ASC 842 Transition Methods Explained

How to Master ASC 842 Transition Methods

The choice of ASC 842 transition method draws close audit review. Get it wrong and the financial statements may need to be restated. Many companies struggle with these first accounting choices, which set how they comply from then on. Companies with large lease portfolios struggle most.

For the whole compliance framework, our detailed ASC 842 guide covers the essentials. This article compares the ASC 842 transition methods. It covers what each method means and what controllers, accounting managers, and auditors need to weigh.

The goal is to pick and apply a transition method that shows an entity's lease obligations accurately. It should also keep disruption and audit risk low.

Understanding the Key ASC 842 Transition Methods

The Financial Accounting Standards Board (FASB) gave entities two primary methods for moving to ASC 842. The first is the modified retrospective transition approach. The second, added by ASU 2018-11, is an optional transition method.

The second method applies the modified retrospective approach at the beginning of the period of adoption, with a cumulative-effect adjustment at that date (ASC 842-10-65-1(c)(2)). The method sets how prior period financial statements are presented and how the cumulative effect of adoption is recognized.

Modified Retrospective Approach at the Earliest Comparative Period

This method, often called the comparative method, is still a modified retrospective approach; ASC 842 does not permit full retrospective application. The entity applies ASC 842 from the beginning of the earliest period presented and records the cumulative effect at that date (ASC 842-10-65-1(c)(1)). Prior comparative periods are restated to show the impact of ASC 842 as if it had always been in effect, subject to the transition requirements (ASC 842-10-65-1(d)).

For calendar year-end public companies, this generally meant restating fiscal year 2017 and 2018 financials on adoption in 2019.

This approach aims for full comparability across all periods presented. But it adds a great deal of data gathering and recalculation.

Scenario: A public company adopted ASC 842 for its fiscal year beginning January 1, 2019. It prepares financial statements with two prior comparative years (2018 and 2017). Under this method, the company would restate its financial statements for 2018 and 2017 to apply ASC 842. It would present all three years (2019, 2018, 2017) as if ASC 842 had been applied from the start.

That means finding all leases in effect during those periods. The company measures the right-of-use (ROU) assets and lease liabilities, and records the journal entries for each comparative period. This level of detail is often a point of dispute in the audit. Auditors check hard that the historical data is complete and accurate.

Modified Retrospective Approach at the Effective Date

The FASB introduced this alternative method in ASU 2018-11. It lets entities apply the modified retrospective approach as of the effective date of the new standard (e.g., January 1, 2019, for calendar year public companies). They do not apply it from the earliest comparative period presented (ASC 842-10-65-1(c)(2)). Prior financial statements are not restated, so for many it is the less burdensome option.

Under this method, the cumulative effect of applying ASC 842 is recognized as an adjustment to the opening balance of retained earnings in the period of adoption. The prior periods presented are not restated. They continue to be reported under ASC 840.

Why does the effective date method simplify comparative financial statement reporting? The effective date method simplifies comparative reporting because prior periods do not need to be adjusted retrospectively.

That cuts the historical data gathering and recalculation a great deal. Entities can focus on current period compliance, without the look-back the comparative method requires. This transition relief was aimed at preparers facing unanticipated costs and complexity under the comparative method.

Practical Expedients and Their Impact on Transition

The ASC 842 practical expedients package gives entities critical relief during the transition. It makes the new standard simpler to apply to existing leases. These expedients must be elected as a package. An entity must choose to apply all of them or none of them (ASC 842-10-65-1(f)).

Practical Expedients Package

The three key practical expedients for existing leases are:

1. Do not reassess whether any expired or existing contracts are or contain a lease: Entities carry forward their ASC 840 conclusions on whether a contract is a lease.
2. Do not reassess lease classification for existing leases: Entities can keep their previous lease classifications (operating or capital) under ASC 840 for existing leases. So an ASC 840 capital lease becomes a finance lease under ASC 842. An operating lease stays an operating lease (ASC 842-10-65-1(f)(2)).
3. Do not reassess initial direct costs for existing leases: Entities can carry forward their prior conclusions about initial direct costs.

These expedients matter under either transition method. For example, applying the modified retrospective transition approach at the effective date with the practical expedients makes the process much simpler. Without them, the entity reassesses each existing contract's lease identification, classification and initial direct costs under ASC 842 (ASC 842-10-65-1(f)).

Hindsight Practical Expedient

How does the hindsight practical expedient affect ASC 842 transition methods? The hindsight practical expedient lets entities use hindsight for existing leases. They can use it to set the lease term, weighing options to extend or terminate the lease and to purchase the underlying asset. They can also use it in assessing impairment of right-of-use assets (ASC 842-10-65-1(g)).

So an entity can use what it now knows about whether options were exercised to set the lease term for transition. It is not limited to what it knew at the lease commencement date. This reduces estimation risk. It can lead to more accurate ROU asset and lease liability measurements on adoption.

Calculation Example: Lease Liability Transition Adjustments

Scenario: A company moves to ASC 842 using the modified retrospective approach at the effective date of January 1, 2022, and elects the practical expedients package. It has an existing operating lease that commenced on January 1, 2020, with a 5-year term. Annual payments of $12,000 are paid at the end of each year (in arrears).

The rate implicit in the lease is not readily determinable, so the company uses its incremental borrowing rate (IBR) of 6% at the transition date.

Objective: Calculate the lease liability transition adjustments and the initial ROU asset balance.

Key Takeaway: For a former operating lease, the lease liability is the present value of the remaining ASC 840 minimum rental payments at the application date (ASC 842-10-65-1(l)). The discount rate is the rate implicit in the lease if readily determinable, otherwise the IBR.

A company that is not a public business entity may instead elect a risk-free rate in place of its IBR, by class of underlying asset (ASC 842-10-65-1(l); ASC 842-20-30-3). Any existing deferred rent or prepaid rent balances from ASC 840 also adjust the ROU asset on transition (ASC 842-10-65-1(m)).

Accounting Entries for Each ASC 842 Transition Method

The specific ASC 842 adoption journal entries vary with the chosen transition method. The method mainly affects how the cumulative effect is recorded and whether comparative periods are restated.

Journal Entries for Modified Retrospective at Earliest Comparative Period

When ASC 842 is applied to the earliest comparative period, each period's financial statements are restated. The entity recognizes the ROU asset and lease liability once, at the application date. That date is the later of the beginning of the earliest period presented and the lease's commencement date (ASC 842-10-65-1(c)(1)). For a former operating lease, the liability is the present value of the remaining minimum rental payments at that date (ASC 842-10-65-1(l)).

Take the example lease above under this method. A private company with one comparative year has an application date of January 1, 2021, and four payments remain. Assuming a 6% rate at that date, payments in arrears, the ordinary annuity factor is 3.46511. The liability is $12,000 × 3.46511 = $41,581.

Example (at the application date):

• To recognize ROU asset and lease liability (for an operating lease):

  • Debit Right-of-Use Asset (e.g., $41,581)
  • Credit Lease Liability (e.g., $41,581)
  • If there were historical adjustments like deferred rent, these would also impact the ROU asset.

• To adjust for cumulative effect (if any, typically to retained earnings at start of earliest period, ASC 842-10-65-1(c)(1)):

  • Debit/Credit Retained Earnings (as applicable)
  • Credit/Debit various balance sheet accounts

Journal Entries for Modified Retrospective at Effective Date

This method is generally less complex because it avoids restatement. The cumulative effect of applying ASC 842 is recognized as an adjustment to the opening balance of retained earnings in the period of adoption.

Example (as of effective date, e.g., January 1, 202X):

• To recognize ROU asset and lease liability for existing operating leases:

  • Debit Right-of-Use Asset (the lease liability, adjusted for any existing lease-related balances like deferred rent, ASC 842-10-65-1(m))
  • Credit Lease Liability (PV of remaining minimum rental payments, ASC 842-10-65-1(l))

• To adjust retained earnings for the cumulative effect of adoption:

  • Debit/Credit Retained Earnings only for items that the transition guidance sends to equity. One example is unamortized initial direct costs written off when the package is not elected (ASC 842-10-65-1(p)). Another is a deferred gain or loss on an ASC 840 sale and operating leaseback, other than any portion from off-market terms (ASC 842-10-65-1(ee)). In KPMG's view, an ROU asset abandoned before the effective date is also written down to zero through equity (KPMG, Handbook: Leases, Question 13A.3.60).
  • For an operating lease carried over with the package, the ROU asset absorbs accrued or prepaid rent. There is usually no retained-earnings entry (ASC 842-10-65-1(m); see Example 13A.3.10 in KPMG's Handbook: Leases).

How to calculate the cumulative effect adjustment for ASC 842 transition? Start with the net balance sheet impact of applying ASC 842 to all existing leases (i.e., ROU assets and lease liabilities). Compare it with any lease-related balances already recognized under ASC 840 (e.g., capital leases, deferred rent, prepaid rent). The cumulative effect adjustment is the difference.

This net difference is then posted directly to the opening balance of retained earnings in the period of adoption. For operating leases carried over with the package, this difference is usually zero. When there is one, it can come from an ROU asset abandoned before the effective date. Without the package, it can also come from initial direct costs written off (ASC 842-10-65-1(p)).

Many companies find this calculation hard, especially with complex portfolios. At scale, doing it by hand gets difficult. It often leads to errors in tracking all the parts that affect retained earnings.

Internal Controls for a Robust ASC 842 Transition

Strong internal controls are paramount to an accurate and complete ASC 842 transition, and they reduce the risk of misstatements and audit findings. What internal controls are essential during the ASC 842 transition process? Essential controls include a robust process to find all lease contracts and to pull key data points accurately. They also include applying accounting policies consistently, and thorough review and reconciliation.

Key Internal Controls Checklist:

• Completeness of Lease Identification: Controls to make sure every contract that contains a lease, including embedded leases, is found and brought into the lease accounting system. This is a common area of failure in audit review. To check quickly whether a service contract contains an embedded lease, use our free AI Lease Analyzer tool to evaluate your agreements.
• Accuracy of Data Extraction: Procedures to verify the accuracy of lease terms, payment schedules, options, and implicit/incremental borrowing rates extracted from lease agreements.
• Consistent Policy Application: Controls to make sure accounting policies for lease classification, lease term, and discount rate are applied the same way across the whole lease portfolio. This also includes sticking to the chosen transition method.
• Review and Approval: Independent review and approval of ROU asset and lease liability calculations, journal entries, and financial statement disclosures prior to posting.
• System Controls: If using lease accounting software, controls over system configuration, data input, and report generation.
• Reconciliation: Regular reconciliation of lease data to general ledger balances and underlying source documents.
• Documentation: Comprehensive documentation of all judgments, assumptions, and calculations made during the transition, vital for external audit.

Auditors will test whether the lease population is complete and the underlying data accurate. They will also test whether the chosen transition method and practical expedients were applied correctly.

Neglecting these controls significantly increases the risk of material weaknesses. Many organizations struggle to scale these controls across thousands of leases. The result is often decentralized processes, with uneven adherence and documentation.

How to document the ASC 842 transition method for external auditors?

To document the ASC 842 transition method for external auditors, companies must keep a full audit trail. That starts with a clear memo on the chosen transition method. It gives the reasons for electing or not electing practical expedients, and the method for setting the incremental borrowing rate. It also holds detailed calculations for ROU assets, lease liabilities, and the cumulative effect adjustment.

All source documents, such as lease contracts and supporting analyses, should be easy to reach and cross-referenced.

Challenges and Audit Risks in Transition Method Selection

Choosing the right transition method and putting it in place well brings several challenges and audit risks. Auditors will look closely at the judgments made and the data used. For more on what auditors expect, see our guide on auditing ASC 842 lease accounting.

Common Mistakes and Audit Findings

1. Incorrect Determination of IBR: Getting the Incremental Borrowing Rate (IBR) wrong, or applying it wrongly, is a frequent audit finding. The IBR must be entity-specific and based on current economic conditions. It must be for a term and collateral similar to the lease (ASC 842-20-20). A lessee that is not a public business entity may elect a risk-free rate in place of its IBR, by class of underlying asset (ASC 842-20-30-3).
2. Missing Embedded Leases: Missing embedded leases in service or supply contracts is a pervasive issue. It can leave the lease population incomplete and materially understate ROU assets and lease liabilities.
3. Incomplete Lease Population: Missing lease contracts, especially those managed outside a central system, causes significant financial statement errors. Under month-end close pressure, the pull to rush this first search can be strong. That leads to significant omissions.
4. Improper Application of Practical Expedients: Misreading the ASC 842 practical expedients package, or applying only parts of it, can lead to non-compliance. It must be applied as a package (ASC 842-10-65-1(f)).
5. Lack of Robust Documentation: Thin support for judgments and calculations makes balances hard to defend in an audit. This applies most to the cumulative effect adjustment and prior period lease data. It often means significant extra audit work.

What are the pros and cons of the ASC 842 transition relief options? ASC 842 transition relief is mainly the modified retrospective approach at the effective date and the practical expedients. Its main pros are a lighter implementation burden and no complex comparative period restatements. Data gathering for historical leases is also simpler.

The cons include a lack of full comparability in financial statements for periods on either side of the adoption date. Some financial statement users may find that less transparent.

Why the FASB Added the Effective Date Method

The FASB added the effective date method in ASU 2018-11 to relieve preparers facing unanticipated costs and complexity under the comparative method. That rationale is in ASU 2018-11, BC7, as discussed in KPMG's Handbook: Leases, 13A.2.60. Private companies also had a later effective date: fiscal years beginning after December 15, 2021.

Choosing the effective date method does not remove every comparative-period obligation. The entity still gives the ASC 840 disclosures for the comparative periods that stay on ASC 840 (ASC 842-10-65-1(jj)).¹

What Auditors Are Looking For in Transition Reviews

During an audit, the focus on transition methods is twofold. Does the chosen method comply with ASC 842? And are the resulting financial statement impacts accurate and complete? Auditors perform substantive procedures and control testing on lease accounting.

Auditors will confirm that the selected effective date transition method matches the entity's policy elections. They will confirm that the practical expedients, if chosen, were applied correctly and consistently. They will trace the cumulative effect adjustment to the opening retained earnings balance. They will review the supporting calculations and assumptions, particularly for the incremental borrowing rate.

Auditors will also assess the internal controls over lease identification, data extraction, and calculation. They look for evidence of independent review and approval. A weak control environment or pervasive errors in lease data can lead to significant audit deficiencies. To strengthen the implementation process, it helps to understand common ASC 842 implementation challenges.

Q&A: Addressing Common Transition Questions

Q: What are the key ASC 842 transition methods available to entities? A: Entities primarily have two transition methods. One is the modified retrospective approach applied to the earliest comparative period presented. The other is the modified retrospective approach applied at the effective date of the new standard, which avoids restating prior periods (ASC 842-10-65-1(c)).

Q: How do the effective dates of ASC 842 impact transition method selection? A: The effective dates set the application date under each method. Under the comparative method, it is the beginning of the earliest period presented. For a calendar-year public business entity adopting January 1, 2019 with two comparative years, that is January 1, 2017.

For a calendar-year private company adopting January 1, 2022 with one comparative year, it is January 1, 2021. Under the effective date method, it is the adoption date itself (ASC 842-10-65-1(c)).

The option to use the modified retrospective approach at the effective date was a direct response to the implementation burden of the initial standard (ASU 2018-11, BC7). For more on this, see our article on effective dates of ASC 842 changes.

Q: When should we use the package of practical expedients during transition? A: The package suits an entity that wants a simpler transition. It carries forward the entity's ASC 840 conclusions on lease identification, classification and initial direct costs for existing leases, so none of them is reassessed (ASC 842-10-65-1(f)).

Q: How do you apply the modified retrospective approach under ASC 842? A: To apply the modified retrospective transition approach, an entity must first identify all existing leases as of the effective date or earliest comparative period. Then, calculate the ROU asset and lease liability for each lease. For a former operating lease, the liability is the present value of the remaining minimum rental payments (as defined under ASC 840) (ASC 842-10-65-1(l)).

Discount them at the rate implicit in the lease if readily determinable, otherwise the incremental borrowing rate, established at the application date. An entity that is not a public business entity may elect a risk-free rate in place of its incremental borrowing rate, by class of underlying asset (ASC 842-20-30-3). Former capital leases carry over their ASC 840 carrying amounts (ASC 842-10-65-1(r)).

Finally, under the effective date method, record the cumulative effect of these adjustments to the opening balance of retained earnings in the period of adoption. Under the earliest comparative period method, restate prior period financial statements and record the cumulative effect at the beginning of the earliest period presented (ASC 842-10-65-1(c)(1)).

Practical Next Steps for Lease Accounting Transition

Managing the ASC 842 transition well takes a structured approach and steady attention. The first choice of transition method has lasting effects on financial reporting and audit outcomes.

For more guidance, see our comprehensive ASC 842 guide for detailed explanations on each aspect of compliance.

Related Articles

• Implementing the New Lease Accounting Standard
• ASC 842 Disclosure Requirements
• Transitioning Equipment Leases to ASC 842
• New Transition Option for Lease Standard

Footnotes