The new lease accounting standard: Private entity risks
By 2022, the FASB’s new lease accounting standards (Topic 842) is expected to go into effect for all entities. That means that any entity with a calendar year end that has not yet adopted this standard will be required to do so effective Jan. 1, 2022 for their annual financial reporting. At this point, private entities have had the benefit of observing public companies adopt the new leases standard, many of whom have indicated that they underestimated the heavy lift of adopting this new standard. Some in the marketplace have gone so far as to say that adopting and applying the new lease accounting standard has been, and continues to be, even more cumbersome, costly, and time consuming than adopting and applying the new revenue standard (Topic 606). Just as the dust from adopting Topic 606 has settled for many private entities, the effective date of ASC 842 can be seen on the horizon.
As the effective date of the new standard inches ever closer, we urge private entities to devise and begin executing their transition strategies now, leaving ample time to address unforeseen challenges. We believe that applying a wait-and-see approach is not the best course of action and could result in transition efforts getting bogged down in unforeseen quicksand.
To recap, Topic 842 brings most operating leases on to lessee balance sheets, requiring lessees to recognize liabilities reflecting the discounted amount of lease payments payable over the lease term. Previously, only capital leases were required to be recognized on lessee balance sheets. The new standard also modifies the definition of a lease and provides that part of a contract can meet that definition.
Through assisting and advising public and private organizations in their transition efforts, we have observed implementation-related risks and issues. We believe it is in the best interest of any organization to understand, evaluate, and address them. We also believe that private organizations, may have more IT system constraints, less robust reporting functions (when compared to public companies), and may also face an elevated level of exposure to these risks and issues. In addition, organizations may not have the in-house capacity and expertise necessary for developing and executing an effective transition strategy to avoid critical missteps, especially when considering the demands of other organizational priorities.
Here are some of the risks we are discussing with our clients:
Risk: Embedded Leases
A portion of a contract can meet the definition of a lease under Topic 842. While not necessarily a new concept as compared to legacy lease accounting, the risk associated with not properly identifying an embedded lease could be significantly higher given that operating leases are on-balance sheet under the new standard. This could require companies to identify contractual terms embedded within seemingly non-lease transactions that meet the definition of a lease. For example, a service contract may contain a lease if it identifies a specific asset to be used when performing under that contract. In those situations, an entity could, depending on the arrangement, be required by US GAAP to allocate the consideration in the contract to the embedded lease component, and measure and recognize a related lease liability reflecting the discounted amount of future lease payments and corresponding right of use asset. Companies are required to determine an appropriate discount rate when measuring lease liabilities, including for those leases classified as operating.
As mentioned above, this exercise was less prominent prior to Topic 842, because operating leases were accounted for off-balance sheet. That has changed under the new standard, highlighting the prominence of identifying embedded leases. Embedded lease identification may sound like a straight-forward exercise, but it could become complicated when contracts are often reviewed and signed by various individuals in different departments throughout an organization who may or may not be conversant with the nuances of the leases accounting standard. This could be compounded in situations involving a lease embedded within a seemingly non-lease contract, such as a service contract. Identifying embedded leases will require a thorough understanding and evaluation of the contractual arrangements, and may necessitate the expansion of existing, or the creation of new, internal controls.
We expect most companies to elect a package of practical expedients when transitioning to Topic 842. Among other things, electing this package of practical expedients allows an organization to avoid re-evaluating expired or existing contracts for embedded leases. However, this exclusion cannot be used to ignore past accounting errors. Electing this package of practical expedients to willfully avoid past errors from coming to light could harm your E&O coverage and poses reputational risk.
Risk: Discount Rates
Under the new standard, lessees and lessors are required to use the rate implicit in the lease when discounting future lease payments. If that rate cannot be reasonably determined, lessees may use their incremental borrowing rates. Determining company-specific incremental borrowing rates will be challenging, especially for lessees that do not frequently issue debt or that conduct their treasury operations in a decentralized way. Incremental borrowing rates reflect, among other things, lessee credit risk, lease term, the amount of lease payments, and the impact of ‘posted collateral’. Early on, private companies should devise an integrated approach to determining appropriate discount rates when applying Topic 842.
One way a private organization can avoid gyrations around determining lessee discount rates is to elect an accounting alternative to use a risk-free discount rate (e.g., US Government Treasury Note rate). However, such an approach should result in significantly higher lease liabilities and right of use assets.
Risk: Debt Covenants
Many companies have debt arrangements containing loan covenants that, if violated, trigger a default by the borrower. Companies may also have agreements containing cross-default provisions or material adverse change clauses that could be negatively impacted by an actual or constructive default under an unrelated agreement, such as in a loan default. Since lease liabilities will be recognized for most operating leases under Topic 842, companies should assess whether their existing covenants will be affected.
Risk: Internal Controls
Many companies perform their accounting for lease arrangements using spreadsheets. Over time, this could have resulted in inconsistency with respect to how the data is maintained and managed. Lessees should ensure they have appropriately functioning internal controls around Topic 842-related calculations. There is expected be a lower margin of error for lessees under Topic 842 as compared to legacy lease accounting because a lease will be on-balance sheet. Regardless of the medium used (e.g., software or spreadsheet), internal controls supporting those calculations should be enhanced to support the information and calculations required by the new standard, including information needed for financial statement disclosure.
There are many vendors offering to sell software designed to automate implementation of the new standard. Unfortunately, many private organizations do not have the enterprise reporting (ERP) systems in place to support these software solutions. For private companies seeking to upgrade their current ERP systems, such solutions may not be the right fit because there is likely little or no benefit to building on top of an ERP system that may soon be obsolete. Further, decisions about ERP systems are made in contemplation of the entire enterprise, not just the accounting and finance departments.
Because there are many lease software solutions available, it is often difficult to know which one will be best for your organization. Without the right system in place, the ability to store lease data and use it appropriately will diminish as sheer volume of data increases. This makes the data difficult to retrieve, which inhibits the usage of such data to gain valuable insights into internal processes and market trends.
Risk: Staffing, Training and Timeline
Organizations need to prepare for adopting Topic 842 now. Underestimating the difficulty and complexity of adopting the standard may pose the biggest risk of all. Adopting Topic 842 may require extensive training and staff time. While initially adopting the standard is a one-time-only effort, there will be ongoing compliance activities that may be more apparent than what organizations have experienced when applying Topic 606 post-initial-adoption. Many companies are looking to hire an external firm as the deadline draws nearer. At this juncture, most of the qualified bandwidth has been taken, limiting the availability of quality employment candidates and consultants in the marketplace.
Topic 842 implementation could require extensive changes in systems and operations, a process that will require time, money, and top talent. Therefore, it is better to lock up the talent sooner rather than later. Organizations that begin planning today can reap risk management benefits and be better positioned to realized efficiency gains post-transition.