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9.4 Lessee transition
Publication date: 31 Jan 2023
us Leases guide
The transition guidance for a lessee differs depending on the classification of the lease. Given that the practical expedients discussed in LG 9.3.1.1 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.
9.4.1 Lessee transition: operating leases
If a lease was classified as an operating lease under the guidance in ASC 840 and will continue to be classified as an operating lease under the leases standard, the lessee should recognize a right-of-use asset and lease liability at the application date of the leases standard. The application date for companies that choose to adjust comparatives periods is the later of: (1) the beginning of the earliest comparative period presented and (2) the commencement date of the lease. The application date for companies that choose to not adjust comparative periods is the effective date.
However, as discussed in LG 2.2.1, a lessee may elect not to recognize right-of-use assets and lease liabilities arising from short-term leases. If a lessee makes this election, it would not apply the transition guidance outlined in this section to such leases. Instead, the lessee should continue to recognize those lease payments on a straight-line basis and variable payments in the period in which the obligation for those payments is incurred.
For leases other than short-term leases when a lessee has made an election to not recognize a lease liability and right-of-use asset, the lease liability should be calculated as the present value of the sum of (1) the remaining minimum rental payments (as defined under ASC 840) and (2) any amounts probable of being owed by the lessee under a residual value guarantee.
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
- Remaining balance of any lease incentives
- Unamortized initial direct costs
- Any impairment
- The carrying amount of any liability related to the lease recognized in accordance with ASC 420, Exit or Disposal Cost Obligations
Unless the entity elects the package of practical expedients discussed in LG 9.3.1.1, unamortized initial direct costs remaining at the application date that would not have qualified for capitalization under the leases standard should be written off with an offsetting entry to equity (or earnings if the entity chooses to adjust comparative periods and the costs were incurred after the beginning of the earliest period presented).
Also, refer to LG 9.3.1.2 when the hindsight practical expedient is elected, regarding whether existing balances should be adjusted.
The transition guidance in ASC 842 does not explicitly discuss the treatment of sublease liabilities under ASC 840. These liabilities arise in certain sublease transactions when the underlying asset was subleased at a loss. Certain of these transactions are not in the scope of ASC 420 when the entity has not ceased use of the leased space for the term of the head lease. We believe it would be appropriate to analogize to the guidance for liabilities under ASC 420 in transition to ASC 842. Consequently, the right-of-use asset recognized at transition should be reduced (netted) by the carrying amount of the sublease liability. Alternatively, we would not object to a reporting entity writing off an existing sublease liability at the application date with an adjustment to opening equity at transition. In this latter case, the reporting entity should also perform an impairment test of the right-of-use asset at the application date. See LG 9.4.1.3.
Question LG 9-8
How should the lessee treat the excess of the carrying amount of the existing liability recognized in accordance with ASC 420, Exit or Disposal Cost Obligations, over the right-of-use asset to be recorded at transition?
How should the lessee treat the excess of the carrying amount of the existing liability recognized in accordance with ASC 420, Exit or Disposal Cost Obligations, over the right-of-use asset to be recorded at transition?
PwC response
This situation is not specifically addressed in ASC 842; however, we believe that the lessee can elect to apply either of the follow methods:
- Derecognize the excess ASC 420 liability through equity: In this scenario, the lessee would debit the liability and credit equity for the amount in excess of the right-of-use asset (which is now zero). Subsequent to transition, losses resulting from the sublease would be reflected in the income statement as they are incurred (subsequent to the effective date).
- Recognize the excess ASC 420 liability as a negative ROU asset (presented as a liability within the financial statements): This treatment would preserve the liability, reducing future losses related to the sublease.
An entity should elect one method and apply it consistently to all leases impacted.
9.4.1.1 Lessee: discount rates in transition
The discount rate used to calculate the present value of the future payments should be determined at the application date as discussed in LG 9.3. For example, a calendar year-end private company adopting on January 1, 2022 that chooses not to adjust comparative periods would determine the rate as of January 1, 2022.
See LG 3.3.4.6 for information on determining the discount rate, including specific private company considerations. When a lessee uses its incremental borrowing rate as the discount rate at transition, the transition guidance does not specify whether the rate should be based on the original lease term or the remaining lease term. We believe that the selection of a rate that is based on either the original lease term or the remaining lease term is reasonable. The approach should be consistently applied.
9.4.1.2 Lessee: lease payments in transition
At transition, a lessee is required to measure a lease liability for leases classified as operating under current GAAP equal to the sum of the present value of (1) the remaining minimum rental payments (as defined in ASC 840), and (2) any amounts probable of being owed by the lessee under a residual value guarantee as defined under the leases standard. When lease classification has not changed, the lease payments used for measurement purposes should be based on the same data as under ASC 840. If the entity has not elected hindsight, the lease term used to determine the payments should be the same as what was used under ASC 840 at lease inception (or the latest reassessment of lease term if the lease had been modified).
Variable payments
ASC 840 requires that variable payments (contingent rentals) that are based on an index or rate be included in minimum lease payments based on the index or rate existing at lease inception (or as of the modification date if the lease has been modified). However, there is diversity in practice regarding how lessees treat rent payments based on an index or rate in their commitments footnote under ASC 840. Some lessees use the inception index or rate whereas others update the amount to reflect the current index or rate. The transition guidance in the new leases standard does not explicitly state whether the index or rate used to measure the lease liability for an operating lease should be as of the transition date or as of the inception of the lease.
We believe that if the lessee historically disclosed the amount of its commitments for operating leases using the index or rate as of the inception of the lease (consistent with the index or rate in effect under ASC 840 that was used to calculate the minimum rental payments), then that rate should be used in measuring the initial lease liability at transition for existing leases. If a lessee that previously used the inception index or rate in its commitment footnote wants to use the current index or rate to measure the lease liability at transition for existing leases, it would need to apply the guidance in ASC 250, Accounting Changes and Error Corrections, including an evaluation of preferability. Note that in evaluating preferability, the SEC staff has indicated that it may be reasonable to conclude that the use of a current index or rate better reflects the lease liability at transition.
We believe that if the lessee historically disclosed the amount of its commitments for operating leases with variable payments based on an index or rate using the current index or rate, the lessee may measure the initial lease liability for its existing leases at transition by either (a) using the current index or rate consistent with its existing policy for disclosures or (b) using the index or rate at the inception of the lease consistent with the definition of minimum rent payments in ASC 840. In this latter case, since the lessee is neither changing its recognition nor disclosure policies for operating leases, we do not believe that application of ASC 250 is required.
Separation of components in transition
Under the new leases guidance, a reporting entity is required to separate lease and nonlease components. However, for new leases on or after the effective date of ASC 842, a lessee may, as an accounting policy election by class of underlying asset, choose to not separate nonlease components from the associated lease components and instead account for each separate lease component and its associated nonlease components as a single lease component. The new leases transition guidance does not specify whether a lessee can make an accounting policy election to not separate lease and nonlease components for existing leases in calculating the lease liability at transition.
Under ASC 842, the measurement of the lease liability for an existing operating lease includes the present value of the remaining minimum rental payments (“as defined in ASC 840”). The term “minimum rental payments,” however, is not actually defined in ASC 840 and the description of “minimum lease payments” is unclear. We believe that the treatment of lease and nonlease components in transition for existing leases depends on whether the lessee elects an accounting policy under ASC 842 to not separate nonlease components from the associated lease components (see LG 2.4.4.1).
Lessee does not elect to combine nonlease and lease components
A lessee must separate nonlease components (other than executory costs) from the associated lease components at transition for existing leases if the lessee has not made an accounting policy election to combine them under ASC 842 for new leases.
When a lease includes executory costs in the fixed rent payments (a gross lease), the guidance in ASC 840 with respect to accounting for those executory costs (such as insurance, maintenance, and property taxes) to be paid by the lessor is unclear. With respect to a lessee, ASC 840 says that minimum lease payments include minimum rental payments called for by the lease over the lease term and comprise payments the lessee is obligated to make in connection with the leased property. As such, it does not directly address the treatment of executory costs. In the minimum lease payments classification test, ASC 842 states that executory costs are excluded. As such, the new guidance could be read to imply that minimum lease payments include executory costs, hence the need to require their specific exclusion for purposes of the minimum lease payments classification test.
Since the guidance in ASC 840 is unclear, we believe there were two acceptable historical practices for a lessee to account for an operating gross lease:
● The lessee could have chosen to separate executory costs from the remainder of the minimum lease payments or
● The lessee could have chosen to include the fixed portion of executory costs within minimum lease payments
Note that in this section, “fixed” could also include payments based on an index or rate.
We believe that a lessee has asserted a policy with regards to including or separating the fixed executory costs based on what the lessee disclosed in its commitments footnote. Note that variable or contingent payments for executory costs would generally be excluded from minimum rental payments irrespective of the treatment of fixed executory costs. Therefore, we believe a lessee should transition its operating gross leases to ASC 842 consistent with its historical accounting policy as follows:
● If a reporting entity has a historical accounting policy to exclude executory costs from minimum lease payments under ASC 840, then executory costs should be excluded from minimum rental payments in transition. Therefore, the portion of payments attributable to these executory costs would not be included in the measurement of the initial lease liability.
● If a reporting entity has a historical accounting policy to include executory costs in minimum lease payments under ASC 840, then fixed executory costs should be included in minimum rental payments in transition. Therefore, the fixed portion of payments attributable to those executory costs would be included in the measurement of the initial lease liability.
If a lessee wants to change how executory costs are treated for existing leases, but is not electing to combine nonlease and lease components under ASC 842, it would need to apply the guidance in ASC 250, Accounting Changes and Error Corrections, including an evaluation of preferability. For example, if the lessee has historically included fixed executory costs in its commitments footnote and it wants to exclude these amounts from its lease liability at transition for existing leases, it would need to treat this as a change in accounting policy and consider whether such a change is preferable.
Question LG 9-9 considers how the treatment of executory costs at transition affects the units of accounting after transition.
Question LG 9-9
How does the treatment of executory costs at transition impact subsequent accounting in the event of a reassessment trigger or a modification that is not considered a new lease?
How does the treatment of executory costs at transition impact subsequent accounting in the event of a reassessment trigger or a modification that is not considered a new lease?
PwC response
We believe a lessee’s separation (or non-separation) during transition creates a unit of accounting that should be carried forward on and after the effective date. For example, assume a gross lease has two nonlease components: maintenance (an executory cost) and ancillary services (not associated with maintenance) provided by the lessor. Assume the lessee chooses to separate nonlease components other than executory costs from the associated lease component during transition. If the lessee does not separate maintenance from the lease component in transition due to its existing accounting policy under ASC 840 but separates the ancillary services at transition, the two units of accounting established in transition would be (1) the lease component that includes maintenance and (2) the ancillary services nonlease component. These would remain consistent even in the event of a modification that is not a new lease or remeasurement on or after the effective date.
Lessee elects to combine nonlease and lease components
A lessee may choose to not separate nonlease components other than executory costs from the associated lease components for existing leases at transition if, and only if, the lessee makes an accounting policy election by class of underlying asset to not separate nonlease components from the associated lease components for new leases on and after the effective date. We believe a lessee that elects to combine lease and nonlease components under ASC 842 may also apply that election to existing leases at transition without applying ASC 250 Accounting Changes and Error Corrections, since the change arises from the adoption of a new accounting standard.
If a lessee elects to not adjust the comparative periods, we believe the lessee should present their comparative periods as they had before adopting ASC 842. We believe that the Board’s intent in providing the optional transition method was to allow entities to continue to report leases for the comparative period as they had under ASC 840.
9.4.1.3 Lessee: impairment in transition
At transition, a lessee should consider whether adjustments are needed for any impairment when determining the amount of the right-of-use asset to record.
We believe that the FASB did not intend for lessees to adjust prior period impairment measurements or allocations to an asset group under ASC 360, Property, Plant, and Equipment upon adoption of the leases standard. If an asset group that includes an operating lease had been impaired under current GAAP, an allocation of the prior period asset group impairment should not be included in the measurement of the operating lease right-of-use asset upon adoption of the leases standard. Instead, a right-of-use asset for a lessee’s operating lease should be assessed for impairment under current GAAP, for example, ASC 420, Exit or disposal cost obligations (if the entity has ceased use of the leased asset), or ASC 840 (if the lessee subleased the underlying leased asset at a loss) during the look-back period.
The impairment provisions of ASC 360 would apply only on or after the effective date of the new standard, unless the scenario in Question LG 9-10 applies.
Question LG 9-10
If previous impairments under ASC 360 in excess of the carrying value of long-lived assets within the asset group were identified prior to the effective date, but were not able to be expensed because the assets cannot be written down below fair value (an “unrecognized impairment”), is a lessee required to expense any additional impairment resulting from the recognition of the right-of-use asset as of the effective date?
If previous impairments under ASC 360 in excess of the carrying value of long-lived assets within the asset group were identified prior to the effective date, but were not able to be expensed because the assets cannot be written down below fair value (an “unrecognized impairment”), is a lessee required to expense any additional impairment resulting from the recognition of the right-of-use asset as of the effective date?
PwC response
We believe that an “unrecognized impairment” should be recorded at the date that the right-of-use asset is initially recognized on the balance sheet. Therefore, if a reporting entity elects not to adjust comparative periods, the impairment should be recorded as either as a charge to income or an equity adjustment at adoption since the impairment is first recorded at the date of initial application (e.g., January 1, 2022 for a calendar year-end private company).
9.4.1.4 Lessee: foreign currency in transition
The transition guidance in the leases standard does not address how to treat the effects of foreign exchange rates in a lease that is denominated in a currency other than a reporting entity’s functional currency. As a result, certain questions have arisen.
Question LG 9-11 and Question LG 9-12 discuss how leases denominated in a foreign currency should be accounted for in transition.
Question LG 9-11
In transitioning to ASC 842, what exchange rate should be used to determine lease payments for purposes of measuring a lessee’s operating lease liability and right-of-use asset for existing operating leases?
In transitioning to ASC 842, what exchange rate should be used to determine lease payments for purposes of measuring a lessee’s operating lease liability and right-of-use asset for existing operating leases?
PwC response
For leases that were classified as operating leases under ASC 840, a lessee should initially recognize a right-of-use asset and a lease liability at the application date described in LG 9.3
We believe it is reasonable to use the foreign exchange rate at the application date (rather than the commencement date) to determine lease payments for both the lease liability and the right-of-use asset. This is because the transition guidance in the leases standard requires the right-of-use asset to be initially equal to the lease liability adjusted for other items, which can only be accomplished by using the foreign exchange rate at the application date.
In addition, ASC 830-20-30-1 states: “At the date a foreign currency transaction is recognized, each asset, liability ... shall be measured initially in the functional currency of the recording entity by use of the exchange rate in effect at that date.” Consequently, the lessee should use the foreign exchange rate in effect at the date of initial recognition of the right-of-use asset and lease liability. For a calendar year-end nonpublic business entity with an effective date of January 1, 2022 choosing to adjust comparative periods, this would be (a) January 1, 2021 for an operating lease that commenced prior to January 1, 2021 or (b) the commencement date of the lease for a lease entered into during the comparative periods. For a calendar year-end nonpublic business entity choosing to not adjust comparative periods, this would be January 1, 2022.
Question LG 9-12
For a reporting entity that chooses to adjust comparative periods in transition, how should foreign currency gains or losses for a lessee’s operating leases during the look-back period be accounted for after the initial application date?
For a reporting entity that chooses to adjust comparative periods in transition, how should foreign currency gains or losses for a lessee’s operating leases during the look-back period be accounted for after the initial application date?
PwC response
The transition guidance in ASC 842-10-65-1(d) of the leases standard states that a reporting entity shall adjust equity and, if it elects to adjust comparative periods, the other prior period comparative amounts, as if the new leases guidance always applied.
For reporting entities that choose to adjust comparative periods, based on the general transition guidance in ASC 842-10-65-1(d), subsequent to the application date the comparative income statements presented should be adjusted to reflect the effect of foreign currency exchange rate movements on lease-related monetary assets and liabilities. These foreign exchange transaction gains or losses should be recognized in income during the comparative periods.
9.4.1.5 Lessee: subsequent recognition and measurement in transition
After initial recognition, a lessee should measure the lease liability and the right-of-use asset in accordance with the subsequent measurement guidance in the leases standard as described in LG 4.4.2.
9.4.2 Lessee: capital leases in transition
If a lease was classified as a capital lease under the guidance in ASC 840 and will be classified as a finance lease under the leases standard, 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 the lease was outstanding beginning with the earliest period presented (if the entity chooses to adjust comparative periods) or the effective date (if the entity chooses not to adjust comparative periods). That is, the initial right-of-use asset and lease liability will be based on the guidance in ASC 840 for capital lease assets and capital lease obligations. However, refer to LG 9.3.1.2 and Question LG 9-6 when the hindsight practical expedient is elected.
If the entity elects the package of practical expedients discussed in LG 9.3.1.1, it does not reassess unamortized initial direct costs. If a reporting entity does not elect the package of practical expedients, costs that do not qualify for capitalization under the leases standard should be written off with an offsetting entry to equity unless the entity chooses to adjust comparative periods and the costs were incurred after the beginning of the earliest period presented, in which case they should be written off to earnings in the comparative period. Any unamortized initial direct costs that meet the definition of initial direct costs under the leases standard should be included in the right-of-use asset established at transition.
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.
Beginning on the effective date, a lessee should measure the right-of-use asset and lease liability in accordance with the subsequent measurement guidance in the leases standard (see LG 4.4.1). A lessee should not, however, remeasure the right-of-use asset or lease liability for changes in the amount probable of being owed under a lessee-provided residual value guarantee. For leases that were capital leases under ASC 840, in cases when remeasurement of the lease liability is required for any reason, the lessee should continue to measure the residual value guarantee it provides on the basis of the stated amount, not the amount probable of being owed. See LG 5 for information on lease remeasurement.
9.4.3 Lessee: modifications during the look-back period
Generally, when there is no change in lease classification, a lessee that elects to adjust comparative periods will apply the modification guidance in ASC 840 for modifications that occur during the comparative periods presented. If the lease classification changes, the lessee should use the modification model in ASC 842 irrespective of whether the modification took place during the comparative periods or after the effective date. Absent a modification, a lessee should not reassess or remeasure leases during the comparative periods under the leases standard.
Question LG 9-13 and Question LG 9-14 discuss how a lessee should account for lease modifications during the look-back period.
Question LG 9-13
If the lessee chooses to adjust comparative periods upon transition, what is the accounting for an operating lease that is modified during comparative periods and the lease remains an operating lease?
If the lessee chooses to adjust comparative periods upon transition, what is the accounting for an operating lease that is modified during comparative periods and the lease remains an operating lease?
PwC response
When a lease classified as an operating lease under ASC 840 continues to be classified as an operating lease under ASC 842, the transition provisions require application of a hybrid model. The lessee would recognize a lease liability and a right-of-use asset under ASC 842 for such a lease using the amounts calculated under ASC 840 at the application date. The transition provisions in ASC 842 further prescribe that the lessee should apply the modification and remeasurement guidance in ASC 842 should such a lease be modified after the look-back period. However, there is no guidance that addresses the accounting when a lease is modified during the comparative periods. In such a scenario, we believe a hybrid model should be applied as follows:
- The lessee should use the model for modifications in ASC 840 to determine the accounting for the modified operating lease.
The lessee should use the guidance in ASC 842 to recognize the modification, i.e., measure payments based on ASC 840 but use the guidance in ASC 842 to adjust the lease liability and the right-of-use asset.
Question LG 9-14
What is the accounting model when a capital lease under ASC 840 (classified as a finance lease under ASC 842) is modified during the look-back period?
What is the accounting model when a capital lease under ASC 840 (classified as a finance lease under ASC 842) is modified during the look-back period?
PwC response
The new leases guidance requires the modification guidance under ASC 842 to be followed when a capital lease under ASC 840 (classified as a finance lease under ASC 842) is modified after the look-back period. There is no guidance when such a lease is modified during the look-back period. We believe the lessee should follow the modification guidance in ASC 840 to account for a modification during the look-back period since there was no change in the lease classification.
9.4.4 Remeasurement events other than modifications
As discussed in LG 5.3, even if a lease is not modified, a lessee is required to remeasure lease payments and the lease liability in certain circumstances. This includes cases in which lease payments and term would not be required to be reassessed under ASC 840. One example of such a triggering event is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset.
In these scenarios, when a lessee recognizes a lease liability at transition, it should evaluate how the initial lease liability should reflect the remeasurement triggering event based on its transition elections.
As discussed in LG 9.4.1, at transition for an operating lease, the lessee’s lease liability should be calculated as the present value of the sum of (1) the remaining minimum rental payments (as defined under ASC 840) and (2) any amounts probable of being owed by the lessee under a residual value guarantee.
As discussed in LG 9.4.2, for capital leases, the lessee should reclassify the existing capital lease asset as a right-of-use asset and the existing obligation as a lease liability.
When a company does not elect to use hindsight, it should continue to use the old lease payment data under ASC 840 as required by ASC 842-10-65-1(l)(1) and ASC 842-10-65-1(r)(1) in transition unless and until a remeasurement triggering event occurs after the date of adoption of the leases standard (1/1/2022 for a private calendar year-end company).
Figure LG 9-2 shows how a lessee should consider the occurrence of a triggering event that occurs prior to the effective date of the leases guidance in the transition for an operating lease. For purposes of the dates in the table, assume a private calendar year-end company is adopting the standard on 1/1/2022.
Figure LG 9-2
Triggering events that occur prior to the effective date (private calendar year-end company with an effective date of January 1, 2022)
Triggering events that occur prior to the effective date (private calendar year-end company with an effective date of January 1, 2022)
Triggering event occurs on 12/31/2021 or earlier |
Hindsight practical expedient is not elected |
Hindsight practical expedient is elected |
|---|---|---|
The entity chooses to not adjust comparative periods
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At transition on 1/1/2022, calculate the transition lease liability and right-of-use asset based on the old lease payment data under ASC 840. Refer to LG 9.4.1 and LG 9.4.2 for transition accounting for operating and capital leases, respectively. Differences between the lease liability and the right-of-use asset not otherwise specified would be recorded in opening equity.
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At transition on 1/1/2022, calculate the transition lease liability and right-of-use asset based on revised information considering the triggering event. Refer to LG 9.3.1.2, LG 9.4.1, and LG 9.4.2. Differences between the lease liability and the right-of-use asset not otherwise specified would be recorded in opening equity.
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The entity chooses to adjust comparative period (2021)
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At transition, adjust the comparative period as follows:
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At transition, adjust the comparative period as follows:
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Note that for remeasurement triggering events that occur after the effective date of the leases guidance (for example, an event on January 2, 2022 for a private calendar year-end company) a lessee should follow the leases guidance discussed in LG 5.3.
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