ASC 842 Lease Accounting for Private Companies: What Preparers and Auditors Need to Know

ASC 842, Leases, requires lessees to recognize most leases on the balance sheet as a right-of-use (ROU) asset and a lease liability. Private companies adopted it for fiscal years beginning after December 15, 2021, so calendar-year private companies first applied it in their 2022 financial statements. The ongoing questions are finding every lease, getting the discount rate and lease term right, and accounting for modifications.

This guide covers the lessee model as it applies to private companies, the elections that matter most to them, and how auditors approach lease balances. It paraphrases the codification and the related ASUs and is not a substitute for them.

Scope: what is and is not a lease

Definition of a lease

A contract is or contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Two questions drive the analysis:

1. Is there an identified asset? The asset can be explicitly or implicitly specified. If the supplier has a substantive right to substitute the asset throughout the period of use, there is no identified asset.
2. Does the customer control its use? The customer must have the right to obtain substantially all the economic benefits from use of the asset and the right to direct how and for what purpose it is used.

Scope exclusions

ASC 842 does not apply to leases of intangible assets, leases to explore for or use minerals, oil and natural gas and similar nonregenerative resources, leases of biological assets, leases of inventory, and leases of assets under construction.

Embedded leases

Leases are often buried in service contracts: a logistics agreement with dedicated trucks, a data center contract with dedicated servers, a supply agreement where a supplier's equipment sits on the customer's site and is used only for that customer. Embedded leases can leave a lease population incomplete.

Related-party and common-control arrangements

Many private companies lease property from an owner or a related entity, sometimes with no written agreement. ASU 2023-01 added a practical expedient for private companies (and certain not-for-profits) that lets them use the written terms and conditions of a common-control arrangement to determine whether a lease exists and how to classify and account for it, without assessing whether those terms are legally enforceable. It also requires leasehold improvements in common-control leases to be amortized over their useful life to the common control group, as long as the lessee controls the use of the underlying asset. Where there are no written terms, the expedient does not apply and the general enforceability analysis is needed.

Classification: finance or operating

A lessee classifies a lease as a finance lease if any of these five criteria is met at commencement; otherwise it is an operating lease:

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.
2. The lease grants an option to purchase the asset that the lessee is reasonably certain to exercise.
3. The lease term is for the major part of the remaining economic life of the asset.
4. The present value of the lease payments plus any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the asset.
5. The asset is so specialized that it is expected to have no alternative use to the lessor at the end of the term.

ASC 842 does not set bright lines for "major part" and "substantially all." Many companies use 75 percent and 90 percent as reasonable approaches, consistent with implementation guidance in the codification, but these are policy choices rather than rules.

Initial measurement

Lease liability

At commencement, the lease liability equals the present value of the lease payments not yet paid. Lease payments include:

• fixed payments, including in-substance fixed payments, less lease incentives receivable
• variable payments that depend on an index or rate, measured using the index or rate at commencement
• the exercise price of a purchase option the lessee is reasonably certain to exercise
• termination penalties if the lease term reflects the lessee exercising a termination option
• amounts probable of being owed under residual value guarantees

Variable payments that do not depend on an index or rate, such as percentage-of-sales rent or usage-based charges, are excluded from the liability and expensed as incurred.

Right-of-use asset

The ROU asset equals the initial lease liability, plus lease payments made at or before commencement, plus initial direct costs, less lease incentives received.

Lease term

The lease term is the noncancellable period plus periods covered by:

• an option to extend that the lessee is reasonably certain to exercise
• an option to terminate that the lessee is reasonably certain not to exercise
• an option to extend or not terminate controlled by the lessor

"Reasonably certain" is a high threshold. Factors include significant leasehold improvements, relocation costs, below-market renewal rates and the importance of the asset to operations.

Discount rate and the risk-free rate election

Default rule

The lessee uses the rate implicit in the lease if it is readily determinable. Lessees rarely know the lessor's residual value assumptions, so the implicit rate is often not readily determinable. In that case the lessee uses its incremental borrowing rate: the rate it would pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

The private company risk-free rate election

Private companies may elect to use a risk-free rate for a term comparable to the lease term instead of the incremental borrowing rate. Under ASU 2021-09, the election can be made by class of underlying asset rather than entity-wide. The same ASU clarified that when the rate implicit in the lease is readily determinable, the lessee must use it, even if it has made the risk-free election for that class.

Things to know about the election:

• A risk-free rate is lower than a typical borrowing rate, so it produces a larger lease liability and ROU asset. The larger liability can affect covenants and ratios.
• Treasury rates for a comparable term are the usual reference. Document the source, the term matching and the date.
• The election is an accounting policy and must be disclosed.

The short-term lease exemption

A lessee may elect, by class of underlying asset, not to recognize ROU assets and lease liabilities for short-term leases: leases with a term of 12 months or less at commencement that do not include a purchase option the lessee is reasonably certain to exercise. Payments are recognized on a straight-line basis over the term.

Two traps:

• The 12-month test uses the lease term as defined in ASC 842, which starts from the enforceable period of the contract and adds renewal periods the lessee is reasonably certain to exercise. For a month-to-month arrangement where both parties can walk away without permission and with no more than an insignificant penalty, the enforceable period, and so the lease term, is usually short, whatever the parties expect. But if the lessee would suffer a more than insignificant penalty on leaving (for example, significant leasehold improvements it would abandon), the enforceable period can run longer and the lease may not qualify.
• If the lease term is reassessed so that the remaining term runs more than 12 months beyond the end of the previously determined term, or the lessee becomes reasonably certain to exercise a purchase option, the lease stops being short-term and is accounted for as if that date were the commencement date.

Other practical expedients

• Combining lease and nonlease components. A lessee may elect, by class of underlying asset, to account for each lease component and its associated nonlease components (such as maintenance) as a single lease component. This simplifies accounting but increases the liability.
• Portfolio approach. Leases with similar characteristics can be accounted for as a portfolio if the result is not materially different.
• Transition expedients. The package of practical expedients at adoption (not reassessing lease identification, classification and initial direct costs for existing leases) and the hindsight expedient affect how the opening balances were built. Auditors testing opening balances in later years may still need to understand them.

Subsequent measurement

Operating leases

A single lease cost is recognized on a generally straight-line basis over the lease term. The liability is measured at the present value of remaining payments, and the ROU asset is the plug that delivers straight-line cost, adjusted for items such as prepaid or accrued rent and impairment.

Finance leases

Interest expense on the liability (using the effective interest method) and amortization of the ROU asset are recognized separately, which front-loads total expense compared with an operating lease.

Remeasurement and modifications

The liability is remeasured for changes such as a change in lease term, a change in the assessment of a purchase option, or changes in amounts probable under residual value guarantees. Lease modifications are either accounted for as a separate contract or as a change to the existing lease, depending on whether additional rights of use are granted at a stand-alone price.

Impairment

ROU assets are subject to ASC 360 impairment testing like other long-lived assets. An abandoned office or subleased space at a loss may indicate impairment.

Presentation and disclosure

On the balance sheet, operating and finance lease ROU assets and liabilities are presented separately or disclosed. Disclosures include the nature of leases, significant judgments (such as discount rate and lease term), lease cost by component, cash paid, and a maturity analysis of lease liabilities reconciled to the balance sheet. The maturity analysis and the disclosure of policy elections, such as the risk-free rate election, are core.

What auditors test

Risk assessment

Leases can be a significant account for private companies with real estate or equipment leases. Under AU-C 315, inherent risk factors for leases include subjectivity (lease term, discount rate), complexity (modifications, variable payments) and susceptibility to omission (embedded and related-party leases). See audit risk model for how these factors place risks on the spectrum.

Completeness of the lease population

Completeness is often the assertion of greatest concern. Procedures:

• review rent, equipment rental, occupancy and service expense accounts for recurring payments to the same vendor
• read significant contracts and board minutes for lease commitments
• ask operations and facilities staff, not just accounting, about equipment and space in use
• review prior-year lease schedule and investigate leases that disappeared
• inquire about related-party arrangements and obtain written terms

Accuracy and valuation

• agree lease inputs (commencement date, payments, escalations, term, options) to the signed lease
• evaluate the lease term judgment, especially renewal options
• test the discount rate: for incremental borrowing rate, compare to the company's borrowing rates and adjust for term and collateral; for the risk-free election, agree to Treasury yields for a comparable term at commencement
• recalculate the liability and ROU asset, or test the client's lease software output for a sample
• test remeasurements and modifications during the year

Classification and presentation

• test classification against the five criteria
• confirm current and noncurrent portions of the liability
• agree the maturity table to the payment schedules and reconcile it to the balance sheet liability
• evaluate disclosure of policy elections, including the risk-free rate and short-term elections

Sampling and materiality

For a large population of similar leases, such as vehicle or equipment fleets, sampling under AU-C 530 may be efficient. Errors found are accumulated on the summary of misstatements under AU-C 450 and evaluated against materiality set under AU-C 320.

Gaps to look for

• leases missing from the schedule, especially embedded and related-party leases
• month-to-month or holdover arrangements treated as short-term without checking whether the lessee faces a more than insignificant penalty on leaving
• escalations and free-rent periods omitted from the payment stream
• discount rate unsupported or applied at the wrong date
• modifications recorded as new leases without derecognizing the old one
• maturity table not reconciling to the liability

FAQ

When did private companies adopt ASC 842?

Private companies adopted ASC 842 for fiscal years beginning after December 15, 2021. A calendar-year private company first applied it for the year ended December 31, 2022.

Can a private company use the risk-free rate for only some leases?

Yes. Under ASU 2021-09 the risk-free rate election can be made by class of underlying asset. If the rate implicit in a lease is readily determinable, that rate must be used instead.

Does a month-to-month lease qualify for the short-term exemption?

It can, depending on the terms. ASC 842 only counts the period the contract is enforceable. If both the lessee and the lessor can end a month-to-month arrangement without the other's permission and with no more than an insignificant penalty, the lease term is usually short enough to qualify. If the lessee would suffer a more than insignificant penalty on leaving, such as abandoning significant leasehold improvements, the lease term may be longer than 12 months.

Why is completeness a focus in lease audits?

Embedded leases in service contracts and informal related-party leases are easy to omit, so the lease population may be incomplete.

Does the risk-free rate election make the lease liability bigger?

Usually yes. A risk-free rate is lower than a typical incremental borrowing rate, so the present value of lease payments, and the liability, is higher.

CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.

Sources

• FASB ASC 842, Leases (842-10 scope, identification, classification and 842-10-55-2 implementation guidance; 842-20 lessee accounting and disclosures)
• FASB ASU 2020-05 (effective dates for private companies: fiscal years beginning after December 15, 2021)
• FASB ASU 2021-09, Discount Rate for Lessees That Are Not Public Business Entities
• FASB ASU 2023-01, Common Control Arrangements
• FASB ASC 360, Property, Plant, and Equipment (impairment of ROU assets)
• AICPA, AU-C Section 315, 320, 450 and 530

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error