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The Three Red Herrings of ASC 842 (What Not to Worry About)

Do not fall victim to wasting time on one of the three red herrings of ASC 842: lease classification, Incremental Borrowing Rate (IBR) and embedded leases.

Eight herrings arranged in rows on a white background, with one fish in the top row colored red and the rest in natural shades of silver and blue.
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When it comes to adopting ASC 842, there are plenty of valid obstacles to consider: differences in transition methods, free rent in the middle of an office lease affecting a straight-line expense or early termination of operating leases. 

That said, certain problems have been overemphasized. When considering where to invest the precious resources allocated for this transition, it’s crucial to know what not to worry about. These are the proverbial red herrings of 842. 

Even though I’ve used the phrase for years, I never knew the origin of the term “red herring.” It turns out, the expression comes from the use of smoked fish to create a strong aroma and distract hunting dogs from catching the scent of their actual targets. 

In our case, the red herrings are three commonly cited complications of ASC 842 that disrupt accurate transition planning. You’ve probably heard of them: I’m talking about embedded leases, classification testing and calculating the incremental borrowing rate.  

Here’s why these three areas are more likely to be distractions than genuine obstacles to adoption. 

Lease Classification 

The concern: Under ASC 840, classifying a lease as operating meant that no asset or liability needed to be recognized on the balance sheet. Only capital leases (which have been rebranded as financing leases under ASC 842) had a balance-sheet impact. This is no longer the case. Both operating and financing leases will be shown on the balance sheet. The game of keeping leases off the balance sheet is over. 

The reality: The FASB offers a package of practical expedients that allows a company to opt out of revisiting classifications. One can simply bring over the same designation a lease had under ASC 840. This means that only leases commencing after the transition date need to be freshly classified. Plus, any decent lease-accounting software will walk you through the five criteria of lease classification. There’s no need to fret about which types of leases are in a portfolio. 

Incremental Borrowing Rate (IBR) 

The concern: Part of the process of calculating lease liabilities includes present valuing minimum lease payments. To do this, one of three discount rates must be used for private companies. 

Most accounting professionals get hung up on using the IBR as their discount rate instead of taking the more practical route of the risk-free rate. Sure, the IBR will most likely result in a smaller balance-sheet impact, but is the juice worth the squeeze? To get an accurate IBR, a valuation specialist will likely need to be engaged. FASB’s guidance on an IBR is more stringent than most realize, so spending an afternoon at your desk calculating an IBR for each leased asset is not a realistic approach.  

The reality: The best option is the risk-free rate. These treasury rates can be accurately gathered from a website in a manner of minutes. If your lease length does not match up to a stated treasury, we can help you get an equivalent rate in seconds for free. Simply use the risk-free rate for discounting and save yourself the headache. 

Embedded Leases 

The concern: The term itself sounds difficult and time-consuming. Embedded leases are essentially hidden leases that don’t have common lease agreements. As we discussed in this recent article, one example could be the specific server on which company hosts cloud-based data. Some experts recommend getting specialists or legal teams to perform a review to find these embedded leases. 

The reality: These embedded leases are not as common as you might think. Even if they do exist, chances are that the value of the embedded lease is immaterial. Do not be overwhelmed by embedded leases. Of course, you should review larger recurring expenses with their associated contracts, but there’s no need to overinvest in this area. 

Bottom line 

These three areas should be on your radar, but by no means should they be the focal point of ASC 842. Instead, direct your efforts toward gathering lease data and identifying software solutions to accurately maintain amortization schedules. Do not fall victim to wasting time on one of the three red herrings of ASC 842. 

For more information on automating your lease accounting, schedule a conversation with one of our CPAs