By LeaseCrunch® on August 30, 2022 at 11:08 AM
The new lease accounting standards can be very complicated.
And because FASB and the IFRS are always listening to the needs of the businesses and CPA firms they seek to serve, they occasionally offer something called practical expedients for lease accounting standards. Although using a practical expedient in lease accounting under certain circumstances can be beneficial, it also makes things a tad more complicated, which is why we put together this guide.
Let’s start from the top.
What is a Practical Expedient?
To understand the practical expedient at its most basic, you need not look farther than the words that make up the term. A practical expedient is a shortcut inserted into the lease accounting standard to make a new standard easier to adopt. It is a practical application of an exception to a rule that makes the transition to the new lease accounting standard more expedient. Companies don’t have to use a practical expedient if they don’t want to, but they can if doing so makes sense from a time-saving perspective.
The Financial Accounting Standards Board, or FASB, recognizes that implementing the new lease standard is difficult, especially for companies that have leases that straddle the adoption date of the standard, or for companies that have a plentitude of leases, or contracts with embedded leases. It is because of these situations that both FASB and the IFRS have practical expedients in place.
ASC 842 Practical Expedients
ASC 842’s practical expedient for short-term leases allows entities with leases 12 months or shorter to leave them off their balance sheet. This practical expedient benefits entities because it saves them time.
However, utilizing this practical expedient can be cumbersome in that companies who use it will use different policies for their short and long term leases, meaning their portfolio will be bifurcated based on their different methods of lease accounting.
Lessees can elect to account for lease and non-lease components as a single combined lease component, which offers a simpler accounting procedure and saves a lessee time, as they don’t have to allocate between lease and non-lease payments..
The downside to using this practical expedient is that the lessee will have a larger lease liability and right of use asset because they are including non-lease component payments with their lease payments.
If a rate implicit in a lease is not readily available, then non-public entities can elect to use a risk-free rate in lieu of determining their incremental borrowing rate.
The benefit of using this practical expedient is that it saves entities time and reduces audit risk. The downside is that the risk-free rate will most likely be a lower rate than what a lease’s specific incremental borrowing rate would be, which creates a larger lease liability.
According to the FASB Accounting Standards Update, if an entity decides to use ASC 842 practical expedients, then it will not evaluate under ASC 842 the land easements that existed or expired before the time they adopted ASC 842 as long as that entity did not account for these easements as leases under ASC 840, and does not modify them on or after their ASC 842 adoption date. This aims to let entities “run off” their land easements that existed before ASC 842 with a historical accounting policy.
Furthermore, if a company decides to apply the ASC 842 practical expedient to one of their land easements that existed before ASC 842 adoption, they must apply the practical expedient to all of their land easements.
ASC 842 Transition Methods
Transition methods are practical expedients that exist specifically to help organizations transition from the old method of lease accounting to lease accounting in compliance with the new standard.
The discount package allows lessees to apply a single discount to a portfolio of leases with reasonably similar characteristics in order to save time.
A lessee can use hindsight for lease renewals and purchase options when determining a lease term. Because this can open a whole can of lease accounting worms, we rarely see organizations elect the hindsight practical expedient.
Package of 3
The package of 3 benefits organizations primarily when it comes to their transition leases. With the package of 3, a lessee doesn’t have to reassess whether any expired or existing contracts are or contain leases, the lease classification for any existing or expired leases, or the initial direct costs for any existing leases.
IFRS 16 Practical Expedients
Some of the IFRS 16 practical expedients may sound a bit familiar, as some of them are close to ones that exist for ASC 842, but some of them differ.
Policy Election for Short Term Leases
A lessee can elect to not apply the lease standard to leases of 12 months or less. If a lessee makes this election, they would follow previous lease accounting guidelines and recognize the lease payments as profit or loss on a straight-line basis over the lease term. This practical expedient can be utilized on a lease-by-lease basis.
The advantage of this practical expedient is that it saves time on accounting for short-term leases. The disadvantage is that you will be utilizing different policy procedures for short-term and long-term leases.
Policy Election for Low Value Assets
Lessees are not required to elect the new standard for underlying assets that have a low value. Instead, a lessee can follow previous accounting guidelines and recognize lease payments as profit or loss on a straight-line basis.
This policy election can save time on accounting for leases of low value assets, but it has the same disadvantage as the policy election of short term leases: It means an organization will have to use two different types of lease accounting.
Policy Election for Nonlease Components
Lessees can elect to account for lease and nonlease components as a single, combined lease component. The components of a contract only include things which transfer a good or service to a lessee, such as parking expense, annual maintenance, or an ROU asset.
If a lessee does not elect to combine their lease and nonlease components, the lessee has to allocate the consideration in the contract on a relative standalone price basis to the separate lease and nonlease components of the contract. If these prices are not available, a lessee is required to estimate them.
Lastly, a lessee can elect to combine lease and nonlease components for all of their underlying assets, some of their underlying assets, or none of them.
This policy election has the benefit of saving a lessee time, but it will make a lessee’s liability and ROU asset larger, which affects debt ratios and bank covenants.
Policy Election for Footnote Disclosures
If choosing to use this policy election, the lessee has to present the ROU assets separately from other assets and the lease liabilities separate from other liabilities either in the statement of financial position or in the footnotes.
The advantage here is that presentation in the financial statement allows for a simpler footnote, but if a lessee’s leases are not significant, then adding line items to the statement of financial position may dilute the reader's review.
Policy Election for Hindsight
A lessee can elect to apply the new lease standard to either all reporting periods presented (or only the most recent period) without restating prior periods. The cumulative impact should be reported in retained earnings.
The advantage of this policy election is that lessees don’t have to restate prior periods. The disadvantage is that the lessee will have inconsistent reporting of leases for each period presented in the financial statements because of no prior period restatement.
IFRS 16 Practical Expedients for Transition Relief
IFRS 16 has practical expedients that are generally for the new standard, as well as ones meant to act specifically as transition relief. Below are the practical expedients included in IFRS 16 meant specifically to give organizations a bit of relief when it comes to transitioning leases to the new standard.
Transition Relief in Paragraph C3
An entity does not have to reassess whether any expired or existing contracts are leases or contain leases. This policy is similar to one in ASC 842, and is, of course, optional.
Practical Expedient Paragraph C8(b) Transition Relief: ROU Asset
An organization can measure the ROU asset at the date of application to the new standard as one of two things, or both:
- Its carrying value, as if the new standard had always been applied since the commencement of the lease. The discount rate is used at the application date, not the commencement date.
- An amount that equals the lease liability, adjusted for prepaid or accrued rent (aka a deferred rent asset or liability)
Practical Expedient Paragraph C10(a) Transition Relief: Discounts
Similarly to a FASB practical expedient, this allows organizations to apply a single discount to a portfolio of leases with relatively similar characteristics, such as leases with similar lease terms for a similar class of underlying asset.
Practical Expedient Paragraph C10(b) Transition Relief
This practical expedient allows organizations to rely on the assessment of onerous leases under IAS 37 immediately before the date of application as an alternative to an impairment review.
It involves the lessee adjusting the ROU asset by the amount of any provision for onerous leases before the date of application. This practical expedient can also be applied on a lease by lease basis.
Practical Expedient Paragraph C10(c) Transition Relief: Long Term Leases
This practical expedient allows organizations to account for leases as short-term leases as described under Paragraph 6: Exempt from implementation under the Standard. This is a practical expedient that can also be applied on a lease by lease basis.
Practical Expedient Paragraph C10(d) Transition Relief
At the date of application, organizations can either choose to include or exclude initial direct costs from their measurement of the ROU asset. This is another practical expedient that can be applied on a lease by lease basis.
Practical Expedient Paragraph C10(e) Transition Relief
Similarly to a FASB practical expedient and also applicable at the date of application is a practical expedient from Paragraph C10(e): A lessee can choose to use hindsight with respect to lease renewals and purchase options when determining lease term. They can also choose to apply this practical expedient on a lease by lease basis.
Practical Expedient Benefits
Although most exceptions to rules tend to cause complications, they wouldn’t exist if there weren't some sizable benefits in their implementation as well. As stated above with each practical expedient/transition relief, the benefits and drawbacks of each are varied based on the effect the practical expedient produces on an organization’s lease accounting.
Some generalized potential benefits of using an ASC 842 practical expedient or an IFRS 16 practical expedient are:
- Faster and easier accounting procedures
- Less errors in accounting
- Simpler footnote disclosures
- Reduction in audit risk
Practical Expedient Challenges
As we have mentioned, there are pros and cons to each practical expedient. At first glance, a practical expedient could appear to lessen the workload of lease accounting, but in fact might end up just creating more work. Additionally, some practical expedients complicate lease accounting in a way that might result in more errors if not given the proper amount of attention. Some other potential challenges of utilizing practical expedients include:
- Increasing ROU asset and lease liability
- The disruption accounting workflow
- Bifurcation of your portfolio
- Increasing the difficulty of maintaining compliance with leasing standards
Balancing the Pros and Cons of Practical Expedients
For starters, we see most organizations elect the package of 3 for their transition leases to simplify implementing the new lease standard.
Organizations then experience the most benefit from practical expedients when they elect them by asset class. For example, say an organization has a 10-year office space lease with common area maintenance (CAM) and has a 2-year lease for a vehicle with a maintenance contract. The accounting team might do the work to separate out lease/non-lease components and calculate the incremental borrowing rate for the office space because reducing their lease liability would have a materially positive effect on their balance sheet. They might then elect the practical expedients for the vehicle lease because the increase in lease liability is immaterial.
There’s an additional way to mitigate the challenges brought about by implementing a practical expedient: Lease accounting software. Lease accounting software makes it easier to use practical expedients, lessening the downsides of particular lease accounting methods.
Interested in seeing how this works? Reach out to us today for a free demo.
Before electing a practical expedient/transition relief or two to improve your transition to the era of the new standard, consider the following variables:
- The reporting requirements for your particular organization
- The types of leases which your organization has in its various contracts
- The accounting bandwidth of your organization
And last but certainly not least, consider investing in a lease accounting software system. LeaseCrunch’s technology automatically updates to match the newest lease accounting standards, so you don’t have to worry about compliance. Best of all, it automates a lot of the complicated process that so often comes with electing to use practical expedients.
So if, after all of this information, you’re still a little confused on what to do with practical expedients and which transition reliefs you should use, don’t hesitate to contact our experts for a little help.
What is the Hindsight Practical Expedient?
The hindsight practical expedient allows entities to elect to use hindsight with respect to determining a lease term and determining any impairment of right-of-use assets for existing leases. “Using hindsight” means that organizations can look at the actual outcome or the modified expectations of a lease renewal, termination option, and purchase option in order to determine the lease term.
What Type of Entity May Elect to Use the Risk-Free Rate as the Discount Rate?
Any non-public entity that does not have an implicit rate readily available in a lease can use a discount rate instead of determining their incremental borrowing rate. However, it is important to note that doing so could result in a larger lease liability.
What is Lease Modification?
Lease modification is the process of going back and changing the scope of a lease (or consideration for a lease) so that it includes something that was not a part of the original terms and conditions of the lease when the lease commenced.
Lease modifications, while often necessary, make lease accounting considerably more difficult. However lease accounting software can make modifying leases much simpler and more risk-averse.
Does ASC 842 Apply to Existing Leases?
Yes, ASC 842 applies to existing leases. However, practical expedients exist partially to ease the transition to the new lease accounting standard presented in ASC 842, so some leases are allowed to follow an updated version of the new standard in their lease accounting practices.
How Should an Entity Account for Non-Lease Components?
An entity can account for non-lease components using either the regular new standard as listed in ASC 842, or they can elect a practical expedient that allows lessees to account for lease and non-lease components as a single, combined lease component.
What is My Initial Application Date?
Determining an Initial Application Date depends on a few things. If your fiscal year ends on December 31, then your Initial Application Date is 1/1/22. If you choose to restate prior periods, then your Initial Application Date is the beginning of the earliest period presented.