ASC 842 Practical Expedients
Any business that leases assets needs to understand lease accounting. The ASC 842 Lease Accounting Standard, introduced by the Financial Accounting Standards Board (FASB), made major changes to how leases are recognized on balance sheets.
To ease the transition to these rules and their ongoing use, the FASB built several "practical expedients" into the standard. ASC 842 practical expedients can simplify your transition and ongoing compliance. To see how they fit your overall compliance plan, read our complete guide to ASC 842. This page defines each practical expedient and gives practical examples.
Key takeaways
- Practical expedients are reliefs the standard provides that cut the work of applying ASC 842. Some of them change what is reported, so each election is an accounting decision, not just an administrative one.
- The package covers expired and existing contracts and leases that commenced before the effective date. An entity that elects it does not reassess lease identification, lease classification, or initial direct costs, and it must take all three together.
- Lessees can elect, by class of underlying asset, to account for lease and non-lease components as a single lease component.
- A short-term lease has a term of 12 months or less at commencement, with no purchase option the lessee is reasonably certain to exercise. For these, lessees can elect not to recognize lease assets and liabilities and instead expense the payments straight-line over the lease term.
- On transition, an entity may elect to use hindsight in determining the lease term and assessing impairment of right-of-use assets (ASC 842-10-65-1(g)).
What is ASC 842?
Before we turn to practical expedients, here is a quick recap of ASC 842.
ASC 842 was put in place to make financial reporting more transparent and easier to compare across entities. It does this in two ways. Entities recognize lease assets and liabilities on the balance sheet, and they disclose key facts about their leasing arrangements. The standard applies to most leases, including property, plant, and equipment, with a few exceptions.
What are practical expedients?
Practical expedients are reliefs the standard provides. They cut the work of applying ASC 842, and some of them change what is reported, so each election is an accounting decision, not just an administrative one.
These expedients let entities adopt the new lease accounting requirements with less effort and less administrative cost.
What is the package of practical expedients?
The FASB offers a "package" of practical expedients that must be elected as a package and applied consistently to all of an entity's leases; a lessee or lessor cannot take one and leave the others (ASC 842-10-65-1(f)). It applies to leases that commenced before the effective date and lets the entity skip reassessing:
- Whether any expired or existing contracts are or contain leases. Entities may carry forward their lease identifications from the previous standards without reassessment.
- Lease classification. Leases classified as operating leases under ASC 840 stay operating leases, and leases classified as capital leases under ASC 840 become finance leases under ASC 842 (ASC 842-10-65-1(f)(2)).
- Initial direct costs. Costs previously capitalized can still be treated that way, so there is no need to reassess initial direct costs for existing leases (ASC 842-10-65-1(f)(3)).
Single Lease Component
A lessee may elect, as an accounting policy by class of underlying asset, not to separate non-lease components from the lease components they relate to. It then accounts for each lease component and its associated non-lease components as a single lease component (ASC 842-10-15-37).
Take a building lease that includes both rent and maintenance services. An entity can choose to treat these as one lease component. That simplifies the accounting and reduces the need to allocate payments in detail. The trade-off is that the maintenance payments become lease payments, so the right-of-use asset and lease liability are larger, and a larger present value can change the classification conclusion. KPMG's Handbook: Leases makes the same point (paragraph 4.4.30).
Short-term Leases
ASC 842 lets lessees elect not to recognize a right-of-use asset and lease liability for short-term leases. A short-term lease is one that, at the commencement date, has a lease term of 12 months or less and does not include a purchase option the lessee is reasonably certain to exercise (ASC 842 Glossary; the election is in ASC 842-20-25-2).
A lessee may elect, as an accounting policy made by class of underlying asset, not to apply the recognition requirements to short-term leases. Instead it recognizes the lease payments in profit or loss on a straight-line basis over the lease term, and variable lease payments in the period the obligation is incurred (ASC 842-20-25-2). This exemption greatly reduces the administrative burden of managing many short-term leases.
What is the hindsight practical expedient?
On transition to ASC 842, an entity may elect to use hindsight in determining the lease term, that is, when considering lessee options to extend, terminate or purchase, and in assessing impairment of its right-of-use assets. The election must be applied consistently to all of its leases, and it may be taken on its own or with the package (ASC 842-10-65-1(g)).
It acknowledges that lease modifications and extensions are common, and that predicting them at lease commencement can be hard. With hindsight, entities can base these determinations on actual events and decisions, which makes them more accurate.
Examples of ASC 842 Practical Expedients
Here are some examples of how the practical expedients work:
Example 1: Package of Practical Expedients
A company has several office leases classified as operating leases under the previous standard. It elects the package of practical expedients when it transitions to ASC 842. So it does not reassess its existing leases for classification, or for whether they contain a lease. That simplifies the transition.
Example 2: Single Lease Component
A retail business leases several stores. Each lease agreement includes rent and maintenance. The company elects the single lease component expedient, so it accounts for the entire payment as part of the lease. It does not have to separate the rent and maintenance costs.
Example 3: Short-term Leases
A delivery company uses various vehicles under 12-month lease agreements. It applies the short-term lease practical expedient. The leases qualify only if the contracts carry no purchase option the company is reasonably certain to exercise. So the company does not recognize these assets and liabilities on the balance sheet. Instead, it expenses the lease payments, which simplifies its financial reporting.
Example 4: Hindsight Practical Expedient
A manufacturing firm leases a factory with an option to extend the lease. At inception the firm was unsure about the extension, but it decided to extend before its ASC 842 effective date. Electing hindsight, it measures the lease at the effective date using the extended term rather than the uncertainty that existed at inception.
Choosing Which Practical Expedients to Elect
The practical expedients under ASC 842 give entities useful tools. They simplify the adoption and ongoing use of the lease accounting standard. Applied well, they help entities reduce administrative burdens, avoid needless complexity, and achieve simpler, more transparent financial reporting.
Finance and accounting professionals should weigh these options carefully and pick the approach that fits their organization's specific circumstances.
At iLeasePro, our leasing experts have worked with both ASC 840 and ASC 842 for years. We understand the changes, the logic behind them, and why they matter.
We can explain them to you so you get them right. We can also provide the right software products to help you record and apply the ASC 842 changes correctly.
To get started, call iLeasePro at 888-351-4606. Or go to iLeasePro to read about our software products and how they can help you with ASC 842. We'll give you all the information you need to simplify the recording process. We'll also show you how to use it to improve your bottom line.