ASC 842 Private Company Elections and Lease Modifications

The basic lessee model is covered in ASC 842 lease accounting for private companies. This post covers the part that decides whether a private company's lease numbers hold up in audit: the policy elections, each of which is a decision to document, and the mechanics when a lease changes after commencement.

Private companies adopted ASC 842 for fiscal years beginning after December 15, 2021, so every calendar-year private company has applied it since its 2022 statements. Elections made at adoption stay in force until changed, and an unwritten election is the first thing an auditor asks about.

The transition expedient package

At adoption, ASC 842 offered a package of three practical expedients. An entity elected all three or none; picking among them was not permitted. Together they let the entity carry forward its prior conclusions on:

whether an expired or existing contract is or contains a lease,
lease classification of existing leases, and
initial direct costs.

The package does not carry forward errors, so improper prior accounting stayed improper. Separate from the package, the hindsight expedient lets an entity use later information in assessing lease term at transition, and the land easements expedient skips reassessing existing or expired land easements for embedded leases. Easements already treated as leases under ASC 840 are not eligible.

For a client in its fifth year under the standard, the package is a history question. The audit file needs the answer to one point: did the client elect the package, and is that election disclosed in the policy note? A client that did not elect the package reassessed classification at the lease commencement or modification date, and the file should show that work.

The risk-free rate election

A lessee measures the lease liability at the present value of lease payments, discounted at the rate implicit in the lease when that rate is readily determinable. When no implicit rate is readily determinable, the lessee uses its incremental borrowing rate. ASC 842-20-30-3 gives a lessee that is not a public business entity another option: use a risk-free discount rate in place of the incremental borrowing rate.

ASU 2021-09, issued in 2021, changed the scope of that election. The text of paragraph 842-20-30-3 now reads that the election is made "as an accounting policy election made by class of underlying asset." Before the update it applied to all leases. Entities that had not adopted ASC 842 by November 11, 2021 adopted the amendment with ASC 842. Entities that had already adopted it applied the amendment for fiscal years beginning after December 15, 2021, with earlier application permitted.

Four points matter for the audit file:

The implicit rate wins. "A lessee should use the rate implicit in the lease whenever that rate is readily determinable." A risk-free election does not override a readily determinable implicit rate, even in an elected asset class.
Disclosure is mandatory. Paragraph 842-20-50-10 requires the lessee to disclose its election and the classes of underlying assets to which it applies.
The class split is a real choice. A lessee can apply the risk-free rate to a class of high-volume, low-dollar leases, such as office equipment, and keep the incremental borrowing rate for real estate. That removes the need to support a borrowing rate for hundreds of small leases and keeps a supportable rate on the large ones.
The election is limited to entities that are not public business entities. A lessee that is a public business entity cannot use a risk-free rate.

The measurement effect is direct. A risk-free rate is lower than a borrowing rate, so the same payment stream produces a higher lease liability and a higher right-of-use asset. The election trades measurement effort for larger balance sheet amounts. Test the election by recomputing a sample of liabilities at both rates and confirming the effect is understood by management and evaluated against materiality. For the risk-free rate itself, document the instrument and the source used at each commencement date.

The short-term lease election

A lessee can elect not to record a lease on the balance sheet when its term is 12 months or less and the lease contains no purchase option the lessee is reasonably certain to exercise. The election is made by class of underlying asset. The short-term lease disclosures are still required.

Auditors test three things: that the class election is documented, that each lease in the elected class has a 12-month-or-less term at commencement with no purchase option the lessee is reasonably certain to exercise, and that every lease the client treats as short-term is assessed for term at commencement, with month-to-month arrangements included in that review.

The lease and nonlease component election

A lessee can account for a lease component and its related nonlease components, such as common area maintenance, as a single combined lease component, by class of underlying asset. The election avoids allocating consideration on standalone prices. The trade-off is a larger liability and right-of-use asset, because the nonlease payments enter the measurement. Disclosure of the election sits in the policy note with the other practical expedients.

Lease modifications

Accounting for a lease modification begins with one question: does the modification create a separate contract?

Separate contract. Under ASC 842-10-25-8 a modification is a separate contract when it grants the lessee an additional right of use not included in the original lease, and the added consideration reflects the standalone price of that additional right, adjusted for the circumstances of the contract. An example is adding a second floor to an existing office lease at market rent. The lessee accounts for the new right as a new lease and leaves the original lease untouched.

Not a separate contract. Any other modification is accounted for as a change to the existing lease. At the effective date of the modification the lessee:

reassesses the classification of the modified lease as of the effective date,
reallocates the remaining consideration between lease and nonlease components,
remeasures the lease liability using the discount rate in effect at the effective date of the modification, and
adjusts the right-of-use asset by the amount of the liability remeasurement.

The discount rate point is the one that draws errors. The lessee does not keep the commencement-date rate. If the rate moved from 6% at commencement to 7% at the effective date, the remeasurement uses 7%. A client file that remeasures an extended lease at the original rate has an error.

Decrease in scope. No gain or loss arises on a modification unless it includes a full or partial termination. When scope decreases, the lessee reduces the right-of-use asset proportionately and recognizes a gain or loss for the difference between the reduction in the liability and the proportionate reduction in the right-of-use asset.

A contract that adds a lease. If modified terms introduce a lease where none existed, the arrangement is treated as a new lease from the change date.

Audit procedures for elections and modifications

Obtain the policy note and the lease schedule, and confirm each election appears in both.
For the risk-free election, confirm the asset classes elected, the disclosure under 842-20-50-10, and that no lease in an elected class has a readily determinable implicit rate.
For the short-term election, trace a sample of leases to contract terms and the commencement-date assessment.
Inquire of management and read board minutes, correspondence and landlord communications for amendments, then trace every amendment to a remeasurement entry. An amendment with no entry is a finding.
Recompute remeasurements for a sample of modifications, checking the effective-date discount rate and the classification reassessment.
Check the classification between current and noncurrent liabilities after each remeasurement.

Connect these procedures to the broader approach in audit procedures by account and to debt-related covenants in ASC 470 debt classification and covenants, since lease liabilities can enter covenant calculations.

Sources

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

Part of CORAA University · US GAAP for private companies: related guides, calculators and templates.

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

ASC 842 for Private Companies: Elections and Lease Modifications