May 13, 2021
Published: Journal of Accountancy
By Sarah O’Sullivan, CPA
It’s been more than a year since the pandemic began, and while the vaccine rollout is reason for optimism, many organizations will be dealing with financial fallout for the foreseeable future. While private businesses and not-for-profit organizations face mounting financial pressures, many are also still contending with the adoption of new guidance for lease accounting. And public companies that have already adopted the new guidance need to ensure they’re applying it correctly amid a sharp increase in lease renegotiations.
The new FASB and International Accounting Standards Board (IASB) lease accounting standards require that organizations recognize assets and liabilities for leases with lease terms of more than 12 months, a significant undertaking even for fully staffed teams. For organizations that were forced to downsize due to the economic downturn, managing the transition and ongoing compliance can be even more daunting.
Bracing for updated guidance
Throughout the pandemic, the boards have continued to meet to evaluate the impact of the transition, release new updates, and address compliance hurdles. For instance, the IASB amended its lease standard to provide an optional practical expedient that allows lessees to forgo assessing whether a rent concession related to COVID-19 is a lease modification, which FASB mirrored with similar guidance.
Since FASB is currently in its post-implementation review process, there’s still a chance that more changes are forthcoming. One topic the board is actively focused on is lease modification accounting. Under FASB ASC Topic 842, Leases, when a lease is modified, its classification must be reassessed and the lease liability must be remeasured, which practically doubles the amount of work needed to account for a single lease. In October of last year, FASB proposed an amendment providing relief for partial terminations in some situations. However, the board received feedback from stakeholders expressing the need to consider additional changes and concern about releasing updates in increments, leading to a decision in February of this year to delay issuing any new amendments until it has done a more comprehensive review of the lease modifications guidance. For now, that leaves the timing of any new amendments in flux.
It’s worth noting that while FASB may add clarity to the rules, it may not make the transition easier.
It’s important to stay on top of the communications from FASB, and the board makes it easy to do so. As part of the transition, companies should carve out time to check the website or review email updates to make sure they’re aware of changes and can incorporate them as soon as possible.
Lease negotiations may complicate audits
The pandemic has initiated a major shift in the number of employees working remotely, and lease negotiations are occurring frequently, particularly for real estate. These negotiations can have a significant impact on the audit process for public companies. Many organizations are making modifications, requesting concessions, and terminating leases early for the first time or at a higher volume than ever before. The new rules for these lease changes are complex and can be a significant burden for accounting teams to address. Because accounting departments typically aren’t involved in the lease negotiation process, it’s also important to keep lines of communication open with lease managers while those conversations are in progress.
Accountants need to make sure they’re on the same page with their auditors as they make these changes and that all parties have a full understanding of what the new rules require. Early, constant communication with auditors is vital to preventing surprises at year end. One simple way auditors can prevent roadblocks is by performing interim testing. For example, if a company has a Dec. 31 year end, perform detail testing as of Sept. 30. By performing testing earlier, auditors will have more time to address client questions and challenges before final reporting deadlines.
Short-term leases may still need to be reported
With all the uncertainty around the impact of remote work on commercial office space, some real estate experts and landlords reported an uptick in interest in short-term leases. And since Topic 842 doesn’t require companies to report leases with terms shorter than 12 months, short-term leasing may seem like an appealing strategy on the surface. But the accounting impact is actually more complex.
Even if a lease appears to be a short-term lease, terms in the new guidance state that companies have to consider their reasonably certain holding period. A 12-month lease with renewal options, or that is highly unlikely to be replaced at the end of its term (such as a warehouse that has been modified to suit a particular company’s logistics infrastructure), may not meet the definition of a short-term lease.
Topic 842 also requires that companies disclose how much of their lease expense relates specifically to short-term leases in the footnotes of their financial reports. That could add complexity to the accounting, since companies need to segregate those expenses from the total, which might require the use of multiple general ledger accounts. Because of these rules, short-term leases don’t offer the automatic benefits that they may appear to on the surface.
The financial pressures of the pandemic will continue to disrupt lease arrangements for some time. To address the complexities of transitioning to the new standard and accommodating updates as they’re released, accounting teams should maintain clear lines of communication with lease managers and their auditors. Lease accounting tools can aid in that communication by centralizing lease documents and easing reporting. By working collaboratively and proactively, organizations can minimize transition hurdles and pivot as financial situations continue to change.