provides a group of optional practical expedients that must be elected as a package and applied by a reporting entity to all of its leases consistently regardless of whether the entity is a lessee or lessor.
An entity may elect the following practical expedients, which must be elected as a package and applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor), when applying the pending content that links to this paragraph to leases that commenced before the effective date:
1. An entity need not reassess whether any expired or existing contracts are or contain leases
2. An entity need not reassess the lease classification for any expired or existing leases (for example, all existing leases that were classified as operating leases in accordance with Topic 840
will be classified as operating leases, and all existing leases that were classified as capital leases in accordance with Topic 840
will be classified as finance leases).
3. An entity need not reassess initial direct costs for any existing leases.
In most cases, reporting entities that choose not to apply these practical expedients will reach the same conclusions as they did under prior GAAP regarding whether a contract is a lease. In the limited circumstances where differences exist, the guidance in ASC 842
is likely to result in a nonlease conclusion when previous GAAP would have concluded a contract was a lease. The practical expedients should not be applied to grandfather incorrect assessments determined under prior GAAP. Reporting entities should ensure that an analysis of contracts for embedded leases has been performed under ASC 840
before using the practical expedient to carry over the conclusions upon adoption of ASC 842
EITF Issue 01-8
, Determining Whether an Arrangement is a Lease,
provided guidance for determining whether an arrangement contains a lease under previous GAAP. The transition provisions of EITF Issue 01-8
explained that its provisions were effective for arrangements (a) agreed to or committed to, (b) modified, or (c) acquired in a business combination initiated after the beginning of a reporting entity’s first reporting period beginning after May 28, 2003. As a result, arrangements at or before the effective date of EITF Issue 01-8
were grandfathered and companies were not required to determine if such arrangements were or contained leases under ASC 840
The leases standard does not address whether or not arrangements that were grandfathered under EITF Issue 01-8
would continue to be grandfathered when a reporting entity adopts the leases standard. We believe a reporting entity electing the package of practical expedients would not be required to reassess whether arrangements grandfathered under EITF Issue 01-8
are or contain leases. However, if a reporting entity does not elect the package of practical expedients, we believe the entity should assess all arrangements that were outstanding as of the application date to determine if they are or contain leases under the new leases guidance, even if such arrangements were previously grandfathered under EITF Issue 01-8
Upon adoption of the new leases guidance, a lessor that chooses to adjust comparative periods needs to consider the interaction of the effective date of the new revenue recognition guidance in ASC 606
. A lessor that chooses to adjust comparative periods should apply the guidance in ASC 606
to contracts with customers that were previously in the scope of ASC 840
but no longer meet the definition of a lease under ASC 842
at the date of initial application of ASC 606
in the comparative periods. The lessor should apply the guidance in ASC 605
to such contracts in the comparative periods before the initial application date of ASC 606
. Note that this only applies to financial statements issued after the adoption of the new leases guidance.
Upon adoption of the leases standard, a reporting entity is required to determine the appropriate lease classification for each lease subject to the standard, unless it elects the practical expedients. Although lessees with operating leases that adopt the package of practical expedients will still be required to recognize leases on the balance sheet, lessees and lessors that elect the practical expedients will generally not need to reconsider how they classified leases that commenced before the effective date. Reconsideration would occur only if required by other lease guidance.
It is possible for a lease to be classified differently under the leases standard than it was under legacy guidance (e.g., leases previously classified as operating leases may now be classified as financing, sales-type, or direct financing leases and vice versa) but instances of such a difference in classification are expected to be infrequent.
Given that the practical expedients allow reporting entities to avoid reconsidering lease classification, we expect that many lease arrangements will retain their original classification and therefore, the accounting for a change in classification is not discussed in this guide. Readers should refer to ASC 842-10-65-1
Irrespective of whether the package of practical expedients is elected, reporting entities will need to apply the new leases guidance after the effective date, which may result in a subsequent change in lease classification in certain cases. For example, if after the effective date a triggering event occurs that results in a reassessment of the lease term, the classification of the lease may change under ASC 842
. See LG 5
for information on lease reassessment.
Question LG 10-3 discusses when to reassess lease classification upon transition to ASC 842
Question LG 10-3
If a reporting entity does not elect the package of practical expedients, should the entity reassess lease classification under the leases standard as of the lease commencement date or at the application date?
We believe a reporting entity should reassess lease classification as of the commencement date of the lease or the last time the lease classification was required to be reassessed under ASC 840
, for example, a lease modification date. Under ASC 842
, an assessment of classification is required at the commencement date and when a lease is modified. For a reporting entity that is not electing the package of practical expedients, the objective is to achieve the lease classification that would have occurred had ASC 842
always been in effect. This can only occur if classification is assessed as of the most recent date that reassessment would have been required.
Initial direct costs
The definition of initial direct costs under the leases standard is narrower than the previous guidance. A reporting entity with unamortized initial direct costs that do not qualify for capitalization under the leases standard that elects the practical expedients may incur more amortization in future periods than if they had not elected the practical expedients. Nevertheless, a reporting entity may find that the cost of reassessing unamortized initial direct costs does not justify any perceived benefit.
Question LG 10-4 discusses when to reassess initial direct costs upon transition to ASC 842
Question LG 10-4
Does a reporting entity need to reassess unamortized initial direct costs at transition to determine if they meet the new definition of initial direct costs in ASC 842
If a reporting entity elects the package of practical expedients in ASC 842-10-65-1
(f) for all leases as of the effective date, it does not need to reassess whether initial direct costs meet the new definition at the initial application date. Otherwise, a reporting entity will need to reassess the initial direct costs under the new leases guidance and should account for the balances that no longer meet the definition as explained in the subsequent section.
Consequences of not electing the package of practical expedients
Reporting entities that do not elect the package of practical expedients will need to reassess all arrangements to determine if they meet the definition of a lease or contain an embedded lease under the new leases guidance. They will also need to assess lease classification using the new criteria for all contracts that meet the definition of a lease under the new guidance and determine whether or not certain prior expenditures meet the new narrower definition of initial direct costs.
When the reporting entity does not apply the package of practical expedients, it will need to reallocate consideration as of the lease commencement date for any contract that contains a lease component in order to reassess lease classification. If the entity is not electing the hindsight practical expedient, this allocation would start with the same lease payment data as used under ASC 840
(for example, reflecting the same lease term as what was used under ASC 840
). The lease payment data should be updated to include amounts allocated to lease components under ASC 842
(for example, property taxes and insurance related to the leased asset should be included in the contract consideration and allocated to lease components). Classification is then reassessed as of the lease commencement date. If the classification of the lease component does not change, then the measurement of the lease upon adoption of ASC 842
would use ASC 840
’s definition of payments; in other words, the entity would revert to the amounts allocated to lease components under ASC 840
When a reporting entity makes an accounting policy election to not separate nonlease components other than executory costs from the associated lease component at transition, a reallocation for nonlease components is not required in transition, as discussed in LG 10.4.1.2
. When a reporting entity elects to account for nonlease components other than executory costs as part of the lease component, it is more likely that lease classification will change (due to a potential increase in the amounts considered to be lease payments).
If a reporting entity does not elect the package of practical expedients in ASC 842-10-65-1
(f), any unamortized initial direct costs at the initial application date that do not meet the new definition of initial direct costs in ASC 842
should generally be written off as an adjustment to equity at the application date (or to earnings when incurred for leases that commenced during the look-back period when comparative periods are adjusted) in accordance with ASC 842-10-65-1
(p) and ASC 842-10-65-1
(v)(3). However, for lessees with capital leases under ASC 840
that remain as finance leases under ASC 842
, only such initial direct costs not included in the measurement of a capital lease asset under ASC 840
should be written off in accordance with ASC 842-10-65-1
(r)(3). Similarly, for lessors with direct financing leases under ASC 840
that are either direct financing leases or sales-type leases under ASC 842
, any unamortized initial direct costs capitalized as part of the lessor’s net investment in the lease in accordance with ASC 840
would not be written off, per ASC 842-10-65-1