renewals and new leases from our transition date forward. Is this true?

This is both true and false. If you elect to apply the package of practical expedients available for transition, you are not required to re-evaluate contracts to determine whether or not there is a lease, whether your leases are finance or operating, or whether any unamortized IDC qualify as such under ASC 842. However, the package of practical expedients is not a free pass for errors. If errors were made in lease classification under ASC 840, they are still considered errors under ASC 842.

If you do not elect to apply the package of practical expedients at transition, each contract should be rereviewed to determine whether or not it contains a lease and the lease classification before continuing on with the initial valuation of the lease under ASC 842.

Materiality

If you have an asset capitalization threshold of $5,000, is any lease with a NPV of less than $5,000 at transition scoped out of ASC 842, regardless of whether it is long or short term?

ASC 842 does not define or suggest a materiality threshold for determining whether or not a lease falls within its scope. However, the standard also does not prohibit using a materiality threshold. Common practice is for entities to look at the facts and circumstances of their business or organization and determine what an appropriate threshold may be for the capitalization of lease liabilities and lease assets. Also to consider is that excluding a large quantity of low dollar leases might result in a material impact on the financials, so the analysis may need to be completed from a couple of different perspectives. The next step is to discuss the threshold and your application of it with your auditors before you are too far along in the transition process.

As for the specific question of how to apply your current asset capitalization threshold, LeaseQuery recommends reviewing your lease capitalization threshold separately from your asset capitalization threshold as the business use and circumstances of your leases are separate from your fixed assets.

Software

Software agreements for 3 years are common, how are they treated for lease adoption?

ASC 842 specifically excludes leases of intangible assets, such as software, and directs organizations to the guidance provided in Topic 350 Intangibles – Goodwill and Other.

Determining the lease term

For a month-to-month lease for equipment with no customization and only a couple of years use, where do we draw the line to determine how long the lease term is, if not month-to-month?

If a lease agreement offers no stated term for the equipment lease, the lessee must consider the facts and circumstances of the lease to determine an appropriate term. Some of the questions to ask include:

• How important is the lease to your operations or a specific project?
• What is the cost to terminate the lease and enter a new lease?
• Historically, how long have you leased this type of equipment?
• Are there any economically compelling reasons to stay in the lease? To terminate the lease?
• Is a notice period required for ending the month-to-month agreement. How long is the notice period?

The answers to these questions and other factors related to the contract, the underlying asset, the entity, and the market help determine the appropriate term for a lease, and will be unique to each entity and lease agreement.

Discount rate

When determining the risk-free rate, is the term to be used the life remaining on the lease at time of adoption or the term of lease at inception?

The guidance doesn’t specify which approach should be used. Generally in practice either approach would be allowable. Whichever option is selected, treat it as a policy and use that timeframe consistently for all leases.

Valuation

What costs associated with the lease agreement should be used to determine the ROU asset and liability? What about property taxes, insurance, etc? If those expenses are required to use the asset, should they be included in the asset value or just expensed when incurred?

To measure the lease liability, include the following payments:

• Fixed and in substance fixed payments
• Variable lease payment that depend on an index or a date, initially calculated at the index or rate in effect as of the commencement date
• Exercise price for options the lessee is reasonably certain to elect
• Penalties for terminating the lease, if the lessee is reasonably certain they will be incurred
• Amount of residual value guarantees the lessee is probable to owe the lessor

Any fees or payments that are variable besides those mentioned above are not included in the measurement of the lease liability and related lease asset. If property tax or insurance payments are fixed amounts specified in the contract, they would be included in the initial measurement. However if the property tax, insurance or other payments are trued up at the end of a period or changed annually based on actual costs, these are not fixed amounts and would not be included in the measurement of the lease liability.

If you have a 5-year lease that contains a renewal option for another 5 years at the future current market rate and you expect you may stay for the total of 10 years, how do you determine the value at date of adoption? If you expect to renew at the time of adoption but later decide NOT to renew, what happens then?

To measure the initial lease liability and ROU asset, calculate the present value of the rent payments for the initial lease term and the renewal period you are reasonably certain to elect at the market rent rate in effect at measurement. The payments for the second term should be included in the calculation because the guidance views fair market rates as an index and variable payments that depend on an index or rate can be included in the measurement of the lease liability.

Note – The rent payments for the renewal term would only be adjusted to a new market rate if and/or when another event occurs to trigger the remeasurement of the lease. A change in an index or rate is not a triggering event for remeasurement of the rent payments by itself.

If you initially measure the lease with the first 5-year period and 5-year renewal term but later decide you will not renew, the lease liability and ROU asset should be remeasured with the remaining payment terms when the decision is made. However, the discount rate will not need to be reevaluated.

We have a lease that consists of parking spaces for our employees. The payment is contingent on the number of employees that signed up. The payment is not fixed from month to month. It is variable. How can we record the ROU asset? The lease term is greater than 12 months.

Under this scenario, the measurement of the lease liability would be $0 because variable payments that do not depend on an index or rate are not included in the initial measurement of the lease liability. The monthly cost would be expensed as incurred.

If, however, the contract specified a minimum number of employees the lease payments had to be calculated from, the lease liability and related asset would be calculated from this minimum value.

Leasehold improvements

If you have existing leasehold improvements that are being depreciated, does this remain in place through the original useful life if ASC 842 is implemented during the lease term? In other words, do you have to adjust the ROU asset at implementation for existing unamortized leasehold improvements?

Under both ASC 840 and ASC 842 leasehold improvements are to be depreciated over the shorter of the remaining useful life of the leasehold improvement or the remaining lease term. Transitioning to ASC 842 would not cause a change in the useful life of the leasehold improvements or the lease term. Therefore no adjustment of the leasehold improvement’s net carrying value is necessary. Additionally, any unamortized leasehold improvements will have no impact on the ROU asset at transition. The leasehold improvements will continue to be accounted for as fixed assets.

After transition, the depreciation of the leasehold improvements is only adjusted if the lease term changes, the useful life of the leasehold improvements changes, or the lessee becomes reasonably certain they will exercise an option to purchase the underlying asset of which the leasehold improvements are a part.

Summary

These are some of the questions our roundtable was able to tackle during our last LEASE Summit. If you have a question regarding the specific application of ASC 842, check out our LEASE Summit – The FASB Series, on December 16 and submit your own questions to be discussed by our panel of experienced lease accountants.

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