Service arrangements: Transitioning from ASC 840 to ASC 842

Oct 16, 2019

The Financial Accounting Standards Board’s Accounting Standards Codification 842, Leases, requires companies to assess all contracts to determine whether those contracts were a lease or contained a lease under the codification. As companies implement the leases standard, they are required to recognize both a lease liability and a right-of-use asset for almost all leases. As a result, it is important to assess those arrangements that previously have not been assessed for potential embedded leases.

Even if management elects the “package of practical expedients” upon adoption of ASC 842, accounting errors resulting from improper application of ASC 840 cannot be carried forward into the transition to ASC 842.

The failure to identify material embedded leases under ASC 840 and apply the appropriate accounting and disclosures will affect the ability to apply the package of practical expedients available when transitioning to ASC 842.

Transitioning from ASC 840 to ASC 842

As management considers how to tackle the exercise of assessing service arrangements for embedded leases, there are certain things that should be considered.

Completeness of the service arrangement population: Management should develop a process to address the completeness of the service arrangement population, which may include (but is not limited to):

  • Performing a deep dive of general ledgers to identify recurring expenses and other arrangements that could contain leases
  • Reviewing vendor listings to ensure understanding of vendors and related arrangements
  • Reviewing cash disbursement registers to identify similar recurring payments to a vendor that may indicate ongoing arrangements
  • Discussing with the procurement department and other relevant stakeholders that have the ability to enter into contracts

Analysis of whether a contract contains a lease under ASC 840: Management should analyze these service arrangements under ASC 840, ensuring the following are considered:

  • Does the contract contain an explicitly or implicitly identified asset? Management should consider whether the arrangement contains substitution rights, and whether it is economically feasible for the vendor to substitute the asset. If it is deemed that it is economically feasible, there is no identified asset within the arrangement.
  • Does the purchaser have the right to operate the asset while obtaining or controlling more than an insignificant amount of the output or other utility of the asset? How an insignificant amount is defined will need to be determined by management.
  • Does the purchaser have the ability or right to control physical access to the asset while obtaining or controlling more than an insignificant amount of the output or other utility of the asset?
  • Will the purchaser obtain substantially all the output; and is the price that the purchaser will pay for the output not fixed or nor equal to the market price at the time of delivery of the output? The term “substantially all” will need to be defined by the management.

If an embedded lease is identified, management should summarize the impact on the financial statement (if the lease is a capital lease) and disclosures (for both capital and operating leases), and evaluate the potential magnitude of any potential historical errors.

Classification of an identified embedded lease: If the service arrangement does contain an embedded lease, management should determine the classification of this lease, i.e., assess whether the lease is a capital lease or an operating lease.  Management should apply the classification tests in ASC 840:

  • Does ownership of the leased asset transfer to the lessee by the end of the lease term?
  • Does the lessee have a bargain-purchase option to buy the leased asset at a price below its fair value?
  • Is the lease term greater than or equal to 75% of the estimated economic life of the leased asset?
  • Is the present value of minimum lease payments at least 90% of fair value of the leased asset?

If none of the criteria above is met, the embedded lease is an operating lease.

Collection of data for both ASC 840 and ASC 842 accounting: Management should identify all relevant data relating to the embedded lease, including data that is not contained in the contract. This noncontract source data may include, but is not limited to, judgment on any options (such as renewal, purchase or termination options) that may exist within the contract; initial direct costs under ASC 840; fair market value of the identified asset; and economic life of the identified asset.

Abstraction of the data: Management should abstract the embedded lease into their selected lease management system, i.e., either into a spreadsheet model (if applicable) or into their technology solution of choice.

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