As with any major new regulatory update, the boards published practical expedients after the initial release of the new lease accounting standards. Electing these expedients will save you time, but if you don’t interpret them properly, you’ll end up with errors in your lease accounting. That’s why it’s critical that you thoroughly understand the substance of each practical expedient and the impact they’ll have on your financial statements.
Let’s take a deep dive into the expedients that have been released so far and the pros and cons of electing them. By the time you’re done reading this blog, you should feel confident that you understand each one and how they apply to your business.
The package of practical expedients
First, let’s cover what’s known as the “package” of practical expedients. They’re referred to as a package because you can’t elect them individually. They must be elected together or not at all.
#1 Lease classification is grandfathered
If a lease was classified as a capital lease under 840, it remains a capital lease, albeit a name change to finance lease. If it was classified as an operating lease under the old standards, it’s still an operating lease. Here’s the caveat: this practical expedient only applies if there are no errors with the initial classification.
#2 No re-evaluation of embedded leases
If you were accounting for leases embedded in service and outsourcing contracts appropriately under the old standards, then you don’t need to re-evaluate. Like the practical expedient above, this assumes that you haven’t made any errors in your previous evaluations. We recommend that you re-evaluate your service and outsourcing agreements to ensure that your records of embedded leases are complete.
#3 You do not have to reassess initial direct costs
Under 840 you could allocate a portion of your internal expenses to initial direct costs. For instance, you could allocate a percentage of the salaries for internal real estate or legal staff. Under 842, initial direct costs are defined as costs you would not have incurred had you not signed the lease – typically external costs, such as broker fees or external legal fees. This expedient states that you don’t need to reassess those costs.
Pros and cons of electing the package of practical expedients
These practical expedients greatly reduce the amount of time you’ll spend re-evaluating your leases. We recommend that everyone elect them to save time. The major con in not electing them is that you’ll have to:
- Reassess initial direct costs, which will lead to an equity adjustment
- Re-evaluate each lease to determine whether to classify them as operating or finance under the new standards
- Re-evaluate existing expired leases
The only good reason to not elect these is if you have a preference for your classification. For instance, capital/finance lease classification can influence EBITDA.
Let’s say that the majority of your operating leases would be re-classified as capital/finance leases under the new standards. If you want the majority of your leases to be capital/finance leases – and they meet the requirements of that classification under the new standards – then you may choose not to elect these expedients.
#4 Combining lease and nonlease components
Under 840, you have executory costs (CAM, insurance, and tax). Under 842, that nomenclature has been jettisoned. It has been replaced with lease and nonlease components.
Under the new standards, you need to identify your fixed consideration and allocate it across the lease and nonlease components. This part of the new standards is commonly misunderstood. Many people think it means that you add up all the lease and nonlease components of a lease and calculate the present value of the total:
The correct interpretation of this rule is that you take only the fixed consideration and allocate that across the lease and nonlease components. You will have to perform an analysis to determine a methodology for this allocation.
It’s important to note:
- Your fixed consideration doesn’t include anything that has variable costs or is marked to market.
- For the vast majority of real estate leases, CAM, insurance, and tax are variable and are not considered part of your fixed consideration.
- Insurance and taxes are not components, (they are neither lease nor nonlease components), as such you would not allocate any fixed consideration to those non-components.
This practical expedient says that you don’t have to perform the analysis to determine the methodology of allocation. You can simply calculate the present value of the fixed payments without having to perform an allocation to the lease and nonlease components.
Pros and cons of electing the lease and nonlease components practical expedient
Like all the other practical expedients, electing this one will save you time. The boards have stated that you can elect to use it by class of asset – for instance you can elect it for your real estate leases, but not for your computers.
If you choose not to elect this practical expedient, you’ll have to:
- Determine your lease and nonlease components.
- Determine the fair value of the lease and nonlease components.
- Figure out a method to allocate your fixed consideration and document that method for your auditors.
- Repeat this process individually for each one of your leases where you did not take the practical expedient.
We recommend that you elect this practical expedient for your real estate leases, but not for equipment. The maintenance component of equipment leases is typically fixed as part of your consideration, and the fair values for each lease and nonlease components are easier to determine.
One con is that your liability will be a little higher, but not as high as you may think.
#5 Short-term leases
First let’s look at the definitions of short-term leases and how they differ under GAAP and IFRS. Under GAAP, a short-term lease is defined as a lease that is 12 months or less without a purchase option that the lessee is likely to exercise. Under IFRS, it is defined as a lease that’s 12 months or less without a purchase option – period.
Under both GAAP and IFRS, there is a short-term lease exemption, which means you don’t have to capitalize those leases and record them on your balance sheet. You can just continue to treat them as operating leases under 840.
Pros and cons of electing the short-term leases practical expedient
Electing this practical expedient will save you time, like all the others. But you still need to disclose them. And that leads to the con. Yes, you’ll save time in terms of capitalizing your leases, but don’t let that lull you into a false sense of security. These leases may not be going on your balance sheet, but you will need to disclose those leases, and their value, in the notes of your financial statements.
#6 Discount rates for private companies
This practical expedient offers a straightforward way to deal with one of the trickiest components of the new standards: discount rates. It states that private companies can use their risk-free interest rate, which provides an alternative to having to calculate your incremental borrowing rate (IBR), or when there is no discount rate implicit in the lease contract.
Pros and cons of electing the discount rate practical expedient
The pro is that this provides companies with an alternative to the legwork required to perform the complex IBR calculation. Of course, if you already know what your IBR is, then this practical expedient won’t apply. The con in electing this practical expedient is that the risk-free interest rate is typically very low, which means you’ll end up with a higher liability on your books.
#7 IFRS 16 fair value practical expedient
If the fair value of the asset is less than $5,000, then you don’t have to record it to comply with the new standards. That applies individually or in the aggregate. So let’s say your company leases golf carts that are worth $4,900. It doesn’t matter if you lease one or 2,000 – this practical expedient still applies because the fair value of each individual asset is less than $5,000.
Pros and cons of electing the fair value practical expedient
The pro of electing this practical expedient is that these leases can keep off-balance sheet treatment. You don’t have to report an asset and liability for those leases. Depending on how they impact your ratios (recall that under IFRS all leases are finance leases, which results in an uptick in EBITDA, but also increases your debt ratios), that can be a pro or a con.
Another key thing to remember about this practical expedient is that these leases are a lot like short-term leases – they need to be disclosed in the notes of your financial statements.
Other practical expedients we didn’t cover
This blog has covered the practical expedients that are relevant for most companies. There are, however, a few that we didn’t cover:
- Land easements – read the practical expedient here.
- Combining the lease and nonlease components for lessors – read the practical expedient here.
- Restate prior year financials – get details on this practical expedient from PwC here.
The bottom line
Ultimately, it’s important that you don’t blindly make the decision to elect or not elect these practical expedients. Watch out for tricky caveats – like short-term leases needing to be disclosed in the footnotes of your financial statements. Finally, make sure that your lease accounting solution is capable of handling your elections. There’s no point in you carefully considering each practical expedient, only to have your software solution fail to address your elections properly.