As year-end is quickly approaching and annual reporting requirements come into play, companies are still in the process of implementing the leasing guidance under ASC 842. We recently held a webinar to discuss a refresher for “day 1” implementation along with “day 2” accounting for new leases and ongoing maintenance of your leasing portfolio.

We are pleased to share our responses to a list of frequently asked questions (FAQs) we have received. Although this article assumes knowledge of ASC 842 Leases, our previously published article summarizes the implementation steps of ASC 842.

FAQ 1: How is my ROU asset impacted by end of year 2021 balance sheet accounts?

GBQ Response: On day 1 of implementation, the balance sheet accounts bulleted below will be considered when calculating your ROU asset. Initially, your ROU asset is equal to your lease obligation calculated and then adjusted for the following balances as of FYE 2021. As a result, these balance sheet accounts will be zeroed out on day 1.

      • Prepaid rent
      • Accrued rent (not accrued percentage rent)
      • Lease incentives
      • Tenant Improvement allowances
      • Unamortized initial direct costs
      • Deferred rent
      • Closed store reserve
      • Non-refundable security deposits

FAQ 2: I had a tenant improvement allowance recorded under the previous lease accounting standard. What is the treatment of tenant improvement allowance at transition to ASC 842 and going forward?

GBQ Response: Upon implementation, the ROU asset is calculated by reducing it for any unamortized TI allowances that existed on the balance sheet. Additionally, for new leases entered into subsequent to the implementation date, any tenant improvement allowances received will reduce the ROU asset upon recording on the commencement date.

FAQ 3: How do I handle a sublease arrangement under ASC 842?

GBQ Response: Original lease and sublease arrangements are accounted for separately so long as the primary obligation still exists under the original lease by the lessee. Follow lessee accounting for the original lease with ROU asset and lease obligation (see calculation above).

For sublease arrangement, lessor accounting is followed:

      • Sublease follows original lease classification
      • Rental revenue is recognized on a  straight-line basis
      • Use unbilled rent receivable for any difference between cash rent paid and GAAP rental income recognized

 FAQ 4: Do I still need to track closed store reserves separately under ASC 842 accounting?

GBQ Response: The answer is no. Under ASC 842, the closed store liability is no longer required to be recorded separately as a lease obligation will be recognized. The existing closed store reserve will offset the ROU asset calculated on Day 1. ASC 842 revised ASC 420 to remove lease obligations within the scope of termination costs. However, if a policy was elected to separate lease and non-lease components, a reserve for non-lease components may be necessary under ASC 420.

FAQ 5: Under ASC 840, I capitalized initial direct costs. What do I do with the unamortized initial direct costs at the transition to ASC 842?

GBQ Response: As noted in FAQ 1, many of the assets previously recorded under ASC 840 will be adjusted through the ROU Asset in the day 1 calculation. Going forward with new leases, incremental costs such as commissions will be recorded as a component of the ROU asset; however, this does not include legal costs for negotiation and should be expensed as incurred.

FAQ 6: Has the accounting for Sale-Leaseback Transactions changed under ASC 842?

GBQ Response: Yes, the sale-leaseback accounting has changed under ASC 842. Upon the implementation date, the company should recognize any deferred gain or loss not resulting from off-market terms as a cumulative adjustment to equity. For transactions post-implementation date, the company should recognize any deferred gain or loss not resulting from off-market terms in earnings in the period the sale occurred.

Deferred Loss: Any deferred loss recognized resulting from the consideration for the sale of the asset not being at fair value or the lease payments not being at market rates as an adjustment to the leaseback right-right-of-use at the later of the transition date and the date of the sale of the underlying asset.

Deferred Gain: Any deferred gain recognized resulting from the consideration for the sale of the asset not being at fair value or the lease payments not being at market rates as a financial liability at the later of the transition date and the date of the sale of the underlying asset.

FAQ 7: What risk-free rate should I use if I’ve elected the practical expedient?

GBQ response: It depends on the lease term used at the implementation date. You can elect to use the original term of your lease or the remaining term of your lease at the implementation date. Based on your decision, you will select the risk-free rate from the Treasury website. Again, you have a policy decision as the Treasury terms will not line up exactly with your lease term. You will need to decide whether to round up, round down, or use the closest term to your lease term policy. The key is to apply the policy consistently to your entire lease portfolio.

FAQ 8: When should my lease term start?

GBQ Response: For all existing leases, upon the implementation date, the lease term start date used will be your first day of fiscal 2022. For some software platforms being used, you may be defaulted to using January 1. For new leases entered into subsequent to the implementation date, the term start date is based on the commencement date, which is the date you have control over the property. Keep in mind this may be months before you make your first rent payment.

For example, if you entered into a lease agreement on February 1, 2022, the first rent payment is due June 1, 2022. You then gain control over the property on March 1, 2022, to start the build-out; your lease term will begin March 1, 2022, with “free rent” recognized as part of the straight-line expense over the entire term of the lease. It is important to get this correct as the “free rent” period can result in substantial rent expenses being recognized.

FAQ 9: Are related party leases within the scope of ASC 842?

GBQ Response: The answer is yes. All related party leases should be recorded based on the legally enforceable provisions. There is a practical expedient expected from the FASB to loosen the requirement of legally enforceable provisions as related party leases can be verbal or not well documented to be legally enforceable. The short answer is that all related party leases need to be recorded, and now is a great time to formalize your related party leases to be legally enforceable.

FAQ 10: Do I need to reassess the lease classification upon the implementation date?

GBQ response: If you have selected the practical expedient, you do not have to reassess the lease classification. However, if you determine an error has been made, you would need to rectify this. For most operators, real estate leases were operating leases and will continue to be treated as operating leases.

For new leases entered into subsequent to the implementation date, it is important and required to assess lease classification as the risk-free rate could impact the classification based on the present value of future minimum payments test. Most lease accounting software programs have a wizard to walk you through this process, so please utilize it to properly document your lease classification testing and ensure your compliance with GAAP.

If you still need to begin your ASC 842 implementation, we highly recommend getting started as it does take a bit of time to implement. This is especially important for the restaurant industry, given that many stores and equipment are under lease.

Should you have questions throughout the process, count on GBQ for guidance. Please reach out to your GBQ advisor for assistance.

 

Article written by:
Kristin Romaker, CPA
Senior Manager, Assurance & Business Advisory Services

Dustin Minton, CPA, MBA
Director, Assurance & Business Advisory Services

 

 

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