FASB re-leases targeted improvements to ASC 842 Bookmark has been added
FASB re-leases targeted improvements to ASC 842
This Heads Up discusses the FASB’s recently issued Accounting Standards Update (ASU) No. 2018-11, Targeted Improvements to ASC 842, Leases, which provides entities with relief from the costs of implementing certain aspects of the new leasing standard, ASC 842.
On July 30, 2018, the FASB issued ASU 2018-11 to provide entities with relief from the costs of implementing certain aspects of the new leasing standard, ASU 2016-02 (codified as ASC 842). Specifically, under the amendments in ASU 2018-11:
- Entities may elect not to recast the comparative periods presented when transitioning to ASC 842 (Issue 1).
- Lessors may elect not to separate lease and nonlease components when certain conditions are met (Issue 2).
These amendments are consistent with the tentative decisions that the Board made at its November 29, 2017, meeting and further refined at its March 7, 2018, and March 28, 2018, meetings. In addition, on July 19, 2018, the FASB issued ASU 2018-10, which made 16 separate amendments to ASC 842. For more information on these amendments, see the appendix in the attached pdf.
Key Provisions of ASU 2018-11
The scope of the amendments in the ASU is as follows:
- Transition Relief (Issue 1) — These amendments, which allow entities to report the comparative periods presented in the period of adoption under ASC 840, affect all entities with lease contracts that elect not to restate their comparative periods in transition.
- Lessor Relief (Issue 2) — These amendments, which give lessors the option of electing, as a practical expedient by class of underlying asset, not to separate the lease and nonlease components of a contract, only affect lessors whose lease contracts meet certain criteria (discussed below).
Note that while the Issue 1 amendments may benefit both lessees and lessors, the Issue 2 amendments will benefit only lessors.
Transition Relief (Issue 1)
ASC 842 originally required all entities to use a “modified retrospective” transition approach that is intended to maximize comparability and be less complex than a full retrospective approach. (See Deloitte’s A Roadmap to Applying the New Leasing Standard for further discussion of the effective date and transition guidance in ASC 842.)
Under the modified retrospective approach, ASC 842 is effectively implemented as of the beginning of the earliest comparative period presented in an entity’s financial statements. That is, a public business entity for which the standard becomes effective on January 1, 2019, would first apply ASC 842 and recognize an adjustment for the effects of the transition as of January 1, 2017 (i.e., the date of initial application).
ASU 2018-11 amends ASC 842 so that entities may elect not to recast their comparative periods in transition (the “Comparatives Under 840 Option”). The ASU allows entities to change their date of initial application to the beginning of the period of adoption. Therefore, a public business entity with a calendar year-end could elect to have a date of initial application of January 1, 2019. In doing so, the entity would:
- Apply ASC 840 in the comparative periods.
- Provide the disclosures required by ASC 840 for all periods that continue to be presented in accordance with ASC 840.
- Recognize the effects of applying ASC 842 as a cumulative-effect adjustment to retained earnings as of January 1, 2019.
The entity would not:
- Restate 2017 and 2018 for the effects of applying ASC 842.
- Provide the disclosures required by ASC 842 for 2017 and 2018.
- Change how it applies the transition requirements, only when it applies the transition requirements.
Connecting the Dots — ASC 840 Disclosures Required in the Comparative Periods
In response to the discussion at its March 7, 2018, meeting, 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 “five-year table”) as of the latest balance sheet presented. Further, the ASU 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 public business entity with a calendar year-end). Therefore, for a public business entity with a calendar year-end, the ASC 840-20-50-2(a) five-year 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.”
We believe that it is still unclear what the U.S. GAAP and SEC reporting requirements would be with respect to the five-year table in the first interim period in the year of adoption of ASC 842. While ASC 842 may not require entities to provide certain of the 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 Financial Reporting Manual 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.
We plan to seek further guidance from the FASB regarding what disclosures are required in interim periods during the year of adoption.
Effective Date and Transition
The transition relief amendments (Issue 1) in the ASU apply to entities that have not yet adopted ASC 842. Entities that have early adopted ASC 842 cannot elect the Comparatives Under ASC 840 Option.
Lessor Relief (Issue 2)
ASU 2016-02, as initially issued, required lessors to separate lease and nonlease components in all circumstances. Under this requirement, once separate components are identified, lessors are required to use the relative stand-alone selling price allocation method in ASC 606 to allocate the consideration in the contract to the separated components. ASC 842 (including the presentation and disclosure guidance) applies to the lease component, while other guidance, typically ASC 606 (including the presentation and disclosure guidance), applies to the nonlease component.
As a result of stakeholder feedback indicating that the costs of complying with the separation and allocation requirements for lessors outweigh the benefits, ASU 2018-11 amends ASC 842 to include a practical expedient under which lessors are not required to separate lease and nonlease components.
Connecting the Dots — Practical Expedient Creates Greater Alignment Between Lessee and Lessor Accounting
ASU 2018-11 aligns the lessor’s accounting for the separation of lease and nonlease components with that for lessees. Unlike lessors, lessees have always been able, under ASC 842, to elect a practical expedient under which they can choose not to separate (and allocate consideration to) lease and nonlease components (see ASC 842-10-15-37). However, lessees do not have an option of accounting for the combined component under ASC 842 or other U.S. GAAP. A lessee’s combined component must always be accounted for under ASC 842. Both lessors and lessees may now elect to account for the nonlease components in a contract as part of the single lease component to which they are related. Note that this election is an accounting policy election that must be made by class of underlying asset.
Criteria for Combining Lease and Nonlease Components
A lessor may elect to combine lease and nonlease components provided that the nonlease component(s) otherwise would be accounted for under the new revenue guidance in ASC 606 and both of the following conditions are met:
- Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.
- Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.
The ASU also clarifies that the presence of a nonlease component that is ineligible for the practical expedient does not preclude a lessor from electing the expedient for the lease component and nonlease component(s) that meet the criteria. Rather, the lessor would account for the nonlease components that do not qualify for the practical expedient separately from the combined lease and nonlease components that do qualify.
Connecting the Dots — Assessing Timing and Pattern of Transfer
In the final ASU, the Board amended Criterion A to focus on the timing and pattern of transfer (i.e., a “straight-line pattern of transfer . . . to the customer over the same time period”) rather than on the timing and pattern of revenue recognition (as was originally proposed). The purpose of this amendment was to address concerns that the originally proposed practical expedient was unnecessarily restrictive and excluded contracts with variable consideration from its scope, since variable payments are accounted for differently under ASC 606 than they are under ASC 842.
Determining Which Component Is Predominant
As with the lessee practical expedient, the FASB originally proposed that a lessor should always be required to account for the combined component as a lease under ASC 842. However, on the basis of feedback it received, the Board revised the final ASU to require an entity to perform another evaluation to determine whether the combined unit of account is accounted for as a lease under ASC 842 or as a revenue contract under ASC 606. Specifically, an entity should determine whether the nonlease component (or components) associated with the lease component is the predominant component of the combined component. If so,
the entity is required to account for the combined component in accordance with ASC 606. Otherwise, the entity must account for the combined component as an operating lease in accordance with ASC 842.
Connecting the Dots — An Entity Will Need to Use Judgment to Determine the Predominant Component
As indicated in the ASU’s Background Information and Basis for Conclusions, the FASB decided not to include a separate definition or threshold for determining whether “the nonlease component is the redominant component in the combined component.” Rather, the Board indicates that an entity should consider whether it would “ascribe more value to the nonlease component(s) than to the lease component.” Further, the Board acknowledged that the term “predominant” is used elsewhere in U.S. GAAP, including ASC 8428 and ASC 606.
The FASB also indicates that it is comfortable with allowing entities to use judgment in making this determination. The Board explains that it does not expect that an entity will need to perform a detailed quantitative analysis or allocation to determine whether the nonlease component is predominant. Rather, it is sufficient if an entity can reasonably determine whether to apply ASC 842 or ASC 606.
At its March 28, 2018, meeting, the Board discussed a scenario in which the components were evenly split (e.g., a 50/50 split of value) and suggested that, in such circumstances, the combined component should be accounted for under ASC 842 because the nonlease component is not predominant. That is, the entity would need to demonstrate that the predominant element is the nonlease component; otherwise, the combined unit of account would be accounted for as a lease under ASC 842.
We believe that the final language in the ASU is intended to indicate that an entity would need to determine whether the lease or nonlease component (or components) is larger (i.e., has more value); only when the nonlease component is larger should the combined component be accounted for under ASC 606.
Connecting the Dots — Accounting for Variable Payments Follows the Scoping of the Combined Component
At its March 28, 2018, meeting, the Board decided that the Background Information and Basis for Conclusions of the new leasing standard should include language regarding the interaction between the practical expedient and the guidance in (1) ASC 842-10-15-39 on consideration in the contract and (2) ASC 842-10-15-40 on the recognition of variable payments. Specifically, the ASU clarified the Board’s intent that the accounting for variable payments should be consistent with that for the combined component. That is, when the combined component is accounted for as a lease under ASC 842, there are no longer any nonlease variable payments; rather, there are only variable payments related to the combined lease component. Conversely, if the combined component is accounted for as a service under ASC 606, all variable payments related to the combined component should be accounted for in accordance with the variable consideration guidance in ASC 606.
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