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Practical Expedient: Simplifying ASC 842 and IFRS 16

The latest lease accounting standards have added layers of complexity for accountants, requiring a more thorough examination of every contract in your portfolio. Organizations must now comb through documents to determine whether each contract is or contains a lease, possibly identify which type of lease it is, and follow a rigorous process to accurately record the liability it represents in your books.

The larger your portfolio, the more complex and time-consuming journal entries and other lease accounting activities become, especially when you have to re-examine leases and contracts you’ve already accounted for under previous standards.

Practical expedients are lease accounting shortcuts, allowing organizations to opt out of some more involved steps without underrepresenting the liabilities in their portfolios. A practical expedient is a time-saving option FASB and IASB created to maintain the integrity of their standards and accelerate adoption while recognizing the burden some new accounting activities place on organizations, particularly those with a multitude of contracts.

Reducing time spent on compliance helps organizations save on lease accounting costs, but at times, these expedients are a tradeoff that may over represent your financial liability. For example, if you opt to save time by not separating lease components from non-lease components within a contract, and instead treat the entire contract as a lease, it all shows up on the balance sheet as a liability, instead of just the lease component.

Each expedient is intended for a specific situation, and some may no longer be exercisable. For example, the practical expedient regarding COVID-related rent concessions only applies to payments originally due on or before June 30, 2021.

If a practical expedient doesn’t actually apply to your situation, implementing them can cause errors you’ll have to correct later, and which could create problems in the event of an audit.

In this article, we’ll cover all of the practical expedients in ASC 842 and IFRS 16, referring directly to the standards themselves and providing more context where helpful.

Practical expedients in ASC 842

The practical expedients in ASC 842 primarily focus on methods for transitioning to the new standard, but some emerged in response to more unique situations, like when entities share common control and enter a lease agreement.

Transition method expedients

Several ASC 842 practical expedients focus on enabling organizations to more easily transition from ASC 840 to ASC 842. FASB requires both lessees and lessors “to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach.”

Packaged practical expedients

If you’ve correctly adhered to ASC 840 and followed the guidelines for your existing leases, you may want to consider ASC 842’s package of practical expedients, which allows you to opt out of re-evaluating expired and existing leases. Old operating leases can remain operating leases, and old capital leases can simply be updated in name only to “finance leases.” However, these expedients can only be used as a package, and have to be applied to all of your leases.

“An entity may elect the following practical expedients, which must be elected as a package and applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor), when applying the pending content that links to this paragraph to leases that commenced before the effective date:

1. An entity need not reassess whether any expired or existing contracts are or contain leases.

2. An entity need not reassess the lease classification for any expired or existing leases (that is, all existing leases that were classified as operating leases in accordance with Topic 840 will be classified as operating leases, and all existing leases that were classified as capital leases in accordance with Topic 840 will be classified as finance leases).

3. An entity need not reassess initial direct costs for any existing leases.”

You can still re-evaluate these leases if you want to, but you can’t selectively utilize the practical expedients package—you have to apply it to all your leases or none of them.

Hindsight expedient

The hindsight expedient can be used with or without the packaged practical expedients above. “Hindsight” lets organizations evaluate lease terms based on actual outcomes, such as whether your ability to use an asset was impaired or whether you’re likely to renew or terminate your lease at the end of the period.

“An entity also may elect a practical expedient, which must be applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor) to use hindsight in determining the lease term (that is, when considering lessee options to extend or terminate the lease and to purchase the underlying asset) and in assessing impairment of the entity’s right-of-use assets. This practical expedient may be elected separately or in conjunction with the practical expedients in (f).”

Note that paragraph (f) refers to the packaged practical expedients listed in the section above.

Separating lease and non-lease components

Since ASC 842 requires organizations to account for embedded leases, which are part of a contract that may also include non-lease components, FASB offers a practical expedient that allows organizations to essentially treat the entire contract as a lease to save time.

“As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.”

Land easement practical expedient

If an existing or expired land easement wasn’t already considered a lease under ASC 840, organizations can adopt a practical expedient to not apply ASC 842 to it.

“An entity also may elect a practical expedient to not assess whether existing or expired land easements that were not previously accounted for as leases under Topic 840 are or contain a lease under this Topic. For purposes of (gg), a land easement (also commonly referred to as a right of way) refers to a right to use, access, or cross another entity’s land for a specified purpose.”

Common control arrangements

When two entities that have some degree of shared control (such as an enterprise and a subsidiary) enter into a lease agreement, ASC 842’s March 2023 update provides a practical expedient that allows them to evaluate the lease based on its terms and conditions. Instead of using costly legal processes to determine what’s legally enforceable based on their relationship, they can simply use the practical implications of the terms.

“The amendments in this Update provide a practical expedient for private companies and not-for-profit entities that are not conduit bond obligors to use the written terms and conditions of a common control arrangement to determine:

1. Whether a lease exists and, if so,

2. The classification of and accounting for that lease.

The practical expedient may be applied on an arrangement-by-arrangement basis. If no written terms and conditions exist (including in situations in which an entity does not document existing unwritten terms and conditions in writing upon transition to the practical expedient), an entity is prohibited from applying the practical expedient and must evaluate the enforceable terms and conditions to apply Topic 842.”

Practical expedients in IFRS 16

Under IFRS 16, the IASB offers practical expedients for six unique situations, and some of those situations include two or more expedient options. Here are all of the practical expedients in IFRS 16.

Not separating lease and non-lease components

As with ASC 842, IFRS 16 added a requirement for organizations to review contracts to determine whether they are or contain a lease. If the contract merely contains a lease, then you have to separate the lease and non-lease components to determine the liability represented by the lease. To save time, the IASB created a practical expedient allowing you to combine these components and consider them all as a single lease on your books.

“As a practical expedient, a lessee may elect, by class of underlying asset, not to separate non-lease components from lease components, and instead account for each lease component and any associated non-lease components as a single lease component. A lessee shall not apply this practical expedient to embedded derivatives that meet the criteria in paragraph 4.3.3 of IFRS 9 Financial Instruments.”

COVID-19 related rent concessions

In May 2020, the IASB amended IFRS 16 with a practical expedient that would allow lessee’s to save time on evaluating COVID-19 related rent concessions to determine whether they constituted lease modifications. If a lessee used this expedient, they could categorically deem applicable rent concessions as not lease modifications.

“As a practical expedient, a lessee may elect not to assess whether a rent concession that meets the conditions in paragraph 46B is a lease modification. A lessee that makes this election shall account for any change in lease payments resulting from the rent concession the same way it would account for the change applying this Standard if the change were not a lease modification.”

“The practical expedient in paragraph 46A applies only to rent concessions occurring as a direct consequence of the covid-19 pandemic and only if all of the following conditions are met: (a) the change in lease payments results in revised consideration for the lease that is substantially the same as, or less than, the consideration for the lease immediately preceding the change;”

Temporary exception arising from interest rate benchmark reform

Interest rate benchmark reform led by the Financial Stability Board has begun replacing benchmark interest rates in some jurisdictions. As this reform progresses, it will impact a greater number of leases in a wider range of jurisdictions. When this pushes an organization to modify an existing lease, IFRS 16 has a practical expedient for handling those modifications.

“As a practical expedient, a lessee shall apply paragraph 42 to account for a lease modification required by interest rate benchmark reform. This practical expedient applies only to such modifications. For this purpose, a lease modification is required by interest rate benchmark reform if, and only if, both of these conditions are met:

(a) the modification is necessary as a direct consequence of interest rate benchmark reform; and

(b) the new basis for determining the lease payments is economically equivalent to the previous basis (ie the basis immediately preceding the modification).”

Paragraph 42 deals with changing your lease liability based on changes to the value of future lease payments, which can occur as a result of reformed interest rate benchmarks.

Leases previously classified as operating leases

When applying IFRS 16 to leases retroactively, lessees have two choices:

  1. Apply IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
  2. Initially apply the standard that was in effect at the date of initial application, but with modifications specified in IFRS 16 paragraphs C7–13.

If you choose the latter, and you’re accounting for leases that were classified as operating leases under IAS 17, there are four practical expedients that may be available to you on a lease-by-lease basis.

“(a) a lessee may apply a single discount rate to a portfolio of leases with reasonably similar characteristics (such as leases with a similar remaining lease term for a similar class of underlying asset in a similar economic environment).

(b) a lessee may rely on its assessment of whether leases are onerous applying IAS 37 Provisions, Contingent Liabilities and Contingent Assets immediately before the date of initial application as an alternative to performing an impairment review. If a lessee chooses this practical expedient, the lessee shall adjust the right-of-use asset at the date of initial application by the amount of any provision for onerous leases recognized in the statement of financial position immediately before the date of initial application.

(c) a lessee may elect not to apply the requirements in paragraph C8 to leases for which the lease term ends within 12 months of the date of initial application. In this case, a lessee shall:

(i) account for those leases in the same way as short-term leases as described in paragraph 6; and

(ii) include the cost associated with those leases within the disclosure of short-term lease expense in the annual reporting period that includes the date of initial application.

(d) a lessee may exclude initial direct costs from the measurement of the right-of-use asset at the date of initial application. C10 IFRS 16 A862 © IFRS Foundation (e) a lessee may use hindsight, such as in determining the lease term if the contract contains options to extend or terminate the lease.”

Portfolio application

If you have a lot of very similar leases in a portfolio, you could spend many hours processing them according to the standard without seeing much variation between them. To save time in these situations, the IASB allows you to employ a practical expedient that considers the whole lease portfolio at once.

“This Standard specifies the accounting for an individual lease. However, as a practical expedient, an entity may apply this Standard to a portfolio of leases with similar characteristics if the entity reasonably expects that the effects on the financial statements of applying this Standard to the portfolio would not differ materially from applying this Standard to the individual leases within that portfolio. If accounting for a portfolio, an entity shall use estimates and assumptions that reflect the size and composition of the portfolio.”

Definition of a lease

For contracts you’ve already applied past standards to (IAS 17 and IFRIC 4), IASB provides a practical expedient to choose whether to re-evaluate the contract according to IFRS 16.

“As a practical expedient, an entity is not required to reassess whether a contract is, or contains, a lease at the date of initial application. Instead, the entity is permitted:

(a) to apply this Standard to contracts that were previously identified as leases applying IAS 17 Leases and IFRIC 4 Determining whether an Arrangement contains a Lease. The entity shall apply the transition requirements in paragraphs C5–C18 to those leases.

(b) not to apply this Standard to contracts that were not previously identified as containing a lease applying IAS 17 and IFRIC 4.”

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