The clock is ticking
Common implementation issues with the new lease standard
May 2018 Footnote
Are you ready?
The lease standard effective date is nearly here. Although this standard truly unleashed a torrent of unhappy responses, the Financial Accounting Standards Board (FASB) moved forward and finalized the standard.
Accounting Standards Update 2016-02 (or ASC Topic 842) was issued in February 2016. The effective date for public entities with annual reporting periods begins after Dec. 15, 2018 (note: public entities include a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed or quoted on an exchange or an over-the-counter market). Nonpublic entities with annual reporting periods have until Dec. 15, 2019, to implement the new lease standard.
Companies are currently in the process of gathering all of their leases (if they can find them) in order to record amounts in the financial statements and provide transparent and accurate disclosures -- and it's not easy.
From FAS 13 to ASC 842
The infamous FAS 13 lease standard was released in 1976. Since that time, there has been no real comprehensive overhaul of lease accounting. None. Fast-forward 40 years and FASB's new standard, ASC 842 issued in 2016, has turned the lease accounting world on its head.
Simply stated, ASC 842 requires all lessees to reflect a lease liability and a right-of-use asset on their balance sheets for all leases with a term of more than one year. A lessee's income statement recognition of lease-related expenses will depend on the classification of the lease as either an operating or finance lease. Of course, several implementation issues have already been identified that might make this difficult.
Not surprisingly, the accounting model for lessors is similar to existing Generally Accepted Accounting Principles (GAAP), but specific changes have been made to better align it with the lessee accounting model and the new revenue recognition standard. These changes could significantly change how lessors account for certain leases, especially those with variable payments and third-party residual value guarantees.
Lease accounting guidance applies to any arrangement that conveys control over the use of an identified asset to another party. An arrangement is a lease or contains a lease if an underlying asset is explicitly or implicitly identified, and the right of use of the asset is controlled by the customer for a period of time in exchange for consideration. Based on this scope, there are two main criterion that should be evaluated further for each lease arrangement regardless of how the arrangement is structured:
- Identified asset. If the lessor or supplier has a substantive right to substitute such asset, then an arrangement does not contain an identified asset. A substitution right is substantive if the supplier can practically use another asset to fulfill the arrangement throughout the term of the arrangement, and it is economically beneficial for the supplier to do so.
- Right to control use of the identified asset. A customer controls the use of the identified asset by possessing the right to obtain substantially all of the economic benefits from the use of such asset and direct the use of the identified asset throughout the period of use.
Where are my leases?
General issues in gathering and establishing a portfolio of your existing leases can be challenging. Here are a few circumstances where the challenges may be greater, and companies may need to allow for more time to implement the standard.
- Global companies with global operations. Given that there may be cultural and language barriers in global companies, additional time may be necessary to gather, interpret and apply ASC 842 to all leases.
- Decentralized organizations. Companies with decentralized operations may have vastly different operations and lease procurement systems. Consolidating this process and laying out specific policies to ensure correct implementation will be necessary.
- Organizations with unique service contracts. Service contracts, although often not titled "operating leases," may be lease agreements based on ASC 842. Gathering and analyzing these embedded leases could be challenging for companies because these were historically off-balance sheet and not on the lease radar.
- Related party leases. Many small, midsize and large private organizations have different lease arrangements with related parties. Often these leases are not written, or the terms are not well-documented. The lease standard does not provide relief for related party leases.
Complicated implementation issues
As companies study the standard, technical questions regarding the standard's application will need to be answered. Here are some of the common issues they will need to address as they begin to draft accounting policies for leases.
The new standard requires all leases to be recorded, so companies must look for embedded lease arrangements, and these contracts seldom include the title "operating leases." These are often hidden components within contracts. Here are a few examples of where to look for embedded leases.
- Supply arrangements: dedicated manufacturing line. Many manufacturers enter into supply arrangements that involve the exclusive use of a dedicated manufacturing line and typically have the right to control the output at a given time. If we assume the supplier does not have a substantive substitution right and is not approved to use the manufacturing line for other purposes, then the ordering process is in substance a dispatch right. Because the customer is making the relevant decisions that impact how and for what purpose the asset is used, the customer is obtaining substantially all of the economic benefit from the exclusive use of the identified manufacturing line. This arrangement could be considered a lease arrangement.
- Exclusive right to advertise. A service contract that gives a customer the exclusive right to advertise on a specified billboard or a taxi tent may contain a lease. If the primary use of a billboard or a taxi tent (specified asset) is to provide space for advertisements, then one could conclude that the customer reaps all of the economic benefits (control) from that asset. This assumes the advertisement is single purpose (for one customer only) and there are no substantive substitution rights.
- Easement contracts. Easement contracts have not historically been labeled as operating leases. However, these contracts contain a legal right to use another's land for a specific limited purpose. Based on that definition, one could conclude there is an identified asset and control over the use of the identified asset.
Variable lease payments
Many times, leases contain terms that revise or adjust the amounts payable to the lessor over the lease term. ASC 842 refers to these payments as variable lease payments. Generally, ASC 842 differentiates between two categories of variability in lease payments.
- Variability based on an index or rate (e.g., escalators based on the consumer price index, rents that are referenced to or are increased on the basis of The London Inter-Bank Offered Rate (LIBOR), or variable rent based on fair market rental rates) should be considered in the determination of lease payments.
- Other variability, including variability that is typically described as based on performance or usage of the asset (e.g., rents based on the percentage of retail store sales or on mileage driven using a leased car), should not be considered in the determination of lease payments.
Discount rate consideration
Once you have updated your portfolio for all leases (even the pesky embedded leases) and we know the fixed lease payments, we are ready to bring most leases to the balance sheet. But at what discount rate?
Clearly, the discount rate will directly affect the amount of lease liabilities to record which, in turn, will impact a slew of financial ratios. Identifying appropriate discount rates may be a challenge for all of those operating leases that have never been recorded on the balance sheet. As a refresher, a lessee discounts the lease payments using the interest rate that is implicit in the lease if readily determinable. Otherwise, the lessee uses the incremental borrowing rate. For the lessee, the implicit rate is sometimes difficult to determine because it is from the lessor's perspective (essentially the measure of the minimum return that the lessor expects to earn). The lessee's incremental borrowing rate is what the lessee would expect to borrow at for a similar item with a similar security on the right of use asset. Companies will now need to determine discount rates for most leases that were previously classified as operating leases.
Ready for complexity
This is an accounting standard that impacts all industries and all companies, big and small. Although the concept may seem simple, the implementation, with its many nuances, is complex. With the effective date upon us, be sure your team is prepared.
Stephanie Markert, CPA is a principal in the National Assurance Technical Group at CliftonLarsonAllen LLP. She has more than 20 years of experience in public accounting. You may reach her at firstname.lastname@example.org.