Perspectives

At "lease" there are answers to transition questions

This Heads Up addresses certain transition issues associated with the adoption of the guidance in FASB Accounting Standards Codification Topic 842, Leases. Topics discussed in this publication include the interim reporting requirements associated with early adoption (including adoption in the fourth quarter of 2018); the determination of the lease obligation for existing operating leases; and the nuances of historical build-to-suit accounting, including the implications of historical impairments.

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Introduction

With less than three months to go before the leasing guidance in ASC 842 becomes effective for public companies, entities are increasing their focus on transition accounting. The purpose of this Heads Up is to provide our views on certain transition issues on which we regularly receive questions and that will have a direct impact on the transition entries recorded by affected companies. Two of the issues have been discussed with the FASB and SEC staffs and may increase flexibility for preparers depending on their historical accounting and materiality. Topics addressed in this Heads Up include the interim reporting requirements associated with early adoption (including adoption in the fourth quarter of 2018); the determination of the lease obligation for existing operating leases; and the nuances of historical build-to-suit accounting, including the implications of historical impairments. This publication also addresses implications of historical cease-use events as well as a common scenario in the retail industry, in which a company has an ASC 420 liability as of the adoption date that exceeds the amount of the right-of-use (ROU) asset that would otherwise be recognized in transition.

This Heads Up is divided into two parts. The body of this publication provides a high-level summary of each of the transition issues. The appendix contains Q&As that comprehensively address each of these issues as well as our views on them.

For more information about transition issues related to the adoption of ASC 842, see Chapter 16 of Deloitte’s A Roadmap to Applying the New Leasing Standard. Readers with any other questions about ASC 842 should also consult this Roadmap, which serves as a comprehensive guide to the new leasing guidance.

Q&A 1 Early Adoption of ASC 842 in an Interim Period Other Than the First Interim Period in a Fiscal Year

For PBEs, as well as certain not-for-profit entities and employee benefit plans, the guidance in ASC 842 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018 (e.g., for calendar-year-end entities, annual periods beginning on January 1, 2019). The guidance allows for early adoption in an interim period. ASC 842 does not address whether an entity is permitted to early adopt the guidance in an interim period other than the first interim period in a fiscal year, nor does it specifically prohibit early adoption in any interim period in a fiscal year. We believe that an entity may elect to early adopt the guidance in an interim period other than the first interim period in a fiscal year and that, if elected, the early adoption should be reflected as of the beginning of the annual period.

Q&A 2 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. ASC 840 does not define the term “minimum rental payments,” but the Background Information and Basis for Conclusions (BC) in ASU 2016-02 indicates that the application of this term should be similar to that under prior guidance. However, under ASC 840, there is diversity in practice related to how an entity quantifies minimum rental payments when preparing the disclosure of future commitments under operating leases (i.e., how to quantify lease payments that depend on an index or rate and whether to include or exclude executory costs), as described in Q&As 3 and 4, respectively. 

Q&A 3 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 under ASC 840. Diversity in practice exists with respect to the variable index or rate used in the disclosure of future operating lease payments (i.e., the “lease commitments table”) under ASC 840, since some entities have historically used an updated index or rate (i.e., a new/current rate each time the disclosure is prepared), while others have used the index or rate that existed at lease inception without updating it.

On the basis of formal discussions with the SEC staff, either historical approach is acceptable and it would be appropriate for a lessee to use the same approach for initial application of ASC 842 as it has historically used for disclosure purposes under ASC 840. An entity that wishes to change from its historical approach may be able to do so on the basis of variousfactors (e.g., materiality of the historical policy to the overall financial statements, the direction of the change, and the basis for the change). The following are some related considerations:

  • If an entity changes its historical approach from using the inception rate to using an updated rate, and the historical approach represents a material accounting policy, preferability is required and the entity must retrospectively apply the change in accordance with ASC 250. A change in this direction would generally be viewed as preferable.
  • If an entity historically updated the rate for disclosure purposes, the entity may change to using the inception rate without needing to perform a preferability assessment. A change in this direction is consistent with formal feedback received from the FASB staff.
  • If, on the basis of materiality, the historical disclosure approach is not considered an elected accounting policy, an entity could change the approach without establishing preferability and is not required to reflect the change in prior periods. 

Q&A 4 Approaches to Accounting for Executory Costs for Operating Leases in Transition

Under ASC 840, it was acceptable for an entity to include executory costs in, or exclude them from, the disclosure of minimum rental payments for operating leases. The FASB staff has generally indicated that a lessee would use its ASC 840 disclosure approach to determine the lease payments when establishing its lease liability upon adopting ASC 842 and would “run off” the balance. On the basis of discussions with the SEC staff, it would be appropriate for a lessee to use the same approach for initial application of ASC 842 as it has historically used for disclosure purposes under ASC 840. An entity that wishes to change its historical approach may be able to do so when making the transition to ASC 842. Some key considerations related to this issue are as follows: 

  • 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. 
  • If an entity’s historical approach related to executory costs has a material impact on its financial statements, it will generally represent the election of an accounting policy. Such a change must be applied retrospectively to all periods presented under ASC 840.
  • We do not believe that it would be appropriate (depending on the materiality of the  impact on the financial statements) for a lessee to change its ASC 840 disclosure approach for executory costs in a manner that reduces comparability to its ASC 842 accounting, including the impact of the lessee’s election to include nonlease components in, or exclude them from, the lease liability under ASC 842.

Q&A 5 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. An entity is not required to assess ASC 842’s principles of control during the comparative periods (regardless of whether the lessee was the deemed owner under ASC 840) as long as construction is complete and the lease commenced before ASC 842’s effective date. This is true regardless of whether an entityelects the Comparatives Under 840 Option. Therefore, the lessee should (1) derecognize any build-to-suit assets and liabilities that were capitalized solely as a result of the lessee’s being the deemed accounting owner and (2) recognize the difference, if any, in equity. Note that 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 and therefore should be retained (and perhaps recharacterized) in transition. For example, costs considered prepaid lease payments or payments for lessee-owned improvements would not be derecognized through equity upon transition. This Q&A discusses the derecognition requirements and contains examples illustrating the application of these requirements.

Q&A 6 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. Under this deemed ownership model, entities looked to the impairment guidance in ASC 360, which may have resulted in the recognition of historical impairment charges related to a build-to-suit asset. As discussed in Q&A 5, the build-to-suit transition guidance specifies that any build-to-suit assets and liabilities recognized under ASC 840 should be derecognized in transition unless the lease has yet to commence as of the effective date and the lessee controls the construction effort in accordance with ASC 842. ASC 842 addresses lease measurement related to situations in which an ASC 420 liability has been previously recorded for an operating lease but does not discuss historical ASC 360 impairments for build-to-suit arrangements that will be accounted for as leases under the new guidance. 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 and replaced by an ROU asset. Specifically, entities have asked whether the prior impairment should affect the measurement of the new ROU asset and, if so, how. 

To the extent that a historical impairment was recognized and the impairment indicator or indicators continue to exist as of the transition date, we believe that a lessee should subject a newly recognized ROU asset to a full impairment test in accordance with ASC 360 as of the effective date of ASC 842. Accordingly, a lessee would determine a “new” impairment amount on the basis of the impairment test conducted as of the effective date.

Q&A 7 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, offset by assumed sublease income. In accordance with ASC 420, an entity would record the liability in this manner regardless of whether the lessee has the intent to sublease the asset.

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, we do not consider an ROU asset to be abandoned if an entity has ceased use of the underlying asset but is currently subleasing (or plans to sublease) the asset. An entity’s receipt of sublease payments is considered as obtaining economic benefits from use of the underlying asset under ASC 842. However, 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, the entity should not recognize an ROU asset upon adopting ASC 842. In that situation, to the extent that any associated 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 should be written off as an adjustment to equity.

Q&A 8 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 costs such as maintenance (including common-area maintenance (CAM)), insurance, and property taxes associated with an exit or disposal activity related to an operating lease. Upon adoption of ASC 842, after the lease liability and corresponding ROU asset are established, ASC 420 liabilities reduce the carrying amount of the ROU asset. In certain circumstances, the carrying amount of a lessee’s ASC 420 liability immediately before ASC 842’s effective date for an existing operating lease may exceed the amount that would otherwise be recognized as the ROU asset as of the effective date (e.g., if the lessee’s ASC 420 liability included CAM, insurance, and property taxes). We do not believe it would be appropriate for a lessee to recognize a negative ROU asset in transition. See Q&A 8 in the appendix for approaches that we believe are acceptable in this scenario.

View the rest of the Heads Up.

Volume 25, Issue 17 | October 17, 2018

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