Ask the Expert: John Hepp Discusses the New Lease Standard

We’re excited this month to share insights from our recent conversation with industry expert John Hepp. John is a retired partner from Grant Thornton and a former FASB project manager. He holds a PhD from the University of Wisconsin-Madison and is currently on the faculty at University of Illinois at Urbana-Champaign.

John discussed several nuances of the new lease accounting standard, from practical expedients (“the spoonful of sugar to help the medicine go down”) to discount rates and much more.

Using Practical Expedients

According to a LeaseCrunch (now Crunchafi) survey, 60% of CPA firms find that most of their clients are electing the practical expedient package, yet 24% say problems have arisen related to which practical expedients should be applied.

John shared that the practical expedients—though not perfect—certainly can reduce the amount of work needed in transitioning to the new standard. For instance, he talks about the option to keep existing leases as-is rather than restating everything:

“You don't want to go back and redo the work of determining whether a transaction contains a lease, lease classification, and whether initial direct costs qualify for capitalization for every lease on the books. That is why the practical expedient package makes a lot of sense. Going forward, of course, if you modify the lease you have to apply the new standard, but it won't be as heavy a burden because you're doing it one transaction at a time instead of hundreds or thousands of past transactions.”

Discount Rates and Lease Terms

Many questions have arisen about discount rates and lease terms for transitioning existing leases. Like many areas of the new lease standard, you have options here and must apply your own judgment.

Determining the Lease Term

Before determining and applying your interest rate, you must identify the lease term. FASB staff allows, for transition purposes, the use of a rate for either the original term of the lease or the remaining term, as long as you are consistent throughout.

John shared:

“Going forward, as you enter into a new lease, it’s much easier to make an assessment on a case-by-case basis. The definition, however, has changed somewhat, so make sure to review your process for determining the discount rate before classifying and recording a lease.”

Assessing Your Discount Rate

Once you determine whether you will go with the original lease term or the remaining term, you must identify your discount rate, and again, there are two options.

John said:

“One way is to determine your credit rating and then look to the bond market to see what approximately the discount rate is for those bonds or your most recent refinancing for a similar term. But this is another situation, especially lately where interest rate spreads have not been high, that a private company could consider using the practical expedient to just use the interest free rate rather than going to all that trouble.”

On Lease Renewals

A final important note John included on lease term is on lease renewals and whether to include the renewal term in the lease term. Renewal terms should only be included if you can demonstrate that there is an economic reason you’re compelled to stay, such as significant leasehold improvements or a termination penalty. Just because you intend to renew or cancel does not necessarily mean that you would include a renewal term.

According to John:

“'Reasonably certain' is a high bar. They were very specific in deliberations about that.”

Previously Capitalized Balances

Many people have questions regarding how the new lease standard handles previously capitalized balances, such as prepaid rent. John explained:

“Under the new model, there’s really no such thing as prepaid rent.”

As for how to handle transitions for existing prepaid rent on the books, his recommendation is:

“First I need to measure my obligation. I won't have an obligation to pay the rent anymore because it's prepaid and any balances or prepayments will go into the ROU asset, which would show that the ROU asset maybe is larger than the obligation due to that prepayment. The same is true with any deferred rent credits or debits arising from straight-line rent, rental payments under the operating lease accounting. They wouldn't get recognized through retained earnings. They go into the ROU asset so all your prepaid and accrued rents are going to go into the ROU asset.”

John made a final important note regarding leasehold improvements, emphasizing that these are separate and will not be treated any differently under the new standard.

We want to thank John for providing his expert insight into some of the more challenging aspects of ASC 842.