A Comprehensive Guide to Implementing the New Lease Accounting Standard
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.
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.
Please contact iLease Management if you are seeking any help complying with this FASB compliance.
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