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9.3 Overall transition and practical expedients
Publication date: 31 Jan 2023
us Leases guide
Upon adoption of the leases standard, lessees and lessors are required to apply a modified retrospective transition approach. Reporting entities are permitted to choose one of two methods to recognize and measure leases within the scope of the leases standard:
- Adjust comparative periods: Apply the leases standard to each lease that existed at the beginning of the earliest comparative period presented in the financial statements, as well as leases that commenced after that date. Under this method, prior comparative periods presented are adjusted. For leases that commenced prior to the beginning of the earliest comparative period presented, a cumulative effect adjustment is recognized at that date. The period from the beginning of the earliest comparative period up until immediately before the effective date is referred to as the “look-back period.”
- Do not adjust comparative periods: Apply the guidance to each lease that had commenced as of the beginning of the reporting period in which the entity first applies the leases standard (referred to as the “application date” or the “effective date” under this method) with a cumulative-effect adjustment as of that date. Prior comparative periods would not be adjusted under this method. An entity that applies this method must provide the required disclosures under ASC 840 for all periods to which ASC 840 is applied.
Regardless of the transition method selected, the transition guidance in ASC 842 does not apply to leases that are entered into prior to the effective date of ASC 842 but have a commencement date after the effective date of ASC 842. In these cases, the leases accounting model in ASC 842 should be applied at the commencement date of the lease.
Application of the modified retrospective transition approach under both of these methods to each lease type is discussed in the following sections.
A lessee must apply the recognition requirements in the leases standard to all leases (even for leased assets that are considered abandoned). However, a lessee may elect not to apply the recognition requirements in the leases standard to short-term leases (a lease that at commencement date has a lease term of 12 months or less and does not contain a purchase option that the lessee is reasonably certain to exercise).
Question LG 9-1 and Question LG 9-2 discuss application of lease recognition requirements to short-term leases.
Question LG 9-1
Is a lease that has a remaining term at the application date of 12 months or less but whose lease term at the commencement date is greater than 12 months eligible for the short-term election?
Is a lease that has a remaining term at the application date of 12 months or less but whose lease term at the commencement date is greater than 12 months eligible for the short-term election?
PwC response
No. 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 application date is 12 months or less.
Question LG 9-2
Does the leases standard need to be applied to leases that exist as of the beginning of the earliest comparative period presented but expire or terminate before the effective date?
Does the leases standard need to be applied to leases that exist as of the beginning of the earliest comparative period presented but expire or terminate before the effective date?
PwC response
It depends. For reporting entities that choose to apply the transition method in which prior comparative periods are adjusted, we believe leases that exist as of the beginning of the earliest period presented and expire or terminate before the effective date are subject to the new standard in a reporting entity’s comparative financial statements upon adoption. For example, a calendar year-end private company with an effective date beginning on January 1, 2022 choosing to adjust the comparative period and adopting the leases standard on 1/1/2022 should apply the new standard to a lease that existed on 1/1/2021 and expired in 2021.
For reporting entities that choose not to adjust prior comparative periods, the leases standard does not need to be applied to leases that terminate prior to the effective date.
9.3.1 Practical expedients
ASC 842 provides various optional transition practical expedients. A reporting entity is required to disclose the use of any of the practical expedients. In summary, these include:
- a package of practical expedients to not reassess:
- whether a contract is or contains a lease
- lease classification
- initial direct costs
- a practical expedient to use hindsight when determining lease term
- a practical expedient to not reassess certain land easements
Each of these expedients is explained in more detail in subsequent sections.
9.3.1.1 Package of practical expedients
ASC 842-10-65-1 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.
Definition of a lease
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.
Lease classification
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 for guidance.
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 9-3 discusses when to reassess lease classification upon transition to ASC 842.
Question LG 9-3
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?
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?
PwC response
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 (e.g., due to a modification). 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 9-4 discusses when to reassess initial direct costs upon transition to ASC 842.
Question LG 9-4
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?
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?
PwC response
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. This includes all leases acquired in a business combination.
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 9.4.1.2. 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(x)(1).
9.3.1.2 Hindsight practical expedient
Upon transition, a reporting entity is permitted to elect to use hindsight with respect to determining the lease term (e.g., they may consider the actual outcome or updated expectations of lease renewals, termination options, and purchase options) and in assessing any impairment of right-of-use assets for existing leases.
An entity also may elect a practical expedient, which must be applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor) to 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 may be elected separately or in conjunction with either one or both of the practical expedients in (f) and (gg).
As noted, this provision may be elected on its own or together with either or both practical expedients, or the land easements practical expedient, but represents a policy election that should be applied consistently to all leases.
We expect that the application of hindsight will be challenging in many cases and could in some cases result in a more complex transition process.
We believe hindsight extends only up until the effective date (e.g., 1/1/22 for a calendar year-end private company) and should not incorporate information that becomes available or events that occur after that date.
The hindsight practical expedient can only be used to refresh estimates or evaluations of contractual terms that exist as of the time of measurement. A reporting entity that chooses to adjust comparative periods at transition should not apply the hindsight practical expedient to push back a contractual modification in terms such as (1) the impact of an early termination when the option to terminate was not included in the original contract or (2) an extension of the term of the lease when that extension option was not already included in the original contract.
Similarly, for payments based on an index or a rate, a reporting entity that chooses to adjust comparative periods would not push back the index or rate at the effective date to measure the lease liability as of a prior date.
A reporting entity applying the hindsight practical expedient should consider the impact on its determination of whether a lease is a short-term lease. For example, a lease may have commenced 15 months prior to the effective date with an original lease term of 10 months with a renewal option for an additional 10 months. Assume exercise of the renewal option was not reasonably assured at lease commencement, but the company subsequently exercised the renewal option. This lease would not meet the definition of a short-term lease because the lease term as of its commencement date using hindsight is 20 months.
When applying hindsight for an operating lease with non-level rents, we believe a lessee or lessor should apply the updated lease term by starting at the lease commencement date and recalculating what the accrued/deferred rent balances would have been as of the application date of the new leases guidance if the lease term known as of the effective date had been known at commencement. The lessee or lessor should record any difference between the prior and adjusted accrued/deferred balances as of the application date as an adjustment to opening equity.
Question LG 9-5 and Question LG 9-6 discuss how to assess leases when electing the hindsight practical expedient for a lessee upon transition to ASC 842.
Question LG 9-5
Does the election of hindsight by a reporting entity require the entity to undertake a fresh assessment of the facts and circumstances that are relevant in determining the lease term even if there have been no triggering events?
Does the election of hindsight by a reporting entity require the entity to undertake a fresh assessment of the facts and circumstances that are relevant in determining the lease term even if there have been no triggering events?
PwC response
We believe a reporting entity should undertake a fresh assessment of the facts and circumstances when applying the hindsight practical expedient, taking into consideration all available information prior to the effective date that would be relevant in determining the term of the lease. For example, assume a calendar year-end private company adopts the leases standard on 1/1/2022 and has chosen to adjust the comparative period (1/1/2021 through 12/31/2021) in transition. The entity has a lease that commenced prior to 1/1/2021 and the lessee exercised an extension option on 3/1/2021. In this situation, we believe if the lessee elects hindsight at the time of adoption on 1/1/2022, the lessee should recognize a lease liability and a right-of-use asset on 1/1/2021 assuming the extended lease term.
This is the case even if the lessee’s extension option was not exercisable in the look-back period (for example, if the extension option is only exercisable on or after 1/1/2021) but as of the effective date (i.e., 1/1/2022) it was reasonably certain that the lessee would exercise the extension option because of a change in facts and circumstances from the original assessment date. Thus, the extended lease term should be used.
Question LG 9-6
How does the use of hindsight interact with other practical expedients to either carryforward capital lease balances or to not reassess lease classification if electing the package of practical expedients?
How does the use of hindsight interact with other practical expedients to either carryforward capital lease balances or to not reassess lease classification if electing the package of practical expedients?
PwC response
ASC 842-10-65-1(r)(1) prescribes transition guidance for a lessee that has a capital lease under ASC 840 that is classified as a finance lease under ASC 842. Under this guidance, the lessee should recognize a right-of-use asset and a leases liability at the carrying amount of the lease asset and the capital lease obligation under ASC 840 at the initial application date. A literal application of this guidance may result in an anomalous discount rate for a lessee that has a capital lease under ASC 840, especially if the lessee elects both the package of practical expedients and applies hindsight (to determine the lease term) when transitioning to ASC 842. The application of hindsight could result in a shortened (or lengthened) lease term because exercise of a renewal option may no longer be reasonably certain (or may have become reasonably certain). In this situation, the discount rate required to amortize the carrying value of the capital lease obligation (determined under ASC 840) to the appropriate amount by the end of the shortened (or lengthened) lease term may get significantly reduced (or increased).
This issue could occur whenever a lessee elects the package of practical expedients as well as the application of hindsight for its existing operating leases. In that case, the lessee would also need to apply the expedients to its existing capital leases. Because the lessee elected the package of practical expedients, it would not reassess lease classification.
Given the transition guidance in ASC 842-10-65-1(r)(1) states that the carrying amount of the capital lease asset and capital lease obligation under ASC 840 should be carried over into the right-of-use asset and lease liability, there are circumstances in which a literal application of that guidance in conjunction with hindsight would produce a materially distorted interest rate. This could result in a significant impact to subsequent expense recognition. Paragraph BC394 in the Basis for Conclusions of ASC 842 indicates that the Board intended for the application of the hindsight election to result in more accurate, updated information for financial statement users. Consequently, we believe a lessee may apply the following approach to transition existing capital leases when the lessee elects to apply hindsight:
- Apply hindsight at the lease inception date to determine the appropriate lease term and discount rate.
- Using such discount rate, recalculate the new capital lease asset and capital lease obligation balance (as well as any deferred initial direct costs balance) under ASC 840 using revised lease payments as of the initial application date as though the lease term was always the updated lease term based on hindsight.
- Any difference between the recalculated and existing balances at the initial application date should be recorded as an adjustment to opening equity. Note, however, that if the reporting entity has elected to adjust the comparative periods upon adoption and the lease commenced during the comparative periods, the adjustment should be reflected in earnings during the comparative periods.
The lessee should then follow the transition accounting in ASC 842-10-65-1(r) through ASC 842-10-65-1(t) using the recalculated balances.
Question LG 9-7 discusses how a lessor evaluates leases when electing the hindsight practical expedient.
Question LG 9-7
What is the lessor transition accounting model for a lease previously classified as a sales-type lease or direct financing lease under ASC 840 when a lessee elects the practical expedient of hindsight for purposes of adopting the leases standard?
What is the lessor transition accounting model for a lease previously classified as a sales-type lease or direct financing lease under ASC 840 when a lessee elects the practical expedient of hindsight for purposes of adopting the leases standard?
PwC response
We believe that a principle similar to the one described in Question LG 9-6 would apply for lessors with sales-type leases and direct financing leases.
The transition guidance in ASC 842-10-65-1(x)(1) requires that a lessor continue to recognize a net investment in the lease at the carrying amount of the net investment under ASC 840. A literal application of ASC 842-10-65-1(x) could produce a materially distorted implicit interest rate in certain cases when a lessor also elects to apply hindsight. This could result in a significant impact to subsequent income recognition. Paragraph BC394 in the Basis for Conclusions of ASC 842 indicates that the Board intended for the application of the hindsight election to result in more accurate, updated information for financial statement users. Consequently, we believe a lessor may apply the following approach to transition existing sales-type and direct financing leases when the lessor elects to apply hindsight:
- Apply hindsight at the lease inception date to determine the appropriate lease term and implicit interest rate.
- Using such discount rate, recalculate the new net investment in the lease balance under ASC 840 using the revised lease payments as of the application date as though the lease term was always the updated lease term based on hindsight.
- Any difference between the recalculated and existing balances at the application date should be recorded as an adjustment to opening equity. Note, however, that if the reporting entity has elected to adjust the comparative periods upon adoption and the lease commenced during the comparative periods, the adjustment should be reflected in earnings during the comparative periods.
The lessor should then follow the transition accounting in ASC 842-10-65-1(x) using the recalculated balances.
9.3.1.3 Land easements practical expedient
An optional practical expedient is available that allows a reporting entity to choose to not apply the leases standard to certain existing land easements at transition. See LG 2.3.2.1 for additional information.
An entity also may elect a practical expedient to not assess whether existing or expired land easements that were not previously accounted for as leases under Topic 840 are or contain a lease under this Topic. For purposes of (gg), a land easement (also commonly referred to as a right of way) refers to a right to use, access, or cross another entity’s land for a specified purpose. This practical expedient shall be applied consistently by an entity to all its existing and expired land easements that were not previously accounted for as leases under Topic 840. This practical expedient may be elected separately or in conjunction with either one or both of the practical expedients in (f) and (g). An entity that elects this practical expedient for existing or expired land easements shall apply the pending content that links to this paragraph to land easements entered into (or modified) on or after the date that the entity first applies the pending content that links to this paragraph as described in (a) and (b). An entity that previously accounted for existing or expired land easements under Topic 840 shall not be eligible for this practical expedient for those land easements.
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