CHAPTER 1: EVERYTHING YOU NEED TO KNOW


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Introduction

The new lease standard (ASC 842 in the U.S. and IFRS 16 internationally) is intended to account for all lease obligations on financial statements, rather than excluding operating leases as has been the standard. This change ensures that a company’s financial situation is reflected as accurately as possible within the financial statements.

 

With the new standard, all leases must appear on the balance sheet as a Right of Use (ROU) Asset and Lease Liability.

 

Grab this quick reference guide now to provide a summary of key points to your clients.

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Timeline

Public and international companies must begin using the new standard during their fiscal year that occurs after Dec. 15, 2018. Private organizations must comply for their fiscal year after Dec. 15, 2019.

 

Why the change?

Under the previous lease standard, ASC 840, payment obligations of “operating” leases are not reflected on the balance sheet even if you have committed to many years of payments. In other words, there is a future debt (a liability) that is nearly invisible on financial statements. Those payments are mentioned in the footnotes, but not prominently among other liabilities on the balance sheet.

 

Many organizations have dozens, or even hundreds, of operating leases, which can result in a huge gap for anyone trying to understand that company’s financial situation via their balance sheets. This is why FASB made the change.

 

Download the full New Lease Standard guide today!

 

What qualifies as a lease?

Because this is a judgment-based standard, judgment is often required to determine whether a contract qualifies as a lease under the new standard (this makes it an excellent area to add value for your clients). Use the following guidelines to determine what qualifies as a lease:

  • It must be a physical asset
  • You must have the right to control or use the asset
  • The asset must be explicitly or implicitly identified

Examples of leases include (but are not exclusive to) rental of office space, photocopiers, computers and servers, vehicles, land, and equipment. Examples of what are not typically considered leases under this standard include software subscriptions, leases for intangible assets, leases for exploration or use of non-renewable resources, and leases of inventory or assets under construction.

 

It’s also important to note that not all costs related to a lease are included in the leased asset and liability, so part of determining exactly what is a lease will be separating lease and nonlease components. There is no hard and fast rule, as the new standard requires quite a bit of judgment, but the key is thinking about the intent of a particular payment. Common items that are likely to be nonlease components include common area maintenance and service contracts for the leased asset.

 

When reviewing lease contracts, it is also important to determine if there are multiple lease components and, if so, whether those components need to be tracked as separate leases on your books, perhaps because they are designed to function separately or they have significantly different economic lives to evaluate. Don't forget to take advantage of the portfolio exception, where separate assets have such similar terms and characteristics that they can be combined into a single lease for reporting purposes.

 


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Impact of the new standard

As you’d expect, implementing the new lease standard means you and your clients will change how you think about and account for individual leases. There are a few additional considerations to keep in mind as well.

 

Debt covenants

Changing accounting methods doesn’t change an organization, but it can affect the way financial results are viewed by outside parties. In particular, adding significant lease liabilities can impact compliance with debt covenants. It’s critical that your clients get a handle on the potential impact and start conversations with their bank as early as possible.

 

Policy elections

The new lease standard requires organizations to make policy decisions about how they will handle leases. Many of these policies make implementation easier but often will result in a larger liability and asset on the books. Early on, your clients need to review and decide which policies are right for their organization.

 

Process and controls

In most organizations, operating lease decisions have been fairly decentralized, especially when multiple locations are involved. The new lease standard requires these decisions to be centrally documented and available for accounting, which introduces a need for new systems, processes, and controls. The good news is that organizations are often finding efficiencies and cost savings with this new approach.


 

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Transitioning leases under the new standard

Implementing the new lease standard requires transitioning all existing leases from ASC 840 to ASC 842 (or IAS 17 to IFRS 16). Here are the steps to help clients do so and capture them accurately on their financial statements:


  • Practical expedients. Have clients consider their policy elections, particularly around the practical expedients that they decide to utilize. Those can dramatically ease the amount of work needed upon transition. Key practical expedients include:
    1. Initial Application Date: You can elect to apply the lease standard to only the most recent period without restating prior periods. If you choose this option and you report on two periods in your financial statements (for example, years that ended December 31, 2019 and 2020), your first entry occurs on January 1, 2020.
      • The advantage of electing this practical expedient is that you do not need to restate prior periods. Of course, this does mean you will have inconsistent reporting on leases between the current and prior periods.
    2. Reassessing Leases: You can elect to not reassess three different lease factors:
      1. Whether expired or existing contracts contain leases
      2. The operating vs. capital (now finance) lease classification on existing or expired leases
      3. Whether initial direct costs for existing leases would have qualified for capitalization under the new lease accounting standard
    3. Use of Hindsight: You can elect to use hindsight on lease renewals and purchase options when determining the lease term, as well as hindsight in assessing impairment of an ROU asset.
    4. Discount Rate: You can elect to apply a single discount to a portfolio of leases with reasonably similar characteristics (such as a similar lease term for a similar class of underlying asset).
  • Lease liability. Calculate the present value of all future lease payments (monthly rents, including known escalators, residual value guarantees, excluding rent holidays) after the Initial Application Date. This is your lease liability.
  • Right of use (ROU) asset. Starting with the lease liability, add or subtract balances on the balance sheet related to this lease. This might include deferred rent amounts, incentives received, or other initial direct costs calculated under ASC 840 or IAS 17.
    1. In general, this excludes leasehold improvements, the accounting for which remains relatively unchanged under the new lease standard.
  • Book it! Record your asset and liability as of your Initial Application Date and you’re ready to go forward with the new lease standard.
  • Equity Affected? We are accustomed to changes in accounting standards affecting equity as a Cumulative Effect on Change in Accounting Principle. Adopting the new lease standard will not affect equity for the most common types of leases. We’ve included a few examples below where equity can be affected.
    1. Initial Direct Costs. If your client chooses to reassess leases by not electing the practical expedient noted in 1(b) above, the definition of Initial Direct Costs has now changed and, as a result, their opening entry might affect equity.
    2. Hindsight for Impairment or Lease Term. If your client does elect the practical expedient to use hindsight on impairment or lease term of a leased asset, noted in 1(c) above, it may affect their equity.
    3. Operating Lease Transition under IFRS 16. Under IFRS 16, there are two options to determine the ROU Asset for what were operating leases. One option is consistent with ASC 842 and would not affect equity. Another option measures the ROU Asset as if IFRS 16 was applied at the lease commencement date. The journal entry for this option (including the new lease liability and removal of existing balances under IAS 17), would include an entry to equity.
    4. Other scenarios that could affect equity. Built-to-suit arrangements, currency translation differences, and sale-leaseback transactions can also affect equity.


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