Lease Accounting Transition Guide from ASC 840 to ASC 842

A detailed guide of how to transition from ASC 840 to ASC 842 with examples.

The process of adopting the new lease accounting standard ASC 842 is no easy task. Not only does ASC 842 require significantly more effort than ASC 840, given all leases are captured on the balance sheet and require complex present value calculations. A company is then required to migrate its entire lease portfolio from ASC 840 to ASC 842 in one effort. 

Before getting into the detail on how to transition to ASC 842, a sound knowledge of how to calculate the lease liability and the right of use asset lease under ASC 842 is recommended. Refer to the below articles for further information:

With the knowledge of how to calculate a lease liability and right of use asset, we’re ready to tackle how to go about your transition from ASC 840 to ASC 842 and the necessary steps to take.

Scope

To understand the required work of transition, an entity will need to identify what contracts are in the scope of ASC 842. The first place to start is how many leases are in the scope of ASC 840. This will prompt questions such as: 

  • How many operating and capital leases are you currently accounting for?
  • Do these include all leased assets such as computers, cell phones, and photocopiers? 
  • Have you identified embedded leases?

You can leverage a practical expedient under the new lease accounting standard that allows you to carry forward previous assessments if the contract contains a lease under ASC 840 - we'll cover more on that later in the guide. However, bear in mind that the auditors may have paid less attention if the lease were classified as an operating lease. The accounting under ASC 840 is consistent with a general expense item. This drastically changes under ASC 842. 

Unlike the IASB with IFRS 16, there is no low-value scope exemption under ASC 842. However, your auditors still need to apply the concept of materiality. Suppose you are deliberating not to account for specific contracts that meet the definition of a lease under either ASC 840 or 842 bases on the concept of materiality. In that case, you will want to initiate this conversation with your auditors ASAP.

Definition of a lease

When determining the scope it’s important to consider the definition of a lease. Under ASC 842-10-15-2 a lease is defined as: 

A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration

Control over the use of the identified asset means that the customer has both 

(1) the right to obtain substantially all of the economic benefits from the use of the asset and 

(2) the right to direct the use of the asset.

Under ASC 840-10-15-6 a lease is defined as:

An arrangement conveys the right to use property, plant, or equipment if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying property, plant, or equipment. The right to control the use of the underlying property, plant, or equipment is conveyed if any of the following conditions is met: 

  1. The purchaser has the ability or right to operate the property, plant, or equipment or direct others to operate the property, plant, or equipment in a manner it determines while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment. The purchaser's ability to operate the property, plant, or equipment may be evidenced by (but is not limited to) the purchaser's ability to hire, fire, or replace the property's operator or the purchaser's ability to specify significant operating policies and procedures in the arrangement with the owner-seller having no ability to change such policies and procedures.A requirement to follow prudent operating practices (or other similar requirements) generally does not convey the right to control the underlying property, plant, or Equipment. Similarly, a contractual requirement designed to enable the purchaser to monitor or ensure the seller's compliance with performance, safety, pollution control, or other general standards generally does not establish control over the underlying property, plant, or equipment. 
  2. The purchaser has the ability or right to control physical access to the underlying property, plant, or equipment while obtaining or controlling more than a minor amount of the output or other utility of the property, plant, or equipment.
  3. Facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than a minor amount of the output or other utility that will be produced or generated by the property, plant, or equipment during the term of the arrangement, and the price that the purchaser (lessee) will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output.

A couple of points to note here:

  • The lease definition of ASC 840 is still applicable if an entity decides to apply the package of practical expedients. Essentially you will transition using ASC 840's definition and only apply the definition on ASC 842 for new leases post-transition. See below for more details
  • Don't forget there are a number of exemptions for certain contracts e.g. Leases of intangible assets subject to ASC 350

Once you’ve had your discussion with your auditors, it’s time to transition all those leases to ASC 842. With the extra scrutiny, you might discover several leases in the scope of the standard.

Effective date

The effective date is the date you apply the new lease accounting standard. Public companies worldwide have already applied the new lease accounting standards ASC 842 and IFRS 16. If you’re a U.S. private company, the latest date you can adopt the standard is for fiscal years beginning after December 15, 2021. For more information, refer here

A company can adopt the standard earlier if wanted. This could be applicable given the standard was pushed back a year because of COVID-19, and a company may already be in the process of transition to the new standard. For most private companies in the U.S., the transition date will be January 1, 2022, assuming you have a year-end of December 31.

Practical expedients

To simplify the transition, the standard setters have made several concessions to reduce the workload in transitioning to the new lease accounting standard. The majority of public companies, when transitioning to ASC 842, leveraged these practical expedients available. 

Package of practical expedients

A lessee has the option to utilize a package of practical expedients as described in paragraph ASC 842-10-65-1, which are: 

  • An entity does not have to reassess whether any expired or existing contracts are or contain leases.
  • An entity does not have to reassess the lease classification under ASC 840. For capital leases, there are now referred to as finance lease under ASC 842.
  • No need to reassess initial direct costs

These concessions must be applied to your entire lease portfolio consistently, no picking and choosing!

Hindsight practical expedient

As per ASC 842-10-65-1(g) an entity can use hindsight in determining the lease term (that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing impairment of the entity’s right-of-use assets. This practical expedient is only applicable to the comparative method and must be applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor)

Transition method

The next step is to determine what transition method you are going to apply. This must be applied to your entire lease portfolio. You have two options:

Comparative method

This method will result in adjusting the comparative periods in your financial statements

A diagram of the comparative method when transitioning to ASC 842

This method is by far the most time-consuming as you’re retrospectively applying the standard as if it was always in place. In other words, you need to change prior periods in your financial statements. This will also include aspects such as modification accounting for current and even certain expired leases. This is not a simple task. The standard-setters understand this and, as a result, made available the effective date method.

Effective date method

Diagram of how the effective date method impacts a company's financial statements

An entity does not have to adjust the comparative periods in a set of financial statements. You may require a cumulative adjustment depending on the circumstances. Compared to the comparative method, this method is extremely straightforward, applying ASC 842 prospectively from the transition date. Another way of looking at is all your leases start at the transition date.

What about the scope exemption of leases shorter than 12 months? 

A short-term lease is defined by the lease term at the commencement date of the lease. Therefore, if the lease has a lease term at the commencement date that is greater than 12 months, it is not eligible for the short-term leases policy election even if the remaining lease term at the transition date is 12 months or less.

Select the transition method

From here the entity must select a transition method. Before selecting the transition method you might want further detail on the nuances required, so feel free to read the guidance on the comparative and effective date method. If you've already decided on a transition method jump straight to that guidance.

Transition under the Comparative method

With the comparative method, an entity is required to not only account for your current leases to reflect that ASC 842 was always in effect but those leases that expired in the comparative periods (also referred to as the "lookback" period). This will include all modifications that have occurred in the past to those applicable leases. As the accounting for capital leases under ASC 840 closely reflects that under ASC 842, the primary focus will be on operating leases transition to ASC 842 given those are the leases that will need to come on the balance sheet for both current and comparative periods.

In your applicable accounting software, you need to remove the ASC 840 accounting. Apply ASC 842 and then input cumulative-effect adjustment to the opening balance of retained earnings at the beginning of the earliest comparative period presented in the financial statements. If the transition date is January 1, 2022, that adjustment will occur on January 1, 2020.

Another way to illustrate the required adjustment is, let's say you have one lease that commenced on January 1, 2019. What was the net impact on the income statement from January 1 to December 31, 2019, accounting for that lease under ASC 840 and then ASC 842? If there's a difference, that will be the retained earnings adjustment. This is the same logic used when applying an accounting policy retrospectively. This is no easy task, and that's why the standard setters provided the effective date method.   

Leases that expire before the comparative period can be ignored as the impact on retained earnings under either ASC 840 and ASC 842 is the same. The interest plus amortization expense under ASC 842 closely matches the lease expense under ASC 840. So at least there's one type of lease not to worry about!

If an entity decides to transition with the comparative method, a general outline of steps to follow are: 

  1. Identify all the leases in scope. This is not just current leases but leases that were active in the comparative period
  2. Reverse out all the applicable journal entries related to identified leases 
  3. Account for the leases as per ASC 842 and post the relevant journal entries
  4. Retrospectively update the financial statements

Operating lease transition example

We’ll now dive into an example to help illustrate the comparative transition method:

Company A 

The transition date is January 1, 2022. The company has two leases:

Office lease:

  • The office lease is classified as an operating lease. 
  • The commencement of this lease was January 1, 2007
  • The expiry of the lease is December 31, 2027
  • The lease payments are $1,000 per month at the start of each month
  • This discount rate used is 6%

Motor Vehicle:

  • Classified as an operating lease. 
  • The commencement of this lease was June 1, 2009
  • The lease payments are $1,000 per month at the start of each month
  • This discount rate used is 6%
  • The lease expires on January 2, 2022

Solution:

1. Work out the date of the accumulated adjustment of the opening balance of retained earnings

The retained earnings adjustment will occur on January 1, 2020

2. Remove the impact of the leases from the financial statements under ASC 840

Given these are operating leases under ASC 840 the impact will be in relation to the income statement in expenses and the cash balance. The cash balance will not change regardless of which lease accounting standard is applied. 

3. Account for the two leases as if ASC 842 was always in effect

Office lease

Account 31 December 2022 31 December 2021
Right of use asset $51,182.05 $61,758.05
Lease liability $64,382.05 $78,268.11

Motor vehicle

4. Retrospectively update the financial statements

The first place in doing that is working out the transition adjustment to opening retained earnings. Focusing on the office space lease the straight-line expense incurred from the commencement of the lease under ASC 840 is $191,100 at 1 January 2020. Whilst if ASC 842 was in place it would be $191,090 resulting in a $10 adjustment to the opening balance of retained earnings. Given the insignificance of the amount the impact of applying either ASC 842 or ASC 840 is negligible from a retained earnings perspective. 

Remember for the comparative balance sheet disclosures they will now include a right of use asset and lease liability.

Capital leases

For reporting entities that choose to adjust comparative periods presented before the effective date, a lessee should measure the right-of-use asset and liability in accordance with the subsequent measurement guidance in Topic 840 during the comparative periods.

The lessee should reclassify the existing capital lease asset as a right-of-use asset and the existing obligation as a lease liability for each period.

With capital leases, there is no disruption to prior year accounting other than renaming some accounts given the lease agreements are already captured on an entity's balance sheet.

Summary

The positive of adopting this method is you have useful comparative information for the users of your financial statements as they’re able to compare “apples with apples.”

The negative is the large amount of work it takes. When looking at lodged financial statements of public companies, 99% adopted the effective date.

Transition under the effective date method 

With the effective date, you apply the lease accounting for ASC 842 from the date of transition. We'll primarily go through the considerations for leases classified as operating under ASC 840. That's because, as mentioned previously, with capital leases, it's pretty much business as usual other than some name changes on the financial statements. 

Operating leases under ASC 840

Suppose a lease was classified as an operating lease under ASC 840 and will continue to be classified as an operating lease under the new lease accounting standard. In that case, the lessee will recognize a right-of-use asset and lease liability at the transition date.

A lessee should measure the operating lease right-of-use asset at an amount equal to the lease liability, adjusted for the following:

  • Prepaid or accrued rent: For example, the lessee pays $1,000 each month in advance. The transition date is January 1, 2022; on December 1, 2021, a month before the transition, the lessee pays the usual $1,000 and pre-pays the month of January, as a result, pays $2,000 in total. When transitioning to ASC 842 on January 1, 2022, $1,000 should be added to the value of the right of use asset. This treatment is prescribed by ASC 842-20-30-5(d). 
  • The remaining balance of any lease incentives: This amount will be subtracted from the right of use asset as per ASC 842-10-30-5(a).
  • Unamortized initial direct costs will be added to the right of use asset value per ASC 842-20-30-5(c). If you haven't applied the practical expedients package, this amount should be written off at transition, with the offsetting entry going to equity. 
  • Any impairment will be deduced from the right of use asset value. 
  • The carrying amount of any liability related to the lease recognized in accordance with ASC 420, Exit or Disposal Cost Obligations which will be added to the value of the right of use asset, it's Dr side to the liability akin to the lease liability.

Sub-leases 

The transition guidance in ASC 842 does not explicitly discuss the treatment of sublease liabilities under ASC 840. These liabilities can occur if the sublease transaction of the underlying asset was subleased at a loss. The most appropriate treatment is to apply the guidance for liabilities under ASC 420 in the transition to ASC 842. As a result, the right-of-use asset value at transition should be reduced by the sublease liability's carrying amount.

Impairment 

At transition, a lessee should consider whether adjustments are needed for any impairment when determining the right-of-use asset's amount to record.

Lease payments and discount rate at transition

You will apply the logic of ASC 842, except you will only include known payments from transition onwards date onwards.  The same principle applies to the discount rate with the assessment performed on the transition date.

FX 

The recognition of the right to use asset and lease liability will be the transition date's foreign exchange rate.

Modification accounting 

Once you’ve transitioned, you’re done with the transition guidance, and going forward, the entity will apply the modification guidance of ASC 842 like you would for any other lease.

Operating lease transition example

The transition date is January 1, 2022. The company has two leases:

Office lease

  • The office lease is classified as an operating lease. 
  • The commencement of this lease was June 1, 2007
  • The expiry of the lease is May 31, 2027
  • The lease payments are $1,000 per month at the start of each month
  • This discount rate used is 6%

Motor vehicle

  • The office lease is classified as an operating lease. 
  • The commencement of this lease was June 1, 2009
  • The lease payments are $1,000 per month at the start of each month
  • This discount rate used is 6%
  • The expiry of the lease is January 2, 2022

Solution

Apply the standard from the transition date: 

The transition date is 1 January 2022. As a result, the balance sheet for company A at year-end would like like this:

Office lease

Account 31 December 2022 31 December 2021
Right of use asset $0 $64.52
Lease liability $0 $64.52
Account 31 December 2022 31 December 2021
Right of use asset $46,804.53 $0
Lease liability $46,843.55 $0

Motor vehicle

For the Office space lease, the lease will be recognized on the company’s balance sheet on January 1, 2022, based on known future payments on January 1, 2022. By year-end, the lease liability is 46,804.53, and the right of use asset of 46,843.55

For the motor vehicle lease, technically, a right of use asset should be recognized on January 1, 2022, for $985.31. That lease expires on January 31, 2022, and that’s when the right-of-use asset will be fully amortized. There is no lease liability as it is fully paid by January 1, 2022, given it’s paid in advance.

If you would like the calculations please reach out to [email protected]

Capital leases under ASC 840

To account for a capital lease under ASC 840 using the effective date transition method as per ASC 842-10-65-1(r)(1) standard states the following:

The lessee should recognize a right-of-use asset and a lease liability at the leased asset's carrying amount and the capital lease obligation under ASC 840 at the initial application date.

As a result, the entity will reclassify the existing capital lease asset as a right-of-use asset and the existing obligation as lease liability.

Company Examples

Given public companies have already transitioned, it makes sense to leverage how they have gone about their transition by referring to their financial statements. This will give you an excellent understanding of the other aspects of transition, such as example reconciliations companies have provided for their users and impacts on other accounts such as deferred tax. 

For the comparative method, refer to Microsoft's financial statements here. For the effective date method, you can pretty much look up any public company's financial statements, and this is the method most companies have used. A few examples are: 

The easiest way to transition

The manual requirements to transition to ASC 842 are already too many. Why not use Cradle to streamline and automate those cumbersome NPV calculations? Schedule a 30-minute demo to see how easy lease accounting can be.

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Account 31 December 2022 31 December 2021
Right of use asset $0 $0
Lease liability $0 $0