Private Companies: Practical Expedients under ASC 842
ASC 842 governs the accounting for leases and is an extensive set of rules; but luckily, the standard includes a handful of practical expedients that may be useful, especially for private companies.
This blog will discuss three practical expedients available to private companies as permitted under ASC 842 to simplify recognition and measurement requirements.
Short-term leases
The first practical expedient available for private companies relates to the ability for lessees to designate arrangements as short-term leases. A short-term lease is defined as:
“a lease that, at the commencement date, has a lease term of 12 months or less and that does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise”.
ASC 842 allows such arrangements to be accounted for as executory contracts. That is, these arrangements do not need to be capitalized on the balance sheet with a corresponding lease liability and can instead be expensed as incurred on a straight-line basis.
The short-term lease practical expedient is an accounting policy election by class of underlying asset and can only be elected at the commencement date.
Keep in mind, entities are still required to disclose the cost of leases (including those designated as short-term leases) within the financial statements; therefore, entities will still have to capture such information for financial reporting.
Lease and non-lease components
ASC 842 requires entities to identify the various components within a contract (we discuss this in our ASC 842 Overview course), which include:
- Lease components
- Non-lease components
- Other components that are not components of the contract
Lease components relate to a lessee’s right to use the underlying asset. Non-lease components are any items or activities within an arrangement that transfer a good or service to the lessee. One common example of non-lease components are charges related to common area maintenance. Charges related to administrative tasks or reimbursement of the lessor’s costs are examples of items that are not components of the contract (e.g., payments related to property taxes or insurance).
It is important to identify these various components, as ASC 842 requires the consideration be allocated between lease and non-lease components. It is the payments related to the lease components that are discounted to determine the amount of the lease liability to be recorded in the balance sheet.
The accounting for non-lease and other components that are not components of a lease contract is outside the scope of ASC 842.
Enter the second practical expedient, which is available to both lessees and lessors! Lessees may choose not to separate non-lease component(s) from the related lease component(s). If elected, the lessee may account for all components as one component. This election is available by class of underlying asset.
Lessors are also allowed to combine both lease and non-lease components as a single arrangement. However, there is an additional hurdle for lessors to analyze the arrangement as a whole and apply the most appropriate guidance to the resulting transaction (i.e., ASC 842 or ASC 606).
While this practical expedient may save some time with the mechanics of allocating consideration to the various components of an arrangement, entities utilizing this practical expedient will inevitably present higher lease liabilities and right-of-use assets in the financial statements. In addition, this election requires additional disclosures on the accounting policy election, the class or classes of underlying assets impacted, as well as the nature of the lease and non-lease components included in these arrangements.
Risk-free rate
In ASC 842, discount rates are used to determine initial lease classification, calculate the present value of the lease payments, and measure either a lessee’s lease liability or a lessor’s net investment in a lease. Accordingly, there are very specific rules to follow when determining the appropriate interest rate to apply to a lease arrangement.
ASC 842 requires lessors to use the rate implicit in the lease as the discount rate. Lessees must also use this rate, if known. However, most of the time lessees are forced to fall back to the incremental borrowing rate (as discussed in this post).
Wondering how to calculate these rates? Luckily, this is where the third practical expedient comes into play for private companies. ONLY private companies are allowed to elect a practical expedient to bypass the calculations and the assessment of both the rate implicit in the lease, as well as its incremental borrowing rate, using instead a risk-free rate. This election can be made by each class of underlying asset, which provides some flexibility to practitioners.
Final thoughts
If you’re looking for additional reminders on lease accounting under ASC 842, check out lease course collection which provides information on all the requirements under ASC 842! Also check out our Leases technical topic page where we discuss other accounting considerations, compare ASC 842 to IFRS 16, and provide links to all of our lease courses and other helpful resources!
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
