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ASC 842 Post-Adoption Reminders

January 30, 2024

Accounting, Article, Business

Authored By Ryan Poage, GreerWalker

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Introduction

The new lease accounting standard, ASC 842, became effective for private companies for all annual reporting periods beginning after December 15, 2021. The Financial Accounting Standards Board (FASB) introduced this standard to increase the transparency of leasing arrangements by requiring companies to recognize most leases on their balances (through right-of-use assets and lease liabilities) and significantly expand the required disclosures. More specifically, it was aimed at bringing previously off-balance sheet leases (operating leases) into the spotlight.

Amid its adoption, many companies directed their efforts solely towards achieving year-end compliance for their annual financial statement reporting; however, the post-adoption phase will necessitate more than mere compliance. Moving forward companies will need to develop a strategic, ongoing approach to lease accounting for sustained compliance, operational efficiency and to ensure accurate year-end and interim financial reporting. As we delve further, we’ll explore some reminders for continued lease accounting and compliance, the practical expedients offered to private companies aimed at reducing the burden of lease compliance, and the post-adoption opportunity to review processes and controls for optimization.

Continued Accounting and Compliance Efforts

Companies spent considerable resources putting together complete lease portfolios for adoption. While continued accounting and compliance efforts won’t require the same burden, companies will need to be intentional about not only identifying new leases, but also identifying and properly accounting for changes to existing leases.

Changes to an existing lease can occur through a formal lease modification that was negotiated with the lessor, or a lease reassessment which does not involve a negotiation but rather a change in the lessee’s facts, assumptions or judgements. The type of change dictates the accounting treatment and companies need to be aware of the difference to ensure they are properly addressed.

Modifications

Lease modifications are easily identifiable as they require a negotiation and agreement between the lessee and lessor. When determining how to properly account for the modification, companies must first consider whether it has created a new leasing arrangement by granting the lessee the right to use an additional asset rather than just modifying the terms for the existing asset. Two criteria must be met for the modification to be accounted for as a separate lease:

  1. The modification grants the lessee an additional right-of-use asset not specified in the original lease
  2. The lease payments required for the additional right-of-use asset are consistent with the standalone price (i.e., fair market value)

If the modification does not meet these criteria and is just a modification of the terms for the original right-of-use asset, companies will need to remeasure the right-of-use asset and lease liability as of the modification date and reassess the following:

  • Lease term, including any renewal or early termination options
  • Purchase options
  • Discount rate
  • Lease classification

Some lease modifications result in the reduction of the lessee’s right to use the leased assets resulting in either a full or partial termination. Full terminations require the derecognition of the related outstanding right-of-use asset and lease liability with any differences between the two recognized as a gain or loss in the period the termination occurred. If the modification only partially reduces the lessee’s right to use the underlying asset, the lease liability is remeasured as of modification date based on the new terms with a proportionate adjustment for the right-of-use asset.

Reassessments

ASC 842 Lease accounting

Lease reassessments are more difficult to identify as they are not triggered by a negotiation and agreement, but rather changes in the lessee’s facts, circumstances and judgements. Reassessments are commonly related to changes in the lessee’s decision related to lease renewal, early termination or purchase options. These changes would be accounted just like a lease modification with a remeasurement and reassessment of term, discount rate and classification. Reassessment can also be triggered by changes in residual value guarantees or resolution of a contingency. These changes require a remeasurement, but not a reassessment of term, discount rate or classification.

Embedded Leases

Companies should continue to be aware of the risk that identifying embedded leases pose to the completeness of their lease portfolios and related accounting. ASC 842 broadened the definition of a lease to “a contract that conveys the right to control an identified asset for a period of time in exchange for consideration”. This change potentially brought service, maintenance, supply and other agreements into the scope of lease accounting. Companies need to ask themselves the following questions when assessing contracts for embedded leases:

  • Is an asset specifically identified in the agreement?
  • Has control of that asset been transferred to the lessee by their right to direct its use and derive the benefits from its use?

A common example in the construction industry would be a service agreement with a contractor that provides the use of equipment at a job site. If the company is directing the use of the equipment on the job site and deriving the benefits by completing their portion of the job by using it, the result is a leasing arrangement under ASC 842.

Leverage Key Practical Expedients for Private Companies

ASC 842 offers private companies key practical expedients aimed at easing the burden of day-to-day lease accounting and compliance. Three of these practical expedients proved notably advantageous during adoption, while the fourth was codified following the effective date but should significantly help with common control leasing arrangements.

Short-Term Leases:

The short-term lease practical expedient permits private companies to account for leases with terms of twelve months or less under previous lease accounting and avoid balance sheet recognition. Companies should keep in mind that the total amount of short-term lease expense is required to be disclosed in the footnotes to the financial statements; however, significant time can be saved by avoiding balance sheet capitalization. Additionally, this practical expedient can be applied to classes of assets rather than the entire lease population; however, in practice it has generally been applied to the whole lease population.

Construction companies should note that all leases with terms less than one month were entirely scoped out of the standard and would not have to be included as a short-term lease. This would include pay-per-use equipment and tool rental arrangements that are common in the construction industry.

Combining Lease and Non-Lease Components:

ASC 842 requires companies to allocate the total consideration in a leasing arrangement between lease and non-lease components based on their relative stand-alone values (i.e., fair market value). This proved to be an arduous task during public company and early private company adoption, so the standard provided private companies a practical expedient to combine lease and non-lease components into a single component when calculating the right-of-use asset and lease liability.

While this practical expedient does simplify the calculation, companies should still assess the lease and non-lease components of their lease population to decide whether it makes sense to adopt. Many non-lease components are related to services like common area maintenance provided with the right-of-use asset. If these payments are considered pass-through expenses, their standalone value would be the amount charged by the lessor and inclusion in the calculation would be unnecessary as they would be permitted to be expensed as incurred. Additionally, companies should note that this practical expedient can be elected by class of assets rather than the entire lease population.

Discount Rate:

ASC 842 accounting

The determination of the discount rate used in the right-of-use asset and lease liability calculation proved to be one of the most challenging aspects of ASC 842 adoption for public companies and early adopting private companies. The standard mandates that companies use either the rate explicitly stated in the agreement, the implicit rate or the companies incremental borrowing rate; however, many agreements didn’t explicitly state a rate and determination of the implicit and incremental borrowing rates were either impractical or burdensome to private companies.

Recognizing these challenges, the standard provided a practical expedient to private companies to use the risk-free rate, commonly the United States treasury rates, for a period that aligns most closely with the lease term. While the use of the risk-free rate results in a higher lease liability, it significantly reduced the complexity and burden of determining individual implicit or incremental borrowing rates and is one of the most useful practical expedients for private company adoption.

Common Control Arrangement:

One area that many companies struggled with during initial ASC 842 adoption was how to properly account for common control leases, especially when there wasn’t an agreement in force, or the term wasn’t defined (i.e. month-to-month leases). The original standard did little to provide clarity as it tasked companies with determining the legally enforceable rights and obligations of the underlying arrangement. This proved to be difficult as it required legal expertise as well as making several assumptions related to the arrangement.

FASB responded on March 27, 2023, by codifying the common control arrangement practical expedient which permits private companies with leasing arrangements between parties under common control to use written terms and conditions to determine if a lease exists and, if a lease exists, to classify and account for them based on the written terms and conditions. While FASB hasn’t explicitly defined the term common control arrangement, it is generally understood to be a scenario where an individual or entity holds more than 50% of the voting ownership of each entity. It’s important to note that this practical expedient is for common control arrangements and not all related party arrangements. Companies will still need to go through the exercise of determining the legally enforceable rights and obligations for non-common control related party leasing arrangements.

This practical expedient has resulted in the formalizing of common control leasing arrangements into written lease agreements but has also nudged companies towards structuring these leases to align with the short-term practical expedient by documenting terms less than twelve months and avoiding balance sheet recognition. While this may be technically consistent with the standard, it does necessitate administrative vigilance as agreements would require re-papering upon expiration and can not include any renewal or early termination options.

Opportunity to Improve Processes and Internal Controls

With year-end compliance in the rearview mirror, companies can now shift their focus towards evaluating the effectiveness of their process and controls related to lease accounting and identify areas for improvement. The ultimate objective post-adoption is to seamlessly integrate the process for identifying and accounting for leases into their financial reporting process.

The most important consideration relates to effective communication between operational and accounting personnel to properly identify leasing arrangements and capture key details within those arrangements for proper accounting. Companies must identify key process stakeholders across all departments who have contract-signing authority and educate them on the nuances of lease accounting. Internal controls should be established like plant, property and equipment transactions to ensure this communication occurs.

Another critical aspect of the post-adoption evaluation is assessing the adequacy of the chosen lease accounting solution. Whether utilizing Excel templates, third-party lease accounting software, or sophisticated lease management platforms, a retrospective evaluation is vital. While Excel templates offered companies cost-effectiveness, they proved to be very labor-intensive, difficult to track and manage changes to leases, and impractical for companies with more than a few leases. On the other end, lease accounting software and lease management platforms offered streamlined accounting and significant time savings but at a cost. Ultimately, the cost-benefit of the lease accounting and management solutions shone through during adoption helping companies quickly and consistently apply the standard to their lease portfolio.

Conclusion

Post-adoption considerations for lease accounting highlights a critical shift from initial compliance to a focus on ongoing maintenance. Companies will be required to exercise diligence in the identification and communication of new leases and changes to existing leases through modifications and reassessments. While private companies are offered several practical expedients to ease the burden, companies will need to commit themselves to the establishment and integration of key processes and controls to ensure continued accounting and compliance with the standard.

This article was originally published in the 2023 Catalyst Construction Journal.

About the Author

Ryan Poage is a manager in our business assurance practice. He has experience with clients in a variety of industries, specializing in manufacturing and distribution and construction. He also provides assurance services to employee benefit plans. Ryan focuses on providing high quality client service by understanding the business needs of each client and seeking to provide practical business solutions to meet those needs.

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The information contained herein is general in nature and based on authoritative guidance that is subject to change. Neither GreerWalker LLP nor GreerWalker Corporate Finance LLC (collectively, “GreerWalker”) guarantee the accuracy or completeness of any information and are not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. GreerWalker assumes no obligation to inform the reader of any changes in tax laws, regulations, accounting standards, or other factors that could affect information contained herein. This publication does not, and is not intended to provide legal, tax or accounting advice, and readers should consult their advisors concerning the application of tax laws or accounting guidance to their particular situation. Any tax analysis in this publication is not advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

 

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