Do you have lingering questions about transition leases and current lease accounting standards? In this blog, we answer the most common questions regarding these leases and the new standards, providing ASC 842 transition guidance and further resources at the end. Read on!

What is a Transition Lease in the Context of ASC 842, IFRS 16, and GASB 87?

A transition lease is a lease with a start date before the effective date of any lease accounting standard. This definition is true for all ASC 842, IFRS 16, and GASB 87 and 96 accounting standards.

What Role Does the Commencement Date Play in Defining a Transition Lease?

The commencement date is the date the lessor makes the asset available to the lessee. For transition leases, you’ll start accounting for the leases under the new standard on the same date as the effective date, so the commencement date therefore plays no role in accounting for transition leases. 

In the Context of Transition Leases, What is the Significance of the Initial Application Date for Reporting Entities?

The date an organization applies the standard to their leases under ASC 842 is the first fiscal year beginning after December 15, 2021. For organizations with a December 31 fiscal year end, the effective date will be January 1, 2022. Leases that were in place as of that date are considered transition leases. 

Lease Transitioning Guidance from ASC 840 to ASC 842

When new accounting standards are announced, it is common for Equity to be affected when applying the changes to the financial statements. However, the new lease accounting standard, ASC 842, handles these adjustments differently. While it seems strange to skip using the “Cumulative Effect of a Change in Accounting Principle” account when implementing the new standard, it’s the right thing to do to ensure the lease assets and lease liabilities are properly recorded, as almost all changes flow through the ROU Asset.

Therefore, when transitioning leases from ASC 840 to ASC 842, start by calculating the lease liability, which is the present value of all future lease payments occurring after the Initial Application Date. This includes monthly rents, known escalators, residual value guarantees, etc.

Next, remove existing lease balances such as operating lease deferred rent or capital lease assets and liabilities from the Balance Sheet. As you reverse these balances off the books, they should flow through the Right of Use (ROU) Asset, not through equity, as is common when implementing a new accounting standard. In most cases, the ROU asset is the lease liability plus initial direct costs and prepaid lease payments, less lease incentives when paid at commencement or transition, and plus or minus the differences of those existing balances.

Items that could also be included as existing balances are unamortized initial direct costs or unamortized incentives received from lessor. Keep this in mind when preparing for transition to the new standard.

Note: As with most rules, there are exceptions where equity will actually be affected depending on policy elections and other scenarios. You’ll find a list of exceptions in this guide.

Missteps to Avoid

The lease transition entries for ASC 842 differ from most accounting standard changes, so here are some mistakes to avoid when making this transition:

• While it may be tempting to have the ROU Asset and Liability equal while adjusting the operating lease deferred rent balances through an equity account, it is an incorrect recording of these balances. Any existing balances will be adjusted through the ROU Asset; therefore, the ROU Asset and Lease Liability may not be equal at transition.
• When transitioning a capital lease from ASC 840 to ASC 842, the existing balances will be reversed and the difference will flow through the ROU Asset.
• It is also important to remember that at transition the lease liability is a “stake in the sand.” As the present value of future lease payments, the lease liability is based on what is actually owed to the lessor.

Additional Resources

This topic is a perfect opportunity to reach out to clients to ask if they need assistance implementing ASC 842. Here are some excellent resources:

• Transitioning to the New Lease Standard (With Sample Journal Entries)
• Lease Review Checklists for Office Space and Vehicle Leases

Although transitioning to the new lease accounting standard is fairly straightforward, spreadsheets become risky as soon as you have more than a few leases. LeaseCrunch is a software solution that vastly simplifies the process of transitioning to ASC 842, including prompts for entering existing balances, creating initial journal entries and performing quantitative calculations for footnote disclosures. 

Start reducing the errors in your lease accounting while decreasing the time spent on journal entries and documentation by learning more or requesting a demo here.