Lease accounting: 5 critical factors for successful implementation
Accounting Standard Codification Topic (ASC) 842, Leases (the “new standard”), is a revolutionary change in lease accounting that will affect entities across all industries. The new standard requires lessees to recognize most leases on their balance sheet. It will also significantly affect the accounting for certain leases and may result in key impacts on an entity’s finances and operations. In addition, given the new accounting and disclosure requirements, it is likely that most companies will need to implement new application solutions to manage these requirements. As a result, the new standard will create numerous risk factors that will require proactive management to ensure compliance and accuracy of financial reporting.
Given the complexities and fundamental accounting changes, the time to evaluate the impacts and implement changes should not be underestimated. In addition, many companies will be concurrently managing the adoption of ASC 842 along with the adoption of ASC 606, Revenue from contracts with customers (the “new revenue standard”), which increases the implementation risks and challenges. For U.S. generally accepted accounting principles (GAAP) filers, ASC 842 goes into effect on Jan. 1, 2019 for calendar year-end public business entities and requires three years of comparative financial statements, which means the initial application date is Jan. 1, 2017. This leaves only about one year to complete a significant amount of work and the adoption for non-public business entities is only one year later.
Consider the following critical factors as your entity undertakes the adoption of the standard:
1. Engage stakeholders from across the entity
Given the management of concurrent significant accounting changes in both lease accounting and revenue recognition, it is critical that companies have a well-organized and comprehensive approach to adoption in order to avoid surprises and potentially significant disruptions to the company’s operations and financial reporting. In order to achieve this, the adoption of the new standard will require engagement and support from key stakeholders across the company. The identification of stakeholders requires thoughtful analysis and might be more comprehensive than initially thought.
For instance, recognition of lease-related assets and liabilities under the new standard may affect accounting for income taxes, requiring the recognition and measurement of deferred tax assets and liabilities and may also create implications regarding state and local taxes, due to changes in the property factor for apportionment of income, along with other tax implications. As a result, it is important to ensure all relevant stakeholders, including treasury, real estate, legal, tax and especially accounting and IT, are identified and engaged early to ensure that companies have a coordinated, agreed-upon approach to the adoption.
2. Data collection and management
Although the task of identification of a company’s leases might sound straightforward, in reality for most organizations, it is not a simple task. This task is a critical first step that is required in order to properly evaluate what changes are necessary to apply the new standard and the level of effort required for adoption.
Many existing lease management systems might include some lease information, but generally do not have all of the information needed to make calculations, judgments, ongoing assessments and disclosures. In addition, as the new standard affects all leases, although companies might have a good handle on information related to their larger real estate leases, the information regarding all of their equipment leases, which could be a substantial number of leases in certain industries, may not be readily available. As a result, the level of effort to gather all of the required lease information may be significant.
In addition, just determining the completeness of the overall lease population and the accuracy of the data may require considerable effort. Certain key factors to consider during this process are: (1) whether arrangements are or contain a lease, (2) the existence of non-lease components, (3) the existence of renewal, termination and purchase options and their impact on the lease term, and 4) lease classification. Companies should complete an initial evaluation of readiness and impact for the adoption of the new standard as soon as possible in order to answer these questions and ensure development of appropriate processes and controls to complete the implementation of the new standard.
3. IT systems, processes and controls
Current lease IT systems are designed with the primary focus of lease management and many of these systems are structured around management of real estate leases. Today, many companies utilize spreadsheets to track leases and prepare required disclosure and accounting evaluation. Given the comprehensive accounting and disclosure requirements of the new standard, companies will likely need to supplement their current IT systems or implement new IT systems to address these requirements.
Changes to or implementation of new IT systems represent a significant undertaking. Therefore, companies need to ensure that they evaluate and identify the appropriate IT system that will meet their requirements. In order to achieve this, it is important that companies define the system requirements and expectations at the outset. The new standard’s transition provisions require adjustment to historical comparative periods. Additionally, companies might be required to maintain multiple sets of financial statements to support local statutory and tax reporting.
The identification, development and implementation of IT changes is not an easy task and will require significant time and effort. Companies should be evaluating their IT requirements to support the new standard, including the requirements for interfacing with current ERP systems. Upfront evaluation and planning can help reduce costs and level of effort.
4. Requirement of significant judgments
The new standard requires significant judgments and estimates. For example, for certain arrangements just evaluating whether they meet the definition of a lease may not be straightforward and require significant judgment. Although the definition of a lease under the new standard is similar to legacy US GAAP, there are differences and these differences could result in some arrangements receiving different accounting treatment compared to current guidance.
Also, there are a number of accounting policy elections that may be taken both at transition and related to ongoing accounting post adoption, including whether to adopt a short-term lease recognition exemption. Companies will need to carefully evaluate and understand the impact of these options to make appropriate decisions.
For example, companies can elect the practical expedient to not separate the non-lease components from the lease components of a lease. While this may seem like a straightforward decision, electing this practical expedient will result in a higher lease-related asset being recorded on the balance sheet which could result in an increased risk for asset impairment, as well as affect certain financial metrics and covenants. Companies will need to update their policies and internal controls to ensure accurate and consistent policies and processes around areas of judgment and estimates.
5. Financial statement and key financial metric impacts
As noted, for most lessees, the new standard will result in the recording of assets and liabilities for substantially all leases on the balance sheet. This significant change in the balance sheet could have material impacts on key financial metrics, such as debt ratios and return on assets. Companies should evaluate the potential impacts on their key financial metrics in order to educate and inform key external stakeholders of these impacts.
Article originally appeared in the Boston Business Journal in November 2017.