16.5 Transition Relief
Under ASC 842’s modified transition approach, an entity must apply the standard
as of the earliest period presented (or as of the effective date if the Comparatives
Under 840 Option is elected). In addition, the standard contains practical
expedients that an entity may elect when adopting the standard as well as other
transition guidance intended to make adoption easier. For example, the so-called
run-off approach described in the Background Information and Basis for Conclusions
of ASU 2016-02 was meant to make the transition from providing ASC 840 disclosures
to recognizing a lease under ASC 842 less cumbersome. Specifically, paragraph BC390
of ASU 2016-02 states, in part:
The practical effect of the modified retrospective
transition method, particularly when combined with the practical expedients
that are offered, is that an entity will “run off” those leases existing at
the beginning of the earliest comparative period presented in accordance
with previous GAAP with the exception that, for operating leases, a
lessee will present a lease liability in the statement of financial position
at each reporting date equal to the present value of the remaining
minimum rental payments (as that term was applied in previous
GAAP) and a right-of-use asset that is derived from the lease liability in
the manner described in paragraph 842-20-35-3. Entities will, in effect,
“run off” existing leases, as described, unless the lease is either
modified (and that modification is not accounted for as a separate contract)
or, for lessees only, the lease liability is remeasured in accordance with
the subsequent measurement guidance in [ASC 842-3024] on or after the effective date.
In theory, a lessee should be able to measure its lease obligations on the basis of the amounts disclosed in its future minimum rental payments table under ASC 840 (see Q&A 16-1 for additional discussion). Similarly, a lessor should be able to run off its existing leases by using its ASC 840 allocation to income streams deemed within the scope of the leasing standard. The transition relief of the run-off approach for preparers is premised on the fact that the entity prepared its previous ASC 840 disclosures completely and accurately.
16.5.1 Hindsight Practical Expedient
ASC 842-10
65-1 The following
represents the transition and effective date information
related to Accounting Standards Update . . . No.
2016-02, Leases (Topic 842) . . .
g. 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 above, as part of its transition to ASC 842, an entity may elect to use hindsight “in determining the lease term . . . and in assessing impairment” of ROU assets. The hindsight practical expedient does not need to be elected in conjunction with the practical expedient package (see Section 16.5.2).
Q&A 16-7 Application of the Use-of-Hindsight Practical
Expedient
Paragraph BC394 of ASU 2016-02 states, in part:
While an entity does not need to use hindsight, the FASB contends
that using hindsight in transition results in better information for
users.
[T]he Board considered that a similar practical
expedient related to the use of hindsight in determining the
transaction price (that is, estimating variable consideration)
was provided in the transition requirements in Topic 606.
Similar to the rationale for that expedient, the Board decided
that reflecting expectations that an entity knows at the time of
reporting are incorrect does not provide useful information to
users. In the context of this practical expedient, the Board
considered that it would generally not provide useful
information to recognize a lease liability on the basis of a
lease term that assumes the entity is reasonably certain to
exercise an option to extend the lease when at the time of
reporting the entity knows that it did not exercise that option.
Question 1
When applying the use-of-hindsight practical expedient,
should an entity consider only discrete events (e.g., the lessee’s
renewal of the lease) that occurred between the original lease
commencement date and the date of adoption?
Answer
No. In addition to discrete events, an entity that
applies the use-of-hindsight practical expedient should consider changes
in facts and circumstances from commencement through the effective date
of ASC 842 when determining the lease term and assessing the impairment
of the ROU asset. For example, in addition to known events, such as the
lessee’s exercise of renewal options, an entity should consider other
events and changes, as discussed in ASC 842-10-55-26 (e.g., a strategic
shift in business, changes in market rentals, evolution of the industry
as a whole), that may affect whether it is reasonably certain that the
lessee will exercise (or not exercise) any remaining renewal options.
The response to this question was informally discussed with the FASB
staff, which agreed with the overall conclusion reached.
Question 2
To which date does the hindsight assessment extend when
an entity applies the use-of-hindsight practical expedient?
Answer
When performing its hindsight assessment, an entity must
consider events and circumstances that occurred up to the effective date
of ASC 842.
Example
In 2003, Company A entered into
a 15-year lease of a store that included three
5-year renewal options. None of the renewals were
deemed reasonably assured to be exercised at
inception. On January 1, 2019, when A adopts ASC
842, it elects to apply the use-of-hindsight
practical expedient. Since the execution of the
lease, the following events occurred:
-
On November 9, 2017, A exercised the first of the three 5-year renewal options.
-
During 2018, the market rent in the area had increased to a point such that A’s rent is now significantly discounted.
-
On January 15, 2019, A’s CEO decided on a strategic shift in business such that the company would exit brick-and-mortar retail and move to online only.
When applying hindsight in
determining the lease term, A should consider the
events that occurred up to the effective date of
ASC 842. Therefore, since A adopted ASU 2016-02 as
of January 1, 2019, A should consider (1) that it
exercised the first renewal option in 2017 and (2)
the effect of the significant increase in market
rent in 2018 in its assessment of whether it would
exercise additional renewal options. Company A
should not consider its decision to exit
brick-and-mortar retail when evaluating the lease
term, since this event occurred after the
effective date of ASC 842.
16.5.1.1 Impact of Hindsight on the Lease Term
The use of hindsight in transition may affect the lease term (see Section 5.2 for a discussion of lease term).
If the practical expedient package described in Section 16.5.2 is not elected, the
impact of the hindsight practical expedient on lease term could affect lease
classification (e.g., a renewal option that is assumed to be exercised
results in a longer lease term and therefore higher lease payments, both of
which increase the likelihood that a lease is a finance lease or sales-type
lease). Regardless of whether lease classification is affected, an entity’s
application of hindsight in establishing the lease term may affect the
initial measurement of a lease. Any change in the lease term as a result of
applying the use-of-hindsight practical expedient should be reflected in the
measurement of the related lease assets and lease liabilities (i.e., any
lease assets or liabilities should be adjusted as if the lease term
determined by using hindsight had always applied). For example, when
operating lease payments are not even throughout the lease term, the
application of a different lease term would have changed the cumulative
straight-line income or expense recognized as of the date of initial
application of ASC 842. This cumulative difference should be reflected in
the lease assets and liabilities as of the date of initial application of
ASC 842, with a corresponding cumulative-effect adjustment to equity. This
is consistent with the overall objective of the use-of-hindsight practical
expedient, which, as described in paragraph BC394 of ASU 2016-02, is to
provide “more accurate, updated information to users.”
Example 16-5
Retailer, a calendar-year-end PBE, enters into a 10-year operating lease of
retail space on January 1, 2014. Annual lease
payments are $50,000 for the first five years and
$60,000 for the next five years. Retailer has a
five-year renewal option for $70,000 per year, for
which exercise is not reasonably assured as of lease
inception. Therefore, as of the adoption date of ASC
842 on January 1, 2019, Retailer has recorded
cumulative straight-line lease expense of $275,000
and has a deferred rent balance of $25,000.
Retailer elects the Comparatives Under 840 Option and the use-of-hindsight practical expedient. Because significant leasehold improvements have been installed in 2018, Retailer concludes that exercise of
the renewal option is reasonably certain as of January 1, 2019. Accordingly, Retailer recalculates the deferred rent balance as if the lease
term had always been 15 years. Since the cumulative straight-line lease expense would have been $300,000
instead of $275,000, Retailer increases the deferred rent balance in transition from $25,000 to $50,000 (which
is then subtracted from the opening ROU asset balance), with a corresponding debit to equity.
Q&A 16-7A Impact of Hindsight on Lease Classification
Question
If an entity elects both the use-of-hindsight practical expedient and the “package of three” practical expedients, is the entity required or permitted to reassess lease classification when the lease term changes as a result of applying the use-of-hindsight practical expedient?
Answer
No. We believe that the “package of three” practical expedients has priority over the use-of-hindsight practical expedient with respect to lease classification. Because one of the practical expedients in the “package of three” allows an entity not to reassess lease classification for existing leases, a change in the lease term resulting from the use-of-hindsight practical expedient would not override the entity’s election not to reassess lease classification. However, as stated above, if an entity does not elect the “package of three” practical expedients, a change in the lease term resulting from the use-of-hindsight practical expedient could affect the lease classification.
Connecting the Dots
Hindsight May Increase Complexity
While the election of hindsight may result in a more accurate reflection of the
measurement of ROU assets and liabilities in transition, it creates
complexity for lessors or lessees. The modified retrospective
approach, in combination with the practical expedient package, gives
entities the opportunity to apply the existing ASC 840 accounting
and disclosure requirements during the transition period (provided
that the entity does not elect the Comparatives Under 840 Option,
which would eliminate the transition period). For example, a lessee
can use the original assumptions for operating leases for its
existing ASC 840 disclosures and to capitalize the present value of
those minimum rental payments. Because hindsight directly affects
the lease term, the inclusion of additional periods in the lease
term may affect straight-line rent calculations for lessors and
lessees as well as the measurement of lease liabilities.
16.5.1.2 The Impact of Hindsight on Impairment
ASC 842 indicates that, if hindsight is elected in transition, the impairment of
an ROU asset by a lessee may be affected. However, as discussed in Q&As 16-4 and
16-4A, an ROU asset does not
generally need to be tested for impairment during the transition period,
given the interaction with ASC 360 and feedback from the FASB staff.
Therefore, we generally believe that the use of hindsight in the assessment
of impairment will not affect the measurement of an ROU asset in transition,
except when (1) an entity does not elect the Comparatives Under 840 Option,
(2) a hidden impairment exists within an asset group that includes an ROU
asset (as discussed in Q&A 16-4A), and (3) the impairment event arose during
the comparative periods.
16.5.2 Practical Expedient Package
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. 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. . . .
An entity has the option of electing the practical expedient package in transition, provided that it elects
all of them and applies them consistently to all of its leases.
16.5.2.1 Whether a Contract Is or Contains a Lease
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. An entity may elect the following practical expedients . . .
1. An entity need not reassess whether any expired or existing contracts are or contain leases. . . .
An entity that elects this practical expedient would not revisit whether a
contract is or contains a lease under the ASC 842 definition of a lease. In
other words, if an entity appropriately determines whether a contract is or
contains a lease under ASC 840 before the effective date of ASC 842, the
entity would not reevaluate that conclusion (i.e., the entity would carry
forward the conclusions reached under ASC 840 even though it may reach a
different conclusion under ASC 842). After the effective date of ASC 842, if
there is a substantive change to the terms and conditions of a contract, the
entity should reassess whether the contract is or contains a lease under ASC
842. See Section 8.6.1.1 for
additional discussion.
Changing Lanes
Definition of a Lease
The definition of a lease under ASC 842 is broadly similar to that under ASC
840; however, there are differences that can affect the
determination of whether a lease exists. For example, under ASC 840,
a lease can exist if it is remote that more than a minor amount of
the output or other utility of PP&E will be received by a party
other than the reporting entity. Under ASC 842, that condition alone
would not cause a contract to contain a lease. Rather, in addition
to receiving substantially all of the output (benefits), a reporting
entity must have control over HAFWP the asset is used. Therefore, in
some instances, a contract containing a lease under ASC 840 will not
contain a lease under ASC 842. The inverse is less likely (i.e., a
contract that does not meet the definition of a lease under ASC 840
but does meet the definition under ASC 842). See Chapter 3 for
more information on how to identify a lease within the definition of
ASC 842, including a description of the changes from ASC 840.
Connecting the Dots
Identification Errors May Not Be Carried Forward
In applying the practical expedient in ASC 842-10-65-1(f)(1), entities may not
carry forward any previous “errors” (i.e., incomplete identification
of leases). In certain circumstances, for example, an entity may not
have previously identified contracts that met the definition of a
lease under ASC 840. This lack of identification may not have had a
material impact on the entity’s financial statements because the
resulting accounting may have had a similar impact on profit or loss
(e.g., an executory contract and an operating lease may have had
similar profit and loss profiles). Similarly, lessors may not have
properly identified which income streams are within the scope of ASC
840 and which are within the scope of the revenue recognition
guidance in ASC 605 or ASC 606. This failure to identify the scope
of the contracts may not have had a material impact on the financial
statements of an entity under ASC 840 because the resulting
accounting would have a similar impact on profit or loss. However,
because ASC 842 prescribes on-balance-sheet treatment for most
leases, the accounting related to properly identifying all leases
may materially affect the entity’s financial statements under ASC
842. Similarly, it will be important for a lessor to identify
contracts that contain leases because of differences between ASC 842
and ASC 606 regarding classification, recognition, subsequent
measurement, and disclosures.
An entity that applies the practical expedient in ASC 842-10-65-1(f)(1) should
ensure that its identification of leases under ASC 840 was complete
and accurate.
Q&A 16-8 Whether Arrangements Entered Into Before May 28,
2003, Are Accounted for as Leases
EITF Issue 01-8 (codified in ASC 840) was updated in 2003 and defined the scope of contracts (or parts of contracts) that should be accounted for as leases. EITF Issue 01-8 indicated that it
only applied to “(a) arrangements agreed to or committed to,
[footnote omitted] if earlier, after the beginning of an entity’s next reporting period beginning after May 28, 2003, (b) arrangements modified after the beginning of an entity’s next reporting period beginning after May 28, 2003, and (c) arrangements acquired in business combinations initiated after the beginning of an entity’s next reporting period beginning after May 28, 2003.” Therefore, there are contracts that otherwise would have been considered leases in accordance with the definition in EITF Issue 01-8 (as codified in
ASC 840) but were previously not accounted for as leases because
they did not meet the effective-date criteria in (a)–(c) above.
Question
If an entity elects the practical expedient package,
would a contract that was not previously accounted for as a lease
because of the above effective dates (but that otherwise meets the
definition of a lease in accordance with ASC 840) need to be
considered a lease in the transition to ASC 842?
Answer
No. Contracts that qualified for exclusion from the
scope of ASC 840 would not be considered leases in the transition to
ASC 842. Since the practical expedient applies, an entity is not
required to change any of its conclusions that it appropriately
reached under ASC 840.
16.5.2.2 Lease Classification
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. An entity may elect the following practical expedients . . .
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). . . .
By electing the above practical expedient, an entity can retain its classification conclusion under ASC
840. In other words, a lease that was deemed an operating lease under ASC 840 will be an operating
lease in the transition to ASC 842 (conversely, a lease that was deemed a capital lease under ASC
840 will be a finance lease). This practical expedient applies to all comparative periods presented,
if applicable. On or after the effective date, the previous lease classification is retained (and not
reassessed) unless the contract is modified or a reassessment event described in ASC 842-10-25-1 takes place.
Q&A 16-9 Impact of Electing the Practical Expedient Package on
Separating Land From a Building
Under ASC 840, in classifying a lease involving both land and a building, an entity is required to assess the land separately from the building when (1) the lease meets either the transfer-of-ownership or the bargain-purchase-option classification criteria or (2) the fair value of the land is 25 percent or more of the total fair value of the leased property at lease inception. Under ASC 842, as discussed in Section 4.2.2, land must be accounted for as a separate lease component (regardless of its relative fair value) unless the accounting effect of doing so would be insignificant.
Question
Does an entity that elects the practical expedient package need to separately
assess lease classification for the land in transition to ASC 842 if
it was considered part of a single lease component with a building
under ASC 840?
Answer
No. An entity should not assess lease classification for the land separately upon adopting ASC 842. Rather, the practical expedient package applies to all lease classification determinations appropriately made in accordance with ASC 840.
Changing Lanes
Classification Under ASC 842 May Differ From That Under ASC
840
The impact of this practical expedient will depend on whether an entity’s policies for lease classification under ASC 842 differ from those under ASC 840. The terminology in two of the lease criteria is more principles-based under ASC 842. Specifically, in ASC 842, the FASB substituted the terms (1) “major part” for the 75 percent bright line related to the length of the lease term and (2) “substantially all” for the 90 percent bright line related to the present value of lease payments. However, the Board acknowledged that an entity may use those bright lines to apply the principles. Further, while the lease classification assessment under ASC 842 is performed as of lease commencement, ASC 840 requires entities to determine classification as of lease inception. See Chapters 8 and 9 for more information on how lessees and lessors, respectively, classify a lease under ASC 842, including a description of the changes from ASC 840.
Connecting the Dots
Classification Errors May Not Be Carried Forward
In applying the practical expedient in ASC 842-10-65-1(f)(2), an entity may not
carry forward any previous “errors” (i.e., incorrect lease
classification).
An entity that applies the practical expedient in ASC 842-10-65-1(f)(2) should ensure that its classification of leases under ASC 840 was accurate.
Q&A 16-10 Inception Date Before Effective Date but Commencement
Date After Effective Date
If an entity elects the practical expedient package and therefore retains its ASC 840 lease
classification conclusions up to ASC 842’s effective date, the entity must determine the
appropriate cutoff for contracts that are within the scope of the ASC 840 classification.
Question
For an entity that elects the practical expedient package, if the inception date
of a lease contract (i.e., the date the contract is executed)
precedes the effective date of ASC 842 but the commencement date of
the lease is on or after the effective date of ASC 842, should the
entity carry forward its classification25 conclusion under ASC 840 or apply the ASC 842 classification
criteria as of the commencement date?
Answer
The entity should apply ASC 842 as of the commencement date. In accordance with ASC 842-10-
65-1(f), the practical expedient package applies to “leases that commenced before the effective
date.” Therefore, while an entity may have evaluated classification at the inception of the lease
agreement under ASC 840, such considerations should be disregarded even if the practical
expedient is elected.
Connecting the Dots
Impact of Hindsight on Lease Classification
Considerations
The application (or lack thereof) of hindsight has
no impact on the lease classification considerations when the
practical expedient package is also elected. However, hindsight
would affect measurement for lessees and lessors in situations in
which the exercise (or nonexercise) of options that existed in the
original contracts became reasonably certain before the effective
date.
Q&A 16-11 Classification Date When Practical Expedient
Package Is Not Elected
Question
Upon transition to ASC 842, if a lease commenced
before the date of initial application and an entity did not elect
the practical expedient package, what date should the entity use to
determine lease classification as of the date of initial
application?
Answer
In such cases, the lease should be classified in
accordance with the ASC 842 lease classification criteria and facts
and circumstances as of the later of the (1) lease commencement date
or (2) date the lease was last modified in accordance with ASC 840.
If a lease was renewed or extended before the date of initial
application, the renewal or extension date would be considered the
lease commencement date for this purpose unless the renewal was
assumed to be reasonably certain as of the initial lease
commencement date.
Example
Entity A, a public
calendar-year-end entity, enters into a lease
agreement and obtains the right to use an office
building on June 1, 2013. On June 1, 2016, A and
the lessor modify the terms of the lease to reduce
the leased space and increase the lease payments
on the remaining space to reflect current market
rates. The change to the terms represents a
modification in accordance with ASC 840-10-35-4.
As a public calendar-year-end entity that did not
elect the practical expedient package, A must
determine the appropriate classification of the
lease as of the date of initial application.
Because the lease was modified after lease
commencement, the lease classification assessment
is performed under ASC 842 as of June 1, 2016 (the
ASC 840 modification date).
The Q&A above addresses
the date as of which to assess lease
classification and what inputs should be used as
of the assessment date. The inputs used (e.g.,
lease payments and discount rate) as of the
classification date would not be the same for
measurement of the lease. For example, for an
operating lease that commenced before the date of
initial application, an entity should measure the
lease obligation and ROU asset by using the
remaining lease payments and discount rate that
existed as of the date of initial application.
16.5.2.3 Initial Direct Costs
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. An entity may elect the following practical expedients . . .
3. An entity need not reassess initial direct costs for any existing leases. . . .
This practical expedient permits a company to carry forward previously capitalized initial direct costs under ASC 840, which would be included in the ROU asset. ASC 842 narrows the definition of initial direct costs as follows:
Incremental costs of a lease that would not have been incurred if the lease had not been obtained.
See Section 6.11
for more information on the scope of, and accounting for, initial direct
costs.
16.5.3 Land Easements
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards
Update . . . No. 2016-02, Leases (Topic 842) . . .
gg. 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 as leases under Topic 840 shall not be
eligible for this practical expedient for those land easements. . . .
The FASB received a significant amount of feedback from stakeholders in several
industries who were concerned about the cost and complexity of evaluating all
existing land easements under ASC 842’s definition of a lease at transition. The
Board observed that the costs of requiring an entity to evaluate all existing
land easements under ASC 842’s definition of a lease outweighed the benefits to
financial statement users. Accordingly, the FASB provided transition relief in
the form of a practical expedient. See Section 2.4 for more information about the
scope of, and accounting for, land easements.
An entity that elects the expedient is relieved from applying ASC 842 to
evaluate all existing land easements that were not previously accounted for in
accordance with ASC 840. The FASB explains in paragraph BC15 of ASU 2018-01 that
the historical accounting treatment for existing land easements — when the
expedient is elected — would be “run off” unless or until the arrangement is
modified on or after the date the entity adopts ASU 2016-02.
The transition practical expedient for existing land easements may be elected alone or with any of
the other transition practical expedients. In a manner consistent with the other transition practical
expedients, entities must disclose whether they are electing the transition practical expedient for land
easements.
The effective date of ASU 2018-01 is aligned with that of ASU 2016-02.
Footnotes
24
See footnote 13.
25
Although this Q&A specifically addresses
classification, we believe that the same conclusion would
apply to the entire practical expedient package. For
example, an entity that has elected the practical expedient
package should reassess whether a contract is or contains a
lease (under the ASC 842 definition of a lease) if the lease
commencement date would be on or after the effective date of
ASC 842.