While it may seem like there is plenty of time, time is of the essence to get started (if you haven’t already) on implementing the new lease standard, FASB Accounting Standards Codification Topic 842, Leases (the “Standard” or “Topic 842”). The Standard was effective for calendar year-end public entities on January 1, 2019 and there is much to be learned from their efforts and challenges to date. Private entities have the advantage of extra time to comply with the standard, however, given the anticipated effort involved, we recommend getting started sooner than later.
There are several components within the standard and several implementation considerations to understand and evaluate. Below are a few of the more significant and challenging components and considerations.
Lessee vs. lessor changes
Under Topic 842, lessees are likely to see the most significant impact, as it requires a right-of-use (ROU) asset and lease liability to be recorded on the balance sheet for all leases over 12 months (with some exceptions) at the present value of the lease payments over the remaining lease term. Under existing guidance, capital leases were recorded on a company’s balance sheet, but only operating leases were required to be reported in the footnotes of the financial statements. Depending on the length of lease arrangements and the rental payment amounts, the ROU asset and lease liability may be substantial.
Although lessor accounting remains primarily unchanged by the standard, it did align certain underlying principles of the new lessor model with those in the new revenue recognition standard, ASC Topic 606.
Operating vs. finance leases
The new standard eliminates the required use of bright-line tests included in current accounting requirements for determining lease classification. As such, determining whether a lease is an operating or finance lease may require more judgment. Additionally, this may present an opportunity to evaluate and update terminology in lease agreements, due to the differing impacts to the financial statements and associated covenant calculations. For finance leases, the interest and amortization of the lease are presented separately on the income statement. However, for operating leases, the two are combined and presented together and the expense is typically straight-lined, while for finance leases, the expense may be front-loaded due to interest on the lease liability.
Definition of a lease
The definition of a lease has changed in the new Standard. In the new Standard, an arrangement contains a lease when such arrangement conveys the right to “control” the use of an “identified asset.” It’s important to keep in mind that these agreements don’t always contain the word lease, and companies may be required to evaluate any contract which meets the above definition.
Under existing guidance, an arrangement can contain a lease even without control of the asset, but this is only if the customer substantially takes all the output over the term of the arrangement. Determining whether an arrangement contains a lease is likely to be more important since all leases will require asset and liability recognition.
Identifying the entire population of leases, including embedded leases
Ensuring a complete inventory of all leases, including those that are embedded in other arrangements, and gathering all related documents (initial agreements, all amendments, exhibits, supplements) is a significant challenge and time-consuming process for many companies. If companies historically haven’t had a central repository for such documents, or have multiple locations or numerous leases, the challenge to identify and gather pertinent records can be amplified. The effort involved in this early and vitally important step should not be underestimated.
Use of practical expedients
Given the complexities with implementation, the FASB has included a package of practical expedients which companies can elect to utilize. This package allows companies to forgo reassessing whether a contract contains a lease, a classification of leases, and whether capitalized costs associated with the lease meet the definition of initial direct costs. The package also effectively allows companies to continue to account for existing leases based on judgments made under the legacy lease guidance in ASC 840, relative to these items.
The FASB also included another expedient allowing an entity to elect to use hindsight to determine the lease term. Accordingly, an entity may use actual knowledge or expectations as of the implementation effective date instead of knowledge and expectations as of the latest date when it assessed lease classification to assess the likelihood that a lessee will exercise its option to extend or terminate a lease, or to purchase the underlying asset.
Another important thing for companies to consider is the application of the transition method. Upon initial release of ASC 842, companies were required to apply the modified retrospective method, meaning the application date was later then the beginning of the earliest period presented in comparative financial statements and the commencement date of the lease. Accordingly, all periods presented will be consistent and reflect the application of ASC 842. Based on feedback, the FASB subsequently issued another practical expedient allowing companies to elect to have the application date be the same as the effective date of the Standard. This transition approach will result in comparative financial statements being inconsistently presented with prior years accounted for pursuant to ASC 840.
Implementing the package of practical expedients can help to reduce the time and analysis required to adopt and implement the Standard.
Determining the lease term and discount rates
The lease term and discount rates are important components in calculating the ROU asset and lease liability. Lease arrangements often include renewal options or termination options. All relevant contractual provisions, including renewal and termination options, need to be considered when determining the term of the lease. However, only renewal or termination options that are reasonably certain of being exercised by the lessee should be included in the lease term. The assessment of whether it is reasonably certain that a lessee will exercise an option should be based on the facts and circumstances at lease commencement. The assessment should not be based solely on the lessee’s intentions, past practices or estimates, but rather it should also focus on factors that create an economic incentive for the lessee. The discount rate should be the implicit rate in the lease, or if not determinable, it should be the lessee’s incremental borrowing rate. A non-public entity is permitted to use a risk-free discount rate for a period comparable with that of the lease term as an accounting policy election for all leases.
Lease vs. non-lease components
Lease arrangements may contain both lease and non-lease components which must be properly identified as they are subject to different accounting models. Non-lease components, such as common area maintenance or service contracts for leased assets, should not be included in the lease unless a lessee elects to include both the lease and non-lease components as a single component, by asset class, and account for it as a lease. While this election relieves the lessee from the obligation to perform a pricing allocation between components, it will result in larger assets and liabilities recorded on the balance sheet.
Variable lease payments
Variable payments that depend on an index, or a rate, should be initially measured using the index, or rate, at the commencement date of the lease. The difference between the payment, and the amount initially included as a lease payment, is a variable lease expense, which is recorded as it is incurred, versus trying to estimate this difference upfront.
Variable payments that do not depend on an index, or rate, should be excluded from the initial determination of the asset and liability. Variable payments that are based on achieving a specified target, like sales volumes, are recognized as a variable lease expense when the time achievement of the target is considered probable.
Implications on internal controls, debt covenants and systems
Aside from the accounting changes pursuant to the new Standard, entities shouldn’t lose sight of potential changes in internal controls, processes, debt agreements and accounting systems. It may be necessary to consider these factors during the implementation to ensure timely and accurate accounting post-implementation. For some entities, these changes or improvements may require significant and additional resources.
The implementation of Topic 842 comes with significant challenges that can consume valuable time and resources. Fortunately for private entities, there is much to be learned from the challenges public companies have faced to date. If you have questions about the components and considerations outlined above, please contact us today.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.