This is the third post in our series on ASC 842, Leases. Read the first, second, and fourth posts here.
Identifying the population of leases and properly stratifying the different types of leases to perform a technical analysis are crucial steps in implementing ASC 842. We find that companies often struggle with maintaining a straightforward process that meets requirements for disclosing under SEC and ASC 840 rules. For many companies a lack of focus on the up front lease decision drives challenges in transparency on lease contracts resulting in the use of manual spreadsheets or multiple data repositories, depending on the type of lease (for example, maintaining a population of real property leases in one software program and a population of equipment leases in excel). Manual spreadsheets pose an efficiency problem, however, because the regular disclosure and reporting necessary under ASC 842 require more consistent and refreshed data.
The initial identification of the population cannot be solved purely by automation and data solutions, although these solutions may be helpful for the future state implementation. Companies must first identify and gain comfort over their lease populations prior to reviewing data solutions to meet the disclosure and reporting requirements under ASC 842. One area that causes a fair amount of challenge is the identification of embedded leases!
Due to the clarification of the definition of a lease under ASC 842, companies must review the impact on existing contracts and arrangements to ascertain if they are affected by this clarified definition or if the impacts are captured. In addition, since all leasing arrangements will be recorded on the balance sheet, there is a heightened importance on the completeness of lease arrangements, including potential leases embedded within other contracts. The fact that a contract is not explicitly defined as a lease does not necessarily mean the arrangement does not contain a lease under ASC 842. If identified, these embedded leases will have to be bifurcated from the contract and accounted for within ASC 842, and a process must be developed within companies to regularly track new arrangements for leasing characteristics as they are entered into or even better, during the contracting process.
It’s important to remember that an embedded lease can be identified where your company is a lessee or a lessor. The best path to developing a process will involve feedback from functions with insight into contractual arrangements involving the company, such as supply chain, revenue teams, or contract teams. It’s important to develop a process in which those functions help identify arrangements that may have leasing characteristics, such as when company assets are held on customer property or when supplier assets are held on company property. The technical accounting teams can then target their focus on identifying a lease on contracts that are likely to be more at risk at meeting the new definition. Consider also leveraging your ASC 606 process to help identify customer arrangements that may require bifurcation of a lease, such as adding lease scoping questions to the initial setup process.
There are a number of practical expedients in ASC 842 designed to ease the burden of the transition, essentially allowing companies to continue to recognize ASC 840 accounting for certain leases. In particular, there is a package of three expedients that allow the adopter to not have to reevaluate conclusions around the identification and classification of a lease under ASC 840. Unfortunately for many, this does not mean that incorrect or missing assessments are grandfathered into ASC 842.