The ASC 842 leasing standard has been saved
The ASC 842 leasing standard
On the Radar: A roadmap to adoption and implementation
Lease accounting is like a tale of two cities, with Companies that have adopted ASC 842 in one and those that have not yet adopted the standard in the other. That means some may be more focused on ongoing activity at the FASB and the impact of real estate rationalization efforts on lease accounting, while others are still grappling with implementation changes.
Ongoing accounting standard-setting activities
This On the Radar applies to both PBEs and non-PBEs and is divided into the following sections on the basis of whether an entity has adopted ASC 842:
- Lease accounting hot topics for entities that have adopted ASC 842
- Ongoing accounting standard-setting activities
- Implementation considerations for entities that have not yet adopted ASC 842
Lease accounting hot topics for entities that have adopted ASC 842
The COVID-19 pandemic ignited a shift in how entities in almost every industry sector are doing business. Many entities are reevaluating where their employees conduct their required business activities and to what extent they will rely on the use of brick-and-mortar real estate assets on a go-forward basis. Specifically, many entities have already initiated (or may soon initiate) a real estate rationalization program to reevaluate their organization-wide real estate footprint. The goal of initiating such programs may be for entities to rightsize their real estate portfolios to manage costs while adequately supporting their evolving business needs.
We have observed an increase in entities abandoning properties, subleasing space they are no longer using, or modifying existing leases to change the amount of space or the lease term. Further, as a financing method to improve their liquidity, entities are increasingly entering into sale-and-leaseback transactions involving real estate. As a result of these real estate rationalization efforts, companies are also more frequently evaluating leases for impairment. Each of these topics is addressed below (also see Deloitte’s March 30, 2021, Accounting Spotlight for a more detailed discussion). Please note that the accounting considerations below apply to entities that have already adopted ASC 842. Entities that have not yet adopted ASC 842 should work with their accounting advisers to determine the impact of real estate rationalization under ASC 840.
Ongoing accounting standard-setting activities
Since the issuance of ASU 2016-02 several years ago, the FASB has released various ASUs to provide additional transition relief and make certain technical corrections and improvements to the standard.
In July 2021, the FASB issued ASU 2021-05, which changed the accounting for lessors of leases with variable payments that do not depend on an index or rate. This new guidance requires a lessor to classify a lease with any variable lease payments as an operating lease at lease commencement if both of the following conditions are met:
- The lease would have been classified as a sales-type lease or direct financing lease in accordance with the classification criteria in ASC 842-10-25-2 and 25-3, respectively.
- The lessor would have recognized a selling loss at lease commencement.
This amendment was designed to eliminate the possibility that an economically profitable arrangement would lead the lessor to recognize a loss at lease inception as a result of the ASC 842 measurement requirements for variable lease payments that are not based on an index or rate.
In addition, in November 2021, the FASB issued ASU 2021-09, which allows lessees that are not PBEs to make an accounting policy election by class of underlying asset, rather than on an entity-wide basis, to use a risk-free rate as the discount rate when measuring and classifying leases.
The FASB has also made several leasing-related tentative decisions at recent meetings. On June 22, 2022, the FASB decided to remove the lease modifications project from its technical agenda. The FASB had previously directed its staff to identify potential improvements to the lease modification model in response to both comment-letter feedback and discussion at the September 2020 public roundtables. During the meeting, the Board directed the staff to evaluate targeted refinements to the lease modifications model as part of its broader postimplementation review of ASC 842.
Moreover, on September 21, 2022, the FASB added a project to its technical agenda and plans to issue a proposed ASU to address the following issues related to arrangements between entities under common control:
1. What terms and conditions an entity should consider for determining whether a lease exists and, if so, the classification and accounting for that lease.
2. Accounting for leasehold improvements associated with leases between entities under common control.
The FASB continues to evaluate stakeholder feedback on the adoption of ASC 842. Stay tuned for future refinements in accounting standard setting as a result of these initiatives.
Implementation considerations for entities that have not yet adopted ASC 842
While the accounting issues discussed above may affect both public and private companies, the accounting implications for those that have adopted ASC 842 may differ from those that are still applying ASC 840.
ASU 2020-05 (issued in June 2020) amended the effective dates of the leasing standard that were previously delayed in ASU 2019-10 (issued in November 2019) to give implementation relief to certain types of entities in response to the COVID-19 pandemic. ASU 2020-05 amends the effective dates of ASU 2016-02 as follows:
The most significant changes in the new leasing standard are as follows:
- Lessees record most leases on the balance sheet.
- Bright-line tests are no longer used to determine lease classification, thus eliminating a potential source of structuring.
- Certain underlying principles of lessor accounting are aligned with those in ASC 606, the FASB’s revenue standard.
- Expanded disclosures are required for both lessees and lessors, including the requirement for lessors to provide more transparent information about their exposure to the changes in the value of residual assets as well as how they manage that exposure.
Non-PBEs that have not yet adopted ASC 842 should work with their accounting advisers when dealing with the real estate rationalization topics described in the previous section and throughout the implementation of ASC 842. Further, entities should review the best practices for adoption below.
Critical areas of adoption process
In implementing ASC 842, entities will need to change not only their accounting for and financial reporting of leases but also their related systems and processes. It is important for all entities to develop an implementation plan well before ASC 842’s effective date. Although some of the accounting changes may seem intuitive, the necessary data and systems changes are significant and, without preparation, may be overwhelming.
Phases of implementation
The sections below highlight five phases of adopting ASC 842, including key activities that an entity may perform and factors it may consider to gauge how much time and effort it will take to complete certain steps in the transition process. Although implementation strategies vary, we developed these recommendations on the basis of experiences with public-company implementation. While an entity works toward adoption of ASC 842, the entity’s normal operations do not cease; new leases are entered into, and existing leases are modified or terminated. Accordingly, the adoption of ASC 842 should not be viewed strictly as a linear process.