Make Sense of the New Lease Accounting Standard Before It’s Too Late

The effective dates for the new lease accounting standard are coming. The standard intends to provide users of financial statements—such as banks, investors, board members, and other stakeholders—greater visibility and transparency into the financial impacts of lease obligations and leased assets.

In February 2016, the Financial Accounting Standards Board (FASB) published guidelines for the new standard with the following effective dates:

  • Public business entities—annual periods beginning after December 15, 2018
  • Other entities—annual periods beginning after December 15, 2019

Although these effective dates are fast approaching, many businesses have yet to start preparing to adopt this accounting standard.

What’s Changing

The most significant change in Accounting Standard Codification® (ASC) Topic 842, Leases, involves the lessee model, which requires lessees to record assets and liabilities on the balance sheet for almost every lease.

This significantly differs from legacy accounting for operating leases under which leases were viewed as executory contracts that weren’t recognized for accounting purposes. Accordingly, they were solely disclosed in the notes of financial statements as future commitments instead of being recorded on balance sheets.

Under ASC Topic 842, entities will record a right-of-use (ROU) asset that represents the lessee’s right to use an asset over the term of the lease. By requiring operating leases be recorded on balance sheets as an ROU asset and a lease liability, the standard ensures all in-scope leases are recorded on the balance sheet.

The new standard also contains a variety of practical expedients and policy elections. For example, as a policy election, entities can elect not to apply the recognition requirements of ASC Topic 842 to leases with a term of 12 months or less at the commencement date.

Why It Matters

Adopting ASC Topic 842 can affect key financial decisions for organizations across industries that use leases. For example, entities may find themselves with lower liquidity ratios or higher working-capital turnover due to the visibility of additional lease assets and liabilities on their balance sheets and financial statements. This could impact their ability to seek additional credit or investment or affect compliance with financial covenants.

Ultimately, implementation of the new lease accounting standard will require a thorough planning and assessment process to help ensure a successful transition.

A Three-Phase Approach

The three essential elements for a successful and efficient transition are detailed below.

Phase One: Planning

Organizations can benefit from creating a task force of internal and external finance professionals who are both capable of assessing the impact of adopting ASC Topic 842 and skilled enough to put it into practice.

Because the standard is new, external auditors also will be looking at the processes for the first time. This means entities will want to involve auditors early and include them on their planning team. In doing so, they enable auditors to provide input during key phases of the implementation process as well as insight into any conclusions.   

Step One: Assess Leases

Planning teams should assess the key characteristics of their organization’s leases, including the following:

  • Variable lease payments
  • Key options, such as renewals, terminations, and purchase options
  • Residual value guarantees
  • Types of initial direct costs
Step Two: Identify Lease Population

The teams then need to identify their organization’s lease population and determine their scoping approach. Key to this step is ensuring the completeness of the lease population because operating leases previously weren’t on the balance sheet.

Additionally, the new guidance includes an increased focus on embedded leases in other contracts, such as service arrangements. This step includes determining whether to apply the guidance on a contract-by-contract basis or to take a portfolio approach that can accommodate leases with nearly the same contract terms and data elements.

Step Three: Create a Roadmap

The final step in the planning phase is creating a realistic roadmap that outlines the following items:

  • Clear implementation stages
  • Key achievements and associated deliverables for each stage
  • A transition timeline, including a completion date

Phase Two: Assessment and Financial-Statement Impact

Step One: Identify Contracts

Determining whether a contract contains a lease under the new standard includes determining whether an entity has the right to control the use of an identified asset. To do so, teams must answer two key questions:

  • Does the entity have the right to gain substantially all the economic benefits?
  • Does the entity have the right to direct the use of an identified asset?

If the answer to both questions is yes, then the contract contains a lease. If the answer to either question is no, then there’s no lease.

Step Two: Evaluate and Record Lease Contracts

Once leases have been identified, organizations will need to evaluate and record their lease contracts. The scoping considerations—contract-by-contract or portfolio approach—identified during the planning phase are critical at this juncture. Entities will need to do the following:

  • Document methodologies and rationale for conclusions
  • Develop accounting calculation logic
  • Record related journal entries for respective financial statement periods

Then, there are two critical areas to address for each identified lease:

  • What type of lease it is—operating or finance.
  • What costs within the lease need to be recorded and which are exempt. These will impact important financial documents, such as balance sheets, statement of operations, and cash flow statements.

Entities may elect the package of practical expedients to not reassess the following:

  • Whether any expired or existing contracts are or contain leases
  • Lease classifications for any expired or existing leases
  • Whether initial direct costs for any expired or existing leases qualify for capitalization under ASC Topic 842

However, identifying operating and finance leases is still essential. Accounting for finance leases under ASC Topic 842 is similar to accounting for capital leases under the legacy lease standard because they both require a lessee to record an asset and liability for the present value of the lease payments. Unlike finance leases, however, accounting for operating leases is substantially different under the new standard.

Key Focus Areas

During this phase of the implementation process, organizations should focus on six specific areas:

  • Determining the lease term by considering extension, renewal, and early-termination clauses
  • Accounting for purchase options
  • Identifying lease payments
  • Accounting for variable lease payments
  • Determining the discount rate or the incremental borrowing rate to use to calculate the present value of operating or finance lease payments
  • Accounting for a lease arrangement’s initial direct costs

An assessment entails a significant amount of work and detail, but it will better position entities to apply the new standard to their financial operations in a way that meets compliance and reporting requirements.

Phase Three: Post-Implementation

After adopting ASC Topic 842, entities must make sure they’ve addressed all necessary changes to operational requirements. This includes the following:

  • Developing updated accounting policies
  • Identifying and implementing new business processes and systems, including IT systems, required for ongoing compliance
  • Creating new post-implementation internal controls

Once these operational requirements have been rolled out, organizations can benefit from performing periodic post-implementation reviews. These reviews can help verify newly implemented processes and internal controls are operating effectively.

Key Takeaway

The more lease transactions in an entity’s portfolio, the longer the transition is likely to take. Regardless of size, however, adoption of ASC Topic 842 will require a great deal of dedicated time, resources, and collaboration and shouldn’t be underestimated.

Putting the right team in place, breaking down the implementation into manageable phases, and enacting the necessary operational processes and procedures for compliance will be key to a successful transition.

We’re Here to Help

For help adopting the new lease accounting standard, contact your Moss Adams professional.