Many of our private company clients that prepare financial statements using Generally Accepted Accounting Principles are spending the summer preparing to implement the Financial Accounting Standards Board’s Revenue Recognition standard. It needs to be fully implemented before they report their Dec. 31, financial results to their banks and shareholders.
However, revenue recognition should not be the only new standard these companies have their eye on. The FASB issued a new lease accounting standard in 2016, scheduled to take effect for private companies approximately one year after revenue recognition. The lease standard already is in effect for public companies, and as of July 17, , the FASB has tentatively decided on an additional one-year delay for private entities (e.g., two years after revenue recognition).
Under legacy GAAP, companies focused on the classification of their lease agreements as either operating or capital leases. This classification dictated whether commitments under leasing agreements appeared as liabilities on the balance sheet (capital lease) or as merely a disclosure within the financial statements notes (operating lease).
By various estimates, this differing treatment resulted in keeping anywhere from $1 to $4 trillion of lease commitments off the balance sheets of reporting entities. Under the new standard, organizations that lease buildings, equipment and other assets will see a more consistent reflection of these commitments on their balance sheet.
Assume for example, a company leases a specific piece of equipment for $200 per month during 24 months with an assumed interest rate of 4%. This results in a present value of this commitment of approximately $4,600. Under the new standard, this amount will be recognized at the inception of the lease as a $4,600 “Right of Use” asset and a $4,600 lease liability that is subject to amortization expense over time. Whereas under legacy GAAP, the company would have expensed the rent on a monthly basis and disclosed a $2,400 commitment per year in its financial statement notes.
In theory, the recording of operating leases similar to historical capital leases is straightforward. In practice, the calculation requires the lessee to consider a number of questions such as:
• Do I have a lease? (Hint: It is not as simple as looking to see if “lease” is part of the contract title.)
• What is the lease term? (Are there are renewal options?)
• Are there service costs associated with the lease payments (i.e., non-lease components)? If so, do I include in minimum lease payments?
• What are my lease payments and monthly expenses? (Some leases have various escalation clauses or contingent consideration based on usage.)
• What interest rate do I use?
• Is the lease a financing (formerly capital lease) or an operating lease?
• Has anything changed since last reporting period?
As noted earlier, many operating and financing leases will have the same initial treatment in the liability section of the balance sheet. Therefore, the key questions is, “Does the agreement that I’ve entered into meet the definition of a lease?” This determination also involves answering a series of questions including:
• Is there an identified asset within scope of the standard?
• Who has “control” of the asset during the lease term?
• Who obtains most of the economic benefits from the asset during the lease term?
Even with the additional year to implement the lease standard, CFOs and their accountants are advised to start planning to implement the new standard now. Although completely different topics, applying the new revenue recognition and lease accounting standards has some similarities that companies might want to consider. These include:
• Both standards involve the evaluation of individual contracts to determine proper accounting treatment. Start by developing an inventory of significant lease and sales contracts for further analysis. Companies also should create appropriate repositories for these contracts so they can be easily accessed.
• Modifications to contracts can result in changes to the original accounting treatment, so implementing effective controls to identify and evaluate contracts and modifications is prudent. This also is a good opportunity to formalize authorization controls over the establishment of initial and modified contracts to ensure appropriate individuals are approving these items.
• Look for ways to reduce unnecessary variability in the number of unique provisions in contracts. Variability will have a direct correlation to the administrative costs of complying with both standards. For example, we anticipate a number of clients will consolidate their leasing arrangements to a few vendors. The contracts inventory discussed in the first bullet should include the relative size (dollars) of each contract, expiration date and number of leased assets involved. This information will identify opportunities to reduce this contract variability.
• Be mindful of current provisions and renewal dates for agreements such as debt agreements that contain financial covenants that may be impacted by a change in accounting treatment.
Now is the time to take steps to set yourself up to adopt this new standard as seamlessly as possible. Like revenue recognition, some entities will need to expend more energy than others to ensure compliance with these new standards.