ASC 842-10-25-2: The Short-Term Lease Exemption
Gain insight into the ASC 842 short-term lease exemption, a policy election based on a nuanced calculation of the lease term and applied by asset class.
The accounting standard ASC 842 changed how companies account for leases, requiring most to be recognized on the balance sheet. This brought greater visibility to leasing obligations that were previously only disclosed in financial statement notes. The standard mandates that lessees recognize a right-of-use (ROU) asset and a corresponding lease liability for the obligation to make payments.
However, the Financial Accounting Standards Board (FASB) included practical expedients to ease implementation. This article focuses on one provision, ASC 842-10-25-2, which offers an exemption for short-term leases, allowing for a simpler accounting treatment that avoids balance sheet recognition.
The Short-Term Lease Recognition Exemption
The core of the short-term lease provision is an optional exemption. A lessee can elect, as an accounting policy, not to recognize a right-of-use asset and lease liability for a short-term lease. Instead, the company can recognize the lease payments as an expense on a straight-line basis over the lease term, a treatment similar to operating leases under the previous standard, ASC 840.
To qualify for this exemption, a lease must meet two criteria at its commencement date. The first is that the lease term must be 12 months or less, and the second is that the lease must not contain a purchase option that the lessee is reasonably certain to exercise. If a lease includes such a purchase option, it is ineligible for the short-term exemption, regardless of its duration.
The assessment of these criteria happens at the lease commencement date, which is the date the lessor makes the underlying asset available for use by the lessee. Companies are not required to use the short-term lease exemption. Some may choose to capitalize all leases for consistency in their accounting processes, especially if they have invested in a system to manage lease accounting under ASC 842.
Determining the Lease Term
The 12-month timeframe is a threshold for the short-term lease exemption, and its calculation is more nuanced than it appears. The “lease term” as defined by ASC 842 is not simply the initial, fixed period. It begins with the noncancelable period of the lease but must also include any additional periods covered by options to extend the lease if the lessee is “reasonably certain” to exercise those options.
A company must evaluate all relevant economic factors that create an incentive to extend the lease. For example, if a lessee has installed significant leasehold improvements in a rented office space that have a useful life longer than the initial lease term, it creates a strong economic incentive to renew, potentially extending the calculated lease term beyond 12 months.
Conversely, the lease term also incorporates periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option. Imagine a 24-month lease with an option for the lessee to terminate after nine months. If significant costs would be incurred to relocate or if the leased asset is unique, the company might conclude it is reasonably certain not to terminate, making the lease term 24 months and thus ineligible for the exemption.
A simple 11-month contract for a piece of equipment could be disqualified if it includes a renewal option that the company is very likely to take due to the high costs of sourcing and installing a replacement.
Making the Accounting Policy Election
Applying the short-term lease exemption is a formal accounting policy election, not a lease-by-lease decision. This election must be made by class of underlying asset, which is a grouping of assets of a similar nature and use, such as real estate, vehicles, or office equipment. A company could decide to apply the exemption for its office equipment leases but not for its vehicle leases.
Once this policy is established for a particular asset class, it must be applied consistently to all new short-term leases within that class. Changing this policy requires justification under the principles in ASC 250. To make an informed election, an entity must have a complete inventory of its leases, identifying key data points like the noncancelable term, renewal options, and purchase options.
The decision to adopt the policy for a given asset class involves weighing the benefits of simplified accounting against the costs of tracking these leases separately. For a company with a large volume of short-term equipment rentals, the exemption can reduce the accounting workload, while for an entity where such leases are rare, it may be more efficient to capitalize all leases.
Accounting and Disclosure for Short-Term Leases
Once a company elects the short-term lease policy for an asset class and identifies qualifying leases, the accounting is direct. The lessee does not recognize a right-of-use asset or a lease liability on its balance sheet. Instead, the lease payments are recognized as an expense in the income statement on a straight-line basis over the lease term.
Even with this simplified accounting, ASC 842 mandates specific disclosures. The company must disclose in its financial statement footnotes that it has elected the short-term lease exemption and identify the asset classes to which it has been applied.
Furthermore, the entity must disclose the amount of cost recognized for its short-term leases during the reporting period. This cost should exclude expenses for leases with a term of one month or less. If the recognized short-term lease expense is not representative of the company’s overall short-term lease commitments, the entity may need to disclose the total amount of its commitments to provide a clearer picture.