Lease Accounting: Keep Pushing Ahead
In February 2016, FASB issued new lease accounting requirements in Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). Under its core principle, a lessee recognizes a right-of-use (ROU) asset and a lease liability on its balance sheet for most leases, including operating leases. This is expected to have a significant impact on most entities' balance sheets, considering how prevalent and routine leasing is to most businesses.
FASB issued the new standard to increase transparency and comparability among entities by recognizing leases on the balance sheet and providing more information about leasing arrangements so that users can assess the amount, timing, and uncertainty of cash flows from leases.
At first glance, adoption of the new lease standard might seem relatively straightforward. After all, is it not just about recognizing the present value of future lease payments on the balance sheet? But, as public companies can attest, adopting the new lease standard can be quite complex and time-consuming, with many important nuances that can impact the amounts initially recorded.
After receiving feedback from various constituents, FASB voted to postpone the adoption date for private companies. On Wednesday, FASB voted to instruct its staff to move forward with drafting a final standard based on its proposed update, Financial Instruments — Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842): Effective Dates, to give private companies additional time to adopt the new lease standard and certain other major standards. This extra time for private companies is welcome relief. However, it does not mean that implementation can be put on the back burner, and private companies are encouraged to continue working on their lease implementation efforts for good reasons that we explore in this article.
How we got here
With FASB retaining the operating versus capital (finance) lease classification for lessees from legacy accounting standards, and with the transition requirements generally designed to run off existing leases, it may have been anticipated that system changes would be limited and that current processes and systems (including spreadsheets) could continue to be used to a large extent. However, most public companies found that they needed to implement software solutions. This makes sense: Unless an entity has a very low number of leases, a software solution is a must, considering the requirements of the new lease standard, from initial recognition through ongoing accounting and reporting, including remeasurement of leases on the balance sheet for specific events, and the number of disclosures to provide.
Public companies were the first to implement the new lease standard, and many encountered challenges. In mid-2017, about a year and a half after the new lease standard was issued, Financial Executives International's Committee on Corporate Reporting (CCR) reported on those challenges, including concerns over software readiness and complexities associated with their leases and the new requirements. The CCR requested among other things that FASB provide entities with an additional and optional transition method to adopt the new lease standard that would leave the comparative periods under legacy GAAP. FASB agreed to provide this new transition approach in ASU No. 2018-11, Leases (Topic 842): Targeted Improvements. But even with this relief, many public companies faced challenges to adopt on time, and many used (and continue to use) varying degrees of manual workarounds for compliance with the new lease standard.
More recently, the AICPA Technical Issues Committee expressed continued concerns regarding effective dates of major standards such as leases for private companies. They cited bandwidth constraints in private company financial reporting staff, continued software issues, and not enough time to learn from public companies' adoption experience and subsequent SEC comment letters. In response to those concerns, FASB voted to approve the delay.
Remaining proactive is key
We live in a world characterized by uncertainty and in which few outcomes are certain — FASB's conceptual framework even acknowledges that. But when it comes to lease adoption, companies can be sure to spend significant time on at least two specific areas: lease identification and lease data input.
Know the lease population
One of the key challenges that many public companies faced was ensuring that their population of lease contracts was complete, including leases for which payments are fully variable. There are usual suspects, of course, like real estate lease contracts, which are relatively easy to identify and generally are already tracked. But an entity's contracts aren't always labeled as "leases." Leases are often embedded in other contracts such as service contracts, IT contracts, and transportation contracts, to name just a few. If a contract includes the right to use an asset that meets the definition of a lease, it should be tracked and accounted for as part of adopting the new lease standard. This is true even if one elects the package of practical expedients, which includes the ability to not reassess existing contracts. As has been said many times, the package of practical expedients does not grandfather errors. For example, if a contract was not evaluated under FASB ASC Topic 840 (the legacy lease guidance) but should have been, or was evaluated but an incorrect conclusion was made, the election of the package does not grandfather those errors. If the entity wants to benefit from the package, it would have to reassess those contracts under Topic 840 first. Entities can also be sure that their auditors will focus on completeness in their audit testing since liability recognition is now the focus.
Accordingly, private companies should not halt their lease implementation efforts. They should continue assessing whether their starting point — that is, their lease population — is complete.
While other ongoing significant projects may be underway, such as adoption of the new revenue standard, continuing to work on the completeness assessment of the lease population will be a critical, likely time-consuming first step that will be a key differentiator for a successful and seamless adoption. This won't simply be an accounting department exercise — it may involve people from various departments across the company, including procurement, treasury, IT, and legal, and potentially from foreign locations.
Lease data input
Another time-consuming step toward implementation involves inputting the lease data so that lease assets and liabilities are accurately calculated and reported in the financial statements after adoption of the new standard. As previously noted, most companies have found that they need a software solution in order to manage compliance with the new lease standard. Use of manual processes such as Excel spreadsheets will generally be laborious and inefficient.
Software solutions can drive effectiveness and efficiency in both initial implementation and continued application of the lease standard. However, lease software can include up to 100 fields to input per lease so that each is accurately reported and disclosed. Multiply that by the number of leases identified, and it becomes clear that significant time is needed simply for lease data input. To that effect, an entity may want to explore artificial intelligence capabilities to find the right balance between manual efforts and automation.
My company's annual financials are not issued until 2022; doesn't that give me more time?
With the new effective dates, a calendar-year-end private company would be required to adopt the new lease standard on Jan. 1, 2021, for its annual financial statements, as opposed to Jan. 1, 2020. Because 2021 financial statements won't be issued until sometime in 2022, it may be tempting to assume that private companies have even more time to adopt.
However, recognizing leases on the balance sheet at adoption is one thing; remaining compliant going forward is another. The calendar-year-end private company described above will be required to recognize its leases on the balance sheet on Jan. 1, 2021. This means that starting on Jan. 1, 2021, the entity should apply the new lease standard and other GAAP requirements to its existing leases and new leases. Businesses are not static, evolving over time to address their customers' needs and changes in business environments and to remain competitive and operate efficiently. Accordingly, it's likely that an entity's plans about leasing a specific asset will change over time, resulting in modifications to existing leases, changes in plans about complementary leased assets, decisions to abandon a leased asset before the end of its lease term, decisions to sublease an asset — the list goes on. All these events will require accounting attention, and many public companies are currently spending significant time to comply with those requirements. If a private company does not address those events as they occur, it could become quickly challenging to catch up.
Remeasurement requirements
Entities, even private companies, will need to implement systems and processes to not only recognize new leases on the balance sheet, but also to capture changes requiring remeasurement of existing leases in a timely manner. Those include certain lease modifications, significant events or changes in circumstances within the lessee's control affecting renewal or purchase options (such as constructing leasehold improvements or extending the term of a complementary asset), and extending the lease for future periods that were previously not expected to be used, to name a few. Those remeasurements will also require an entity to provide additional disclosures, such as noncash information about lease liabilities arising from ROU assets. While the software an entity uses will help calculate and report leases, the identification of events requiring initial recognition (for a new lease) or remeasurements (for existing leases) will likely need to be designed and implemented outside the software solution. The entity will therefore need to ensure that it captures the complete picture of events and changes in circumstances requiring remeasurements of its leases, just as it needs to make sure its lease population on adoption and afterward is complete.
Interaction with other standards
The lease standard requires an entity to apply other GAAP, as applicable, including the guidance on impairment of long-lived assets (ASC Topic 360, Property, Plant, and Equipment) to ROU assets. Now that operating leases will be recognized on the balance sheet, there are additional complexities related to impairment and other standards that an entity will need to consider. For example, after a lease has begun, an entity may consider subleasing or abandoning either the leased asset or a portion of the asset. These may be necessary business decisions, but they will result in additional accounting questions that need to be addressed. Some of those questions include:
• Did the entity appropriately identify its lease components (the unit of account under the new lease standard)?
• Does it affect asset groupings for impairment testing purposes?
• Is the entity required to test the asset group for impairment?
• Should the entity revise the useful life of some of the assets, including the leased asset?
• Should the entity record additional liabilities under other standards, such as exit or disposal cost obligations (ASC Topic 420, Exit or Disposal Cost Obligations)?
The above are just a few examples illustrating how challenging it will be for an entity to identify all events requiring remeasurements and other accounting changes for its leases if it does not apply the new lease standard and related GAAP requirements starting on Jan. 1, 2021. Even with the deferral, the effective date will be less than a year and a half from now for calendar-year-end private companies, with critical steps like lease identification and data input taking a significant portion of that time. Private companies should therefore proactively continue their lease implementation efforts, allowing them to not only get the accounting right, but to improve the quality of their processes and potentially even improve their business approach to leasing activities. Starting after the adoption date, it's game on!
(Source: AICPA – CPA Letter Daily - Journal of accountancy – October 22, 2019)