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Even with a delay, the time is now to prepare for lease accounting standard ASC 842

As of November 15, 2019, the Financial Accounting Standards Board (FASB) officially delayed the effective dates for specified accounting standards, including those for Accounting Standard Codification (ASC) 842 related to leases. After the Board voted to issue proposed accounting standards updates in August of this year, the move to officially delay implementation comes with little surprise. Through the November vote, the FASB has agreed to delay the effective date of accounting standard updates for ASC 842 for some organizations.

The vote only affects private companies and not-for-profits. Large public business entities, such as SEC filers and all other public business entities (PBEs), have already implemented the new lease accounting standards. However, with the recent vote, private companies and not-for-profits will not have to implement ASC 842 until the fiscal year and interim periods beginning after December 15, 2020.

While there is a temporary reprieve for private companies and not-for-profits, the deadlines are only one year away. There is a lot to learn from public companies and others as those left to integrate the new lease accounting standard begin to prepare for implementation.

What is ASC 842?

ASC Topic 842, known as Accounting Standards Update (ASU) 2016-02, requires organizations to include lease assets and liabilities on their balance sheets. Originally published by FASB in February 2016, the new standard closes a major accounting loophole in the previous lease accounting standard, ASC 840.

The off-balance sheet operating lease loophole allowed companies to omit certain lease assets and liabilities from their balance sheets, potentially skewing their debt-to-equity ratio. In 2016, the International Accounting Standards Board (IASB) estimated that public companies using either the IFRS Standards or US generally accepted accounting principles (US GAAP) had around $3.3 trillion of lease commitments. The Board estimated that companies did not record an astounding 85% of those commitments on their balance sheets. This, of course, makes it difficult for shareholders, investors and lenders to make true assessments of a company’s financial health. For example, when electronics retailer Circuit City closed down in 2009, its balance sheet reflected $50 million in debt. However, the company also had off-balance sheet leasing liabilities of $3.3 billion, which comes out to 65 times the reported amount.

Under ASC 840, the only required disclosure of operating leases was in the footnotes of corporate financial statements. Now, under ASC 842, the only leases that may be omitted from financial statements are short-term leases with an original term of less than 12 months. Considering the prevalence and routine nature of leasing for most businesses, the new standard is expected to have a significant impact on most entities’ balance sheets. Furthermore, by closing the loophole, ASC 842 increases financial transparency and comparability among organizations that enter into lease agreements and provides a more defined picture of an entity’s leasing obligations including amounts, timing, and uncertainty of cash flows.

When is ASC 842 effective?

ASC 842 effectively impacts any entity that enters into a lease, save for some designated exemptions. Following the November 15 official announcement of implementation delays, the effective dates for ASC 842 are as follows:

  • Public business entities; not-for-profit entities that have issued or are conduit bond obligators for securities that are traded, listed or quoted on an exchange or over-the-counter market; and employee benefit plans that file or furnish financial statements with or to the Securities Exchange Commission (SEC) for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (Unchanged)
  • All other entities for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021 (Amended)
  • Early application continues to be permissible.

What is lease accounting?

Lease accounting encompasses the accounting standards regarding lease activities. The new ASC 842 requires nearly all leases to be present on a company’s balance sheet. Therefore, it is critical to understand what actually qualifies as a lease and whether or not a contract contains one. Improperly characterizing an agreement as a service contract rather than a lease, or failing to identify a lease component in an arrangement could lead to a material misstatement on a company’s balance sheet.

So, what is a lease?

The technical definition of a lease, as defined in the standard, reads:

“A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce.)”

How is this definition of a lease different from before?

Under the previous standard, ASC 840, a customer did not need to obtain substantially all the economic benefits and direct the use of the asset to control the use of the asset. Therefore, an arrangement could contain a lease even without control of the use of the asset if the customer took substantially all of the output over the term of the arrangement. However, the new standard, ASC 842, explains that in order to meet the criteria for control, the customer must have the right to:

  1. Obtain substantially all of the economic benefits from using the asset, and
  2. Direct the use of the asset (i.e., determine how and for what purpose the asset will be used throughout the period of use)

What can private companies and not-for-profits learn from public companies?

As required by the new lease accounting standard, most public companies instituted the necessary changes to comply with ASC 842 by January 1, 2019. However, change did not come easily.

Ultimately, ASC 842 posed a number of challenges for many public companies. For example, the standard requires over 100 fields of data from every lease that exists on, or will exist after, the effective date. Thus, companies needed to direct considerable time and resources towards analyzing leases to identify and extract those details for inclusion in the balance sheet. In fact, a survey of 500 professionals responsible for tracking, accounting or expensing leased assets for their organizations found that over 80% of companies have leases that, under ASC 842, must show up on their balance sheets. Furthermore, the survey determined that most of those leases are material to financial reporting.

Specific challenges emerge regarding embedded leases. Embedded leases are a large component of larger business agreements, such as service, outsourcing or maintenance contracts. They are also found within warehousing, security, transportation or data storage contracts. The embedded nature of these leases, as made clear by their name, makes them more difficult to recognize than agreements specific to assets such as real estate or equipment. In addition, embedded leases exist across departments outside of accounting. In turn it is particularly time-consuming and complicated when it comes to identifying these leases and procuring the required information.

What are best practices for ASC 842 implementation?

As demonstrated through the initial run with public business entities, implementing ASC 842 is both time-consuming and complicated. However, there are proven approaches to ease the burden and streamline the process:

1. Get the entire firm involved

The onus primarily falls on the accounting department to facilitate successful implementation of ASC 842. However, the accounting practice requires support across the entirety of the firm, especially when the company has a large real estate portfolio or embedded leases. If multiple parties within the organization have the ability to enter into a leasing arrangement, those other groups need to work together to assure all leases are covered. These efforts may entail assistance from IT, legal or procurement departments. At the end of the day, ASC 842 touches nearly every component of an organization, so it is ideal to have everyone involved and on the same page.

2. Use technology to your advantage

For organizations with an established and robust data governance program, or specific procedures to collect and manage enterprise data, implementation should be a considerably easier feat. Although most organizations do not have the same technology and structures in place it is not too late to get technology or advanced software involved. In fact, there are off-the-shelf and purpose-built technology solutions with the capability to standardize and aggregate the information. For example, some software programs have the ability to store key lease terms and agreements in a central database, as well as grant relevant team members access to pertinent leasing information. Furthermore, advanced leased asset systems with web services and rules engines can export, transform and load data.

Technology is useful for both aggregating information and simply collecting and managing contracts. For ASC 842 compliance, it is important to collect all contracts, including master lease agreements and addendums. Additionally, this helps to separate and properly classify each embedded lease as an operating or finance lease. Best practices indicate that integrating a leased asset software product that includes document management saves time, improves financial controls, and streamlines accounting and audit efforts downstream.

3. Determine whether the contracts are or contain leases

Each contract needs diligent analysis to determine whether the contract contains or includes a lease. Companies should also be highly aware of embedded leases. As mentioned before, contracts that include the outsourcing of services, data centers, hosting and other IT arrangements are common examples of embedded leases.

Another key step in the transition to ASC 842 is discerning whether a lease can be grandfathered in as part of the practical expedients selection. This particular selection prevents companies from having to reassess old contracts. Instead, organizations can simply claim that the agreement was not a lease before and based on prior conclusions it is not a lease now. Keep in mind, however, that certain guidelines exist regarding the application of practical expedients.

4. Keep an open line of communication

For public companies, ASC 842 evokes challenges related to the communication of earnings and other guidance to the investing community. As the new leasing standard requires disclosures of operating leases on a company’s balance sheet, it may imply higher leverage. According to the Wall Street Journal, corporate balance sheets have the potential to grow by as much as $2 trillion under ASC 842.

While their reporting requirements are different, public companies’ experiences communicating financial health to investors based on these new regulations should have private companies thinking about their own communication to stakeholders. In this scenario, transparency is vital. With such sizable adjustments to an organization’s financial statements – particularly the balance sheet – it is important for leadership to keep stakeholders, especially those with a financial interest in the company, well-informed throughout the transition.

5. Do. Not. Wait.

Between identifying and reclassifying lease commitments, compliance with ASC 842 is clearly a time-consuming process. Private companies may have gained an extra year before implementation requirements kick in, but that should not encourage any further delays in preparing for the transition. These entities should develop an implementation timeline with a number of factors top of mind, including existing lease commitments, data governance maturity and cross-firm coordination needs.

In particular, retailers, drug stores, restaurants, supermarkets, airlines and telecommunications companies have seen an outsized impact on their balance sheets because of a large brick-and-mortar presence. Those industries should factor in extra time for both implementation and informing stakeholders. A company’s implementation timeline should also account for unanticipated roadblocks, such as a delay in receiving the necessary data from external sources.

For more information on this topic or to learn how Baker Tilly specialists can help, contact our team.

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