Chapter 16 — Effective Date and Transition

16.2 Considerations Related to Applying Transition Guidance

ASC 842 requires all entities to apply the modified retrospective approach. The determination of lease balances under this approach is generally based on the remaining lease payments and discount rate as of the date of initial application. Under the full retrospective approach (which is not permitted), by contrast, lease balances would be determined as of lease commencement and rolled forward. In addition, an entity may elect various transition-related accounting policies under ASC 842, which could affect its comparability to other entities.

Specifically, ASC 842 offers relief from implementing the transition provisions by permitting an entity (lessee or lessor) to elect not to reassess:

Whether any expired or existing contract is or contains a lease.
The lease classification of any expired or existing leases.
Initial direct costs for any existing leases.

An entity that elects this transition relief (i.e., the “practical expedient package”) is required to adopt all three relief provisions and is prohibited from applying the relief on a lease-by-lease basis. In addition, the entity must disclose that it has elected the practical expedient package. Separately, the entity is also allowed to use hindsight in evaluating the lease term (e.g., renewal, termination, and purchase options for existing leases) and impairment of the ROU asset. As a result, when preparing for transition, entities must consider the following transition and accounting policy elections:

Transition Elections (Entity-Wide for All Leases)	Accounting Policy Elections
Practical expedient package (Section 16.5.2). Lease identification (Section 16.5.2.1). Lease classification (Section 16.5.2.2). Initial direct costs (Section 16.5.2.3). Hindsight (Section 16.5.1). Land easement practical expedient for transition (Section 2.4).	Separation of consideration in the contract between lease and nonlease components by class of underlying asset (Chapter 4). Portfolio approach (Chapters 8 and 9). Short-term lease exemption by class of underlying asset (Chapter 8). Other materiality-influenced judgments. Discount rate (nonpublic entities only) (Chapter 7). Sales taxes and other similar taxes collected from lessees (Chapter 4).

Transition Elections (Entity-Wide for All Leases)

Accounting Policy Elections

Practical expedient package (Section 16.5.2).
- Lease identification (Section 16.5.2.1).
- Lease classification (Section 16.5.2.2).
- Initial direct costs (Section 16.5.2.3).
Hindsight (Section 16.5.1).
Land easement practical expedient for transition (Section 2.4).

Separation of consideration in the contract between lease and nonlease components by class of underlying asset (Chapter 4).
Portfolio approach (Chapters 8 and 9).
Short-term lease exemption by class of underlying asset (Chapter 8).
Other materiality-influenced judgments.
Discount rate (nonpublic entities only) (Chapter 7).
Sales taxes and other similar taxes collected from lessees (Chapter 4).

Connecting the Dots

Considerations Related to Selecting Expedients and Accounting Policies

As companies prepare to implement ASU 2016-02 and assess its impact, the appropriateness to their organization of policies related to practical expedients may continue to evolve. For example, although the practical expedient package may be an efficient manner of adopting the standard, an entity that elects this package may miss the opportunity to reassess whether a lease under ASC 840 would be outside the scope of ASC 842. In addition, some may find the income statement presentation of a finance lease to be more favorable than that of an operating lease and therefore may wish to assess lease classification under ASC 842. We recommend that companies work with various stakeholders at their organizations (e.g., accounting, finance, real estate, and IT professionals, as well as the audit committee) to determine the impact and costs/benefits of the above elections for each stakeholder. Further, companies should consider discussing the impact of the elections with their professional advisers.

Hindsight Expedient May Increase Complexity

While the hindsight practical expedient only applies to lease term and impairment considerations (see Section 16.5.1), we believe that the expedient could make adoption more complex given that both of these matters affect other aspects of lease accounting.

16.3 Lessee

The transition approach for lessees — except for reporting entities that elect, as an accounting policy, to exclude short-term leases4 (see Section 5.2.4.3) — is to recognize all lease obligations and ROU assets on the balance sheet. For leases previously classified as operating under ASC 840, this approach represents a significant change because ASC 840 required that only capital leases be included on the balance sheet. For leases previously classified as a capital lease, the finance lease transition generally carries forward the previous capital lease balances, subject to the application of the practical expedients described in Section 16.5.

16.3.1 Lease Previously Classified as an Operating Lease Under ASC 840

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) . . .

k. A lessee shall initially recognize a right-of-use asset and a lease liability at the application date as determined in (c).

l. Unless, on or after the effective date, the lease is modified (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8) or the lease liability is required to be remeasured in accordance with paragraph 842-20-35-4, a lessee shall measure the lease liability at the present value of the sum of the following, using a discount rate for the lease (which, for entities that are not public business entities, can be a risk-free rate determined in accordance with paragraph 842-20-30-3) established at the application date as determined in (c):

1. The remaining minimum rental payments (as defined under Topic 840).

2. Any amounts probable of being owed by the lessee under a residual value guarantee. . . .

p. If a lessee does not elect the practical expedients described in (f), any unamortized initial direct costs that do not meet the definition of initial direct costs in this Topic shall be written off as an adjustment to equity unless the entity elects the transition method in (c)(1) and the costs were incurred after the beginning of the earliest period presented, in which case those costs shall be written off as an adjustment to earnings in the period the costs were incurred.

q. If a modification to the contractual terms and conditions occurs on or after the effective date, and the modification does not result in a separate contract in accordance with paragraph 842-10-25-8, or the lessee is required to remeasure the lease liability for any reason (see paragraphs 842-20-35-4 through 35-5), the lessee shall follow the requirements in this Topic from the effective date of the modification or the remeasurement date.

Leases previously classified as an operating lease under ASC 840 could be accounted for as either an operating lease or a finance lease under ASC 842. The classification under ASC 842 depends on whether an entity elects the practical expedient package (see Section 16.5.2.2). If so, the entity does not reassess the ASC 840 classification (i.e., the classification is carried forward when the entity adopts ASC 842). However, if the practical expedient package is not elected, the lease must be assessed under the ASC 842 classification criteria. Because there are only minor differences between the lease classification criteria under ASC 840 and those under ASC 842, the lease classification conclusion often will remain unchanged even if the practical expedient package is not elected.

The two transition scenarios for an operating lease under ASC 840 are as follows:

ASC 840 Classification	ASC 842 Classification	Roadmap Section
Operating	Operating	16.3.1.1
Operating	Finance	16.3.1.2

As discussed further below, transition in both of these scenarios is the same with respect to (1) the timing of recognizing the ROU asset and lease liability, (2) the initial measurement of the lease liability, (3) unamortized initial direct costs that do not meet the definition of initial direct costs under ASC 842, and (4) modifications on or after the effective date of ASC 842. Sections 16.3.1.1 and 16.3.1.2 discuss these two scenarios and highlight how the accounting differs between the two with regard to the initial measurement of the ROU asset.

Timing of Recognition

In both scenarios, a lessee recognizes the ROU asset and lease liability at the later of the date of initial application or the commencement date of the lease.

Initial Measurement of the Lease Liability

The lease liability is measured in the same manner regardless of whether lease classification has changed. In both scenarios, the lease liability should represent the present value of the sum of:

The remaining minimum rental payments (as defined under ASC 840).
Any amounts that it is probable the lessee will owe under a residual value guarantee (see Section 6.7 for guidance on how to measure these amounts).

These amounts are measured at their present value by using a discount rate established at the later of (1) the date of initial application or (2) the commencement date of the lease. See Chapter 7 for more information on the identification of the appropriate discount rate.

Q&A 16-1 Identifying Minimum Rental Payments

In the transition to ASC 842, the lease obligation for an operating lease is typically measured by using the remaining minimum rental payments, as described in ASC 840.

Question

What is included in minimum rental payments?

Answer

Although ASC 840 does not define the term “minimum rental payments,” ASC 840-20-50-2 indicates that lessees must disclose future minimum rental payments as of the balance sheet date for operating leases that meet certain conditions:

For operating leases having initial or remaining noncancelable lease terms in excess of one year, the lessee shall disclose both of the following:

Future minimum rental payments required as of the date of the latest balance sheet presented, in the aggregate and for each of the five succeeding fiscal years
The total of minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented. [Emphasis added]

The FASB has confirmed that the intent of requiring, in transition, lessees to measure operating leases by using the ASC 840 minimum rental payments is to ease the burden of determining the lease liability in transition. That is, in referencing the above disclosure under ASC 840, a lessee should be able to determine the gross amounts due under the lease and discount those required payments to determine the initial lease liability under ASC 842. This is consistent with paragraph BC390 of ASU 2016-02, which states that the application of the term “minimum rental payments” should be similar to that under prior guidance.

We have noted diversity in practice related to two aspects of the disclosure of future minimum rental payments under ASC 840:

Lease payments that depend on an index or rate — Some entities have included the most current rate as of the balance sheet date when disclosing future minimum rental payments, whereas other entities have included the rate in effect at the inception of the lease. ASC 840-10-25-4 and 25-5 define what does or does not constitute a minimum lease payment (as opposed to a minimum “rental” payment):
25-4 This guidance addresses what constitutes minimum lease payments under the minimum-lease-payments criterion in paragraph 840-10-25-1(d) from the perspective of the lessee and the lessor. Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety. . . . However, lease payments that depend on an existing index or rate, such as the consumer price index or the prime interest rate, shall be included in minimum lease payments based on the index or rate existing at lease inception; any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and thus affect the determination of income as accruable.
25-5 For a lessee, minimum lease payments comprise the payments that the lessee is obligated to make or can be required to make in connection with the leased property, excluding both of the following:
1. Contingent rentals
2. Any guarantee by the lessee of the lessor’s debt and the lessee’s obligation to pay (apart from the rental payments) executory costs such as insurance, maintenance, and taxes in connection with the leased property. [Emphasis added]
At the 2018 AICPA Conference on Current SEC and PCAOB Developments (the “2018 AICPA Conference”), the SEC staff indicated that either historical approach is acceptable and that an entity may, depending on the facts and circumstances, deviate from its historical policy when measuring its leases as of the date of initial application. See Q&A 16-2 for further discussion of lease payments that fluctuate on the basis of a variable index or rate in the context of transition of a company’s operating leases under ASC 840 to the new leasing guidance under ASC 842.
Executory costs (i.e., insurance, property taxes, and CAM) — Some entities have concluded that executory costs are part of minimum rental payments under ASC 840 and other entities have not. A technical inquiry with the FASB staff has confirmed that either interpretation is acceptable under ASC 840. See Q&A 16-2A for additional information regarding the inclusion or exclusion of executory costs in the determination of a lessee’s lease liability for existing operating leases in transition, including considerations for entities that wish to change their historical approach under ASC 840.

Q&A 16-2 Operating Lease Payments That Fluctuate on the Basis of a Variable Rate or Index — Transition Considerations

In transitioning its operating leases under ASC 840 to the new leasing guidance under ASC 842, a lessee must measure its lease liabilities as of the date of initial application by using the remaining minimum rental payments, as defined in ASC 840. Like ASC 842, ASC 840 contains guidance designed to address variable payments that depend on an index or rate, including how an entity should view these payment mechanisms when determining minimum rental payments for classification and measurement purposes. While ASC 842 is clear on the treatment of variable lease payments that depend on an index or rate, we are aware of diversity in practice related to how such payments have been treated under ASC 840, particularly with respect to the disclosure of future operating lease payments required by ASC 840-20-50-2(a) (commonly referred to as the “lease commitments table”). While ASC 840 appears clear on the treatment of such payments for classification and initial measurement purposes (if applicable), it is less clear on how the lease commitments table should be constructed in the required footnote disclosures. For classification and initial measurement purposes, ASC 840 requires lessees to compute the minimum rental payments on the basis of the index or rate existing at lease inception. However, ASC 840 does not discuss how to determine future lease payments for disclosure purposes, and some entities have used updated index/rate information for this purpose under the belief that the disclosure is primarily a liquidity disclosure and therefore should reflect updated information about an entity’s obligations as of each balance sheet date. Other entities have continued to present future lease payments for disclosure purposes by using the index or rate existing at lease inception.

Question 1

In making the transition to ASC 842, what date should a lessee in an operating lease use to determine the rate or index that it should employ to determine the lease payments that are included in the calculation of the lessee’s lease liability under ASC 842?

Answer

It depends. ASC 842-10-65-1(l) addresses the transition for operating leases and states, in part:

[A] lessee shall measure the lease liability at the present value of the sum of the following, using a discount rate for the lease . . . established at the application date . . .

The remaining minimum rental payments (as defined under Topic 840).
Any amounts probable of being owed by the lessee under a residual value guarantee.

As discussed in paragraph BC390 of ASU 2016-02, the FASB intended for a lessee to effectively “run off” leases existing under ASC 840 upon adopting ASC 842 (i.e., the lessee should use its minimum rental payment table disclosed under ASC 840 as the basis for initially measuring its operating lease liabilities under ASC 842). However, the transition guidance in ASC 842-10-65 is silent on the index or rate that should be used to determine lease payments in transition, other than via the reference to minimum rental payments under ASC 840, which, as described above, has been interpreted differently in practice for purposes other than classification and initial measurement. For this reason, stakeholders have expressed two potential alternatives:

Alternative 1 — Use the index or rate that was employed to calculate the lessee’s minimum lease payments as of lease inception.
Alternative 2 — Use the index or rate existing as of the date of initial application of ASC 842.

At the 2018 AICPA Conference, the SEC staff stated that it would be acceptable for a lessee to use the same approach for initial application as it has historically used for disclosure purposes under ASC 840. In other words, if a lessee used the inception rate for its ASC 840 disclosure, it would be acceptable for the lessee to apply Alternative 1 upon adopting ASC 842. Likewise, if a lessee used an updated index or rate for its ASC 840 disclosure, it would be acceptable for the lessee to apply Alternative 2 upon adopting ASC 842. The SEC staff indicated that it considers the definition of minimum rental payments in ASC 840 — for purposes other than classification and initial measurement — to be ambiguous and that it is therefore acceptable either to use the original index/rate or to update the index/rate for ASC 840 disclosure purposes. The SEC staff also indicated that it views the historical approach related to developing the ASC 840 disclosure as a policy election and therefore would generally expect an entity to apply its chosen approach consistently when making the transition to ASC 842. However, an entity may be able to change its historical approach on the basis of various factors, including the materiality of the historical policy to the overall financial statements, the direction of the change (e.g., changing from inception rate to initial application rate or vice versa), and the basis for making the change. The following are considerations related to each of these factors:

Materiality5 — An entity should first assess the significance of its policy (the use of the inception rate as opposed to an updated rate) in the context of the overall financial statements. We generally believe that an entity can change its historical approach to the extent that the policy is immaterial to the overall financial statements.
Direction of the change — We believe that an entity can change from using an updated rate to using the inception rate when determining its lease liabilities upon adopting ASC 842. A change in this direction is consistent with formal feedback received from the FASB staff regarding the requirements of ASC 840, and many entities have relied on such feedback as part of their implementation processes. Such a change is also more consistent with a literal read of the definition of minimum lease payments in ASC 840. Therefore, we do not believe that an entity would be required to apply the accounting guidance in ASC 250-10 when making such a change. However, we also believe that, under certain circumstances, a company can change from using the inception rate to using an updated rate when determining its lease liabilities upon adopting ASC 842. An entity wishing to do so may be subject to the preferability requirements in ASC 250-10, as discussed in the next bullet.
Basis for the change — If an entity that has historically used the inception rate for its ASC 840 disclosure wishes to change the rate (i.e., wishes to use the rate as of the date of initial application) to determine its lease liabilities upon adopting ASC 842, it may be able to do so if the change is appropriate on the basis of the guidance in ASC 250-10 on accounting changes. In other words, if the historical approach represents a material policy and the entity wants to change its historical treatment, it would be subject to the preferability requirements in ASC 250-10-45-2(b). In this regard, the SEC staff stated in its prepared remarks at the 2018 AICPA Conference that “it would be reasonable for a registrant to consider as part of its Topic 250 analysis, if the lease obligation that results from using current index or rate values represents a better measurement of the registrant’s current lease obligations.” Therefore, we believe that the SEC staff would generally view the use of an updated index/rate as preferable.

The table below summarizes our understanding of the SEC staff’s and FASB staff’s views on whether it is acceptable for an entity to change its historical disclosure approach upon transition to ASC 842 when calculating its initial lease liability under ASC 842.

Historical ASC 840 Disclosure Approach	ASC 842 Transition Approach	Views on Acceptability
Inception rate	Inception rate	SEC staff views as acceptable
Updated rate	Updated rate	SEC staff views as acceptable
Inception rate	Updated rate	Assess preferability6 — SEC staff
Updated rate	Inception rate	FASB staff views as acceptable

Question 2

If an entity changes its accounting policy from using the rate at lease inception to using an updated rate when calculating its lease liability upon adopting ASC 842, must that change be reflected retrospectively in accordance with ASC 250?

Answer

It depends. If the use of an inception rate (as opposed to an updated rate) represents a material accounting policy, the change to an updated rate would need to be preferable and retrospective application would be required in accordance with ASC 250. However, if the policy is not deemed material to the overall financial statements, an entity could make the change without establishing preferability and would not be required7 to reflect the change in prior periods.

As discussed in Question 1, on the basis of prepared remarks by the SEC staff at the 2018 AICPA Conference, we understand that it would generally be preferable to use an updated rate since the use of such a rate results in better information regarding a lessee’s future commitments upon adoption of the new guidance.

Question 3

The discussion above refers to the appropriate rate for an entity to use in making the transition from ASC 840 to ASC 842 for operating lease liabilities. Does an entity’s decision to change its approach (i.e., use a different rate for adoption) affect its recognition of lease liabilities in transition for capital/finance leases?

Answer

It depends. We generally believe that the analysis in Questions 1 and 2 is limited to an entity’s operating lease portfolio and would not affect the measurement of capital/finance lease liabilities in transition. An exception to this rule could arise for entities that do not elect the “practical expedient package” and that have capital leases under ASC 840 that become operating leases under ASC 842.

When the practical expedient package is elected or when classification of a capital lease otherwise remains unchanged upon adoption of ASC 842, we would not expect a change related to the measurement of operating leases to affect the measurement of capital/finance leases. We do not believe that a policy choice (inception rate vs. updated rate) existed for capital leases under ASC 840. ASC 840 is clear on the initial measurement of capital lease liabilities and does not require (or allow) remeasurement for changes in an index/rate. Since the initial measurement of capital lease liabilities is clear and footnote disclosures of total outstanding capital lease liabilities under ASC 840 are tied directly to the balance sheet, there is no ambiguity in the index/rate used to meet the disclosure requirements for capital leases under ASC 840. Furthermore, the transition guidance in ASC 842 for capital/finance leases indicates that they should be recognized at the carrying amount of the lease asset and capital lease liability immediately before adoption (i.e., the balances are simply carried forward).

When the practical expedient package is not elected and the classification of a lease changes from capital to operating, the lessee is required to derecognize the previous capital lease recorded under ASC 840 and record the new operating lease under ASC 842 by measuring an operating lease liability and ROU asset. We believe that, in such circumstances, an entity should measure its lease liability in a manner consistent with its other operating lease liabilities recognized upon transition. In doing so, the entity should consider a change in the index/rate used to measure these liabilities in transition, if applicable.

Q&A 16-2A Approaches to Accounting for Executory Costs for Operating Leases in Transition

Under ASC 840, executory costs include three primary components: (1) property taxes, (2) insurance, and (3) maintenance (e.g., CAM). Since ASC 840 does not distinguish between these three components, a historically acceptable approach has been to fully include executory costs in (or fully exclude them from) disclosures about remaining rental payments provided under ASC 840. However, under ASC 842, maintenance is considered a nonlease component while property taxes and insurance are considered neither a lease component nor a nonlease component; instead, the consideration attributable to property taxes and insurance is allocated to the components in the arrangement.

As described above and further discussed in Q&A 16-1, it was acceptable under ASC 840 for executory costs to be included in or excluded from the disclosure of minimum rental payments for operating leases. Further, the FASB has generally indicated that a lessee (1) would use its ASC 840 disclosure to determine the lease payments when calculating the lease liability upon adopting ASC 842 and (2) would “run off” the balance.8 In addition, at the 2018 AICPA Conference, the SEC staff stated that it “did not object to registrants consistently applying their historical accounting policy regarding the composition of minimum rental payments when concluding whether executory costs should be included in remaining minimum rental payments for purposes of establishing the lease liability in transition.”

However, given the differences in how these costs are treated under ASC 842, questions have arisen about whether it would be acceptable for an entity, upon adopting ASC 842, to treat executory costs differently when calculating the lease liability in transition than it has historically treated the costs for disclosure purposes (e.g., changing from including executory costs in, to excluding them from, the determination of lease payments).

Question 1

Is it acceptable for an entity’s treatment of executory costs to differ from historical practice when the entity is initially measuring the lease liability as part of its transition from ASC 840 to ASC 842?

Answer

It depends. On the basis of remarks made by the SEC staff at the 2018 AICPA Conference, if an entity’s policy on executory costs has a material impact9 on the entity’s financial statements, a change in whether executory costs are included in minimum rental payments meets the definition of an “accounting change” and would be subject to the preferability requirements in ASC 250-10-45-2(b). ASC 250-10-20 defines a “change in accounting principle,” in part, as a “change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply.” Thus, a lessee’s change in the treatment of executory costs as of the effective date of ASC 842 represents a change from its historical policy under ASC 840.

In assessing preferability, an entity must conduct a well-reasoned analysis and should consider, among other factors, the prospective accounting policy of the lessee under ASC 842, including an entity’s election to combine lease and nonlease components. We believe that an entity may elect the practical expedient for either (1) both the existing lease population and new or modified leases or (2) only new or modified leases. For example, if a lessee plans to elect the practical expedient to account for the nonlease components in a contract as part of the single lease component to which they are related under ASC 842 for new or modified leases only (i.e., the entity is not choosing to elect the practical expedient to combine lease and nonlease components for existing leases), this election would generally be a factor supporting the preferability of changing from excluding executory costs from minimum rental payments under ASC 840 to including them under ASC 842 for the existing lease population (see Question 3). We also understand that a change from including executory costs to excluding such costs would be viewed negatively by the SEC staff, and would generally not be preferable, if the change is made solely to reduce the lease liability at transition.

Further, we believe that when an entity makes the transition from ASC 840 to ASC 842 and elects both (1) to change its historical practice related to accounting for executory costs on the basis of the preferability requirement in ASC 250 and (2) the Comparatives Under 840 Option, the change must be applied retrospectively. The change in this historical practice is an elective accounting policy change made on the basis of ASC 250 and is not required by ASC 842. Therefore, the historical financial statement disclosures (i.e., the future minimum rental payments required by ASC 840-20-50-2(a), commonly referred to as the “lease commitments table”) that will be presented when an entity adopts ASC 842 by using the Comparatives Under 840 Option should take into account the accounting change made in accordance with ASC 250.

In summary, when making the transition to ASC 842, a lessee may be allowed to change the approach it has historically used under ASC 840 to include or exclude executory costs. If the existing approach under ASC 840 has a material impact on the financial statements, a change would need to be made on the basis that it is preferable. On the other hand, if an entity’s historical approach related to executory costs does not have a material impact on the financial statements, the entity may change its historical approach under ASC 840 and would not be required to assess preferability. In developing the transition requirements, the FASB expected that a lessee could “run off” its existing minimum rental payments. Therefore, in making the transition to ASC 842, a lessee should consider the following principles in determining its approach related to executory costs:

It was acceptable for an entity to either include executory costs in, or exclude them from, a disclosure of minimum rental payments; therefore, diversity in practice has arisen. Either historical approach would have never affected measurement of operating leases (because of off-balance-sheet treatment under ASC 840), and the historical policy may have never been material to the financial statement disclosures.
If the inclusion (exclusion) of executory costs does not have a material impact on the financial statements, a lessee may change its treatment of executory costs before or upon adopting ASC 842 without assessing preferability and would not be required10 to reflect the ASC 840 policy change in prior periods, since those periods would continue to be presented under ASC 840 if the entity is electing the Comparatives Under 840 Option. If a lessee has explicitly disclosed in its financial statements its approach for including (excluding) executory costs under ASC 840, such disclosure may be an indication that the policy is material.
As discussed above, a choice between two acceptable methods of presenting disclosure information is an accounting principle for which a change in method must be preferable under ASC 250-10-45-11 through 45-13 if an entity’s policy on executory costs has a material impact on its financial statements. This change must be retrospectively applied to all periods presented under ASC 840. Practically, the only impact of retrospective application should be a revision of the lease commitments table disclosure for the year ended immediately before the date of initial application. This historical table must be included again in the financial statements (quarterly and annual) in the year of adoption if the Comparatives Under 840 Option is elected.

Question 2

When making the transition from ASC 840 to ASC 842, how should an entity treat executory costs if the entity elects, as a practical expedient, to combine lease and nonlease components for existing leases at transition?

Answer

A lessee may elect, as an accounting policy for each underlying asset class,11 not to separate lease and nonlease components (including executory costs) on the effective date. We believe that a lessee may elect such a policy for both the existing lease population and new or modified leases, since the lessee may prefer comparability and consistent application for all leases regardless of whether they commenced before the effective date.

The guidance on the practical expedient under which a lessee may elect not to separate lease and nonlease components is silent on the treatment of noncomponents in a contract (i.e., executory costs such as property taxes and insurance). Specifically, ASC 842-10-15-37 only discusses lease and nonlease components, stating the following:

As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.

When the practical expedient is elected, any portion of the consideration in the contract that would otherwise be allocated to the nonlease components is instead accounted for as part of the related lease component for classification, recognition, and measurement purposes. In addition, any payments related to noncomponents would be accounted for as part of the related lease component (i.e., the associated payments would not be allocated between the lease and nonlease components since they are all treated as a single lease component). Therefore, an entity electing the practical expedient would do so for both the nonlease components and noncomponents of the contract (e.g., executory costs). An entity that elects this accounting policy for existing leases would therefore account for all executory costs as part of its lease payments, regardless of whether the entity had included or excluded executory costs when determining the minimum rental payments (i.e., the “lease commitments table”) under ASC 840.

As discussed in Question 1, the SEC staff indicated in prepared remarks at the 2018 AICPA Conference that a change in whether executory costs are included in minimum rental payments meets the definition of a “change in accounting principle,” and would be subject to the preferability requirements in ASC 250-10-45-2(b), if an entity’s policy on executory costs has a material impact on its financial statements. However, we do not believe that the same requirement would apply when an entity elects the practical expedient to combine lease and nonlease components, including noncomponents of a contract (e.g., executory costs), for existing leases at transition. The question raised to the SEC staff that it discussed at the 2018 AICPA Conference involved a registrant’s ability to change its treatment of executory costs but was not premised on the election of the practical expedient. We believe that an entity can elect to apply the practical expedient in transition to all existing leases, regardless of the entity’s prior treatment of executory costs, without being subject to the preferability requirement in ASC 250-10-45-2(b).

Question 3

Answer

As discussed in Question 2, a lessee may elect, as an accounting policy for each underlying asset class, not to separate lease and nonlease components (including executory costs) on the effective date. We believe that the lessee may elect such a policy for either (1) both the existing lease population and new or modified leases or (2) only new or modified leases. With respect to new or modified leases, this election only applies to those that commence or are modified on or after the effective date of ASC 842. When this election is made for new or modified leases only, a lessee that has historically excluded executory costs from its minimum rental payment disclosures under ASC 840 may be able to change to including executory costs under ASC 842 for the existing lease population, as described below.

As discussed in Question 1, the SEC staff indicated in prepared remarks at the 2018 AICPA Conference that a change in whether executory costs are included in “minimum rental payments” meets the definition of a “change in accounting principle,” and would be subject to the preferability requirements in ASC 250-10-45-2(b), if an entity’s policy on executory costs has a material impact on its financial statements. We believe that this requirement would apply when an entity does not elect the practical expedient to combine lease and nonlease components, including noncomponents of a contract (e.g., executory costs), for the existing lease population at transition (i.e., the entity elects the practical expedient for new or modified leases only) but wishes to change from excluding executory costs under ASC 840 to including executory costs when determining the opening lease liability under ASC 842. See Question 4 below for considerations that may be relevant to the evaluation of preferability. As discussed in Question 2, if the entity had elected to apply the practical expedient in transition to all existing leases, a change regarding the entity’s prior treatment of executory costs would not be subject to the preferability requirement in ASC 250-10-45-2(b).

Question 4

In what situations is it appropriate for an entity to change its ASC 840 disclosure approach for executory costs for existing leases at transition?

Answer

We do not believe that it would be appropriate (depending on the materiality of the impact under ASC 840) for a lessee to change its ASC 840 disclosure approach for executory costs, as discussed in Question 1, in a manner that reduces comparability to its ASC 842 accounting, including the impact of the lessee’s election to include or exclude nonlease components.

We expect that one of the scenarios below will apply to an entity that wishes to change its disclosure approach for executory costs in transition. We further expand on whether we believe it may be appropriate for an entity to change its ASC 840 disclosure approach for existing leases at transition, depending on the scenario.

Scenario 1 — An entity historically excluded executory costs from its minimum rental payment disclosures under ASC 840 but intends to elect the practical expedient related to combining lease and nonlease components for new or modified leases only (see Question 3). The entity may prefer to change from excluding executory costs under ASC 840 to including them under ASC 842 for the existing lease population. Such an entity will be subject to the preferability determination discussed in Question 1 if the inclusion/exclusion of executory costs under ASC 840 has a material impact on the financial statements.
Scenario 2 — An entity historically excluded executory costs from its minimum rental payment disclosures under ASC 840 and intends to elect the practical expedient to combine lease and nonlease components for both existing and new or modified leases. The entity will then include nonlease components under ASC 842 in the calculation of the lease liability for the existing lease population at transition. Such an entity will not be subject to the preferability determination, as discussed in Question 2, when the entity elects the practical expedient to combine lease and nonlease components, including noncomponents of a contract (e.g., executory costs), for existing leases at transition.
Scenario 3 — An entity historically included executory costs in its minimum rental payment disclosures under ASC 840 and does not intend to elect the practical expedient to combine lease and nonlease components for new or existing leases. The entity wishes to exclude executory costs for existing leases when initially calculating its lease liability upon adopting ASC 842. Such an entity will be subject to the preferability determination discussed in Question 1 if the inclusion/exclusion of executory costs under ASC 840 has a material impact on the financial statements. An entity in this scenario should also contemplate the makeup of the executory costs under ASC 840 as follows:
- Scenario 3A — The entity’s executory costs under ASC 840 predominantly consist of maintenance costs, which are considered a nonlease component under ASC 842. In this situation, changing from including executory costs under ASC 840 to excluding executory costs in the transition to ASC 842 generally enhances comparability between existing and new or modified leases.
- Scenario 3B — The entity’s executory costs under ASC 840 predominantly consist of property taxes and insurance (i.e., noncomponents under ASC 842). In this situation, changing from including executory costs under ASC 840 to excluding executory costs in the transition to ASC 842 generally does not enhance comparability between existing and new or modified leases.

Achieving perfect comparability between ASC 840 and ASC 842 may be difficult (unless all lease and nonlease components are combined for new and existing leases) because “executory costs” is an ASC 840 concept and the components of executory costs are characterized differently under ASC 842, as described above. In the above scenarios, the entity’s treatment of costs for property taxes, insurance, and maintenance upon adoption of ASC 842 changes from the historical treatment under ASC 840. We believe that such a change should enhance comparability between ASC 840 and ASC 842, as illustrated in Scenarios 1, 2, and 3A above. Scenario 3B will not enhance comparability since property taxes and insurance (i.e., noncomponents) are greater than maintenance. Therefore, when assessing preferability, lessees should carefully consider the significance of property taxes and insurance compared with that of maintenance.

As indicated above, we do not believe that it would be appropriate for an entity to change its ASC 840 disclosure approach in a manner that reduces comparability to its ASC 842 election to include or exclude nonlease components. Consider the following additional scenario in which comparability is not enhanced:

Scenario 4 — An entity historically included executory costs in its minimum rental payment disclosures under ASC 840 and intends to elect the practical expedient to combine lease and nonlease components for new or modified leases. The entity wishes to change its treatment to exclude executory costs when initially calculating its lease liability upon adopting ASC 842 for the existing lease population. An entity electing to do so would be subject to the preferability determination, as discussed in Question 1, if the inclusion/exclusion of executory costs under ASC 840 has a material impact on the financial statements. However, we believe that it would be inappropriate for such an entity to change its treatment of executory costs for existing leases upon adoption of ASC 842, since doing so would reduce comparability between ASC 840 and ASC 842.

The table below summarizes whether (1) the scenarios above enhance comparability between the disclosure approach under ASC 840 and the measurement approach under ASC 842; (2) an entity in these scenarios is required to determine preferability under ASC 250 to change its historical approach of accounting for costs related to property taxes, insurance, and maintenance; and (3) the change in treatment of such costs is appropriate.

	Enhances Comparability?	Preferability Determination Required Under ASC 250?12	Change in Treatment of Executory Costs Appropriate?13
Scenario 1	Yes	Yes	Generally yes, subject to a well-reasoned preferability analysis
Scenario 2	Yes	No	Yes
Scenario 3A	Yes	Yes	Generally yes, subject to a well-reasoned preferability analysis
Scenario 3B	No	Yes	Generally no
Scenario 4	No	Yes	Generally no

Because executory costs are characterized differently under ASC 840 than they are under ASC 842, the following are generally true:

The lease liability in a gross lease of real estate that excludes executory costs under ASC 840, and for which the lessee elects to separate nonlease components, will be lower if the lease commences before the effective date of ASC 842 than it will if the lease commences on or after the effective date of ASC 842. The reason for the lower liability in this case is that property taxes and insurance would be excluded under ASC 840 but would be allocated primarily (or totally) to the lease component under ASC 842.
Conversely, the lease liability in a gross lease of real estate that includes executory costs under ASC 840, and for which the lessee elects to separate nonlease components, will be higher if the lease commences before the effective date of ASC 842 than it will if the lease commences on or after the effective date of ASC 842. The reason for the higher liability in this case is that maintenance would be included under ASC 840 but would represent a nonlease component under ASC 842.
The chosen approach for including or excluding executory costs under ASC 840 in a triple net lease should not have a significant impact, because the executory costs are typically variable (and reimbursed, or paid directly, by the lessee) and therefore are not included in the minimum rental payments.

Q&A 16-2B Determining the Lease Term at Transition

On January 1, 2010, Company W enters into a lease that includes a noncancelable period of 10 years with two, five-year renewal options. At lease inception, the lease term is determined to be 10 years. In 2016, W completes significant leasehold improvements and, as a result, it is reasonably certain that W will exercise the first five-year renewal option. Under ASC 840, the installment of leasehold improvements does not trigger a reassessment of the lease term. Company W has elected the Comparatives Under 840 Option (see Section 16.1.1), and its ASC 842 adoption date is January 1, 2019; however, W has not elected the “use-of-hindsight” practical expedient.

Question

How should W determine the lease term at transition?

Answer

Because W did not elect the use-of-hindsight practical expedient, it would be inappropriate for W to reconsider the remaining lease term at transition. Although the addition of leasehold improvements would be a reassessment event under ASC 842-10, the renewal options should not be reassessed since the event occurred before the ASC 842 adoption date. Rather, W would determine the ROU asset and lease liability on the basis of the remaining minimum rental payments for the remaining term, as was determined under ASC 840 (i.e., the lease term at transition would be the one year that is remaining in the original lease term).

This conclusion is supported by the fact that the FASB’s overall objective with transition is to allow lessees to run off their existing leases by using the assumptions that were in place under ASC 840. For this reason, the “remaining minimum rental payments” under ASC 840 are used to initially measure the lease liability in transition (the amounts that are included in the lease commitments table). This is consistent with the discussion in paragraph BC390 of ASU 2016-02, which states, in part:

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 Subtopic 842-30[14] on or after the effective date. To ensure that the financial statements provide relevant and reliable financial information, lessees and lessors should apply the subsequent measurement guidance in Topic 842 beginning on the effective date. For lessees, this includes the subsequent measurement guidance in Subtopic 842-30[15] on lease term and purchase option reassessments and assessing impairment of right-of-use assets. [Emphasis added]

Paragraph BC390 of ASU 2016-02 highlights that transition is designed to allow entities to “run off” their legacy leases unless there is (1) a modification or (2) a liability remeasurement event on or after the effective date of ASC 842. We believe that this conclusion would also apply to the determination of lease term. Therefore, it does not appear appropriate to revise the lease term to reflect events or changes in facts and circumstances that occurred before the application date of ASC 842. On the other hand, if an entity elects the use-of-hindsight practical expedient, the lease term (and assessment of impairment) should be evaluated by using facts and circumstances up to the effective date of the standard. (See Section 16.5.1 for discussion of the use-of-hindsight practical expedient.) We do not believe that the determination of lease term, as discussed above, would be affected by whether the entity elected the practical expedient package. (See Section 16.5.2 for more information about the practical expedient package.) For example, if the practical expedient package is not elected, an entity is required to reassess, upon transition, (1) lease classification, (2) whether a contract is or contains a lease, and (3) initial direct costs. In performing this reassessment, an entity would not reevaluate the lease term unless it elects the use-of-hindsight practical expedient. Likewise, if an entity elects the practical expedient package, the lease term would not be reassessed unless the use-of-hindsight practical expedient is elected.

Connecting the Dots

Hindsight Impact Related to Lease Term and Liability Measurement (Lease Classified as an Operating Lease Under ASC 840)

The measurement of the lease liability is affected by the identification of the lease term. If a lessee elects the hindsight practical expedient, any changes to expectations regarding renewals during the comparative period should be reflected in the measurement of the lease liability as of the date of initial application or at lease commencement, if later. (See Section 16.5.1 for more information on the hindsight practical expedient.) Further, an entity must identify the amounts that it is probable will be owed under a residual value guarantee as of the later of the date of initial application or the lease commencement date. This amount should be measured on the basis of the facts and circumstances as of that date, which should include the impact of any change in lease term.

Q&A 16-2C Transition for Leasehold Improvements With Amortization Period Greater Than Remaining Lease Term

In some cases under ASC 840, leasehold improvements installed significantly after lease inception or acquired in a business combination can have an amortization period greater than the remaining lease term. As a result, questions have arisen about whether the amortization period for such leasehold improvements existing as of the date of initial application of ASC 842, when that period is greater than the remaining lease term, should be retained or whether it should be updated to align with the “lease term,” as defined under ASC 842.

ASC 840-10-35-6 states:

Leasehold improvements in operating leases that are placed in service significantly after and not contemplated at or near the beginning of the lease term shall be amortized over the shorter of the following terms:

The useful life of the assets
A term that includes required lease periods and renewals that are deemed to be reasonably assured (as used in the context of the definition of lease term) at the date the leasehold improvements are purchased. [Emphasis added]

In addition, ASC 840-10-35-9 states:

Paragraph 805-20-35-6 requires that leasehold improvements acquired in a business combination or an acquisition by a not-for-profit entity be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are deemed to be reasonably assured (as used in the definition of [the] lease term) at the date of acquisition. [Emphasis added]

The above guidance suggests that the period for amortization of certain leasehold improvements under ASC 840 could differ from the “lease term” used for lease classification and disclosure of remaining rental payments. That is, notwithstanding the requirement to determine the appropriate amortization period for leasehold improvements (1) placed in service significantly after the beginning of the lease term or (2) acquired in a business combination, ASC 840 does not permit lessees to reassess the lease term related to accounting for the lease itself.

Upon the adoption of ASC 842, the above guidance is superseded.

Example

Company X, a public company with a calendar-year-end, acquires 100 store leases as part of a business combination transaction on January 1, 2018. The acquiree’s remaining lease term immediately before the transaction is three years, which represents the remaining noncancelable term of the lease and excludes one lease renewal option of five years (exercise of the option was originally determined not to be reasonably assured as of lease inception). However, upon acquiring the store leases in a business combination, X determines that the exercise of the five-year renewal option is reasonably assured. The lease does not transfer ownership of the leased stores to X at the end of the lease term, and X does not have the option of purchasing the stores. The leases are classified as operating leases under ASC 840.

In accordance with ASC 840-10-25-27, X did not revisit the lease term and classification of the store leases acquired in the business combination. Therefore, X considers the remaining lease term of the 100 store leases to be three years (i.e., X continues to exclude the five-year renewal option from the lease term, even though exercise of the renewal option is now reasonably assured).

Each of the stores also includes certain leasehold improvements that have a useful life of 10 years. In determining the amortization period of the leasehold improvements, X concludes that the renewal is reasonably assured. In accordance with ASC 840-10-35-9, X determines that the amortization period for the acquired leasehold improvements should be eight years, because this period represents the lesser of (1) the useful life of the improvements (10 years) or (2) eight years (i.e., the remaining noncancelable lease term of three years plus the five-year renewal option whose exercise is deemed reasonably assured as of the acquisition date).

On January 1, 2019, X adopts ASC 842 by using the “Comparatives Under 840 Option” transition method (i.e., elects not to restate comparative periods under ASC 842). Company X elects the “package of three” practical expedients in ASC 842-10-65-1(f) and therefore does not reassess the lease classification of its existing leases, including the 100 store leases acquired on January 1, 2018. However, X does not elect the hindsight practical expedient in ASC 842-10-65-1(g) related to reassessing the lease term.

Question

Upon adopting ASC 842, over what period should X amortize the leasehold improvements related to the 100 store leases previously acquired in the business combination?

Answer

ASC 842-20-35-12 states:

Leasehold improvements shall be amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which case the lessee shall amortize the leasehold improvements to the end of their useful life.

Further, ASC 842-20-35-13 states:

Leasehold improvements acquired in a business combination or an acquisition by a not-for-profit entity shall be amortized over the shorter of the useful life of the assets and the remaining lease term at the date of acquisition.

Under ASC 842 (after transition), any leasehold improvements installed after commencement or purchased in a business combination would be reassessed in conjunction with a reassessment of the lease term used for measuring the lease. That is, there will be no disconnect between the “lease term” for measuring the lease and the amortization period for leasehold improvements arising after the initial application of ASC 842, because both are reassessed. However, since lease term is not reassessed under ASC 840, it is less clear whether the previous amortization periods should be conformed to the remaining lease term used for measuring the lease liability in transition. The following two approaches have emerged:

Approach A — Under this approach, X should retain the amortization period in place at the time of adoption. We do not believe that the FASB intended to shorten the amortization period of leasehold improvements in situations in which a lessee elects not to apply hindsight in determining the lease term upon adopting ASC 842. Further, use of the amortization period already in place at the time of adoption better reflects the economics of the arrangement and the fact that the leasehold improvements will continue to be used for a period longer than the remaining lease term under ASC 842; therefore, under this approach, it is acceptable to use the longer amortization period of seven years.
Approach B — Under this approach, X should shorten the amortization period as of the date of initial application of ASC 842 so that it is aligned with the remaining lease term for measuring the lease, because only a single remaining lease term is contemplated in ASC 842-20-35-12. Therefore, if X uses this approach, upon adopting ASC 842, it would shorten the amortization period of the leasehold improvements to align it with the remaining lease term.16

In the example above, because X did not elect the hindsight practical expedient, the remaining lease term upon the adoption of ASC 842 is two years (i.e., three years as of the date of the business combination less one year that has passed before the adoption of ASC 842). We believe that because ASC 842-10-65-1 does not specifically address amortization of leasehold improvements, a lessee applying Approach B may recognize a cumulative-effect adjustment to retained earnings for the change in amortization period. In the example above, X amortized one-eighth of the leasehold improvements as of the effective date of ASC 842, but if the amortization period would have always been consistent with the three-year remaining lease term at the time of the business combination, one-third of the leasehold improvements would have been amortized before the effective date.

We believe that either of the above approaches is acceptable, provided that it is applied consistently as an accounting policy.

Q&A 16-3 Discount Rate Considerations in Transition

In transition, the present value of the lease liability is determined by using a discount rate “established at the application date.”

Question

On what date should entities identify the discount rate applied to measure the minimum rental payments used in the lease liability?

Answer

The discount rate (generally, for the lessee, its incremental borrowing rate) used to measure the lease liability is established as of the later of the (1) date of initial application or (2) commencement date of the lease. This has been consistently interpreted as meaning that a lessee should use the interest rate environment as of the appropriate later-of date. Factors that affect the interest rate environment include, but are not limited to, the credit standing of the lessee and the economic environment on the initial measurement date (see Chapter 7 for additional information on determining the appropriate discount rate). However, an incremental borrowing rate is also affected by the lease term (i.e., the length of the borrowing) and the lease payments (i.e., how much is being borrowed). Questions have arisen about whether (1) the original lease term and lease payments should be determined and incorporated into the discount rate calculation or (2) those inputs should be determined as of the same date on which the interest rate environment is considered (i.e., whether the remaining lease term and lease payments should be considered).

On the basis of a technical inquiry with the FASB staff, we believe that either approach is acceptable as an accounting policy choice. Although the lease term and lease payments should be higher under approach 1 (resulting in a higher discount rate), we expect that the information an entity needs to apply approach 2 will be more readily available. In addition, the SEC staff confirmed this position at the 2017 AICPA Conference on Current SEC and PCAOB Developments, stating that “the selection of either of these rates, that is either the rate based on the original lease term or the remaining lease term, is reasonable” and that the staff “ultimately did not object to a registrant’s consistent application of either approach to determine the lessee’s lease liabilities in transition.”

Connecting the Dots

Hindsight Impact on Discount Rate

When hindsight is applied, any impact on the lease term will indirectly affect the discount rate (e.g., a longer term will generally result in a higher discount rate). As discussed above, an entity must also consider the credit standing of the lessee, the nature and quality of the security provided, and the economic environment in which the transaction occurs. Because these factors are unrelated to the lease term, we do not believe that an entity can elect to apply hindsight when evaluating them.

Unamortized Initial Direct Costs Not Capitalized Under ASC 842

The accounting for initial direct costs when the practical expedient package is not elected is the same regardless of whether classification changes upon an entity’s adoption of ASC 842. ASC 842 reduces the types (and therefore amounts) of costs that qualify as initial direct costs. As discussed in Section 16.5.2.3, lessees that elect the practical expedient package do not need to reassess previously capitalized initial direct costs. However, if the practical expedient package is not elected, previously capitalized initial direct costs that no longer meet the definition of initial direct costs under ASC 842 must be accounted for as follows:

Any costs incurred before the date of initial application should be recognized as an adjustment to equity.
Any costs incurred on or after the date of initial application should be recognized in earnings for the respective comparative period under ASC 842, if applicable.

Modifications and Reassessment of Lease Liability in Comparative Periods (Only Applicable if the Comparatives Under 840 Option Is Not Elected)

The transition guidance is clear that the provisions of ASC 842 should be applied to modifications on or after the effective date as well as to any reassessments of the lease liability (see Section 8.5). However, the guidance is less clear on the framework for modifications and potential reassessments that occur during the transition period. Entities may therefore encounter significant complexities in transition, since the modification and reassessment guidance in ASC 842 significantly differs from that in ASC 840. For leases previously classified as operating leases under ASC 840, the transition paragraphs ASC 842-10-65-1(k)–(q) do not mention modifications or reassessments during the transition period. However, the transition guidance for capital leases does provide some insight into the potential framework. Specifically, ASC 842-10-65-1(r)(4) indicates that if a capital lease under ASC 840 is classified as a finance lease under ASC 842 (i.e., classification did not change), the lease should be subsequently measured in accordance with ASC 840 during the transition period. In contrast, ASC 842-10-65-1(s)(4) stipulates that if a capital lease under ASC 840 is classified as an operating lease under ASC 842 (i.e., classification changed), the lease should be subsequently measured under ASC 842 during the transition period.

On the basis of these insights, we believe that the modification and reassessment guidance should generally be governed by whether lease classification changes when an entity adopts ASC 842. That is, if lease classification changes upon the adoption of ASC 842 (which can only occur if the practical expedient package is not elected), an entity should apply ASC 842 modification and reassessment guidance throughout the transition period. However, if lease classification does not change upon the adoption of ASC 842 (irrespective of whether the practical expedient package was elected), an entity should apply ASC 840’s guidance on modifications and reassessment.

We note that there is no “measurement” guidance in ASC 840 for operating leases because they are off-balance-sheet. Therefore, although an entity would apply the ASC 840 modification guidance to determine whether lease classification has changed, the general ASC 842 measurement principles would be applied to the revised lease payments. That is, unless lease classification changes as of the earliest period presented (e.g., a company that does not elect the practical expedient package and has a lease whose classification changes from operating to finance), this framework creates a mixed model in transition. The lease classification and impact on the income statement during transition is governed by previous ASC 840 treatment. However, the balance sheet is governed by the ASC 842 measurement principles applied to the minimum rental payments, as described in Q&A 16-1.

16.3.1.1 Lease Is an Operating Lease Under ASC 840 and ASC 842

The graphic below outlines the steps lessees should perform in transition for leases that were previously classified as operating leases and that are considered operating leases under ASC 842 because either (1) an entity elected the practical expedient package and therefore would not reassess lease classification or (2) classification was assessed in transition to ASC 842 and the lease retains its classification as an operating lease. In this transition scenario (i.e., operating lease classification was retained), the election of the practical expedient package only affects the amounts that qualify as initial direct costs for inclusion in the ROU asset.

Example 29 from ASC 842 illustrates the measurement of the lease liability and ROU asset in transition.

ASC 842-10

Illustration of Lessee Transition — Existing Operating Lease

55-248 Example 29 illustrates lessee accounting for the transition of existing operating leases when an entity elects the transition method in paragraph 842-10-65-1(c)(1).

Example 29 — Lessee Transition — Existing Operating Lease

55-249 The effective date of the guidance in this Topic for Lessee is January 1, 20X4. Lessee enters into a five-year lease of an asset on January 1, 20X1, with annual lease payments payable at the end of each year. Lessee accounts for the lease as an operating lease. At lease commencement, Lessee defers initial direct costs of $500, which will be amortized over the lease term. On January 1, 20X2 (and before transition adjustments), Lessee has an accrued rent liability of $1,200 for the lease, reflecting rent that was previously recognized as an expense but was not yet paid as of that date. Four lease payments (1 payment of $31,000 followed by 3 payments of $33,000) and unamortized initial direct costs of $400 remain.

55-250 January 1, 20X2 is the beginning of the earliest comparative period presented in the financial statements in which Lessee first applies the guidance in this Topic. On January 1, 20X2, Lessee’s incremental borrowing rate is 6 percent. Lessee has elected the package of practical expedients in paragraph 842-10-65-1(f). As such, Lessee accounts for the lease as an operating lease, without reassessing whether the contract contains a lease or whether classification of the lease would be different in accordance with this Topic. Lessee also does not reassess whether the unamortized initial direct costs on January 1, 20X2, would have met the definition of initial direct costs in this Topic at lease commencement.

55-251 On January 1, 20X2, Lessee measures the lease liability at $112,462, which is the present value of 1 payment of $31,000 and 3 payments of $33,000 discounted using the rate of 6 percent. The right-of-use asset is equal to the lease liability before adjustment for accrued rent and unamortized initial direct costs, which were not reassessed because Lessee elected the practical expedients in paragraph 842-10-65-1(f).

55-252 On January 1, 20X2, Lessee recognizes a lease liability of $112,462 and a right-of-use asset of $111,662 ($112,462 – $1,200 + $400).

55-253 From the transition date (January 1, 20X2) on, Lessee will continue to measure and recognize the lease liability at the present value of the sum of the remaining minimum rental payments (as that term was applied under Topic 840) and the right-of-use asset in accordance with this Topic.

55-254 Beginning on the effective date of January 1, 20X4, Lessee applies the subsequent measurement guidance in Section 842-20-35, including the reassessment requirements.

The following is a summary of the steps a lessee would perform in calculating the lease liability and the ROU asset in the scenario above:

Step 1: Measure the Lease Liability as of the Earliest Period Presented

Step 2: Measure the ROU Asset

Lease liability – accrued rent + unamortized initial direct costs

$112,462 – $1,200 + 400 = $111,662

Step 3: Record the Journal Entries

16.3.1.1.1 Lease Is an Operating Lease Under ASC 840 and ASC 842 — Initial Measurement of Lease Liability

In transition, when a lease is an operating lease under ASC 840 and ASC 842, the lease liability is calculated as the present value of the minimum rental payments and expected payment under any residual value guarantee discounted by the rate determined at the later of the date of initial application or the lease commencement date.

16.3.1.1.2 Lease Is an Operating Lease Under ASC 840 and ASC 842 — Initial Measurement of ROU Asset

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) . . .

m. For each lease classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3, a lessee shall initially measure the right-of-use asset at the initial measurement of the lease liability adjusted for both of the following:

1. The items in paragraph 842-20-35-3(b), as applicable.

2. The carrying amount of any liability recognized in accordance with Topic 420 on exit or disposal cost obligations for the lease. . . .

In transition, when a lease is an operating lease under ASC 840 and ASC 842, the ROU asset is calculated as follows:

The sum of:
- The lease liability calculated in accordance with the guidance in Section 16.3.1.1.1.
- Prepaid rent (i.e., any amounts prepaid but not yet expensed under ASC 840).
- Unamortized initial direct costs — after consideration of whether the practical expedient package is applied in the manner described in Section 16.5.2.3.
Less the sum of:
- Accrued rent (i.e., any amounts previously recognized under ASC 840 but not yet paid).
- Lease incentives (i.e., recorded and not yet expensed in accordance with ASC 840-20-25-6 and 25-7).
- Impairment (as described below).
- The carrying amount of any ASC 420 liability (as described below).

Q&A 16-3A Initial Measurement in Transition of an Operating Lease When the ROU Asset Would Be Reduced Below Zero Because of Accrued Rent

In the transition to ASC 842, the ROU asset is measured at the amount of the lease liability adjusted by (1) accrued or prepaid rents, (2) remaining unamortized initial direct costs and lease incentives, (3) impairments of the ROU asset, and (4) the carrying amount of any liability recognized under ASC 420. An accrued rent balance would have been established when escalating lease payments are present for a portion of the lease term (e.g., fixed lease payments in early years are lower than those in later years). In a long-term lease with escalating lease payments (e.g., a 40-year ground lease), the accrued rent balance can be greater than the lease liability balance as of the date of initial application. Therefore, if the full amount of the accrued rent were applied against the lease liability, the ROU asset in transition would be negative (i.e., the measurement exercise described in ASC 842-10-65-1(m) would yield an amount below zero).

Question

When applying the transition guidance related to an operating lease, how should a lessee account for the ROU asset when the accrued rent balance is greater than the lease liability as of the date of initial application?

Answer

We believe that when the ROU asset would be reduced below zero because the accrued rent balance is greater than the lease liability, the ROU asset should be reclassified and presented as a liability as of the date of initial application. This presentation would be retained until the balance of the ROU asset returns to a positive amount, at which point the balance should be presented as an ROU asset rather than as a liability. We think that this approach is appropriate because we do not believe that it is appropriate to present a negative ROU asset, thereby offsetting other positive ROU assets. Similarly, we do not believe that it would be appropriate to adjust the discount rate (i.e., impute a lower discount rate) in these situations to “solve” for this problem (i.e., disallow the ROU asset from becoming negative). See Section 8.4.3.2.1 for a discussion of accrued rent balances that would result in a negative ROU asset after the date of initial application (which could apply to leases that commenced before or after the adoption date), along with a discussion of the subsequent accounting and an illustrative example.

Impairment

The ROU asset should initially be measured net of impairment. However, several implementation questions have arisen regarding how impairment should be measured during the transition period, if at all, because the ROU asset will generally be included with other assets in a preexisting asset group. On the basis of the Q&As below, an entity is generally not required to consider the ROU asset separately for impairment in the comparative periods presented under ASC 842, if applicable. See also Section 16.5.1.2 for a discussion of the impact of electing the hindsight practical expedient.

Q&A 16-4 Reallocating Prior Impairment Losses Within an Asset Group

ASC 360 provides guidance on identifying, recognizing, and measuring an impairment of a long-lived asset or asset group that is held and used. Under the ASC 360 impairment testing model, a lessee is required to test a long-lived asset (asset group) for impairment when impairment indicators are present. Under this testing approach, a lessee would be required to test the asset (asset group) for recoverability and, when necessary, recognize an impairment loss that is calculated as the difference between the carrying amount and the fair value of the asset (asset group).

A lessee must subject an ROU asset to impairment testing in a manner consistent with its treatment of other long-lived assets (i.e., in accordance with ASC 360). Also, upon transition, a lessee is required to include any associated impairment losses in its initial measurement of an ROU asset (see Q&A 16-4A).

If the ROU asset related to an operating lease is impaired, the lessee would amortize the remaining ROU asset in accordance with the subsequent-measurement guidance that applies to finance leases — typically, on a straight-line basis over the remaining lease term. Thus, the operating lease would no longer qualify for the straight-line treatment of total lease expense. However, in periods after the impairment, a lessee would continue to present the ROU asset amortization and interest expense together as a single line item.

Question

Upon transition to ASC 842, is a lessee required to reallocate prior impairment losses of an asset group to the ROU asset?

Answer

No. An ROU asset will typically be added to a preexisting asset group under ASC 360. However, the effect of recognizing an ROU asset on an asset group’s allocation of a prior impairment loss is an indirect effect of a change in accounting principle. In accordance with ASC 250-10-45-3 and ASC 250-10-45-8, indirect effects of a change in accounting principle should not be recognized.

At the FASB’s November 30, 2016, meeting, the Board indicated that on the effective date of ASC 842 and in all comparative periods presented under ASC 842 (if applicable), a lessee should not revisit prior impairment loss allocations within the asset group. In addition, the Board indicated that a lessee should not include in the initial measurement of an ROU asset at transition any allocation of prior impairment losses recognized within the asset group. Therefore, lessees should not revisit any impairment losses that were allocated to the asset group before the effective date of the standard regardless of whether an impairment loss was recognized in a comparative period.

Q&A 16-4A Accounting for Impairment (Including “Hidden” Impairments) Upon Adoption of ASC 842

Questions have arisen regarding whether the guidance in Q&A 16-4 implies that a lessee may never recognize an impairment related to a newly created ROU asset as an adjustment to equity upon adopting ASC 842. That is, because operating leases were not previously subject to an impairment test under ASC 360, stakeholders have questioned whether an ROU asset should only be reduced in transition if the lessee previously recognized a liability under ASC 840 or ASC 420. Although that is generally the implication, there are limited situations in which an impairment to an ROU asset may need to be recognized as of the effective date17 of ASC 842 (i.e., as an adjustment to equity).

For example, a retailer may have fully impaired all of the long-lived assets (e.g., leasehold improvements) in an asset group (e.g., an individual store) before adopting ASC 842. That is, long-lived assets in an asset group may have been previously written down to their individual fair values (which may have been zero). In those instances, it is not uncommon for unrecorded “hidden” impairments to exist as of the previous impairment date for the asset group. A hidden impairment can occur because of the mechanics of the ASC 360 impairment test. If an asset group is tested for recoverability (see ASC 360-10-35-21) and the undiscounted cash flows are less than the carrying amount of the asset group, the impairment loss is measured as the amount by which the carrying amount of the asset group exceeds its fair value (see ASC 360-10-35-17). However, the impairment loss recorded is limited to the carrying value of the long-lived assets in the asset group, and individual long-lived assets within that asset group cannot be written down below their individual fair values (see ASC 360-10-35-28). As a result of these limitations, additional economic impairment could have been previously measured but not previously recognized as a loss in the income statement.

Question 1

Should a lessee consider whether impairment indicators exist for ROU assets recognized upon the adoption of ASC 842?

Answer

Yes. A lessee should consider whether events or changes in circumstances exist that indicate that the carrying value of the asset group (which includes or solely consists of an ROU asset) is not recoverable as part of the adoption of ASC 842. That is, the lessee should determine whether impairment indicators exist upon adoption.

The requirement to consider whether impairment indicators exist is not equivalent to a requirement to perform the two-step impairment test in ASC 360. ASC 360 does not require an entity to perform the ASC 360 impairment test for all asset groups. Rather, ASC 360 requires entities to consider whether there are indicators that the carrying value of an asset group may not be recoverable (i.e., the asset group may be impaired). When such indicators are identified, the entity must perform the recoverability test (step 1) for any affected asset group and would be required to evaluate fair value in step 2 of the test if the asset group does not pass step 1. (See Section 8.4.4.2 for additional considerations related to performing the ASC 360 impairment test.)

ASC 360-10-35-21 lists examples of indicators of potential impairment. In addition, decisions to sublease or cease use of an asset under lease (even if the conditions for recognizing a liability in accordance with ASC 420 have not been met) may be indicators of potential impairment because, in both cases, future cash flows may not be sufficient to cover the contractual lease payments. Further, previous impairments to asset groups are indicators of potential impairment when the assets subject to ASC 360 in the asset group were written down to their fair values (which may have been zero) and an additional unrecognized economic impairment remained. (See Question 5 for more information.)

Questions 2, 3, and 4 below only apply to asset groups that existed before adoption (i.e., they do not solely consist of a newly recognized ROU asset). Asset groups that solely consist of newly recognized ROU assets would not have existed as of the reporting date immediately before the adoption of ASC 842. See Question 5 for further considerations related to situations in which an asset group solely consists of a newly recognized ROU asset.

Question 2

As of which date should a lessee consider whether impairment indicators exist for preexisting asset groups that include newly recognized ROU assets (“asset groups”)?

Answer

ASC 842 must be applied as of the first day of an entity’s fiscal year of adoption. However, while ASC 842 requires lessees to recognize new assets at adoption, it does not introduce any new requirements for how the lessee should consider asset groups for potential impairment. Therefore, a lessee should evaluate whether impairment indicators exist for asset groups as of the last day of the lessee’s reporting period before the adoption of ASC 842, as the entity otherwise would have been required to do under ASC 360.

Accordingly, at the end of the reporting period immediately before the adoption of ASC 842, a lessee should follow its normal processes and procedures (as supported by relevant internal controls) in an effort to determine whether there have been events or changes in circumstances indicating that the carrying value of an asset group may not be recoverable.

Question 3

If no impairment indicators for a preexisting asset group are identified as of the reporting date immediately before the adoption of ASC 842, or if indicators existed but the asset group’s carrying value was determined to be recoverable, is a lessee required to test the asset group for impairment upon the adoption of ASC 842?

Answer

No. A lessee does not need to test the asset groups for recoverability on the adoption date when there are no impairment indicators or when the lessee concluded that the asset group’s carrying value was recoverable at the end of the previous reporting period. The addition of an ROU asset to an asset group should not change the conclusion that the asset group’s carrying value is recoverable (i.e., recognition of adoption-date ROU assets is a neutral event in the determination of whether the asset group’s carrying value is recoverable). This is because a lessee will either (1) include the corresponding lease liability in the asset group in such a way that the net carrying value of the asset group is unchanged (because the ROU asset and lease obligation would generally offset) and the net undiscounted cash flows would not decrease or (2) exclude the lease liability from the asset group and adjust the cash outflows used in performing the step 1 impairment test to exclude the corresponding lease payments in such a way that the increased carrying value of the asset group is offset by an increase in future net cash flows. See Section 8.4.4.2 for considerations related to including or excluding the lease liability in an asset group for both finance and operating leases.

Question 4

Are there situations in which impairment indicators exist for a preexisting asset group as of the reporting date immediately before the adoption of ASC 842 but the lessee would not be required to test the asset group for impairment upon the adoption of ASC 842?

Answer

Yes. A lessee would not be required to test asset groups for impairment on the adoption date of ASC 842 when the lessee performed the ASC 360 test as of the reporting date immediately before the adoption of ASC 842 and concluded either of the following:

The asset group was not impaired because there were sufficient net future cash flows to recover the asset group’s carrying value or the fair value of the asset group exceeded its carrying value.
There was an impairment to the asset group but the assets subject to ASC 360 in the asset group were not fully written down to their respective fair values, or such assets were written down to their respective fair values and there was no additional unrecognized economic impairment (i.e., no hidden impairment).

In these situations, a carrying value (which may be the fair value of individual assets in the asset group when an impairment is recognized) related to the asset group generally remains and this remaining carrying value is recoverable. Therefore, despite the existence of impairment indicators, we do not believe that a lessee would be required to test asset groups for impairment upon the adoption of ASC 842 in these circumstances for the reasons noted in the answer to Question 3. That is, the recognition of new ROU assets is generally expected to be a neutral event that should not change the conclusion that the asset group’s carrying value is recoverable.

Question 5

Provided that a lessee adopts ASC 842 by using the Comparatives Under 840 Option (rather than presenting comparative periods under ASC 842), are there situations in which it would be appropriate for a lessee to recognize an impairment of a newly created ROU asset as an adjustment to equity upon adopting ASC 842?

Answer

Yes. We believe that a lessee will generally only have an impairment of an ROU asset upon the adoption of ASC 842, and thus recognize a transition-period adjustment to equity, in either of the following situations:

There was a hidden impairment, as discussed above and illustrated in the retail example below. That is, the lessee previously fully impaired all of the long-lived assets in the asset group that now includes the ROU asset (e.g., fully impaired leasehold improvements for an individual retail store), and an additional economic impairment was measured but was not previously recognized as a loss in the income statement. Further, the events and conditions that resulted in the previous impairment (an impairment that was not recognized to the extent that it was measured) continue to exist as of the ASC 842 adoption date.
The ROU asset represents its own asset group under ASC 360 and is determined to be impaired as of the effective date of ASC 842. That is, impairment indicators existed before (and continue to exist upon) the adoption of ASC 842, but because there were no ROU assets recognized for operating leases under ASC 840 and there are no other long-lived assets in the asset group, no impairment exercise was performed and no impairment charge was recognized in the lessee’s historical financial statements.

In these situations, when impairment indicators continue to exist, we believe (as discussed above) that a lessee must apply the ASC 360 impairment guidance (as described in Section 8.4.4.2) as of the effective date of ASC 842.18 If an impairment exists, the lessee should recognize a reduction of the ROU asset in transition that is equal to the lesser of (1) an amount to adjust the ROU asset to its fair value or (2) an amount to adjust the asset group’s excess carrying value to fair value. This impairment should generally be recognized as an adjustment to equity on the date of adoption, unless the impairment conditions did not exist as of the reporting date immediately before the adoption of ASC 842.

Although expected to be rare, there may be events or changes in circumstances occurring on the adoption date that indicate that the carrying value of the asset group may not be recoverable. Because such events or changes in circumstances occurred after the adoption of ASC 842, if an asset group is impaired as a result, the associated impairment charge should be recognized through earnings (i.e., not through equity).

Example

Retailer A leases two store locations under operating leases. The two stores are separate asset groups under ASC 360. Retailer A uses the Comparatives Under 840 Option to adopt ASC 842 on January 1, 2019.

Store 1

Store 1 has had and continues to have robust sales and positive cash flows and is located in a metropolitan area in which the real estate market is (and has been) strong. In addition, Store 1 has had no prior impairments. As of December 31, 2018, because there were no events or changes in circumstances to suggest that Store 1’s carrying value is not recoverable, Retailer A did not test Store 1 for recoverability in accordance with ASC 360. When Retailer A adopts ASC 842 on January 1, 2019, and recognizes an adoption-date ROU asset, it would be reasonable for Retailer A to conclude that there is no reason to test the asset group containing the adoption-date ROU asset for impairment.

Store 2

Store 2 is located in a depressed economic area and has had significantly reduced sales and cash flows. In 2017, on the basis of impairment indicators at that time, Retailer A tested Store 2 for recoverability under ASC 360 and concluded that Store 2 was impaired. Retailer A reduced the long-lived assets (consisting completely of leasehold improvements) to zero, but an excess unrecognized impairment remained. Sales and cash flows have not sufficiently recovered since 2017 and, although impairment indicators existed as of December 31, 2018, no impairment testing was performed because there were no additional assets in the asset group that could be reduced in accordance with ASC 360.

Because of Store 2’s hidden impairment and conditions (i.e., impairment indicators) that continue to exist as of the date of adoption of ASC 842, Retailer A should test Store 2 for recoverability at adoption. That is, because the recoverability test is a new test (rather than a reallocation of a previous impairment), Retailer A should perform the ASC 360 test for the asset group as of January 1, 2019 (i.e., the asset group should include the ROU asset).19 Further, because (1) the events and conditions that led to the recognition of the adoption-date impairment existed before the adoption date and (2) Retailer A elected the Comparatives Under 840 Option, any impairment should be recognized as an adjustment to Retailer A’s beginning equity on January 1, 2019.

The decision tree below summarizes the discussion in this Q&A regarding how to determine whether an asset group containing a newly created ROU asset should be evaluated for impairment upon the adoption of ASC 842, provided that an entity elects the Comparatives Under 840 Option.

As noted above, throughout this Q&A, we have assumed that the lessee used the Comparatives Under 840 Option to adopt ASC 842 and, therefore, does not present comparative periods under ASC 842. However, the same concepts would apply if the lessee presented comparative periods under ASC 842 upon adoption.

We generally believe that, if the lessee presents comparative periods under ASC 842, the timing of recognizing the hidden impairment should be based on an assessment of when the impairment economically occurred/existed. Therefore, the lessee should consider whether the incremental impairment should be recognized as (1) an adjustment to equity as of the beginning of the earliest period presented or (2) an impairment loss in the income statement for a comparative period. Nevertheless, on the basis of discussions with the FASB staff, we also believe that it would be permissible for a company to recognize those impairments (whether related to (1) or (2) in the preceding sentence) in the income statement as of the effective date (e.g., January 1, 2019, for a calendar-year-end public company). We think that such an approach is consistent with Q&A 16-4 and may limit the need for entities to search for previous “hidden” impairments as well as new impairment indicators during the comparative periods, which could be numerous for some entities. Under this approach, the impact of the impairments would be recorded as a charge to income in the first period after the effective date (e.g., January 1, 2019, for a calendar-year-end public company), since it would be inappropriate to record an adjustment to equity on that date when the date of initial application (the only date on which an equity adjustment would be appropriate) is January 1, 2017. This approach is meant to simplify the transition accounting and is restricted to entities that choose to recast the comparative periods upon adoption. That is, we generally do not believe that it would be appropriate for a company that elects the Comparatives Under 840 Option to record an impairment charge to earnings on January 1, 2019, if the impairment economically occurred/existed on December 31, 2018. If a company is contemplating an alternative approach to the recognition of an impairment charge in these circumstances, discussion with the company’s accounting advisers and auditors is highly encouraged.

Transition for Cease-Use Liabilities and Sublease Liabilities

ASC 420 required entities to recognize a liability for the cost associated with an exit or disposal activity, including operating leases when an entity ceases to use a leased asset and the underlying asset has no remaining benefit to the entity. ASC 420-10-25-11 describes “contract termination costs” as either of the following:

Costs to terminate the contract before the end of its term
Costs that will continue to be incurred under the contract for its remaining term without economic benefit to the entity.

Entities accrue for the remaining costs to be incurred under the lease and, if applicable, the cost of terminating the lease contract. Therefore, to the extent that such balances were recognized, the balances should reduce the ROU asset balance as of transition. This balance should be recognized against the ROU asset as of the later of the date of initial application or the date the ASC 420 liability was recognized.

Consider the example below from ASC 420.20

ASC 420-10

55-12 An entity leases a facility under an operating lease that requires the entity to pay lease rentals of $100,000 per year for 10 years. After using the facility for five years, the entity commits to an exit plan. In connection with that plan, the entity will cease using the facility in 1 year (after using the facility for 6 years), at which time the remaining lease rentals will be $400,000 ($100,000 per year for the remaining term of 4 years). In accordance with paragraphs 420-10-30-7 through 30-9, a liability for the remaining lease rentals, reduced by actual (or estimated) sublease rentals, would be recognized and measured at its fair value at the cease-use date (as illustrated in the following paragraph). In accordance with paragraphs 420-10-35-1 through 35-4, the liability would be adjusted for changes, if any, resulting from revisions to estimated cash flows after the cease-use date, measured using the credit-adjusted risk-free rate that was used to measure the liability initially (as illustrated in paragraph 420-10-55-15).

55-13 Based on market rentals for similar leased property, the entity determines that if it desired, it could sublease the facility and receive sublease rentals of $300,000 ($75,000 per year for the remaining lease term of 4 years). However, for competitive reasons, the entity decides not to sublease the facility (or otherwise terminate the lease) at the cease-use date. The fair value of the liability at the cease-use date is $89,427, estimated using an expected present value technique. The expected net cash flows of $100,000 ($25,000 per year for the remaining lease term of 4 years) are discounted using a credit-adjusted risk-free rate of 8 percent. In this case, a risk premium is not considered in the present value measurement. Because the lease rentals are fixed by contract and the estimated sublease rentals are based on market prices for similar leased property for other entities having similar credit standing as the entity, there is little uncertainty in the amount and timing of the expected cash flows used in estimating fair value at the cease-use date and any risk premium would be insignificant. In other circumstances, a risk premium would be appropriate if it is significant. Thus, a liability (expense) of $89,427 would be recognized at the cease-use date.

55-14 Accretion expense would be recognized after the cease-use date in accordance with the guidance beginning in paragraph 420-10-35-1 and in paragraph 420-10-45-5. (The entity will recognize the impact of deciding not to sublease the property over the period the property is not subleased. For example, in the first year after the cease-use date, an expense of $75,000 would be recognized as the impact of not subleasing the property, which reflects the annual lease payment of $100,000 net of the liability extinguishment of $25,000).

55-15 At the end of one year, the competitive factors referred to above are no longer present. The entity decides to sublease the facility and enters into a sublease. The entity will receive sublease rentals of $250,000 ($83,333 per year for the remaining lease term of 3 years), negotiated based on market rentals for similar leased property at the sublease date. The entity adjusts the carrying amount of the liability at the sublease date to $46,388 to reflect the revised expected net cash flows of $50,000 ($16,667 per year for the remaining lease term of 3 years), which are discounted at the credit-adjusted risk-free rate that was used to measure the liability initially (8 percent). Accretion expense would be recognized after the sublease date in accordance with the guidance beginning in paragraph 420-10-35-1 and in paragraph 420-10-45-5.

On the basis of the facts in the above example, the entity would have recorded the following (assume that rental payments and sublease income receipts are paid at the beginning of each year):

Only the initial measurement of the ROU asset should be affected by any ASC 420 liability associated with the lease. Therefore, if the ASC 420 liability is recorded before the date of initial application, the balance as of the date of initial measurement should be recognized as a reduction to the ROU asset.

Assume that the entity is a calendar-year-end public company, it did not elect the Comparatives Under 840 Option, and that January 1, 2017, is the beginning of Year 8 in the example above. The entity would initially measure the ROU asset reduced by the ASC 420 liability balance (including any true-ups) as of December 31, 2016. Further assume a discount rate of 14 percent.

Measurement of the ROU Asset as of January 1, 2017

Reclassification of Incremental ASC 420 Liability During the Periods Ended December 31, 2017, and December 31, 2018

Connecting the Dots

Impact of Hindsight Practical Expedient on ASC 420 Liabilities Versus That on Impairment

We do not believe that the hindsight practical expedient can be applied to ASC 420 liabilities. For example, if an entity ceases use of a leased asset during the comparative periods, it would not be appropriate to push back that conclusion to the earliest period presented. While the impact of incorporating ASC 420 liabilities is similar to the impact of an impairment, they are nonetheless not the same, because the triggering event for an ASC 420 liability is related to terminating or ceasing use of the property, which should not be moved into a reporting period different from that in which the event occurred.

Q&A 16-5A Transition Considerations Related to Lease Measurement When an Entity Ceases Use of a Leased Asset Before the Adoption of ASC 842

Under ASC 840, when an entity ceases use of an asset subject to an operating lease, the entity applies the guidance in ASC 420 to determine whether to recognize a liability for its costs related to terminating the operating lease and costs that will continue to be incurred without economically benefiting the entity. Provided that the criteria in ASC 420 related to recognizing a liability are met, the liability is measured as the difference between the remaining lease costs to be paid by the lessee, offset by an assumption for sublease income. In accordance with ASC 420-10-30-8, an entity would record the liability in this manner regardless of whether the lessee has the intent to sublease the asset. ASC 420-10-30-8 states:

If the contract is an operating lease, the fair value of the liability at the cease-use date shall be determined based on the remaining lease rentals, adjusted for the effects of any prepaid or deferred items recognized under the lease, and reduced by estimated sublease rentals that could be reasonably obtained for the property, even if the entity does not intend to enter into a sublease. Remaining lease rentals shall not be reduced to an amount less than zero. [Emphasis added]

Therefore, under ASC 420 and ASC 840, an entity is considered to have ceased use of an asset even if the entity has the intent and ability to sublease the asset. However, under ASC 842, the cease-use determination is no longer relevant; rather, an entity must determine whether the leased asset is abandoned in accordance with ASC 360.

Under ASC 842, if an entity plans to abandon the leased asset, we believe that the entity should change the useful life of the ROU asset prospectively in such a way that the ROU asset is fully amortized by the abandonment date.

Question 1

Under ASC 842, is an ROU asset considered abandoned if an entity has ceased use of the underlying asset but is currently subleasing (or plans to sublease) the asset?

Answer

No. Under ASC 842, an ROU asset is recognized during the period in which an entity has the right to use an asset subject to a lease. One of the conditions for a lease is that the entity must obtain substantially all of the economic benefits from the use of the underlying asset. In a sublease scenario, although the entity itself is not using the asset, the entity’s receipt of sublease payments would be considered as obtaining economic benefits from use of the underlying asset under ASC 842. ASC 842-10-15-17 provides evidence for this notion and states, in part:

A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding, or subleasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits from using the asset that could be realized from a commercial transaction with a third party. [Emphasis added]

Because the entity is still obtaining economic benefits from use of the asset through subleasing the asset, we do not believe that a lessee has abandoned an asset if an entity has both the intent and ability to sublease. This holds true even if the lessee has not yet identified a sublessee before the lessee ceases use of the asset.

Question 2

If an entity ceases use of a leased asset before adopting ASC 842 and does not have the intent and ability to sublease the asset, should the entity recognize an ROU asset upon adopting ASC 842?

Answer

No. We do not believe that it is appropriate to recognize an ROU asset upon adopting ASC 842 if an entity both (1) has ceased using an asset before the adoption date of ASC 842 and that designation has not changed as of the adoption date and (2) does not have the intent and ability to sublease the asset. However, the entity would still be required to recognize a lease liability equal to the present value of the remaining lease payments under the contract. Normally, the entity would recognize a corresponding ROU asset; however, in this situation, any liabilities previously recognized under ASC 420 (e.g., cease-use liabilities) would be recognized as a reduction to the carrying amount of the ROU asset. Furthermore, to the extent that the ASC 420 liability is less than the carrying amount of the ROU asset that would otherwise be recognized to offset the corresponding lease liability, any remaining portion of the ROU asset not offset by the ASC 420 liability would be written off as an adjustment to equity. We believe that it is appropriate to record the adjustment through equity because the cease-use event occurred before the date of initial application of ASC 842. See the Q&A below for discussion of the effect of a previously recognized ASC 420 liability that exceeds the lease liability that must be recognized in transition.

Q&A 16-5B Initial Measurement of an ROU Asset When a Previously Recognized ASC 420 Liability Exceeds the Lease Liability Recognized in Transition

Before adopting ASC 842, a lessee may have recognized, in accordance with ASC 420, a liability for the cost associated with an exit or disposal activity related to an operating lease. Specifically, ASC 420-10-30-9 states that a “liability for costs that will continue to be incurred under a contract for its remaining term without economic benefit to the entity shall be [recognized and] measured at its fair value” when the entity ceases using the right conveyed by the contract. In addition, ASC 420-10-30-8 indicates that “[i]f the contract is an operating lease, the fair value of the liability at the cease-use date shall be determined based on the remaining lease rentals.”

Under ASC 840, a lessee may have included amounts related to maintenance (including CAM), insurance, and property taxes in the measurement of its ASC 420 liability. The lessee would have done so regardless of whether such costs were fixed or variable, in which case they would be estimated.

When a lessee is applying the transition requirements in ASC 842, to the extent that ASC 420 liabilities were recognized, such balances should reduce the carrying amount of the ROU asset in accordance with ASC 842-10-65-1(m)(2), which states, in part:

For each lease classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3, a lessee shall initially measure the right-of-use asset at the initial measurement of the lease liability adjusted for both of the following: . . .

2. The carrying amount of any liability recognized in accordance with Topic 420 on exit or disposal cost obligations for the lease.

In certain circumstances, the carrying amount of a lessee’s ASC 420 liability immediately before the ASC 842 effective date for an existing operating lease may exceed the amount that will be recognized for the lease liability as of the effective date (e.g., if the lessee’s ASC 420 liability included CAM, insurance, and property taxes). Consequently, measuring the ROU asset, including the full adjustment for an ASC 420 liability in accordance with ASC 842-10-65-1(m)(2), may result in an ROU asset carrying amount below zero.

Question

How should a lessee account for a lease at transition in which the existing ASC 420 liability exceeds the ROU asset that would otherwise be recognized at transition?

Answer

We do not believe that it would be appropriate for a lessee to recognize a negative ROU asset at transition. Although ASC 842 does not provide clear guidance on this situation, we think that it would be acceptable for a lessee to use one of the following approaches:

Approach 1: Retain the ASC 420 liability for amounts that exceed the initial ROU asset — An entity could reduce the ROU asset to zero, with a corresponding decrease to the ASC 420 liability. The remaining portion of the ASC 420 liability would be retained and would be accounted for after the effective date in the same manner as it was accounted for before the effective date (i.e., in accordance with ASC 420). We believe that this approach is acceptable because it would allow a lessee to effectively “run off” its remaining liability. As part of this approach, an entity would not be required to recognize those costs through the income statement a second time (i.e., once when the ASC 420 liability was established before the effective date and again when those costs are actually incurred after the effective date).
Approach 2: Retain the portion of the ASC 420 liability related to the executory costs — As discussed in Q&A 16-5A, if an entity (1) has ceased using an asset before the adoption date of ASC 842 and that designation has not changed as of the adoption date and (2) does not have the intent and ability to sublease the asset as of the adoption date, we do not believe that it is appropriate for an entity to recognize an ROU asset upon adoption. Accordingly, the application of Approach 2 will depend on an entity’s intent and ability to sublease.
- Approach 2(a) — If the entity has the intent and ability to sublease, the entity could reduce the ROU asset by the portion of the ASC 420 liability related to the lease costs. An entity would also reduce the ASC 420 liability by a corresponding amount and retain the portion of the ASC 420 liability to the extent that it is related to executory costs.
- Approach 2(b) — If the entity does not have the intent and ability to sublease, the entity could reduce the ROU asset to zero, with a corresponding decrease to the ASC 420 liability, retaining the ASC 420 liability only for the remaining portion related to executory costs.
In both Approach 2(a) and Approach 2(b), the ASC 420 liability that remains would be accounted for after the effective date in the same manner as it was accounted for before the effective date (i.e., in accordance with ASC 420). As with Approach 1, we believe that this approach is acceptable because it would allow a lessee to effectively “run off” its remaining liability. As part of this approach, an entity would not be required to recognize those costs through the income statement a second time (i.e., once when the ASC 420 liability was established before the effective date and again when those costs are actually incurred after the effective date).
Approach 3: Derecognize any remaining ASC 420 liability, after the ROU asset is written to zero, through an adjustment to equity — An entity could reduce the ASC 420 liability by the same amount that reduced the ROU asset to zero. The remaining portion of the ASC 420 liability could be written off with an adjustment through equity. The costs underlying the amount that would be adjusted to equity would be recognized through the income statement in future periods as an expense since they are incurred after the effective date. Accordingly, under this approach, a lessee will recognize certain costs through the income statement twice (i.e., once in periods before the adoption of ASC 842 when the ASC 420 liability was established with its corresponding expense, and again when those costs are incurred after the adoption of ASC 842, because an offsetting liability on the balance sheet no longer exists). Although we do not think that this is an intended outcome of the transition guidance in ASC 842 or a desirable outcome for lessees, we do believe that this approach is acceptable because it would allow the removal of the existing ASC 420 liability, as contemplated under the ASC 842 transition guidance.

Q&A 16-5C Treatment of Existing Sublease Liabilities Under ASC 840 Upon Transition to ASC 842

Under ASC 842, when the costs expected to be incurred under an operating sublease exceed the expected related revenue, a sublessor should consider whether the ROU asset of the head lease is impaired in accordance with ASC 842-20-35-9. However, under ASC 840, the sublessor would have instead recognized a sublease liability for this anticipated loss. Specifically, ASC 840-20-25-15 states:

If costs expected to be incurred under an operating sublease (that is, executory costs and either amortization of the leased asset or rental payments on an operating lease, whichever is applicable) exceed anticipated revenue on the operating sublease, a loss shall be recognized by the sublessor.

The transition guidance in ASC 842-10-65-1(m) states:

The items in paragraph 842-20-35-3(b), as applicable.
The carrying amount of any liability recognized in accordance with Topic 420 on exit or disposal cost obligations for the lease.

Therefore, the ROU asset is established in transition and adjustments are made for items in ASC 842-20-35-3(b), including “impairment of the [ROU] asset” and the carrying amount of ASC 420 liabilities.

Question

How should a sublessor account for an existing sublease liability recognized under ASC 840-20-25-15 upon transition to ASC 842?

Answer

ASC 842 does not provide explicit guidance on accounting for existing sublease liabilities upon transition. The ASC 842 transition guidance states that the initial ROU asset recognized in transition should be net of ASC 420 liabilities and ROU impairment but does not mention existing sublease liabilities. In the absence of explicit guidance, we believe that the following are acceptable approaches for a sublessor to use in accounting for an existing sublease liability upon transition:

Approach A — The sublessor writes off the existing sublease liability upon transition to ASC 842, with a credit to equity. Contemporaneously, the sublessor must test the asset group containing the ROU asset for impairment in accordance with ASC 842 (see Q&A 16-4A), because subleasing at an amount less than the head lease payments may be an indicator of impairment. If the ROU asset is impaired, any impairment would also be an adjustment to equity in transition.
Approach B — The sublessor nets the existing sublease liability recognized under ASC 840-20-25-15 against the ROU asset established upon transition to ASC 842. Under this approach, the existing sublease liability is considered akin to an impairment loss. As a result, in accordance with ASC 842-20-25-7, the sublessor would subsequently amortize the remaining ROU asset balance on a straight-line basis; accordingly, the sublessor would not recognize total lease expense on a straight-line basis (see Section 8.4.4 for additional discussion of subsequent measurement of the ROU asset after an impairment is recognized).

A sublessor should elect one of the above approaches and apply it consistently to all existing sublease liabilities in transition.

16.3.1.1.3 Subsequent Measurement

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) . . .

n. For each lease classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3, a lessee shall subsequently measure the right-of-use asset throughout the remaining lease term in accordance with paragraph 842-20-35-3(b). If the initial measurement of the right-of-use asset in (m) is adjusted for the carrying amount of a liability recognized in accordance with Topic 420 on exit or disposal cost obligations for the lease, the lessee shall apply the recognition and subsequent measurement guidance in Sections 842-20-25 and 842-20-35, respectively, when the right-of-use asset has been impaired. . . .

For operating leases whose balance neither reflects an impairment nor includes an ASC 420 liability upon transition, the ROU asset and liability should be subsequently measured in accordance with ASC 842-20-35-3(b). A lessee’s expense recognition pattern for lease payments is the same under ASC 840 as it is under ASC 842 (i.e., generally straight-line). Therefore, during the comparative periods under ASC 842 (if applicable), the expense recognized under ASC 840 does not need to be altered. For operating leases whose balance reflects an impairment21 or includes an ASC 420 liability, the lessee should subsequently measure the ROU asset and liability in accordance with ASC 842-20-25 and ASC 842-20-35 as if the ROU asset had been impaired. The ROU asset should be amortized on a straight-line basis over the remaining lease term, unless a more systematic basis is more representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset. The entity should accrete the lease liability initially measured at the amount that produces a constant periodic discount rate related to the remaining balance of that liability.

Further, as discussed in Section 16.3.1, an entity should apply the provisions of ASC 842 to the accounting for modifications and the reassessment of the lease liability on and after the effective date. During the comparative periods presented under ASC 842 (if applicable), the accounting for modifications and the reassessment of the lease liability should be in line with the provisions of ASC 840 (if lease classification did not change upon the adoption of ASC 842) or ASC 842 (if lease classification did change upon the adoption of ASC 842).

16.3.1.2 Lease Is a Finance Lease Under ASC 842 (Operating Lease Under ASC 840)

The graphic below outlines the steps lessees should perform in transition for leases that were previously classified as operating leases and are considered finance leases under ASC 842.

16.3.1.2.1 Initial Measurement of Lease Liability

For more information about the initial measurement of the lease liability, see Section 16.3.1.1. For leases classified as operating under ASC 840, the initial measurement of lease liabilities in transition is the same, regardless of whether classification changes.

16.3.1.2.2 Initial Measurement of ROU Asset

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) . . .

o. For each lease classified as a finance lease in accordance with paragraph 842-10-25-2, a lessee shall measure the right-of-use asset as the applicable proportion of the lease liability at the commencement date, which can be imputed from the lease liability determined in accordance with (l). The applicable proportion is the remaining lease term at the application date as determined in (c) relative to the total lease term. A lessee shall adjust the right-of-use asset recognized by the carrying amount of any prepaid or accrued lease payments and the carrying amount of any liability recognized in accordance with Topic 420 for the lease. . . .

The measurement of the ROU asset is intended to reflect the proportion of the ROU asset that would have remained if the lease had always been classified as a finance lease, including any prepaid (or accrued) balances and ASC 420 liabilities. However, the guidance above indicates that this amount “can be imputed from the lease liability determined in accordance with (l).” This appears to be an accommodation, because the calculation of the lease liability under ASC 842-10-65-1(l) only takes into account remaining lease payments as of the date of initial application for any lease that commences before that time. That is, a true calculation of the lease liability as of the commencement date would include payments that were made before the date of initial application. ASC 842 does not provide additional guidance on how a lessee may impute the lease liability without using all the payments since lease commencement. However, the 2013 ED of the leases standard did illustrate how this may be done. Under the approach discussed in the ED, an entity would average the remaining minimum rental payments from the calculation in ASC 842-10-65-1(l) and would assume that those average payments existed for the entire lease term. This calculation could materially differ from a true calculation of the original lease liability at lease commencement. For example, this could occur if the lease payments significantly differed from those on a straight-line basis (e.g., step rents or significant deferred payments). Therefore, we believe that a lessee could either calculate the original lease liability at lease commencement (Alternative 1 below) or develop a policy that is consistent with imputing the amount related to the components from the calculation in ASC 842-10-65-1(l) (Alternative 2 below).

Example 16-2

Assume the same facts as in Example 29 of ASC 842 (see Section 16.3.1.1) except that the lessee did not elect the practical expedient package and the lease was determined to be a finance lease in transition. Further assume that the entity did not elect the Comparatives Under 840 Option and that the remaining balance of initial direct costs as of the earliest period presented is $250 because of the exclusion of certain initial direct costs capitalized under ASC 842. Finally, assume that the payment made in 20X1 was $31,000.

Step 1: Measure the Lease Liability as of the Earliest Period Presented

Alternative 1

Step 2: Measure the ROU Asset

Calculate the present value of the lease payments from lease commencement and multiply this amount by the remaining lease term divided by the original lease term.

Step 3: Record the Journal Entries

Alternative 2

Step 2: Measure the ROU

Determine the average lease payments over the remaining term as of the earliest period presented, as calculated in step 1 (31,000 + 33,000 + 33,000 + 33,000) ÷ 4 = $32,500.

Calculate the present value of the average lease payments imputed over the entire lease term and multiply this amount by the remaining lease term divided by the original lease term.

Step 3: Record the Journal Entries

16.3.1.2.3 Subsequent Measurement

There are no separate paragraphs in the transition guidance on subsequent measurement for a lease that was an operating lease under ASC 840 and becomes a finance lease upon the adoption of ASC 842. However, since the lease classification in this scenario changed to a finance lease in accordance with ASC 842, the finance lease must be subsequently measured in accordance with ASC 842 after the date of initial application.

16.3.2 Lease Previously Classified as a Capital Lease Under ASC 840

Leases previously classified as a capital lease under ASC 840 could be accounted for as either a finance lease or an operating lease under ASC 842. The classification considerations related to the practical expedient package are the same as those for leases previously classified as operating leases (see Section 16.3.1).

The two transition scenarios for a capital lease under ASC 840 are as follows:

ASC 840 Classification	ASC 842 Classification	Roadmap Section
Capital	Finance	16.3.2.1
Capital	Operating	16.3.2.2

16.3.2.1 Lease Is a Finance Lease Under ASC 842 (Capital Lease Under ASC 840)

The graphic below illustrates how an entity should recognize the ROU asset and lease liability for leases that were previously classified as capital leases and are considered finance leases under ASC 842 because either (1) an entity elected the practical expedient package so that lease classification would not be reassessed or (2) classification is assessed in transition to ASC 842 and the lease is determined to be a finance lease.

In short, other than changing the characterization of the asset (to an ROU asset) and obligation (to a lease liability), the lessee does not record any entries as part of the transition from a capital lease to a finance lease, except the impact of any nonqualifying initial direct costs, if any, when the practical expedient package is not applied. Example 28 in ASC 842 illustrates this transition as follows:

ASC 842-10

Illustration of Lessee Transition — Existing Capital Lease

55-243 Example 28 illustrates lessee accounting for the transition of existing capital leases when an entity elects the transition method in paragraph 842-10-65-1(c)(1).

Example 28 — Lessee Transition — Existing Capital Lease

55-244 The effective date of the guidance in this Topic for Lessee is January 1, 20X4. Lessee enters into a 7-year lease of an asset on January 1, 20X1, with annual lease payments of $25,000 payable at the end of each year. The lease includes a residual value guarantee by Lessee of $8,190. Lessee’s incremental borrowing rate on the date of commencement was 6 percent. Lessee accounts for the lease as a capital lease. At lease commencement, Lessee defers initial direct costs of $2,800, which will be amortized over the lease term. On January 1, 20X2 (and before transition adjustments), Lessee has a lease liability of $128,707, a lease asset of $124,434, and unamortized initial direct costs of $2,400.

55-245 January 1, 20X2 is the beginning of the earliest comparative period presented in the financial statements in which Lessee first applies the guidance in this Topic. Lessee has elected the package of practical expedients in paragraph 842-10-65-1(f). As such, Lessee accounts for the lease as a finance lease, without reassessing whether the contract contains a lease or whether classification of the lease would be different in accordance with this Topic. Lessee also does not reassess whether the unamortized initial direct costs on January 1, 20X2, would have met the definition of initial direct costs in this Topic at lease commencement.

55-246 On January 1, 20X2, Lessee recognizes a lease liability at the carrying amount of the capital lease obligation on December 31, 20X1, of $128,707 and a right-of-use asset at the carrying amount of the capital lease asset of $126,834 (which includes unamortized initial direct costs of $2,400 that were included in the capital lease asset). Lessee subsequently measures the lease liability and the right-of-use asset in accordance with Subtopic 840-30 until the effective date.

55-247 Beginning on the effective date, Lessee applies the subsequent measurement guidance in Section 842-20-35, including the reassessment requirements, except for the requirement to reassess amounts probable of being owed under residual value guarantees. Such amounts will only be reassessed if there is a remeasurement of the lease liability for another reason, including as a result of a lease modification (that is, not accounted for as a separate contract).

16.3.2.1.1 Initial Measurement of Lease Liability and ROU Asset

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) . . .

r. For each lease classified as a finance lease in accordance with this Topic, a lessee shall do all of the following:

1. Recognize a right-of-use asset and a lease liability at the carrying amount of the lease asset and the capital lease obligation in accordance with Topic 840 at the application date as determined in (c).

2. Include any unamortized initial direct costs that meet the definition of initial direct costs in this Topic in the measurement of the right-of-use asset established in (r)(1).

3. If a lessee does not elect the practical expedients described in (f), write off any unamortized initial direct costs that do not meet the definition of initial direct costs in this Topic and that are not included in the measurement of the capital lease asset under Topic 840 as an adjustment to equity unless the entity elects the transition method in (c)(1) and the costs were incurred after the beginning of the earliest period presented, in which case those costs shall be written off as an adjustment to earnings in the period the costs were incurred. . . .

If a lease was previously classified as a capital lease under ASC 840 and the lease remains a finance lease, the entity should recognize an ROU asset and lease liability in transition at their existing carrying amounts as lease assets and capital lease obligations, respectively. That is, the transition guidance for a capital lease that is classified as a finance lease under ASC 842 results in the carryforward of existing assets and liabilities recognized under ASC 840.22 The amounts should be recognized at the later of the date of initial application or the commencement date of the lease.

In addition, any unamortized initial direct costs (after an entity considers the ASC 842 definition, unless the practical expedient described in Section 16.5.2.3 is applied) should be added to the ROU asset.

Connecting the Dots

Hindsight Impact Related to Lease Term and Liability Measurement (Lease Classified as a Capital Lease Under ASC 840)

The measurement of the lease liability is affected by the identification of the lease term. If an entity elects the hindsight practical expedient, any changes to the lease term during the comparative period should be reflected in the measurement of the lease liability as of the later of the date of initial application or lease commencement. Therefore, a different initial measurement of the finance lease could be required in transition, since balances under ASC 840 will reflect a different lease term assumption. See Section 16.5.1 for more information on the hindsight practical expedient.

For capital leases that are finance leases under ASC 842, the only difference between electing and not electing the practical expedient package is that an entity that does not apply the package would only include in its ROU asset initial direct costs that qualify as such costs under ASC 842. Previously capitalized initial direct costs that no longer meet the definition of initial direct costs under ASC 842 must be accounted for as follows:

Any costs incurred before the date of initial application should be recognized as an adjustment to equity.
Any costs incurred on or after the date of initial application should be recognized in earnings for the respective comparative period under ASC 842, if applicable.

16.3.2.1.2 Subsequent Measurement

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) . . .

r. For each lease classified as a finance lease in accordance with this Topic, a lessee shall do all of the following: . . .

4. If an entity elects the transition method in (c)(1), subsequently measure the right-of-use asset and the lease liability in accordance with Section 840-30-35 before the effective date.

5. Regardless of the transition method selected in (c), apply the subsequent measurement guidance in paragraphs 842-20-35-4 through 35-5 and 842-20-35-8 after the effective date. However, when applying the pending content in paragraph 842-20-35-4, a lessee shall not remeasure the lease payments for amounts probable of being owed under residual value guarantees in accordance with paragraph 842-10-35-4(c)(3).

6. Classify the assets and liabilities held under capital leases as right-of-use assets and lease liabilities arising from finance leases for the purposes of presentation and disclosure. . . .

t. If a modification to the contractual terms and conditions occurs on or after the effective date, and the modification does not result in a separate contract in accordance with paragraph 842-10-25-8, or the lessee is required to remeasure the lease liability in accordance with paragraph 842-20-35-4, the lessee shall subsequently account for the lease in accordance with the requirements in this Topic beginning on the effective date of the modification or the remeasurement date. . . .

A finance lease must be subsequently measured in accordance with ASC 840 in the comparative periods before the effective date. That is, if classification does not change as of the earliest period presented, the ASC 840 reassessment, modification, and measurement principles should be retained (other than those related to the classification of the assets and liabilities as ROU assets and lease liabilities, respectively, for presentation and disclosure purposes). On and after the effective date, an entity must apply the ASC 842 subsequent-measurement guidance, including that on modifications and reassessment of the lease liability.

Connecting the Dots

Lessee Does Not Remeasure Residual Value Guarantee Upon Transition

Under ASC 840, a lessee includes in its minimum lease payments the entire amount of the residual value guarantee; however, under ASC 842, a lessee only includes in its lease payments those amounts that it is probable the lessee will owe under the residual value guarantee at the end of the lease term. As a result, the ROU asset and lease liability recognized on the lessee’s balance sheet for a new lease under ASC 842 will generally be lower than it would have been had the same lease been classified as a capital lease under ASC 840.

However, for existing leases that were classified as capital leases under ASC 840 and that will be classified as finance leases under ASC 842, ASC 842 specifically states that a lessee is not allowed to “remeasure [upon transition] the lease payments for amounts probable of being owed under residual value guarantees.” As a result, a lessee’s lease payments would not be reduced only to reflect the change in the amount of the residual value guarantee that is included in lease payments under the two standards.

16.3.2.2 Lease Is an Operating Lease Under ASC 842 (Capital Lease Under ASC 840)

For leases that were previously classified as capital leases and are considered operating leases under ASC 842 (which can only occur if the practical expedient package is not elected), the lessee must derecognize the previous capital lease amounts at the later of the date of initial application or the commencement date. Upon derecognition of the previous capital lease amounts, the lease is accounted for as an operating lease under ASC 842, as discussed further below.

16.3.2.2.1 Initial Measurement

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) . . .

s. For each lease classified as an operating lease in accordance with this Topic, a lessee shall do the following:

1. Derecognize the carrying amount of any capital lease asset and capital lease obligation in accordance with Topic 840 at the application date as determined in (c). Any difference between the carrying amount of the capital lease asset and the capital lease obligation shall be accounted for in the same manner as prepaid or accrued rent.

2. If an entity elects the transition method in (c)(1) and the lease commenced before the beginning of the earliest period presented in the financial statements or if the entity elects the transition method in (c)(2), recognize a right-of-use asset and a lease liability in accordance with paragraph 842-20-35-3 at the application date as determined in (c).

3. If an entity elects the transition method in (c)(1) and the lease commenced after the beginning of the earliest period presented in the financial statements, recognize a right-of-use asset and a lease liability in accordance with paragraph 842-20-30-1 at the commencement date of the lease. . . .

5. Write off any unamortized initial direct costs that do not meet the definition of initial direct costs in this Topic as an adjustment to equity unless the entity elects the transition method in (c)(1) and the costs were incurred after the beginning of the earliest period presented, in which case those costs shall be written off as an adjustment to earnings in the period the costs were incurred. . . .

The lessee should measure the ROU asset and lease liability under ASC 842-20-30-1 as of the later of the date of initial application or the date the lease commenced. Before measuring the ROU asset and lease liability, the lessee would need to identify and allocate the consideration to the separate lease and nonlease components in the contract (see Chapter 4). Because the lessee could not have elected the practical expedient package if the classification of a lease changes upon the adoption of ASC 842, any unamortized initial direct costs that would not be capitalized under the changed definition of such costs in ASC 842 should be written off as an (1) adjustment to equity if the costs are incurred before the date of initial application or (2) expense in the period in which the costs are incurred, which is only applicable if the Comparatives Under 840 Option is not elected.

16.3.2.2.2 Subsequent Measurement

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) . . .

s. For each lease classified as an operating lease in accordance with this Topic, a lessee shall do the following: . . .

4. Account for the operating lease in accordance with the guidance in Subtopic 842-20 after initial recognition in accordance with (s)(2) or (s)(3). . . .

After the commencement date, the lessee should subsequently measure the operating lease under ASC 842 in a manner similar to how it would measure any other operating lease that commenced after the effective date (see Section 8.4.3.2). That is, since lease classification changed upon the adoption of ASC 842, an entity should apply all of the guidance on subsequent measurement (including that on modifications and reassessment of the lease liability) under ASC 842 during the comparative periods presented (if applicable) and on or after the effective date.

Footnotes

We do not believe that the short-term lease exemption applies to leases that, upon transition, have a remaining term of 12 months or less if the original term was greater than 12 months. The ASC master glossary defines a short-term lease as “[a] lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.” While a lease may have a remaining lease term of less than 12 months at transition, it would not meet the definition of a short-term lease if the lease term as of the original commencement date would have been greater than 12 months.

An entity is not required to apply U.S. GAAP to immaterial items; therefore, materiality is always a consideration in the preparation of financial statements. The assessment of materiality is company-specific and involves qualitative and quantitative considerations. A company’s explicit financial statement disclosure of its historical approach under ASC 840 may serve as qualitative evidence that the policy is material.

A preferability determination is required under ASC 250 if an entity that is making the transition from ASC 840 to ASC 842 wishes to change from using an inception rate to using an updated rate to calculate its lease liability, provided that the historical policy has a material impact on the financial statements.

While an entity is not required to reflect the change in historical periods in this circumstance, we believe that an entity is permitted to do so since the change would increase comparability.

Paragraph BC390 of ASU 2016-02 states, in part, that 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” (emphasis added).

See footnote 5.

While not required to reflect the change in the historical periods in this circumstance, we believe that an entity is permitted to do so since the change would increase comparability.

Depending on an entity’s election (made by underlying asset class) to combine lease and nonlease components, all or a portion of an entity’s leases may be affected by this election. In contrast, an entity’s ASC 840 policy choice for including or excluding executory costs is an entity-wide election. Accordingly, inconsistencies between ASC 840 and ASC 842 may arise in such circumstances.

The preferability determination is required under ASC 250 if an entity wishes to treat executory costs differently than historical practice when making the transition from ASC 840 to ASC 842 and the inclusion (exclusion) of executory costs has a material impact on the financial statements (see Question 1).

An entity should perform a well-reasoned preferability analysis to determine whether a change in executory costs is appropriate (see Question 1). The fact that the change enhances comparability between ASC 840 and ASC 842 is not solely determinative of whether a change in policy is preferable. Other factors to consider in a preferability analysis include, but are not limited to, whether the change in policy is consistent with guidance under ASC 842, the composition of costs associated with expected leasing activity after adoption, comparability with relevant peer companies, and whether the change results in relevant measurement of the liability upon adoption of ASC 842.

[14]

ASC 842-20, not ASC 842-30, contains the subsequent-measurement guidance for lessees; we believe that this is a typographical error.

[15]

See footnote 14.

Since this approach uses the remaining lease term as of the date of initial application of ASC 842 as the revised amortization period of the leasehold improvements, it would not be appropriate to fully write off leasehold improvements that have remaining utility through equity as of the date of initial application of ASC 842.

Throughout this Q&A, we have assumed that the lessee used the Comparatives Under 840 Option to adopt ASC 842 and therefore does not present comparative periods under ASC 842. However, the same concepts would apply if the lessee presented comparative periods under ASC 842 upon adoption. See Question 5 for more information.

We do not believe that it would be appropriate for a lessee to impair the ROU asset simply because it would have been previously impaired if it existed at the time that a historical impairment was recognized for the asset group. A lessee should only recognize an impairment of the ROU asset as of the date of initial application of ASC 842 if an economic impairment exists as of that date.

See Section 8.4.4.2 for additional information regarding testing the asset group that is or includes an ROU asset.

ASU 2016-02 supersedes the four paragraphs below.

As discussed in Q&A 16-5C, we believe that netting an existing sublease liability against an ROU asset in transition (i.e., Approach B in the Q&A) is akin to an impairment loss and thus should result in the same subsequent measurement as an impairment.

We believe that in addition to carrying forward the existing assets and liabilities recognized under ASC 840, an entity should also carry forward the discount rate used under ASC 840.

16.6 Illustrative Examples — Transition Approaches

In summary, there are several potential transition approaches an entity may select, some of which will affect lease classification:

As discussed above, hindsight does not affect lease classification, when the practical expedient package is also elected, but may have an impact on lease measurement in transition. The examples below illustrate the potential impact of these approaches on sample leases. These examples should be read in conjunction with the guidance above and the “Modifications and Reassessment of Lease Liability in Comparative Periods” discussion in Section 16.3.1. In all examples, assume that the entity is a calendar-year-end public entity; the entity’s adoption date is January 1, 2019; the entity did not elect the Comparatives Under 840 Option; and the entity’s earliest comparative period presented is January 1, 2017.

Lease A	Transition Impact
Lessee or Lessor? Lessee Lease Inception: February 10, 2015 Lease Commencement: February 14, 2015 Original Lease Term: 10 years ASC 840 Lease Classification: Operating Other Terms: No renewal options or purchase options
Approaches A and B	Retain the operating lease classification upon transition, because the practical expedient package was elected. The election of hindsight has no impact on lease term because there are no renewal options to consider.
Approaches C and D	Assess lease classification under ASC 842 as of the commencement date of the lease (i.e., February 14, 2015). The election of hindsight has no impact on lease term because there are no renewal options to consider.

Lease B	Transition Impact
Lessee or Lessor? Lessee Lease Inception: February 10, 2015 Lease Commencement: February 14, 2015 Lease Term: Three years, exercise of renewal option not reasonably assured as of lease inception ASC 840 Lease Classification: Operating Other Terms: One two-year renewal option, no purchase option; renewal option was exercised in 2018 Previous ASC 840 Considerations: Upon renewal, the lease was also classified as an operating lease under ASC 840
Approach A	Retain the operating lease classifications in all periods presented, because the practical expedient package was elected. For measurement purposes, since hindsight was elected, the renewal exercised in 2018 would be included retrospectively, as if its exercise were reasonably certain, in the measurement of the lease as of the earliest period presented.
Approach B	Retain the operating lease classifications in all periods presented, because the practical expedient package was elected. Do not alter ASC 840 accounting performed in 2018 other than to increase the lease liability and the ROU asset (because the renewal option is exercised).
Approach C	Assess lease classification under ASC 842 as of the commencement date (i.e., February 14, 2015). Since hindsight is elected, the exercised renewal would affect lease term for both the ASC 842 classification test and the measurement of the lease as of the earliest period presented.
Approach D	Assess lease classification under ASC 842 as of the commencement date (i.e., February 14, 2015). Since hindsight was not elected, the exercised renewal would not affect the original lease term as of lease commencement for the ASC 842 classification test. If lease classification did not change upon the adoption of ASC 842, do not alter ASC 840 accounting performed in 2018 other than to increase the lease liability and the ROU asset (because the renewal option is exercised). However, if the lessee concludes that the lease is a finance lease upon adopting ASC 842 (i.e., classification changed), all of the reassessment and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods. See “Modifications and Reassessment of Lease Liability” in Section 16.3.1 for more information.

Lease C	Transition Impact
Lessee or Lessor? Lessee Lease Inception: February 10, 2015 Lease Commencement: February 14, 2015 Lease Term: 8 years ASC 840 Lease Classification: Capital Other Information: The lessee and lessor modified the terms of the contract so that the lessee would pay less rent over the remaining lease term on August 6, 2017 Previous ASC 840 Considerations: Modification would have changed classification if the terms were in effect as of the original lease inception; new contract was deemed an operating lease as of August 6, 2017
Approaches A and B	Because the practical expedient package was elected, ASC 840 accounting should be retained in the comparative periods. Therefore, the lessee should retain finance (capital) lease classification as of the earliest comparative period through the date of modification and retain operating lease classification as of the modification date for the new lease contract. Further, hindsight does not affect this fact pattern because the modification only affected the amount the lessee would pay, which had no effect on the lease term. In addition, a modification should never result in an adjustment to the lease balances in transition before the modification date.
Approaches C and D	Assess lease classification under ASC 842 as of the commencement date (i.e., February 14, 2015). The transition guidance is not clear on situations in which the practical expedient package is not elected and a modification occurs during the transition period. In accordance with the principles discussed in Section 16.3.1, when lease classification does not change upon the adoption of ASC 842, the ASC 840 subsequent-measurement guidance would be applied until the effective date (i.e., January 1, 2019). However, this principle appears incompatible with Approaches C and D, because the practical expedient package was not elected. That is, for a modification date of August 6, 2017, an entity is required to perform an additional lease classification determination under ASC 842. We believe that there may be multiple acceptable approaches to analyzing this lease, including applying the ASC 842 modification and reassessment guidance entirely under ASC 842 or a mixed model that takes into account relevant concepts from both ASC 840 and ASC 842. If the lessee concludes that the lease is an operating lease at lease commencement upon adopting ASC 842 (i.e., classification changed), all of the ASC 842 reassessment and subsequent-measurement guidance should be applied during the comparative periods (see Section 16.3.2.2). Hindsight does not affect this fact pattern because the modification only affected the amount the lessee would pay, which had no effect on the lease term. In addition, a modification should never result in an adjustment to the lease balances in transition before the modification date.

Lease D	Transition Impact
Lessee or Lessor? Lessor Lease Inception: August 9, 2006 Lease Commencement: September 2, 2006 Lease Term: 12 years ASC 840 Lease Classification: Operating Other Terms: The lessor and lessee modified the terms of the contract for the lessee to extend the lease for an additional five years on June 6, 2016 Previous ASC 840 Considerations: Modification changed classification to a sales-type lease as of the modification date
Approaches A and B	Since the practical expedient package was elected (and the classification changed before the earliest comparative period presented), sales-type lease classification would be retained upon adopting ASC 842. In addition, since the extension occurred before the earliest period presented and there are no lessee-controlled options after the earliest period presented, the application of hindsight would not have any impact on lease term at adoption.
Approach C	Assess lease classification under ASC 842 as of the modification date (i.e., June 6, 2016). In addition, since the extension occurred before the earliest period presented and there are no lessee-controlled options after the earliest period presented, the application of hindsight would not have any impact on lease term at adoption.
Approach D	Assess lease classification under ASC 842 as of the modification date (i.e., June 6, 2016).

Lease E	Transition Impact
Lessee or Lessor? Lessor Lease Inception: August 9, 2006 Lease Commencement: September 2, 2006 Lease Term: 12 years ASC 840 Lease Classification: Operating Other Terms: The lessor and lessee modified the terms of the contract for the lessee to extend the lease for an additional five years on June 6, 2018 Previous ASC 840 Considerations: Modification changed classification to a sales-type lease as of the modification date
Approach A	Since the practical expedient package was elected, the lessor would not change lease classification upon adopting ASC 842 (i.e., the lease would be an operating lease as of the earliest period presented and the ASC 840 modification guidance would apply to the modification of a sales-type lease). In addition, although hindsight was elected, since the extension was the result of a mutual negotiation to modify and extend the lease (rather than a lessee-controlled option to extend), the application of hindsight would not have any impact on lease term.
Approach B	Since the practical expedient package was elected, the lessor would not change lease classification upon adopting ASC 842 (i.e., the lease would be an operating lease as of the earliest period presented and the ASC 840 modification guidance would apply to the modification of a sales-type lease).
Approaches C and D	Assess lease classification under ASC 842 as of lease commencement (i.e., September 2, 2006). In addition, even if hindsight was elected under Approach C, since the extension was the result of a mutual negotiation to modify and extend the lease (rather than a lessee-controlled option to extend), the application of hindsight would not have any impact on lease term. If lease classification did not change upon the adoption of ASC 842, the ASC 840 modification and subsequent-measurement guidance should be applied (including the guidance on the assessment, classification and measurement of the lease on June 6, 2018, the date of the extension). If lease classification changed upon the adoption of ASC 842, all of the modification and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods.

Lease F	Transition Impact
Lessee or Lessor? Lessee Lease Inception: July 10, 2010 Lease Commencement: July 13, 2010 Lease Term: 10 years; the lessee has a 5-year renewal option for which exercise was determined not to be reasonably assured as of the inception date ASC 840 Lease Classification: Operating Other Information: On September 15, 2018, the lessee installs and pays for tenant improvements with a useful life that extends through 2025. The tenant improvements would be costly to remove and, at that time, it is reasonably assured that the lessee will exercise the renewal option. Previous ASC 840 Considerations: There are no changes to the lease as a result of the exercise of the renewal option becoming reasonably assured. That is, there are no reassessment requirements in ASC 840 other than modifications, extensions, or renewals.
Approach A	Retain the operating lease classification in all periods presented because the practical expedient package was elected. We believe that, under this approach, lease classification would not need to be reassessed as of the effective date despite the change in facts and circumstances before this date. However, for measurement purposes, since hindsight was elected, the renewal would be included retrospectively as if its exercise were reasonably certain in the measurement of the lease as of the earliest period presented.
Approach B	Since the practical expedient package was elected, the operating lease classification should be retained during comparative periods. We believe that lease classification would not need to be reassessed as of the effective date despite the change in facts and circumstances before this date. In accordance with ASC 842-10-35-1, lease term is reassessed when an event “occurs.” However, because the lessee elected the practical expedient package and did not elect hindsight, we do not believe that the lessee should consider events that occurred before the effective date but did not result in a modification under ASC 840.
Approach C	Assess lease classification under ASC 842 as of the commencement date (i.e., July 13, 2010). Since hindsight is elected, the change in facts and circumstances regarding the renewal would affect the lease term for both the ASC 842 classification test and the measurement of the lease as of the earliest period presented. If lease classification did not change upon the adoption of ASC 842, the ASC 840 subsequent-measurement guidance should be applied until the effective date (i.e., January 1, 2019). However, if the lessee concludes that the lease is a finance lease at lease commencement upon adopting ASC 842 (i.e., classification did change), all of the reassessment and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods. Therefore, in accordance with ASC 842-10-35-1, lease term is reassessed as of September 15, 2018, because an event occurred (installing leasehold improvements) for which reassessment was required under ASC 842 and that was controlled by the lessee.
Approach D	Assess lease classification as of the commencement date (i.e., July 13, 2010). If lease classification did not change upon the adoption of ASC 842, the ASC 840 subsequent-measurement guidance should be applied until the effective date (i.e., January 1, 2019). However, if the lessee concludes that the lease is a finance lease at lease commencement upon adopting ASC 842 (i.e., classification did change), all of the reassessment and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods. Therefore, in accordance with ASC 842-10-35-1, lease term is reassessed as of September 15, 2018, because an event occurred (installing leasehold improvements) for which reassessment was required under ASC 842 and that was controlled by the lessee.

16.8 Build-to-Suit Transition

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) . . .

u. A lessee shall apply a modified retrospective transition approach for leases accounted for as build-to-suit arrangements under Topic 840 that are existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements (if an entity elects the transition method in (c)(1)) or that are existing at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if an entity elects the transition method in (c)(2)) as follows:

1. If an entity has recognized assets and liabilities solely as a result of a transaction’s build-to-suit designation in accordance with Topic 840, the entity shall do the following:

i. If an entity elects the transition method in (c)(1), the entity shall derecognize those assets and liabilities at the later of the beginning of the earliest comparative period presented in the financial statements and the date that the lessee is determined to be the accounting owner of the asset in accordance with Topic 840.

ii. If an entity elects the transition method in (c)(2), the entity shall derecognize those assets and liabilities at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph.

iii. Any difference in (i) or (ii) shall be recorded as an adjustment to equity at the date that those assets and liabilities were derecognized in accordance with (u)(1)(i) or (ii).

iv. The lessee shall apply the lessee transition requirements in (k) through (t) to the lease.

2. If the construction period of the build-to-suit lease concluded before the beginning of the earliest comparative period presented in the financial statements (if the entity elects the transition method in (c)(1)) or if it concluded before the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if the entity elects the transition method in (c)(2)), and the transaction qualified as a sale and leaseback transaction in accordance with Subtopic 840-40 before that date, the entity shall follow the general lessee transition requirements for the lease. . . .

Under ASC 840, a lessee may have capitalized the construction cost of an asset under construction with an offsetting liability on the basis of an assessment of the involvement during construction, which is primarily based on the risks to which the lessee was exposed. In addition, if a lessee is deemed the owner of the construction project, it is required to assess whether a sale and leaseback is achieved, which often results in a failed sale and leaseback because of continuing involvement. ASC 842 significantly changes the assessment of whether a lessee is the accounting owner of the asset during construction, which is an assessment of control (see Chapter 11 for a general overview of these arrangements). As a result, it will be common for a lessee to be the deemed owner of the asset under ASC 840; however, the lessee may not be the deemed owner of an asset under ASC 842 because it does not meet ASC 842’s concept of control. The general transition provisions indicate that a lessee that recognized an asset solely because it was the deemed owner under the ASC 840 build-to-suit guidance would derecognize the related assets and liabilities as of the later of the date of initial application or the date the lessee was determined to be the deemed owner.

Although the transition guidance indicates that the difference between the asset and liability should be recognized as an adjustment to equity as of that later-of date, we think that a lessee should carefully consider the impact of such adjustments as follows:

If a lease has not commenced as of the date of initial application, the asset and liability will generally be equal, because the lessee’s accounting as the deemed owner before placing the asset into service is a gross-up of the asset with an offsetting financing obligation. Therefore, the adjustments in transition to ASC 842 generally will not affect equity for leases that commenced after the date of initial application.
A lessee should reverse any of the accounting entries that were recognized during the comparative periods for the respective line items (e.g., depreciation expense, interest expense) rather than as an adjustment to equity. That is, it would not be appropriate to reverse the accounting after placing the asset into service through equity if those comparative periods are shown in accordance with ASC 842.
If a lease commenced before the date of initial application and the lessee continued to recognize the asset and liability as a failed sale and leaseback under ASC 840, there typically will be a difference between the asset and liability that should be recognized in equity as of the date of initial application.
Although the transition guidance related to build-to-suit arrangements does not specifically address situations in which the lessee is the deemed owner of an asset under construction in accordance with ASC 842, we have provided our interpretive guidance on such scenarios in the Q&A below.

Q&A 16-12 Derecognition of Existing Build-to-Suit Assets and Liabilities in Transition

The build-to-suit transition guidance specifies that any build-to-suit assets and liabilities recognized under ASC 840 should be derecognized in transition. However, the transition guidance does not explicitly address whether ASC 842’s principles related to controlling an asset under construction should be applied during the comparative periods under ASC 842, if applicable.

Question 1

Must ASC 842’s principles related to controlling an asset during construction be applied when construction was completed and the lease commenced before ASC 842’s effective date?

Answer

No. An entity is not required to assess ASC 842’s principles of control (regardless of whether the lessee was the deemed owner under ASC 840) as long as construction is complete and the lease commenced before the ASU’s effective date. The FASB staff agreed with this application of transition for build-to-suit arrangements. This answer is applicable regardless of whether an entity elects the Comparatives Under 840 Option.

Therefore, in such circumstances, the transition derecognition guidance in ASC 842-10-65-1(u) should be applied. ASC 842-10-65-1(u) states:

A lessee shall apply a modified retrospective transition approach for leases accounted for as build-to-suit arrangements under Topic 840 that are existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements (if an entity elects the transition method in (c)(1)) or that are existing at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if an entity elects the transition method in (c)(2)) as follows:

If an entity has recognized assets and liabilities solely as a result of a transaction’s build-to-suit designation in accordance with Topic 840, the entity shall do the following:
1. If an entity elects the transition method in (c)(1), the entity shall derecognize those assets and liabilities at the later of the beginning of the earliest comparative period presented in the financial statements and the date that the lessee is determined to be the accounting owner of the asset in accordance with Topic 840.
2. If an entity elects the transition method in (c)(2), the entity shall derecognize those assets and liabilities at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph.
3. Any difference in (i) or (ii) shall be recorded as an adjustment to equity at the date that those assets and liabilities were derecognized in accordance with (u)(1)(i) or (ii).
4. The lessee shall apply the lessee transition requirements in (k) through (t) to the lease.
If the construction period of the build-to-suit lease concluded before the beginning of the earliest comparative period presented in the financial statements (if the entity elects the transition method in (c)(1)) or if it concluded before the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if the entity elects the transition method in (c)(2)), and the transaction qualified as a sale and leaseback transaction in accordance with Subtopic 840-40 before that date, the entity shall follow the general lessee transition requirements for the lease. [Emphasis added]

Accordingly, the lessee should (1) derecognize any build-to-suit assets and liabilities that were recognized solely as a result of the lessee’s being the deemed accounting owner and (2) recognize the difference, if any, in equity. However, lessee-paid costs that were included in the build-to-suit asset may not have been capitalized solely as a result of the build-to-suit designation. For example, the deemed accounting owner may have funded part of the construction costs and such costs may be considered prepaid lease payments or payments for lessee-owned improvements when the arrangement is accounted for as a lease. Accordingly, in transition, these costs would be carried over and retained at their currently recognized amount (i.e., the amortized or depreciated balance). That is, these costs would have been recognized in the absence of the build-to-suit designation and therefore should not be derecognized through equity upon transition.

Example

Company C, a calendar-year public entity that has elected the option not to recast the comparative periods presented when transitioning to ASC 842 (the Comparatives Under 840 Option), entered into an agreement with Developer D to lease a newly constructed corporate headquarters.30 Developer D began building the corporate headquarters on August 1, 2016, and construction is expected to be complete on November 12, 2018, at which time the lease will commence. Company C funded $6 million of the construction costs during the construction period, and the total project costs are expected to be $40 million. Therefore, D will fund $34 million of the construction costs. In addition, C incurred $1 million for furniture and fixtures (the “improvements”). Assume that C was considered the accounting owner of the corporate headquarters during construction and that sale-and-leaseback accounting would not be achieved upon lease commencement under ASC 840. The various journal entries to account for the construction project resulted in the following account balances as of November 12, 2018:

Upon transition to ASC 842, C is required to derecognize the amounts related to the build-to-suit accounting because construction of the corporate headquarters was completed, and the lease commenced, before January 1, 2019 (the effective date of ASC 842). Therefore, on its adoption date (January 1, 2019), C would derecognize the entire financing obligation because it was recognized solely as a result of the build-to-suit designation. Company C would retain a portion of its PP&E balance related to the amount it paid before lease commencement less adjustments for subsequent measurement (i.e., depreciation), even though this amount was included in the carrying amount of the build-to-suit asset. As a result, the unamortized portion of the $6 million construction funding payment should be carried forward into the ROU asset because it represents a prepaid lease payment. Similarly, the unamortized balance of the $1 million for improvements paid by the lessee should be carried forward in transition and not written off as an equity adjustment. The remaining build-to-suit asset would be derecognized. The offset between the resulting build-to-suit asset balance and the financing obligation, if any, would be recognized in equity.

The subsequent accounting for the improvements should be consistent with that for other leasehold improvements. That is, the amortization period would be limited to the lease term in accordance with ASC 842-20-35-12.

The journal entries in transition are shown below. Note that, for simplicity, there are no adjustments for subsequent measurement between November 12, 2018, and the effective date of ASC 842 (i.e., depreciation of the building, amortization of the $6 million in prepaid rent, or payments on the financing obligation). These subsequent-measurement adjustments would most likely result in an adjustment to equity, which is not depicted below.

Company C would also recognize any remaining lease payments as a lease liability, along with an offsetting ROU asset, in accordance with the lessee transition requirements in ASC 842-10-65-1(k)–(t).

Question 2

How should a lessee approach the transition for a build-to-suit arrangement when construction was not completed, and the lease had not commenced, as of the effective date of ASC 842?

Answer

The table below summarizes the transition approach an entity should use in those circumstances.

ASC 840 Determination	ASC 842 Determination	Transition Approach
Lessee was the deemed owner	Lessee has control during construction	No change in accounting; asset and financing obligation remain on the balance sheet during the comparative periods and as of the effective date.
Lessee was the deemed owner	Lessee does not have control during construction	If the lessee was determined to be the deemed accounting owner under ASC 840 before the date of initial application, derecognize the asset and financing obligation recognized solely as a result of the build-to-suit designation and reflect the difference, if any, in equity. If the lessee was determined to be the accounting owner of the asset during the comparative periods (i.e., construction commenced during the comparative periods), and the Comparatives Under 840 Option was not elected, the lessee should reverse the impact of the accounting for the appropriate line items and not reverse the impact through equity.
Lessee was not the deemed owner	Lessee has control during construction	Recognize the asset and financing obligation as of the later of the date of initial application or the date as of which the lessee is determined to be the accounting owner of the asset in accordance with ASC 842. If a lessee elects the Comparatives Under 840 Option, the asset and financing obligation will be recognized as of the effective date of ASC 842. See the example below.

Example

Company A, a calendar-year-end public entity that has not elected the Comparatives Under 840 Option, has entered into an agreement with Company B to lease a newly constructed television studio. Company B began building the television studio on June 8, 2017, and construction is expected to be complete on November 5, 2019. The lease will commence once construction is complete. During the construction period, A can acquire the television studio in process of construction and therefore is deemed to control the construction project under ASC 842. Assume that A was not determined to be the deemed owner in accordance with ASC 840. When A initially applies ASC 842, because A is deemed to control the construction project under ASC 842 as of the effective date, it must recognize the cost of the in-process asset (and an offsetting financing obligation) during the comparative periods beginning June 8, 2017.

If A had elected the Comparatives Under 840 Option, A would first recognize the asset and financing obligation as of January 1, 2019 (the ASC 842 effective date).

Connecting the Dots

Lease Classification Assessment for Derecognized Build-to-Suit Arrangements in Transition

If a previous build-to-suit arrangement (for which construction was completed and the lease commenced before the effective date of ASC 842) was capitalized under ASC 840 and reversed upon the adoption of ASC 842, we generally believe that the appropriate framework for determining lease classification will depend on multiple factors as follows:

If the practical expedient package is not elected, lease classification should be determined under ASC 842, as follows:
- If the lease commenced before the date of initial application, lease classification would generally be determined as of the later of the (1) lease commencement date or (2) date the lease was last modified. 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.
- If the lease commenced after the date of initial application, the initial lease classification would generally be determined as of the lease commencement date.
The transition guidance is not clear on situations in which the practical expedient package is elected and the lessee has accounted for the transaction as a failed sale and leaseback through the effective date of ASC 842. We believe that, notwithstanding the election of the practical expedient package, it would be acceptable to determine lease classification in accordance with ASC 842 (i.e., as of the later of the (1) lease commencement date or (2) date the lease was last modified — see bullet above), because the lease (for accounting purposes) was never recognized or assessed under ASC 840 (i.e., the lease classification is assessed for the first time upon adopting ASC 842). However, we understand that others believe, because of the lack of clear guidance, that it would also be acceptable to determine lease classification as of lease inception under ASC 840. We think that either approach would be acceptable as an accounting policy that must be applied consistently.

Q&A 16-12A Accounting for a Previously Impaired Build-to-Suit Asset

Under ASC 840, a build-to-suit asset and financing obligation may be recognized on a lessee’s balance sheet as a result of a transaction’s build-to-suit designation, as described in Q&A 16-12. Thereafter, under ASC 360, a lessee could have determined that the asset group containing the build-to-suit asset was impaired, resulting in the measurement of an impairment loss, of which a portion was recognized against the build-to-suit asset.

The general transition provisions in ASC 842 indicate that a lessee that recognized an asset because it was the deemed owner under the ASC 840 build-to-suit guidance would, in accordance with ASC 842-10-65-1(u),31 (1) derecognize the asset and financing recognized solely as a result of the build-to-suit designation and (2) apply the general lessee transition requirements. Further, ASC 842-10-65-1(m)(2) and ASC 842-10-65-1(o), which apply to operating leases and finance leases, respectively, provide the following guidance on accounting for the ROU asset at transition when there is an existing ASC 420 liability:

2. The carrying amount of any liability recognized in accordance with Topic 420 on exit or disposal cost obligations for the lease. . . .

On the basis of the above guidance, it is clear that the initial ROU asset is generally recorded net of any ASC 420 liability at transition. However, under a deemed ownership model, entities have historically looked to the impairment guidance in ASC 360 instead of the exit cost guidance in ASC 420. As a result, entities have questioned how previous impairment charges recognized on a build-to-suit asset should be treated in transition given that the asset to which the impairment is related will be derecognized upon adoption of ASC 842. In other words, entities have asked whether the historical ASC 360 impairment charge should or could affect the measurement of the ROU asset in transition.

Question

When a lessee previously recognized impairment for a build-to-suit asset subject to derecognition under ASC 842-10-65-1(u)(1), how should the lessee consider the historical impairment when recognizing and measuring the related ROU asset at transition?

Answer

We believe that a lessee should subject the newly recognized ROU asset to a full impairment test in accordance with ASC 360 as of the effective date of ASC 842 if an impairment indicator continues to exist as of this date. Accordingly, a lessee would determine a “new” impairment amount on the basis of the test conducted as of the effective date. In addition, we believe that it is acceptable to recognize the impairment loss, if any, determined as of the date of initial application of ASC 842 through an adjustment to equity, with a corresponding reduction to the carrying amount of the ROU asset. We think that recognition of the impairment loss in equity is appropriate since it reflects a unique circumstance in which the adjustment effectively results from an impairment indicator that arose before the date of initial application of ASC 842.

However, since ASC 842 does not provide clear guidance on this situation, there may be other acceptable approaches. We encourage stakeholders who are affected by this issue to consult with their accounting advisers and auditors to understand their views.

Footnotes

The outcome of this example would not be affected by whether the entity elected the Comparatives Under 840 Option.

See Q&A 16-12 for an excerpt of the transition guidance in ASC 842-10-65-1(u).

16.10 Amounts Previously Recognized From Business Combinations

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) . . .

h. If an entity has previously recognized an asset or a liability in accordance with Topic 805 on business combinations relating to favorable or unfavorable terms of an operating lease acquired as part of a business combination, the entity shall do all of the following:

1. Derecognize that asset and liability (except for those arising from leases that are classified as operating leases in accordance with Topic 842 for which the entity is a lessor).

2. Adjust the carrying amount of the right-of-use asset by a corresponding amount if the entity is a lessee.

3. Make a corresponding adjustment to equity if assets or liabilities arise from leases that are classified as sales-type leases or direct financing leases in accordance with Topic 842 for which the entity is a lessor. Also see (w). . . .

Lessee

For any assets or liabilities recognized in accordance with ASC 805 that are related to favorable or unfavorable terms of an operating lease for which an entity is a lessee, the entity should derecognize the asset or liability and commensurately adjust the ROU asset. In other words, if a lessee has a favorable lease intangible (asset), the lessee should derecognize the intangible asset and add an offsetting amount to the ROU asset. If a lessee has an unfavorable lease intangible (liability), the lessee should derecognize the liability and reduce the ROU asset by the same amount.

Lessor

When a lessor has previously recognized assets or liabilities for an off-market operating lease in a business combination, the asset or liability should continue to be recognized separately from the lease accounting. Generally, an acquirer in a business combination that is a lessor under a sales-type or direct financing lease would include any off-market assets or liabilities in the net investment in the lease (i.e., a separate asset or liability would not be recognized). In those cases, the lessor would not make any adjustment for the off-market terms. However, if any separate balances exist regarding a lessor’s sales-type or direct financing lease (other than in-place lease intangibles), the entity should derecognize the asset or liability and “make a corresponding adjustment to equity” in accordance with ASC 842-10-65-1(h).

16.11 Transition Disclosures

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) . . .

Disclosure

i. An entity shall provide the transition disclosures required by Topic 250 on accounting changes and error corrections, except for the requirements in paragraph 250-10-50-1(b)(2) and paragraph 250-10-50-3. An entity that elects the transition method in (c)(2) shall provide the transition disclosures in paragraph 250-10-50-1(b)(3) as of the beginning of the period of adoption rather than at the beginning of the earliest period presented.

Note: See paragraph 250-10-S99-6 on disclosure of the impact that recently issued accounting standards will have on the financial statements of a registrant.

j. If an entity uses one or more of the practical expedients in (f), (g), and (gg), it shall disclose that fact.

jj. An entity electing the transition method in (c)(2) shall provide the required Topic 840 disclosures for all periods that continue to be in accordance with Topic 840. . . .

An entity adopting ASC 842 should provide the transition disclosures required by ASC 250, excluding the disclosure in ASC 250-10-50-1(b)(2) about the effect of the change on income from continuing operations, net income, any other financial statement line item, and any per-share affected amounts for any of the periods. Moreover, entities do not need to provide the corresponding interim disclosures required by ASC 250-10-50-3. The disclosure required by ASC 250-10-50-1(b)(3) regarding “[t]he cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position” must be provided as of the date of initial application of ASC 842.

An entity adopting ASC 842 must also disclose the transition practical expedients used, as applicable.

An entity electing the Comparatives Under 840 Option must provide the ASC 840 disclosures for all periods that are presented in accordance with ASC 840 (see Section 16.1.1).

Connecting the Dots

ASC 840 Disclosures Required in the Comparative Periods

The Board revised the language in ASU 2018-11 to clarify that an entity must provide the ASC 840 disclosures for all periods that are presented in accordance with ASC 840. As part of this requirement, the entity must apply the guidance in ASC 840-20-50-2(a) (commonly referred to as the “lease commitments table”) as of the latest balance sheet presented. Further, paragraph BC14 of ASU 2018-11 indicates that the latest balance sheet date presented should be the latest balance sheet date presented under ASC 840 (e.g., December 31, 2018, for a PBE with a calendar year-end). Therefore, for a PBE with a calendar year-end, the ASC 840-20-50-2(a) lease commitments table as of December 31, 2018, will be presented in the annual financial statements for the year ended December 31, 2019. Also, paragraph BC14 of ASU 2018-11 indicates that the ASU does not change, or create additional, “interim disclosure requirements that entities previously were not required to provide.” In discussions with the FASB staff regarding what disclosures are required in interim periods during the year of adoption, the staff clarified that it would expect an entity to disclose the lease commitments table as of December 31, 2018 (on the basis of the fact pattern described above) in each interim period in the year of adoption. For example, an entity would present the lease commitments table for the year ended December 31, 2018, in the first-quarter 2019 Form 10-Q. The table would not be updated to reflect a run-off of three months of activity that occurred during the first quarter of 2019, nor would the entity need to present a lease commitments table as of March 31, 2018. Rather, the table presented in the December 31, 2018, Form 10-K would be carried forward to the first-quarter 2019 Form 10-Q.

While ASC 842 may not require entities to provide certain of the above prescribed disclosures in interim financial statements, SEC rules and staff interpretations require SEC registrants to provide both annual and interim disclosures in the first interim period after the adoption of a new accounting standard and in each subsequent quarter in the year of adoption. Specifically, Section 1500 of the SEC Division of Corporation Finance Financial Reporting Manual (FRM) states:

[Regulation] S-X Article 10 requires disclosures about material matters that were not disclosed in the most recent annual financial statements. Accordingly, when a registrant adopts a new accounting standard in an interim period, the registrant is expected to provide both the annual and the interim period financial statement disclosures prescribed by the new accounting standard, to the extent not duplicative. These disclosures should be included in each quarterly report in the year of adoption.

See Chapter 18 for further discussion of SEC reporting considerations for SEC registrants, including SAB Topic 11.M disclosure requirements.

	Public Companies1	Public NFPs2	All Other Entities
As originally issued (ASU 2016-02)	Fiscal years beginning after December 15, 2018, and interim periods therein	Fiscal years beginning after December 15, 2018, and interim periods therein	Fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020
As amended by ASU 2019-10	No changes	No changes	Fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021
As amended by ASU 2020-05	No changes	Fiscal years beginning after December 15, 2019, and interim periods therein	Fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022