Practice Management Small Business

Implementing the New Lease Accounting Standard

Written by Sean Egan

Leases (Topic 842) was issued by the Financial Accounting Standards Board (FASB) in February 2016 and represented a rather substantial change in how leases are to be accounted for, especially for lessees. More than 30 months have gone by and the effective date to implement the new standard is fast approaching. The effective date for public business entities is for annual periods beginning after December 31, 2018 and for other entities (private companies) for annual periods beginning after December 15, 2019. Since the new revenue recognition standard was issued at about the same time as Topic 842, many companies focused almost all of their attention on revenue recognition and delayed focusing on lease accounting. However, time is running out and there are a number of issues that must be addressed quickly as part of the Topic 842 implementation.

In this article, we will discuss some of the key decisions and more difficult assessments that have to be made by lessees as part of implementing the new standard.

Topic 842 implementation

Transition Method

When the FASB originally issued the standard, it set the transition date requirements as the later of: (1) the beginning of the earliest period presented in the financial statements or (2) the commencement date of the lease. In a recently adopted update to the standard, the FASB provided a significant time saving transition option which would allow the transition date to be the date of initial application. As a practical matter, this allows public companies to apply the standard on January 1, 2019 (private companies on January 1,2020) and not have to restate the prior periods presented in the financial statements. Companies that choose this transition option would be required to provide Topic 840 comparative period disclosures.

In a recent survey by KPMG LLP, almost 75% of companies surveyed intend to avail themselves of this alternate transition approach.

Package of Practical Expedients

There is a package of practical expedients provided in Topic 842 as a means of lessening the burden of transition. An entity may elect not to reassess:

  • Whether expired or existing contracts contain leases under the new definition of a lease;
  • Lease classification for expired or existing leases; and
  • Whether previously capitalized initial direct costs would qualify for capitalization under Topic 842.

Note that Topic 842 has curtailed what may be considered an initial direct cost when compared with Topic 840.

This list of practical expedients would have to be adopted on an all or nothing basis for the entire portfolio of leases. And note that errors in the application of Topic 840 are not grandfathered as part of this provision. The overall effect of this transition option will be that existing leases will continue to be recognized in accordance with current US GAAP except that entities will have to (1) recognize a lease liability and right of use asset for operating leases and (2) if the lease is modified, account for the lease under Topic 842 at the date of modification.

In the survey noted above, a vast majority of public companies plan to elect the package of practical expedients, with many private companies still undecided. Almost all private companies are ultimately expected to adopt this option.

Use of Hindsight

Hindsight is allowed when considering the likelihood that an option to extend or terminate the lease will be exercised or a purchase option will be exercised and assessing the impairment of a right of use asset. This transition option can be elected on its own or in combination with the package of practical expedients noted above.

In the KMPG survey, most of the respondents indicated that they were undecided as to whether to elect this option. The main drawback to hindsight is that necessary transition adjustments cannot be finalized prior to the effective date and entities have to evaluate all relevant factors impacting hindsight at the effective date.

Embedded Leases

Embedded leases are a somewhat new concern coming out of adoption of the new standard. Embedded leases are components within contracts that entail the use of a particular asset, where the user has control over that asset. Therefore, they meet the definition of a lease. The language in the contract may not contain the word “lease”. These lease arrangements may not have been previously identified and the portion of the contract that meets the definition of a lease may be a relatively small component of the contract. These types of arrangements may be found in IT services contracts and supply contracts to name a few.

Under Topic 840, these lease arrangements may have been accounted for substantially the same as an operating lease with no material financial statement impact. Topic 842 requires operating leases to be recognized on the balance and thus the importance of identifying these embedded lease arrangements. Consequently, certain contracts may require a fresh look with an evaluation of whether they contain a right to use an identified asset.

Conclusion

If your lease portfolio is relatively small and your lease terms are relatively straight forward, it may not be difficult to conclude upon the aforementioned issues. But for many, transition matters will have to be closely evaluated and matters such as embedded leases will require a fresh evaluation and establishment of processes and procedures going forward. If you have not thought about these matters yet, now is the time to start.

About the author

Sean Egan

Sean T. Egan is co-founder and Managing Partner of
iLease Management LLC and is responsible for the overall corporate governance and strategy of the company. Sean retired from the accounting and advisory firm of KPMG LLP in 2008 after having spent 35 years with the Firm. Among his responsibilities while at KPMG were Managing Partner of the Hartford, Connecticut office and Partner in Charge of the Firm’s Northeast Real Estate Practice. His client responsibilities were focused in the financial services area and his clients included major national and regional financial services firms. From 2008 until 2010, Sean was Senior Vice President of a major technology company where he had overall responsibility for two of the company’s technology solutions for real estate managers and commercial and residential lenders. He holds a Bachelors degree from Fordham College.

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