Are you ready to adopt ASC 842?
INSIGHT ARTICLE |
The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 842 for leases is effective for public business entities, certain nonprofits and employee benefit plans for fiscal years beginning after Dec. 15, 2018; for those on a calendar-based fiscal year, it is effective Jan. 1, 2019. Private companies on a calendar-based fiscal year are required to adopt by Jan. 1, 2020. Early adoption is permitted.
A company’s accounting function cannot implement ASC 842 on its own, and a critical element of a successful implementation is identifying a cross-functional implementation team. These teams are often led by accounting, but an effective team should also include the many corporate functions that have an interest in or responsibility for leases. These often include:
- Corporate accounting (lease accounting and financial reporting)
- Equipment leases management
- Financial planning and analysis
- Information technology
- Internal audit
- Real estate management/lease administration
The implementation of ASC 842 could take longer than six months, considering the requirements of the new standard and integration of a technology solution with enterprise resource planning (ERP). Depending on the complexity and size of the lease portfolio, it could take as much as a year to implement the new standard and related new systems, processes and controls.
There are a number of key considerations that could have wide-ranging effects across an organization. Following are some issues to consider regarding preparing for and implementing the new standard.
Transitioning to the standard
The provisions of the standard are applied using a modified retrospective approach based upon current guidance. There is a proposed accounting standards update (ASU) which would permit an organization to apply the transition provision at the adoption date instead of the earliest comparative period in its financial statements. As of May 8, 2018, this guidance was not yet finalized. Companies have several choices to make in adopting the standard.
Practical expedients: There are a number of practical expedients related to transition. Lessees and lessors are permitted to make an election to apply a package of practical expedients and/or a hindsight practical expedient. This package, where all items have to be elected as a package, allows an entity to not reassess: (a) whether expired or existing contracts contain leases under the new definition of a lease; (b) lease classification for expired or existing leases; and (c) whether previously capitalized initial direct costs would qualify for capitalization under ASC 842.
The standalone hindsight expedient can be adopted by itself or in conjunction with the package of expedients. This expedient allows entities to use hindsight to determine lease terms and assess impairment of right-of-use (ROU) assets. An optional transition practical expedient allows an entity to continue applying its current accounting policy for certain land easements that exist or expire before the standard’s effective date.
In addition, there are a couple additional optional expedients that are out for exposure. The FASB has proposed amendments to give entities another option for transition and to provide a practical expedient for lessors. The proposed transition method would allow entities to not apply the new leases standard in the comparative periods they present in their financial statements in the year of adoption. The proposed practical expedient would provide lessors with an option to combine lease and non-lease components when certain criteria are met.
Policy elections: There are a number of policy elections available in the standard that must be made and documented. A lessee can elect, by class of underlying asset, not to apply the recognition requirements of ASC 842 to short-term leases (lease terms of 12 months or less) and instead to recognize the lease payments as lease cost on a straight-line basis over the lease term. This requires careful evaluation of renewal options.
A lessee can elect, by underlying class of asset, not to separate related non-lease components from lease components.
Lessees that are not public entities can calculate liabilities by using a risk-free discount rate for the lease.
A portfolio approach may be used if the results of applying the approach will not differ materially from the application to the individual leases in that portfolio.
Estimates and judgments
One of the differences between ASC 840 and ASC 842 is the number of key estimates and judgments that companies need to consider when adopting the new standard.
One such estimate is the discount rate to be applied to the lease payments to calculate the lease liability and right-of-use asset. For a lessee, the discount rate is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate (i.e., the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment). For a lessor, the discount rate for the lease is the rate implicit in the lease. In general, there will be multiple discount rates within a lease portfolio.
One key judgment is to determine whether a contract is or contains a lease. Many contracts convey the right to use property, plant or equipment, but are not explicitly identified as lease agreements. Examples include service contracts (including contracts for information technology services), dedicated supply agreements, advertising and construction contracts.
Under ASC 840, an entity may not have had a significantly different expense recognition pattern or balance sheet treatment regardless of whether an agreement was accounted for as an operating lease or as an executory or service contract. Accordingly, entities may not have previously focused their efforts on identifying contracts that explicitly or implicitly contained operating leases. Under ASC 842, identifying leases is critical as entities are required to recognize lease liabilities and right-of-use assets on the balance sheet for each lease for which the short-term election has not been made.
Validation of completeness of lease portfolio and data is critical to ensure a successful lease implementation.
Current financial statement disclosures, including footnotes, are good places to start for validating completeness. Companies should:
- Sample rent expenses and tie them back to their lease schedules and disclosures
- Sample other general ledger accounts to determine if any rent expense is recorded in a different account and tie that back to the lease schedule
- Reconcile rent expense accounts to the lease schedule
- Review material contracts to determine if they contain embedded leases
Data quality and decentralization of lease data is a key challenge. Low-quality and difficult-to-read documentation, along with decentralized filing processes, can be factors that will slow the process of capturing complete data. Key information that will be needed to complete lease accounting assessment and disclosures may be significantly greater than the lease information historically accumulated and maintained. Calculations of lease liability and the right-of-use asset will only be as good as the data that go into them, so getting the right data is crucial. In addition, the required disclosures under the new lease standard are significantly greater than historical disclosures and will require significant additional analysis and documentation to ensure completeness and accuracy.
For global companies, the implementation process may be even more challenging if leases are in multiple languages. Decisions must be made on whether or not to translate the leases into English for a central review process or whether it’s best to assign an 842 specialist in each country to handle the data abstraction and lease review. Controls and validation of calculations will depend on the choices companies make as they gather disparate data.
Technology solution considerations
Companies with more than a nominal number of leases may want a technology solution in place for a number of reasons: Data validation will only need to take place once. Managing contracts with embedded leases becomes much easier in a centralized system that can perform the underlying calculations—and with lower risk. With a technology solution, complex leases for real estate and equipment can be managed and modified more easily than by using a spreadsheet.
There are still significant judgments that need to be made in the standard. While technology can provide support for calculations, process automation, controls over financial reporting and even evaluating of contract changes, setting up new leases will still require management’s assessment.
When choosing a technology vendor, companies will want to consider what can be provided for both compliance with the standard and ongoing management of their leases, among other functional requirements such as lease vs. buy analysis, automated notifications related to renewals and lease procurement process controls.
Starting an implementation process
Broadly speaking, there are two fundamental phases in an approach to implementing ASC 842:
- Assessment and strategy: What leases and assets does the company have and how will the new standard affect the company? This process can take one to two months to complete.
- Implementation management: What is the plan and will the company need to outsource it? Implementation can take up to six months or more. Often, the lease abstraction process consumes more resources than any other task.
Depending on their resources, organizations may want to consider getting outside support for this complex but necessary implementation process.
For more implementation considerations, listen to the webcast.