By now most public companies have implemented FASB’s new lease accounting change, ASC 842. The new standard impacts both lessees and lessors and creates a significant compliance challenge for public and private companies alike. The implementation deadline for private companies approaches. Here’s an overview of the new standard and lessons learned from companies who are already compliant.
Overview of ASC 842
Under prior rules, lessees did not report operating leases on their GAAP balance sheets. The new lease accounting change classifies leases into finance leases (which transfer control of assets at the end of their term) and operating leases and requires lessees to recognize operating leases as an asset on their balance sheets with a corresponding lease liability. As a result, companies with substantial operating leases will see their assets and liabilities increase significantly under the updated guidance.
The new standard also includes some “targeted improvements.” They are designed to align lessor accounting with both the lessee accounting changes and updated revenue recognition rules. Including:
- Requiring lessors to recognize some lease payments received as deposit liabilities where the collectability of lease payments is uncertain
- Changing the definition of “initial direct costs” to include only incremental costs that wouldn’t have been incurred if the lease hadn’t been obtained
- Requiring lessors to separate lease components from non-lease components, such as common area maintenance or utilities
Lessons learned from public company implementation
Consider these lessons learned from early adopters.
Don’t underestimate the effort required
According to a 2018 Q4 survey from PwC, 87% of companies surveyed said adopting the recent accounting changes (including the revenue recognition standards) has been somewhat or very difficult. Respondents identified the following top implementation challenges:
- Ensuring for completeness of lease population: 77%
- Identifying embedded leases: 72%
- Collection, quality assurance, and remediation of data: 69%
- Human capital/resource requirements: 66%
Start taking inventory of all critical documents needed for analyzing and accounting for leases, including initial agreements, amendments, exhibits, and non-lease arrangements.
Spreadsheet vs. software
More than half (58%) of public companies surveyed by PwC implemented new lease management software. Another 17% modified or upgraded existing systems to accommodate the new standard. However, 22% are using spreadsheets.
As your company gets deeper into implementation, consider whether you will need a lease management system. Spreadsheets might suffice for smaller organizations, but those that leverage technology may benefit from increased accuracy, streamlined audits, and reduced time and costs in preparing financial reports and footnotes.
Testing is important
Many companies have tested their systems with sample cases that mimicked actual uses of the company’s lease accounting system. Use cases can be run through the system and also calculated manually or using an Excel spreadsheet. If the system’s results are materially different, you’ll have time to resolve those differences before the go-live date.
Look for process improvement opportunities
While you may feel rushed to get into compliance, don’t miss this chance to look for improvements in your accounting processes. Many public companies recognized the opportunity to streamline and enhance processes that had been largely manual and realized some efficiencies, better controls, and even cost reductions around their lease accounting processes.
Lease negotiations impacted going forward
The new rules may change lease negotiations moving forward. For example, determinations of a lessee’s asset and liability exclude variable lease payments, such as those based on a percentage of retail sales. Lessees may want to negotiate more variable terms in their lease payment structures, as their liability for a fixed payment lease will generally be greater than that of a variable payment lease. Lessees may also prefer shorter lease terms since lessees may elect not to include leases with a term of 12 months or less on their balance sheets.
Private companies have more time to implement ASC 842. But don’t underestimate the effort it will take to get ready for the new lease accounting standard. Learn from the challenges identified by public company implementation. Start gathering the resources to fully understand how the new lease accounting standard will impact your business. Develop a phased implementation plan, and identify the right team to put it in motion.
About the Author
Cory Prosperie is a staffing manager with Parker + Lynch Consulting in the Houston market specializing in CFO advisory, project execution, change management, process optimization, private equity services, mergers & acquisitions and interim solutions. Contact him today for help discovering proactive placement solutions to your organization’s pain points.