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Ask the Expert: John Hepp Discusses the New Lease Standard

Important note: This is a judgment-based standard, which means there are few hard-and-fast rules and the treatment of your leases will depend on your unique situation. It's important that you always double-check decisions with an accounting professional who knows your circumstances. This blog should not be considered or take the place of professional advice or services.

We’re excited this month to share insights from our recent conversation with industry expert John Hepp. John is a retired partner from Grant Thornton and a former FASB project manager. He holds a PhD from the University of Wisconsin-Madison and is currently on the faculty at University of Illinois at Urbana-Champaign.

John discussed several nuances of the new lease accounting standard, from practical expedients (“the spoonful of sugar to help the medicine go down”) to discount rates and much more.

Using practical expedients

According to a LeaseCrunch® survey, 60% of CPA firms find that most of their clients are electing the practical expedient package, yet 24% say problems have arisen related to which practical expedients should be applied.

John shared that the practical expedients—though not perfect—certainly can reduce the amount of work needed in transitioning to the new standard. For instance, he talks about the option to keep existing leases as-is rather than restating everything:

“You don't want to go back and redo the work of determining whether a transaction contains a lease, lease classification, and whether initial direct costs qualify for capitalization for every lease on the books. That is why the practical expedient package makes a lot of sense. Going forward, of course, if you modify the lease you have to apply the new standard, but it won't be as heavy a burden because you're doing it one transaction at a time instead of hundreds or thousands of past transactions.”

Discount rates and lease terms

We’ve received many questions about discount rates and lease terms for transitioning existing leases, and John was able to shed some light on these crucial topics. Like many areas of the new lease standard, you have options here and must apply your own judgment.

Determining the lease term

Before determining and applying your interest rate, you must identify the lease term. We recently received the news that FASB staff would allow you, for transition purposes, to use a rate for either the original term of the lease OR the remaining term, as long as you are consistent throughout. {Editor's note, this can be found on page 317 of the linked EY document in Section 11.3.3b.}

Then, as John shared, “going forward, as you enter into a new lease, it’s much easier to make an assessment on a case-by-case basis. The definition, however, has changed somewhat, so make sure to review your process for determining the discount rate before classifying and recording a lease.”

Assessing your discount rate

Once you determine whether you will go with the original lease term or the remaining term, you must identify your discount rate, and again, there are two options.

Said John: “One way is to determine your credit rating and then look to the bond market to see what approximately the discount rate is for those bonds or your most recent refinancing for a similar term. But this is another situation, especially lately where interest rate spreads have not been high, that a private company could consider using the practical expedient to just use the interest free rate rather than going to all that trouble.”

On lease renewals

A final important note John included on lease term is on lease renewals and whether to include the renewal term in the lease term. John reminded us that renewal terms should only be included if you can demonstrate that there is an economic reason you’re compelled to stay, such as significant leasehold improvements or a termination penalty. Just because you intend to renew or cancel does not necessarily mean that you would include a renewal term.

The bottom line, according to John, is that “‘reasonably certain’ is a high bar. They were very specific in deliberations about that.”

Previously capitalized balances

Many people have questions regarding how the new lease standard handles previously capitalized balances, such as prepaid rent. John explained to us that “under the new model, there’s really no such thing as prepaid rent.”

As for how to handle transitions for existing prepaid rent on the books, here is his recommendation:

First I need to to measure my obligation. I won't have an obligation to pay the rent anymore because it's prepaid and any balances or prepayments will go into the ROU asset, which would show that the ROU asset maybe is larger than the obligation due to that prepayment. The same is true with any deferred rent credits or debits arising from straight-line rent, rental payments under the operating lease accounting. They wouldn't get recognized through retained earnings. They go into the ROU asset so all your prepaid and accrued rents are going to go into the ROU asset.”

John made a final important note here regarding leasehold improvements, emphasizing that these are separate and will not be treated any differently under the new standard.

We want to thank John for providing his expert insight into some of the more challenging aspects of ASC 842. Want more resources on implementing the new lease standard? Check out our library of
tools and resources.