ASC 842 and IFRS 16: Understanding Practical Expedients
During the creation, evaluation, codification and ultimate adoption of ASC 842 and IFRS 16, the Boards -- FASB (Financial Accounting Standards Board) and IASB (International Accounting Standards Board) -- considered the enormity of the task that would be undertaken by the firms implementing the standards.
They inserted several shortcuts or considerations -- called practical expedients -- to lessen certain impacts to companies in the adoption of ASC 842 and IFRS 16 and provide relief in the task at hand. This article will explore several of those practical expedients.
The following sections highlight useful practical expedients and potential traps:
Potential Traps of Practical Expedients
First, let us explain a "trap." A "trap" is when the selected expedient appears to lessen the amount of work necessary to adopt a standard, but in actuality, only works to move the workload elsewhere.
Certain expedients may lessen the work necessary to report on a firm's lease portfolio. However, if by chance an expedient allowed a firm to avoid placing individual leases, i.e., the Present Value (PV) of the leases, onto the balance sheet of the company, as a Right-of-Use Asset (ROU) and Lease Liability (LL), that does not mean that a firm cannot report on those leases benefitted by the expedient.
It more accurately means that the footnotes to their financial statements need to be beefed-up and expanded to address and inform the recipient of a firm's financial statements of the benefit gained by selecting said adopted expedient(s).
Short-Term Lease Exemption
The Short-Term Lease Exemption expedient -- adopted by both the FASB and IASB -- allows a firm to classify a lease term of 12-months or less as a short-term lease and not present them on their balance sheet. Instead, a firm can continue to treat them as operating leases.
The critical difference between how the FASB and IASB adopted this rule is that under the IASB adoption, a lease with a purchase option in it cannot be a short-term lease no matter how short the lease term.
Meanwhile, the FASB adoption of their short-term lease expedient allowed more leniency, in that even if the lease of 12-months or less had a purchase option, it could still be classified as a short-term lease provided the lessee was reasonably certain not to exercise the option.
This Short-Term Lease Exemption is one of the "Trap" expedients mentioned above in that while it will not be on your balance sheet technically, it does need to be in the footnotes.
Low-Value Asset Exemption
A similar practical expedient is the one commonly known as the Low-Value Asset Exemption, which unfortunately was only adopted by the IASB. This expedient allows a firm to avoid placing lease assets on their balance sheet provided they had a value, when new, of less than $5,000.
Here it is important to note that whether a lease is for one asset at the sub-$5,000 value or 1,000 assets at the sub-$5000 value -- both lease scenarios qualify.
This, too, is another "Trap" expedient in that while it will not be on the balance sheet, it also needs to be in the footnotes.
Practical Expedients Under ASC 842
The aforementioned expedients are individual and can be adopted that way. However, there is a package of practical expedients available under the FASB adoption rules of ASC 842 that must be adopted jointly and applied, whether a firm is a lessee or lessor.
This package contains three expedients, and their adoption will have significant time-saving benefits during the kick-off and initialization of an ASC 842 project:
- The first expedient is that contracts do not have to be reassessed as to whether they contain a lease. The presumption is that organizations are already accounting for leases properly under ASC 840. As such, they do not have to do this re-evaluation. This speaks directly to the issue of Embedded Lease(s).
- The second expedient allows for organizations to not have to reassess whether the lease was classified as an Operating or Capital lease under ASC 840. Going forward under ASC 842, they will be referred to as Operating Leases or Financing Leases -- instead of Capital Leases.
- The third and final practical expedient in this package is the reassessment of Initial Direct Costs in existing leases. Previously under ASC 840, a firm could allocate the internal costs of acquiring a lease to Initial Direct Costs. Under ASC 842, Initial Direct Costs are now defined as costs that would not have incurred had a lease not been acquired -- typically external costs.
The bottom line is that reassessment of existing lease(s) Initial Direct Costs is not necessary upon adoption of ASC 842 if this package of practical expedients has been adopted.
Uncovering the Benefits
Practical expedients were crafted as a response to significant challenges concerning the new lease accounting standard and financial reporting. Electing to use these practical expedients can help your organization save time and money, but if they are not used correctly, they can end up causing accounting errors and disrupting cash flows.
For further information about how practical expedients can help your organization, contact us today.