Private companies can ease the pain of implementing the new lease accounting standards by leveraging the lessons learned by public entities as they implemented the changes. The new FASB lease accounting standards are effective for private companies, including not-for-profit entities, for fiscal years beginning after December 15, 2019 (i.e., January 1, 2020, for a calendar year entity), and interim periods within fiscal years beginning after December 15, 2020. Early implementation is permitted.
Private companies in large part are focused on finalizing their implementation of the revenue recognition standards. It is important that their focus begin to include the new leases standards as soon as is practicable. The FASB’s policy of private company effective dates following those for public entities by a year is providing the intended benefits. The lessons learned from public entity implementation of the new leases standards are significant. In an attempt to ease the pain of implementation for private companies, this edition of A Closer Look reviews some of these lessons including:
- Start Early
- Agreement Review and Lease Inventory
- System Selection
- Policy and Procedure Improvements
- Auditor Communication
- Amendments and Practical Expedients
The single largest lesson that can be learned from the public entity implementation is how important it is to start early. A large number of public entities have reported that implementing the new leases standard was more challenging, and required a larger cross functional effort than the implementation for revenue recognition. For example, 47% of public entity respondents in an Ernst and Young survey indicated that they anticipate $1-$5 million in implementation costs.
Additional surveys have noted that as of December 2018, less than 5% of public entities had completed their lease accounting implementation, but most had implementation in process. Approximately 15% were currently assessing the impact of the standard, and less than 5% had not yet begun the process. Private companies were evenly split between implementation in progress, assessing the impact, and not yet started the process. Several entities reported that the time had vanished and they will initially implement using heavily manual approaches (spreadsheets) and make large scale changes after the initial implementation.
Financial reporting professionals are very good at cranking through the technical implementation details of accounting standards. One of the greatest challenges related to the new leases standards is getting to the position where implementation work can begin.
Agreement Review and Lease Inventory
Analysts have estimated that there are approximately $3 trillion in off-balance sheet lease commitments now coming onto the financial statements. An item consistently challenging all entities as they implement the new leasing standard is stated to be reviewing agreements and identifying the population of leases and creating an inventory listing of the entity’s leases. Public entities reported that it is common to find lease agreement processes are not centralized and lease agreements and related documentation exist at many or all locations.
The definition of a lease has changed. ASC Topic 842 provides that only property, plant, or equipment (which includes only land and depreciable assets) can be the subject of a lease. The new guidance specifically provides that leases of right-of-use assets in a sublease are in scope, but excludes from scope the following:
- Leases of intangible assets;
- Leases to explore for or use minerals, oil, natural gas, and similar non-regenerative resources;
- Leases of biological assets, including timber;
- Leases of inventory; and
- Leases of assets under construction.
Service concession arrangements within the scope of ASC Topic 853, Service Concession Arrangements also are not within the scope of the new lease guidance.
Some agreements that did not include a lease under ASC Topic 840 may contain a lease under ASC Topic 842. Private companies should consider conducting a physical inspection of facilities to identify leased assets that do not appear on a fixed asset ledger. If your entity has “rental agreements” there is a good chance that some or all of these agreements will qualify as a lease under ASC Topic 842. Entities implementing the new standard described the review of all agreements in order to identify such embedded leases as extremely time consuming. Many entities are not doing a good job identifying whether their service arrangements include embedded leases within larger business arrangements. It is critical that there is a detailed analysis to identify and document contracts that may contain embedded leases.
Documentation for older agreements may exist only on paper in a drawer somewhere. Although many agreements for things like office equipment are small, if every location or department handles its own leasing agreements, the cumulative effect will likely be material to the financials.
Implementation can succeed or fail based on getting the inventory of leases correct. Once the population of agreements/leases is identified, an entity can more accurately assess the level of effort and resources needed to complete the implementation process. Begin the search for all agreements early and inquire at every location to ensure all lease documentation is found and intelligible. Don’t underestimate the time it will take to gather the required lease information.
A significant percentage of entities implementing the new lease standards have indicated that they plan to change/upgrade/replace systems related to accounting for leases. Private companies will need to consider whether current systems including software can handle the required leasing calculations and reporting criteria. Is there a need to upgrade current systems or purchase new software? Will the entity use manual processes such as spreadsheets?
System testing is Critical. Many lease software solutions are still working out the kinks. Private companies should run test cases through their systems and compare results to those calculated manually (Microsoft Excel). A lesson from early implementers is that this testing should include the outputs when the system processes a change to the discount rate, payment amounts, or lease terms. If the results are materially different, the company will have to resolve those differences. If a third party is engaged to develop new systems or take the lead on implementation, the entity will still need to provide a detailed set of requirements. That in itself requires a significant commitment.
Policy and Procedure Improvements
An important lesson learned from public entity implementation relates to policies and procedures. Entities should take the time during implementation to improve the accounting process for leases and the related internal controls over financial reporting (ICFR). Implementation presents an opportunity to evaluate processes for inefficiencies and internal controls for weaknesses. If there are leases with one vendor across business units that are individually negotiated, there may be an opportunity to combine the agreements into one master lease agreement and negotiate the group of leases centrally possibly leading to pricing discounts. Public entities report process improvements in both information quality and processing efficiency. Policies and controls should, at a minimum, include those related to:
- Entering lease agreements;
- Modifying lease agreements;
- Terminating lease agreements;
- Maintaining accurate and consistent records of above; and
- Financial statement disclosures.
Early communication with the financial statement auditors in order to understand the auditor’s approach to testing lease implementation was also a key takeaway from entities that have had successful implementations. As audit quality reviewers continue to report audit deficiencies related to the auditors’ work around ICFR, it is likely that your auditor will expend significant time and effort reviewing, at a minimum, documentation of:
- Management’s analysis of embedded leases.
- Management’s updates to controls policies, and procedures;
- Support for management’s significant judgements and estimates
ASC Topic 842 requires new disclosures designed to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The new disclosures are both qualitative and quantitative. For example, entities must now disclose significant leases entered into but not yet effective. Entities must disclose key lease information as well as the judgments made in applying the requirements of the new standards and the amounts recognized in the financial statements related to leases. Public entities have indicated that the required disclosures were more complex and time consuming than anticipated.
Incremental Borrowing Rate Disclosure
An item consistently noted by public entities as challenging is the incremental borrowing rate. Companies must use an incremental borrowing rate to calculate lease liabilities in transition if the rate implicit in the lease is not known or calculable. The transition guidance for lessees indicates that upon adoption, the lessee should measure the lease liability using the discount rate established as of the beginning of the earliest period presented in the financial statements or the commencement date of the lease, if later. Public entities have noted that the transition guidance does not specify whether the discount rate selected should be based on the original lease term or the remaining lease term.
Some public entities concluded that the lessee should select a discount rate based on the original lease term as they believe that rate better reflects the borrowing rate embedded within the contract when the lessee entered into the arrangement. Others concluded the lessee should select a rate based on the remaining lease term as they believe the rate more accurately reflects the rate applicable to the remaining lease liability recognized in transition. The SEC’s Office of the Chief Accountant (OCA) noted that the transition guidance does not specify the lease term that should be used to determine the discount rate and further observed that either rate used in transition may significantly differ from the rate that would have been determined at commencement of the lease (i.e., the original commencement date of the lease).
OCA concluded that the selection of either of these rates, that is either the rate based on the original lease term or the remaining lease term, is reasonable and ultimately did not object to consistent application of either approach to determine the lessee’s lease liabilities in transition.
Amendments and Practical Expedients
The FASB has issued several additional standards to amend the new lease accounting guidance. Russ Golden, FASB Chairman, has stated “The targeted improvements … represent the FASB’s commitment to proactively address implementation issues raised by our stakeholders to ensure a successful transition to the new standard without compromising the quality of information provided to investors”. The amendments include correcting errors, clarifying words and, in some cases, providing alternative accounting approaches to reduce the cost and complexity of implementing and complying with the new guidance. Because most of these standards use the word “improvements” in the title, we have opted to refer to the four incremental standards as follows:
- ASU No. 2018-01 (January 2018) – Land Easements
- ASU No. 2018-10 (July 2018) – Technical Corrections
- ASU No. 2018-11 (July 2018) – Transition and Lessor Improvements
- ASU No. 2018-20 (December 2018) – Narrow Scope Improvements for Lessors
Several of these new standards may reduce implementation costs for both lessees and lessors.
For lessees, the most significant changes affect transition:
- The practical expedient related to land easements (ASU No. 2018-01.) This transition option effectively grandfathers a company’s accounting for land easements that were not previously accounted for as leases.
- The additional transition option (ASU No. 2018-11.) This alternative transition approach eliminates the requirement to restate comparative periods and requires any cumulative effect adjustment to be reported in beginning retained earnings in the period the new lease rules are first adopted.
Lessors may benefit from several changes:
- The additional transition option (ASU No. 2018-11.) This accounting election is available to companies at transition. Specifically, rather than restating comparative prior periods upon adoption of the new lease standard, a company can now elect to use the cumulative catch up approach. Under this election, the cumulative effect of applying the new requirements is recorded as an adjustment to beginning retained earnings in the year the standard is first implemented. This accounting election results in less information to investors about the effect of the new standard on an individual company and reduces comparability between entities in the year of adoption. However, it reduces a company’s cost of transition.
- The practical expedient related to the separation of lease and non-lease components (ASU No. 2018-11). Real estate lessors are likely to find this particularly significant given the prevalence of common area and similar maintenance services in real estate leases.
- The proposed additional improvements related to sales taxes collected by lessors and lessor costs (such as property taxes) directly paid by the lessee (Proposal August 2018.) Both proposals would provide an ongoing benefit to lessors.
Private companies are finishing implementation of the revenue recognition standards and looking up to see that the time to begin the implementation process for the leases standard is upon them. Understanding the new accounting rules are only one of the tasks that need to be completed before implementation. Lessons learned from public entities are many and significant. The largest of the challenges has been identifying the potential lease population and determining which contracts include a lease. With the effective date looming near, private companies need to begin the planning and implementation process now if they have not yet started.
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