ASC Topic 842 is the culmination of a decade-long, joint project with the FASB’s international counterpart, the International Accounting Standards Board (IASB). The IASB released its standard on lease accounting, IFRS 16, Leases, on January 12, 2016. As the standard was being drafted, it sent shock waves through the accounting profession because of its potential significant impact on companies’ financial statements. The new standard requires lessees to recognize a right-of-use asset and a corresponding liability on the financial statements for almost all of their leases. Not only does the adoption requires companies to allocate resources to evaluate its existing leases and their accounting, it also has significant impact on companies with loan covenants. Immediately, CPAs received questions from Controllers and CFOs ranging from evaluation of existing leases, its implementation, the technical accounting calculation of the right-of-use asset and corresponding liability, how to structure future leases to ease adoption, and guidance on having a dialogue with bankers on the potential impact on covenant compliance.
Public companies have already adopted the standard effective January 1, 2019 and we have seen quite a diversity of lease structures and their impact on the financial statements. Private companies have another year to prepare for the adoption on January 1, 2020. Let’s take a look at what we learned.
Companies can elect to apply the new lease accounting standard in one of two ways:
Method A – applied retroactively to each prior reporting period presented in the financial statements with a cumulative-effect adjustment recognized as the beginning of the earliest period presented; or
Method B – applied retrospectively to the beginning of the period of adoption through a cumulative-effect adjustment recognized as of the beginning of that period.
As you can imagine, given the difficulty in retrospectively applying the standard, even on a modified retrospective basis, most companies chose Method B.
As expected, most companies also elected certain practical expedients when applying the standard in order to gain efficiency. These practical expedients must be chosen as a package, and they allow companies to not reassess the prior conclusions under the old lease accounting standard regarding the followings:
- Whether a pre-existing contract is or contains a lease
2. Whether a pre-existing lease should be classified as an operating or finance lease
3. Whether the initial direct costs capitalized for a pre-existing lease under the old standard qualify for capitalization
It is important to note the these practical expedients cannot be used by companies to grandfather errors in the application of the old standard.
Hindsight Practical Expedient
Companies are allowed to make an election to use hindsight when determining lease term and impairment of the right-of-use asset. This practical expedient may be elected separately or in conjunction with the package of practical expedients mentioned above. Companies must apply the hindsight practical expedient to all pre-existing leases or apply it to none of them. If companies elect this practical expedient, they should consider all facts and circumstances that have changed through the adoption date. If companies do not elect this practical expedient, they should determine the lease term and impairment of the right-of-use asset based on facts and circumstances in existence when those determinations were otherwise made.
Electing this practical expedient could lead to a change in lease term, which may or may not be a desirable outcome. This may require more effort in initially measuring the lease liability and the right-of-use asset than if the lease term does not change or when not electing the hindsight practical expedient. Companies should carefully consider the effects of electing this practical expedient by determining whether those effects are worth the additional effort.
Land Easement Practical Expedient
A land easement is also known as a right of way that provides the lessee with the right to use, access or cross another entity’s land for a specified purpose. When companies elect the land easement practical expedient, they are allowed to not assess whether pre-existing or expired land easements that were not previously accounted for as leases under the old standard are or contain a lease under new standard. Only those pre-existing or expired land easements entered into on or after the adoption date are considered. The land easement practical expedient may be elected separately or in conjunction with either or both the package of practical expedients and (or) the hindsight practical expedient. Companies must apply the land easement practical expedient to all preexisting land easements or apply it to none of them.
We saw that most companies elected the land easement practical expedient because they have not typically identified land easements as leases in the past and the difficulties that would arise in assessing whether pre-existing or expired land easements are or contain a lease under the old standard.
Related Party Leases
The new lease accounting standard requires companies to account for related party leases on the basis of legally enforceable terms and conditions of the lease. This means that off-market terms should not be adjusted when determining the proper accounting for the transaction but the detail of the related party transaction would need to be disclosed.
Companies should also look beyond the stated terms of the lease and consider all facts and circumstances when evaluating related party leases and the initial measurement of the right-of-use asset and its corresponding liability. Companies may find themselves having to estimate future cash flows when measuring the initial right-of-use asset and the corresponding liability. Companies also should use judgement in determining lease term and consider asset and entity specific factors when evaluating related party leases under the new standard.
Don’t underestimate the effort required to comply with the disclosure requirements in the new standard. The new standard spells out the required qualitative and quantitative information that needs to be disclosed but doesn’t offer much guidance in terms of the manner of its presentation. As a result, we are seeing a diverse practice in how companies present the required information.
Qualitative information required to be disclosed includes, but not limited to, description of the lease, information about leases that have not commenced but have significant rights and obligations for the companies, information about significant judgements and assumptions made in accounting for the lease, and whether an accounting policy was made for short-term lease exemption.
Quantitative information required to be disclosed include, but not limited to, lease expense for finance and operating leases, right-of-use assets obtained in exchange for lease liabilities for finance and operating leases; weighted average remaining lease term for finance and operating leases; weighted average discount rate for finance and operating leases, etc.
Adopting any new accounting standard shouldn’t take away resources from companies from carrying out their most important mission – growing and making an impact in their communities. We can help you navigate through the new accounting standard by helping you evaluate whether this standard applies to you, and if so, determining lease classification, how to treat non-lease components, determine lease term and other variables that go into the initial measurement of the right-of-use asset and its corresponding liability, how to handle lease modifications, lease incentives, related party leases and provide the necessary information required to be disclosed. Keep Calm and Contact Us.