Op Ed: In Lease Accounting, ASC 842 Changes the Rules
The Financial Accounting Standards Board (FASB) has released a new lease accounting standard, known as ASC 842, and companies need to adapt to the change going into effect in 2019.
Historically, accounting for many leases has been straightforward: Determine whether you have a capital or an operating lease. For the latter, disclosure of operating lease amounts is included as a component of future commitments only, as these relationships and contracts are classified as “off-balance sheet”.
This off-balance sheet treatment creates challenges for analysts and investors as they try to understand a company’s financial obligations and future profits.
Why the Change?
The new lease standard seeks to provide more transparency to solve those challenges by changing the accounting view and the way companies account for future leasing transactions. Companies should have inventory current leases and assess the effect of the new guidance on financial statements and the resulting impact on key metrics, agreements and operations.
Furthermore, for capital leases the process will be relatively consistent in terms of the balance sheet, but there are some changes to the mechanics that will adjust the actual asset and liability at each balance sheet date.
Finally, the definition of a lease is clarified and generally increases the scope of impact, but in other situations it results in non-lease treatment for items that today may be included in the future “lease” commitments disclosure and may not be a lease.
What is Changing?
Under the new guidance of ASC 842, both the lessor and lessee will first need to identify the specific asset or property that is included in the contract.
The parties will independently assess the right of use of the specified asset to document their perspective on control, intended duration of use, and separate aspects of the contract that require consideration under other guidance (such as ASC 606 and 610).
There are certain elections that can be made to “simplify” the accounting. However, it is important to understand the substance and characteristics of the transactions and contractual relationships before electing to such treatment.
Most organizations today do not track all of their leased arrangements, so it may be challenging to ring fence the contracts in question.
The following is a list of changes:
- Modified retrospective transition method of adoption is required as of the earliest period presented.
- New definitions as to what constitutes a lease as well as what are considered as initial direct costs.
- Practical expedients are available for those leases existing upon adoption as well as several policy elections (provided that current data and detail are accurate and can be relied upon).
- Lessees will recognize a right-of-use asset and a lease liability on the balance sheet for ALL leases longer than 12 months.
- New requirements increase judgment and disclosure in accounting for leases and changes in detailed calculations.
- Under finance leases, expenses will be front-loaded and, therefore, have a front-loaded income statement impact.
- Real estate specific and “build-to-suit” guidance will be eliminated and leveraged leases will be grandfathered in.
- Early adoption of the new standard is possible.
How do I Determine the Impact of These Changes?
For many organizations, the best place to start is to understand the volume of transactions that are currently classified as leases. This could be as simple as understanding their disclosure for commitments and contingencies to get a general sense of the scale of leased assets.
Next, we would recommend reviewing material recurring payment streams to consider if additional relationships or arrangements fall within the scope of ASC 842.
For sales and revenue that could have embedded leases included, most organizations will have identified these as part of their ASC 606 assessment. These should be modeled consistent with ASC 606 processes.
In addtion, we would recommend understanding any covenants or coverage ratios as these may be affected by the change in presentation — having a handle on what the potential impacts may look like will inform more focused discussions to management on potential implications.
Some things to consider:
- Debt covenants, ratios and other metrics — Review key metrics and act upon change before it’s too late.
- New transactions, processes, systems and controls — Include internal controls in your strategic plan.
- Lease vs. buy analysis — Reconsider your leasing strategy: "off-balance sheet" financing no longer permitted.
- Construction property — Take advantage of reducing debt on the balance sheet via early adoption.
When is This Change Taking Place?
The new lease standard goes into effect for calendar year-end publicly traded companies and certain other entities beginning on January 1, 2019, including interim periods, and for all other entities beginning January 1, 2020, and interim periods the year thereafter.
What Next Steps Should I Take?
You can undertake the following steps:
- Understand new requirements under ASC 842.
- Inventory lease population and required data.
- Evaluate lease data in light of accounting requirements.
- Assess capabilities of existing technology and whether they will meet the future accounting and disclosure requirements.
- Determine how new guidance affects current negotiations on lease extensions or new leases.
- Consider effects on existing policies and procedures and related controls.
- Calculate preliminary impact on debt covenants and other financial metrics.
As you evaluate the new revenue standard, ASC 606, Revenue from Contracts with Customers, don’t fall behind in your basic understanding of ASC 842.
The new lease guidance requires fundamental changes in accounting for leases, increased use of judgment, expansive disclosures, and may require changes to your current system or the implementation of new systems.
While ASC 606 allows companies to restate prior periods or apply the standard in the first year of adoption only, ASC 842 allows no such election. Companies must restate all prior comparative periods. Restating prior periods two years in a row could be avoided by adopting both standards simultaneously.
An additional consideration that some organizations are taking a deeper look at is leases that are not in line with a company’s disclosed borrowing rate. For example, a company may utilize operating leases today as an alternative to balance sheet capitalization but pay a premium to achieve this treatment.
It may be advantageous to terminate these practices before adoption as the balance sheet presentation of these transactions may not be viewed positively.
The new lease standard affects leasing transactions, but it doesn’t need to interrupt operations. It is critical for your organization to become familiar with the new requirements, gauge the impact, and propose adoption strategies to stay ahead of the curve and drive better business outcomes.
Tom Roland serves as Managing Director at MorganFrankin Consulting where he is responsible for finance, reporting, and operations practice development and client service delivery, primarily in support of multi-national organizations.