It’s almost the time we all have been waiting for – theimplementation of ASC 842! After several FASB deferrals, calendar-year private companies will need to implement ASC 842 starting January 1, 2022.
Private companies with fiscal year ends will luckily have up to an additional year to prepare and wait for us all to work the kinks out. Since private companies do not require implementing ASC 842 on interim financial statements until after their first annual reporting period, they may feel like they have some additional flexibility to wait a little longer. However, the longer you postpone, the more difficult it will be to comply under a compressed time frame.
The implementation of ASC 842 takes longer than expected depending on the size and complexity of your lease portfolio, along with the depth of your accounting department – planning is needed for a seamless transition.
Here, we highlight some details within ASC 842 that may require some additional analysis for implementation, such as identifying “embedded leases” and “substitution rights”:
Under this new leasing standard, a contract contains a lease if the customer has the right to control the use of identified property for a specific period of time, in exchange for consideration.
While the assessment of whether a lease exists is relatively straightforward, the evaluation is more complex when an arrangement involves both a service component and a leasing component, or when both the customer and supplier can make decisions about the use of the underlying asset (an “embedded lease”). Given that part of a contract can meet the definition of a lease, it’s essential to ensure all boxes are checked, as leases could be buried within seemingly non-lease transactions – making it challenging to identify.
Implementing ASC 842 Example
A company (the customer) enters a contract with an information technology provider to host its data on a specific server. If a server is specifically identified (e.g., model and serial number) and the company has the right to direct the use of a specified server, the contract may meet the definition of a lease. However, if the contract is non-specified “server space,” where the provider can “move your data around” at their discretion, then it is not a lease.
In determining whether a customer has the right to control the use of the specified asset, for a specific time frame, the customer must determine whether it has both:
- The right to obtain substantially all of the economic benefits from the use of the asset, and
- The right to direct the use of such asset.
A. Right to Obtain Economic Benefits Considerations
- The customer has the exclusive right to use the asset through the life of the contract.
- The customer obtains economic benefits by using, holding or subleasing the asset.
- These economic benefits include the direct output of the asset and the related cash flows, or other benefits resulting from contracts with third parties.
- Conditions that may limit the scope of economic benefits, such as mileage limits on a vehicle, do not impair the economic benefits obtained. If this type of limitation exists, the customer assesses whether substantially all economic benefits have been obtained for the specified period.
- Additional payments made to the supplier above the base rate, such as a percentage of sales, do not offset economic benefits; they are simply considered additional consideration for the use of the asset.
B. Right to Direct the Use of the Asset are Present When
- The customer determines how the asset is used through the life of the contract; or
- The use of the asset is predetermined per the terms of the contract and the terms cannot be changed by the supplier during the life of the contract, or the customer has designed the asset in such a way that the use of the asset is predetermined by virtue of such design.
According to paragraph 842-10-15-10 of ASC 842, even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
- The supplier has the practical ability to substitute alternative assets throughout the period of use. For example, the customer cannot prevent the supplier from substituting an asset. Alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period.
- The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
ASC 842 further states, “If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive.”
A contract should be carefully evaluated to determine whether a substantive substitution right exists throughout the period of the asset’s use.
One of the most significant benefits available to private companies is the opportunity to learn from major public companies that have already gone through the implementation process over the past two years. Reviewing and tailoring their footnotes makes their financial reporting a bit easier. In addition, several software packages have been developed to assist with the process and automate the reporting. Although auditors are unable to perform management functions, many private companies will ask their accountants to help track their leases like they do their fixed assets.
Maybe you’ve already started the implementation process, or maybe you have no idea where to begin. No matter where you are, our specialists can assist.
Author: Kyle McClure | [email protected]
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