In February, the Financial Accounting Standards Board issued Accounting Standards Update 2016-02 – Leases (Topic 842). This Update replaces 40 years of lease accounting rules with principles-based guidance. While ASC 842 started its life over 10 years ago as a converged project between the FASB and the International Accounting Standards Board, there is a key difference between the two…more on that later. But they do share one main feature: almost all leases will now be accounted for on the balance sheet. By some estimates, this will mean an additional $2 trillion on U.S. balance sheets.
What’s in the New Standard?
The first thing to know is that ASC 842 applies to all business enterprises – public, private, and not-for-profit. Generally, for calendar-year public entities the new standard will be effective in 2019, while all other entities will need to adopt it in 2020. Companies will need to present comparable financial statements using a “modified retrospective” approach. For a typical public company, this means 2017 and 2018 will need to be presented under the new rules (although somewhat modified).
Similar to the new Revenue Recognition standard (ASC 606) issued two years ago, the concept of “control” is fundamental in the new lease accounting standard. The question to be answered by a potential lessee is whether or not you have control over an identified asset, with control being identified as (1) the right to obtain substantially all of the economic benefits from the use of the asset and (2) the right to direct the use of the asset. If you meet these criteria, you have a lease.
Lessee Balance Sheet Requirements
The new rules don’t impact lessors much, but lessees will see significant changes. Leases with a term of one-year or more will be accounted for on the balance sheet as a lease liability with an offsetting “right-of-use” asset. Further, at inception of every new lease, a company will need to determine whether to classify the lease as a finance or operating-type lease. This will impact the treatment on the income statement with finance leases receiving similar treatment to today’s capital leases and operating leases receiving a generally straight-line expense treatment. There are numerous judgment and documentation points that will come into play when making these determinations.
Leases Combined With Services
One area that will undoubtedly cause many companies a lot of work is the concept of the lease combined with a service contract. Historically, some lessees have left these leases “buried” within the larger contract and accounted for the contract as a combined expense item. Under the new guidance, companies will either need to separate the lease component(s) from the rest of the contract terms or account for the entire contract as a lease via a policy election.
As mentioned above, there is a big difference between ASC 842 and its IFRS equivalent: lease classification. In IFRS, there is no operating lease equivalent. All leases are treated consistently with finance leases in the U.S. This will result in different income statement treatment for leases that are classified as operating under the U.S. model.
Expect Questions When Covenants Apply
The addition of all these lease liabilities on a balance sheet could have a significant impact on financial ratios and loan covenants. Many companies can expect to see material increases in their debt-to-equity ratios. Your bankers will be very interested to see the results.
Where Should You Start?
First, don’t wait. There is a lot of work that needs to happen between now and your required adoption date. Similar to my advice on the new Revenue Recognition standard, I recommend beginning with an adoption timeline. After determining when you need to be finished, come up with reasonable and attainable milestones.
The first task in the process is to gather and inventory your leases. Most companies will begin with the list of leases that is updated annually for the lease disclosure footnote. That’s a good place to start, but it’s exactly that – a starting point. Let’s face it, many accounting departments view that annual exercise as “only a disclosure” and don’t put 100% effort into getting a complete list of leases. So I recommend a “sweep” for any missed leases. You will need to consider all other contracts that may contain embedded leases. For many companies, this will be a new undertaking – and will be very time consuming.
Now is also a good time to rethink the processes for which you accumulate, categorize and warehouse leases. Consider your internal and external resources and determine whether or not your team has the bandwidth to get it all done.
Lease Accounting Priority
One surprising thing I have noted. The new Leases guidance seems to be getting more attention – and early adoption effort – than other standards that have been issued recently, including Revenue Recognition. Perhaps it’s the notion that it could have a significant impact on loan covenants or the fear that rounding up all those leases could turn into a massive effort. While my perception is based on anecdotal evidence only, it’s an interesting and somewhat unexpected twist.
What Is Aventine Hill Doing to Help Our Clients?
Our team is currently assisting clients in the areas of project management, lease collection, individual lease analysis and disclosures. We are researching implementation issues, preparing whitepapers, and advising clients on recommended courses of action. We also help design new business processes for tracking leases; and, select and implement lease accounting software that is often required to perform the new capitalization calculations accurately. Read our Lease Accounting Software Buyers Guide here.
We would be pleased to help you better understand your Leases assessment and adoption challenges. If you would like to learn more on what this means to your organization, please use our Contact Form or call your nearest Aventine Hill office.