Accounting Standard Codification Topic (ASC) 842, Leases, offers a major change in lease accounting. The new standard will require organizations that lease assets—referred to as “lessees”—to recognize on the balance sheet the assets and liabilities created by those leases.
The notion of improved reporting is at the core of the new standards, with outcomes including better representation of a lessee’s rights and obligations, fewer opportunities for organizations to structure leasing transactions to achieve a particular outcome, improved comparability of lessees’ financial statements, and providing users of financial statements with a greater depth of information about lessors’ leasing activities.
Given the complexities and fundamental accounting changes, it is more than likely the case that organizations will need to make a significant investment in analyzing and managing accounting and disclosure requirements. One cannot stress strongly enough that the time to evaluate impacts and implement changes should not be underestimated.
In broad terms, organizations should consider how to involve and engage individuals from across the enterprise, determine the best means by which to gather data on leases, understand what information will be necessary for analysis and preparing financial disclosures and the impact on financial metrics, as well as the resources necessary to make judgments regarding lease transactions.
It is critical that companies have a well-organized and comprehensive approach to adoption in order to avoid surprises and disruptions to the company’s operations and financial reporting process. In order to achieve this, the adoption of the new standard will require engagement of stakeholders across the entity. For example, recognition of lease-related assets and liabilities under the new standard may affect accounting for income taxes and may also create implications regarding state and local taxes, requiring expert input from various functions. It is important to ensure that all relevant stakeholders, including legal, tax and especially accounting and IT, are engaged early to ensure that companies have a coordinated, agreed-upon approach to adoption.
While the identification and collection of lease data may sound simple, the reality is, for most organizations, it is not a simple task. The new standard affects all leases, not just larger real estate leases, and comprehensive data for all leases may not be readily available. Gathering relevant and accurate data is required in order to properly evaluate what changes are necessary to apply the new standard and the level of effort required for adoption calculations and judgments, ongoing assessments and disclosures.
Compiling the overall lease population will require considerable effort, not to mention the need for verification of accuracy. Certain key factors to consider for all use arrangements include whether arrangements are or contain a lease, the existence of non-lease components, and the existence of renewal, termination and purchase options and lease classifications.
Currently many organizations utilize spreadsheets to track leases and prepare required disclosures and accounting evaluation. Depending on the depth and breadth of leasing arrangements, this approach may no longer be adequate, requiring the adoption of new IT systems, which is a significant undertaking in and of itself. And because the standard’s transition provisions require adjustment to historical comparative period, some companies might find the effort even more onerous.
If comprehensive data-gathering were not a heavy enough lift, the new standard requires significant judgments and estimates regarding whether arrangements meet the definition of a lease and may not be straightforward. Further, while the definition of a lease under the new standard is similar to current U.S. GAAP, there are differences that could result in some arrangements receiving different accounting treatment compared to current guidance.
To add to the challenge, there are a number of accounting policy elections that may be taken at transition and are related to post-adoption accounting, including whether or not to adopt a short-term lease recognition exemption. And then there is consideration of the practical expedient to not separate the non-lease components from the lease components of a lease. While “practical expedient” may sound like the path of less resistance, this may not necessarily be the case, as electing this practical expedient will result in a higher lease-related asset being recorded on the balance sheet, which could result in an increased risk for asset impairment, as well as affecting certain financial metrics and covenants.
Because the new standard will result in the recording of assets and liabilities for substantially all leases on the balance sheet, the changes could have material impacts on key financial metrics, such as debt ratios and return on assets. Organizations should evaluate the potential impacts on their key financial metrics sooner rather than later, in order to communicate with lenders, oversight bodies and other external stakeholders. While implementation may seem a speck on the distant horizon, and these conversations not currently relevant, the time to act is now.
New lease accounting requirements are effective for periods beginning after December 15, 2018, for public business entities and certain not-for-profit entities and employee benefit plans filing with the SEC, and for annual periods beginning after December 15, 2019, for other entities. Earlier application is permitted.