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In the world of finance and accounting, understanding the complexities of lease accounting is crucial for businesses that lease assets. The ASC 842 Lease Accounting Standard, introduced by the Financial Accounting Standards Board (FASB), brought significant changes to how leases are recognized on balance sheets. To ease the transition and ongoing application of these rules, the FASB included several "practical expedients" within the standard. This article will explore these practical expedients, offering a clear definition and practical examples to enhance understanding.
What is ASC 842?
Before diving into practical expedients, let's briefly revisit ASC 842. The ASC 842 standard was implemented to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and disclosing key information about leasing arrangements. This standard applies to most leases, including property, plant, and equipment, with a few exceptions.
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Understanding Practical Expedients
Practical expedients are essentially shortcuts or simplifications provided by accounting standards to reduce complexity and burden in applying the standards, without significantly altering the outcome of financial reporting. Under ASC 842, these expedients allow organizations to adopt the new lease accounting requirements more efficiently and with less administrative cost.
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Package of Practical Expedients
The FASB offers a "package" of practical expedients that entities can elect to apply together, related to how leases existing at the adoption date are treated. These include not reassessing:
- Whether any expired or existing contracts are or contain leases. Entities are permitted to carry forward their lease identifications from the previous standards without reassessment.
- Lease classification. Leases previously classified as operating or finance leases under the old standard can maintain their classification.
- Initial direct costs. Costs previously capitalized can continue to be treated as such, avoiding the need to reassess all past transactions. -
Single Lease Component
Another practical expedient allows lessees to account for lease and non-lease components as a single lease component. For example, in a building lease that includes both rent and maintenance services, an entity can choose to treat these as one lease component, simplifying accounting and reducing the need for detailed allocation of payments.
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Short-term Leases
ASC 842 provides a practical expedient for short-term leases, defined as leases with a term of 12 months or less. Lessees can choose not to recognize lease assets and liabilities for such leases, instead recognizing lease payments as an expense on a straight-line basis over the lease term. This exemption significantly reduces the administrative burden for managing numerous short-term leases.
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Hindsight Practical Expedient
This expedient allows entities to use hindsight when determining the lease term and assessing impairment of right-of-use assets. It acknowledges that lease modifications and extensions are common and that predicting them at the lease commencement can be challenging. By using hindsight, entities can make more accurate determinations based on actual events and decisions.
Examples of ASC 842 Practical Expedients
To better understand practical expedients, let's look at some examples:
Example 1. Package of Practical Expedients A company with several office leases classified as operating leases under the previous standard elects the package of practical expedients upon transitioning to ASC 842. This decision means they do not reassess their existing leases for classification or whether they contain a lease, simplifying the transition process.
Example 2. Single Lease Component A retail business leases several stores, each with a lease agreement that includes rent and maintenance. By electing the single lease component expedient, the company accounts for the entire payment as part of the lease, avoiding the complexity of separating the rent and maintenance costs.
Example 3. Short-term Leases A delivery company uses various vehicles under 12-month lease agreements. By applying the short-term lease practical expedient, the company does not recognize these assets and liabilities on the balance sheet, instead expensing the lease payments, which simplifies their financial reporting.
Example 4. Hindsight Practical Expedient A manufacturing firm leases a factory with an option to extend the lease. Initially uncertain about the extension, the firm eventually decides to extend the lease. Using the hindsight practical expedient, the firm can account for the lease extension in its financial statements based on the actual decision to extend, rather than its initial uncertainty.
The practical expedients provided under ASC 842 offer organizations valuable tools to simplify the adoption and ongoing application of the lease accounting standard. By understanding and applying these expedients appropriately, entities can reduce administrative burdens, avoid unnecessary complexity, and achieve more straightforward, transparent financial reporting. It's important for finance and accounting professionals to thoroughly evaluate these options and determine the best approach for their organization's specific circumstances.
At iLeasePro, our leasing experts have worked with both ASC 840 and ASC 842 for years, and we understand the changes, the logic behind them, and why they’re important.
We can help explain them to you to make sure you get them right, and we can provide the right software products to help you record and implement the ASC 842 changes correctly.
To do this, you can call iLeasePro at 888-351-4605, or you can go to iLeasePro and access our excellent information 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 and show you how to use it to improve your bottom line.
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