Lease accounting: A private company perspective

March 29, 2019

Published: Journal of Accountancy

By Stephen G. Austin, CPA; Michael G. Fraunces, J.D.; and Alisia Scudder, CPA

By now, most public companies in the United States have adopted the new lease accounting standards as required on Jan. 1, 2019. Companies with noncalendar fiscal year ends will adopt the new standards sometime over the next few months.

Moving the measurements of operating leases from the footnotes of GAAP financial statements under FASB ASC Topic 840, Leases, to the balance sheet as assets and liabilities under Topic 842, Leases, has not been a simple task for corporate America. Now, private companies and most not-for-profit organizations face the same task. Entities with more than a handful of leases may be in for a surprise as to the time and expense required to address the complexity of the transition and analyze the related accounting rules that must be considered. They may also be surprised with the effect on financial statements and, perhaps, loan covenants due to potential significant changes in debt and related ratios.

Here are some of the lessons learned from act one with the public companies:

Gathering documents is a chore. In many cases, document management systems for operating leases have been less than ideal and certainly not well-organized to be “Topic 842 friendly.” In our work assisting a Fortune 100 company in its compliance with Topic 842, a major challenge was locating and organizing all the relevant documents for making the assessment. Our work included assessing, on the company’s behalf, thousands of its agreements to determine whether they constitute leases under the new standard. The relevant documents include not just the initial agreement, but all amendments, exhibits, addenda, supplements, and enhancements thereto plus the amendments to each exhibit, addendum, supplement, and enhancement. As a threshold matter, you and your outside auditors must have confidence that you have captured the universe of documents to be evaluated under Topic 842. Do not underestimate this challenge.

Lesson learned: Start early by taking inventory of all critical documents needed for properly analyzing and accounting for documents that may be “leases” under Topic 842. You need to thoroughly think through what constitutes a lease under the new guidelines. Start broad in what should be considered for analysis. At a minimum, these documents must include the initial agreement plus all amendments, exhibits, addenda, supplements, and enhancements as well as nonlease arrangements such as parking charges and initial direct costs like brokers’ fees.

This is a lengthy standard. The guidance surrounding Topic 842 is extensive and includes hundreds of pages of mandated GAAP from FASB (and the International Accounting Standards Board for non-U.S. GAAP), including FASB developments issued last summer called “Targeted Improvements.”

Lesson learned: Spend time understanding the guidance. Everyone needs to allocate sufficient time to this task to learn the new rules and get appropriate training. It is also important to understand how the guidance specifically applies to each company. For example, due to the complicated nature of the leases of a Fortune 50 company we worked with, identifying an “identified asset” necessary for concluding that an arrangement is a “lease” under Topic 842 proved more difficult than initially expected. In one case, a 150-page document had a line buried in an exhibit stating that the other party to the agreement was providing two dedicated strands of fiber to the lessee, making the arrangement a “lease” under Topic 842.

In another case, the arrangement had a “lease component” under Topic 842 even though virtually all the equipment being used to deliver the service was owned and controlled by the other party to the agreement because a single rack in an equipment room was being provided to the lessee for its equipment. Another example of the complexity of the analysis is an agreement that allowed a property owner to move the lessee’s equipment to a new location at will, but this right did not disqualify the arrangement as a “lease” under Topic 842 because the practical reality underlying the right was not “substantive” due to the prohibitive expense of moving the lessee’s equipment and the practical reality that such rights were rarely, if ever, exercised. Using and analyzing the implementation guidance and illustrations provided in Topic 842 can be helpful in applying the new standard to a company’s specific documents.

Practical expedients can be helpful. FASB issued a package of “practical expedients” in July 2018 that many public companies embraced once they began thinking about the challenges involved in restating prior-period financials.

Lesson learned: The “package of three” provides a type of “hall pass” as to lease classification, reevaluation of embedded leases, and reassessment of initial direct costs for existing leases.

The practical expedients allow the company to use the prior accounting for leases (e.g., Topic 840 accounting) such that they do not have to determine whether the lease is a finance or operating lease, or capture and account for initial direct costs, such as legal fees incurred in the past associated with the original lease negotiations and drafting leases.

Implementing this package can help reduce the large amount of time and analysis required to adopt and implement Topic 842.

Two-stage transition is necessary. It is critical to bifurcate the lease accounting transition process for implementing the project between pre-practical expedients applications and post-practical expedients applications and to understand what each portion of the project means to the company or organization.

Lesson learned: Depending on the remaining terms of a company’s existing leases and the renewal dates occurring after the fiscal year ending after Dec. 31, 2019, full implementation of Topic 842 could take years due to the various analyses required to take place for existing, amended, renewed, and new leases.

Lease arrangements may be hidden in other contracts. Embedded leases — contracts that contain a lease — constitute the “mystery” portion of the new lease accounting. While companies have often accounted for many arrangements as service agreements with no balance sheet liability, companies now must assess and identify those arrangements that meet the criteria for a “lease” under Topic 842.

Lesson learned: Start this process early and engage your accounts payable and supply chain departments to help you through that process. Develop new or updated systems and controls to identify any embedded leases at the commencement of all new contracts or arrangements.

Evaluate carefully the lease accounting software choices. While many lease administration software solutions have added modules to address the actual recording of the lease liability and right of use (ROU) asset, other software solutions have been developed within the last two years by accountants solely for Topic 842. If you have a large number of documents to assess under Topic 842, consider using machine-learning or artificial intelligence software specifically designed to abstract legal documents. This technology, while still in its infancy, can substantially speed the Topic 842 analysis and reduce overall costs.

Lesson learned: Test-drive these software solutions to see how well they work with your team and interface with your current accounting software. Also, be sure to obtain the software solutions’ most recent System and Organization Controls (SOC) reports and read them carefully to ensure that the IT security and accounting algorithms are properly designed and are effective. Experience has shown that because these solutions are relatively new, many bugs are still being worked out.

Auditors’ involvement can help. Reach out early to your independent accounting firm and discuss your implementation plan for Topic 842. There are well over 3,000 pages of guidance already available in the public domain that were published by regional and national accounting firms for the purpose of helping companies successfully implement, and auditors effectively audit, Topic 842.

Lesson learned: Look at any published guidance from the large independent accounting firms’ internal technical groups. Discuss timing of the auditing process with your independent auditors to ensure that there is time for remediation if needed.

Companies will need to implement or modify internal accounting controls. Develop key controls surrounding the implementation process, lease document retention/organization, and internal quality control of the input of leases into the lease accounting software. Alternatively, for companies not using software solutions, consider a checklist of key areas to be addressed.

Lesson learned: Since this concept is new to most accountants, companies should develop a robust quality-control program. To aid in having a clear audit trail of the new or modified internal control procedures, companies should clearly document the steps required to properly perform these controls, clearly communicate these updates and procedures to all involved individuals, and maintain proper evidence of review and approval of key control performance. Licensing software specifically developed for Topic 842 in combination with specialists with expertise both in Topic 842 and the legal terms of your documents can substantially reduce your risk of noncompliance.

Debt covenants may be affected. Reach out to your lending institutions and discuss the pro forma effect on debt covenants and the need to modify existing debt arrangements or proactively address the new covenants needed in a post-Topic 842 world.

Lesson learned: The lease liability may have a material impact not only on debt covenants, but also on bonus arrangements or EBITDA-sensitive earnouts that may need to be amended. The significant effects that the lease liability can have on these factors may cause an increased risk of fraud due to added pressures of maintaining the appearance of healthy debt ratios or positive earnouts. Companies should address this risk when making modifications to their control environments.

Time and costs may be substantial. Many companies, especially those with over 100 leases (real estate, equipment, embedded) in their portfolio, have had to engage consultants to help in both the accounting and the project management needed for accurate implementation of Topic 842.

Lesson learned: Many public companies have noted that the actual time and fees are well in excess of their original budgets.

Lease accounting is becoming a specialty area that requires the ongoing maintenance of the appropriate amounts in monthly, quarterly, and annual financial statements as the world, in compliance with Topic 842, and its counterpart IFRS 16, Leases, moves significant amounts of off-balance-sheet liabilities into their new home on the balance sheet.

https://www.journalofaccountancy.com/news/2019/mar/lease-accounting-private-company-perspective-201920415.html

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