In 2016, the Financial Accounting Standards Board (FASB) issued the new lease accounting standard-ASC 842, Leases that modifies and replaces current financial accounting and reporting of lessees and lessors. Public companies are required to adopt the new standard for fiscal years beginning after December 15, 2018, while private companies have an additional year to comply.
The additional year granted to private companies for adopting the new lease accounting rules has led to a certain level of complacency amongst many C-suite leaders and financial executives at private companies. In many cases, the new standard is viewed as yet another accounting change among a plethora of other priorities. From our experience, we believe that many private companies will find it more difficult and time-consuming to transition to the new leasing standard than they anticipate. This article, the first in our thought leadership series, Lease Accounting: Your Guide through Change, is focused on assisting private companies when navigating transition and to address potential challenges posed by implementing the new standard.
Topic 842 brings most operating leases on to lessee balance sheets. Previously, only capital leases (referred to as “finance leases” under the new standard) were required to be recognized on lessee balance sheets as capital lease assets with a corresponding debt-like liability. The new standard also modifies the definition of a lease and provides that part of a contract can meet that definition. Lease identification is a prominent exercise under the new standard, especially for lessees whose operating leases will be reflected on-balance sheet as right of use assets (component of property, plant and equipment) with corresponding lease liabilities reflecting the discounted amount of lease payments payable over the lease term. The criteria used to classify leases by lessees and lessors have been changed to be more principles based, and a new lease classification criterion has been added for specialized assets. The table below provides an overview of lessee accounting under Topic 842.
J.P. Morgan expects the new lease accounting rules to have a $10 billion impact on its balance sheet. In fact, more than three-quarters of the top 100 U.S. companies expect to see a material impact on their balance sheets. These reports alone, which are emanating from companies that possess state-of-the-art reporting and compliance capabilities, should serve as a wake-up call for any private company CFO, CAO, or Controller planning to apply a wait-and-see approach to tackling the new standard.
“Outside of larger public companies, my sense is reporting entities are generally not as prepared for this as they probably should be at this point. There are considerations involved with transition. Adjustments will be necessary to accounting processes and policies, and there may be unique considerations for private entities, especially those that are closely held,” says Matthew Derba, Director, National Assurance at CohnReznick.
“Many companies are unprepared for the wide-ranging effort required to meet the leasing standard, especially after they just tackled revenue recognition,” added Marisa Garcia, a Managing Director within CohnReznick Advisory.
The first step toward compliance is to identify the population of leases that exist throughout the organization and how to treat them under the new standard. This is easier said than done because many companies do not have centralized, controlled processes around their leases outside of those involving real estate. Many companies have historically not viewed lease accounting to be a significant accounting process in the scope of their internal control environments. That view is expected to change as potentially significant lease liabilities and corresponding right-of-use assets, which are subject to impairment assessments, will be recognized on lessee balance sheets. The new standard raises the risk level for financial statement errors and internal control deficiencies.
In addition to office space, companies often lease most of their basic assets, such as copiers and printers, computers, company-provided cell phones, telephones and other telecommunications equipment, office furniture, and IT systems. For a manufacturer, a distributor, or contractor, the leasing list can become much longer and more complex. Add in vehicles, trucks, heavy equipment, warehouse space, and you gain an appreciation for the magnitude of leasing activities occurring at entities operating across different industries. A reporting entity may have built an extensive international manufacturing and distribution network on a foundation of leasing arrangements. Moreover, many of those leased assets, especially certain types of equipment, may be subject to master leasing arrangements necessitating reporting entities to wade through lengthy legal documents as part of implementing the new standard.
The new lease accounting standard requires lessees and lessors to discount future lease payments using the rate implicit in the lease. A lessee, however, may use its incremental borrowing rate if the rate implicit in the lease cannot be readily determined. A lessee’s incremental borrowing rate will generally vary between leases having different terms and payment amounts, and is the rate a lessee would pay on funds borrowed on a collateralized basis. However, leases having similar characteristics may qualify for a portfolio approach, enabling a single discount rate to be applied to a portfolio of similar leases. The lessee’s incremental borrowing rate must be specific to:
- The lessee: an incremental borrowing rate is company-specific, and considers the lessee’s credit risk. This can pose challenges for large organizations with decentralized operations, as well as smaller organizations that have not had recent financing transactions.
- The term of the lease: a discount rate applied to a 5-year lease will probably not be the same as a discount rate applied to a 20-year lease.
- The amount of the funds ‘borrowed’: a higher amount of lease payments is presumed to result in a higher discount rate as compared to a discount rate determined for a lease with a lower amount of lease payments.
- The ‘security’ granted to the lessor: the standard requires a lessee’s incremental borrowing rate to reflect that of a secured borrowing. Accordingly, the nature and quality of the collateral must be considered.
- The economic environment: the market conditions in the geographic location the lease is originated and the currency in which the lease is denominated must be considered. This adds complexity for companies with global operations that conduct their treasury operations locally or regionally.
Many companies are being contacted by lease administration and accounting technology companies offering to sell software that will facilitate and automate the transition to the new lease accounting standard. If only it were that simple. Internal resources are often stretched on other critical IT projects, including current and future upgrades to enterprise resource planning (ERP) software, and the finance and accounting departments often do not have the resources with the necessary skills to deploy a new system. An accounting software will facilitate and automate the process, but it will not provide the technical assessments previously discussed. Further, the data collection effort to identify the population of leases and their key terms remains, regardless of whether a system is deployed. CohnReznick’s partnership with artificial intelligence technology leader, Leverton, automates the lease abstraction process and provides efficiency in the data collection process.
When properly planned for and implemented correctly, a technology platform for lease accounting may be the right component of an implementation plan for companies of a particular size seeking to automate and centralize their processes. While there are many platforms available, it is also difficult to know which one will be best for your organization. Without the right system in place, manual processes may become onerous as the sheer volume of data continues to grow.
This issue is especially critical for a manufacturer working through its factory’s connectivity and automation as part of industry 4.0. Companies that are planning to automate all their other processes must bring in an accounting platform that will speak to every other system to potentially offer cost-saving opportunities. Anything less would be counterproductive. However, the implementation of a new system, that will work with those currently in place, can also add to the implementation timeline.
The new lease accounting standard is poised to impose significant and possibly unforeseen transition challenges. That’s why it’s important to start planning for the transition now. We believe it can take six months to complete all the necessary steps to become fully compliant. This timeline does not necessarily factor in possible delays and complications. We believe that each organization comes with its own set of challenges and will therefore need to adjust their implementation timelines accordingly.
Of course, some companies will be tempted to put off their compliance efforts, as Topic 842 does not carry direct fines or penalties for noncompliance. However, we believe procrastination carries significant organizational risks. In our follow-up article, we will focus on the unforeseen risks your company might run into waiting too long to plan for transitioning to Topic 842, and steps that can be taken to reduce such risks.
Lease Accounting Resource Center
On-Demand Webinar: The Leasing Standard Maintaining Momentum Through The Final Stages
Taking Action and Challenges to Consider