Beginning January 1, 2022, both operating and finance leases will have an impact on the balance sheet. The unfortunate reality of this requirement is that the calculations to determine ROU assets and lease liabilities are inherently difficult. The Financial Accounting Standards Board (FASB) isn’t all bad, though. To ease just a little bit of the pain, a few reliefs were offered. These reliefs are referred to as practical expedients.
Note to auditors: Practical expedients provide an opportunity to connect with audit clients to ensure they are aware of the easier option for some aspects of the new lease standard. Getting this information in front of clients sooner rather than later will make their lives better and, as a major plus, will make audits much smoother.
The entire list of reliefs that the FASB outlined is worth exploring, but here is a summary of a couple of particularly worthwhile practical expedients to alleviate some ASC 842 stress.
The discount rate used in lease calculations to determine the ROU asset and lease liability is one of three options.
- The rate implicit in the lease.
- The company’s incremental borrowing rate (IBR).
- The risk-free rate (for private companies only).
The rate implicit in the lease is essentially the profit margin for a lessor, so chances are very high that a lessee is not going to get their hands on that information. An IBR becomes difficult to calculate extremely quickly. At Netgain, very few clients use this rate because getting an accurate IBR typically involves hiring a valuation specialist. While using the IBR would expectedly result in a lower balance sheet impact, the benefit is probably not worth the consulting fees of the valuation specialists for just a few leases. This leaves the risk-free rate.
Help your clients understand that they can get their discount rate with just a few clicks. The Department of Treasury’s website is much easier than picking apart a valuation team’s IBR calculation or tracking down a lessor to verify the rate implicit in their lease. If your private-company client does not know the risk-free rate is an option. Clients surely will be happy they were informed.
Effective Method Transition
Another helpful practical expedient is the effective method of transition. Essentially, a company is not required to calculate the ROU asset and lease liability for prior period financial statements. Leases can simply be presented under ASC 842 beginning in January 2022. Consider a leased office space that began in January 2017 and is leased through December 2026. Instead of calculating the balance-sheet amounts for 2017 through 2021, the practical expedient allows a company to calculate the balance-sheet impact for the five remaining years beginning in January 2022.
A few nuances exist with this relief, so give the actual FASB guidance a thorough review. The thought of retroactively applying this new leasing standard is formidable, to say the least.
Note to auditors: A quick conversation with a client to share the option of the use of hindsight could potentially save the day. Not to mention, a prospective approach will also make for a quicker audit if, and when, the lease accounts are scoped in.
When it comes to enjoyability, lease accounting falls short of visiting the in-laws or going to the dentist. But the process of adopting ASC 842 can be less terrible after carefully applying the correct reliefs for an audit client. Spend some time reviewing the practical expedients in full and then be sure clients are on board with them. Getting on top of this process now could save a few late nights and Saturdays next busy season.
For more information for auditors, check out our Transition Guide for Auditors.