It is has been more than three years since the new lease accounting standard (FASB ASC 842) was issued. Has your company evaluated the impact of the new standard on your financial statements or started implementation? If you have not started the process, I suggest beginning now so that you are prepared and can avoid any potential surprises.
For public companies, the transition occurs in fiscal years beginning after December 15, 2018, including interim periods within those years (meaning for many public companies, it is already in effect for 2019). Private companies get an extra year to implement. For private companies that report on a calendar year basis, it is effective for their 2020 financial statements. Early adoption is also permitted. However, as expected, most public companies have not early adopted, and it is likely that most private companies will not early adopt either.
The majority of companies will be impacted by the new standard to some extent, with some impacted more than others. Companies with a significant amount of operating leases or leases with longer terms will see a significant balance sheet impact, because the present value of future payments under those leases will be recorded as a long-term asset as well as both a current and long-term liability. As a result, the standard will have an impact on certain financial statement ratios, such as liquidity ratios and leverage ratios; however, in many cases, there should be minimal impact to net income and cash flows.
Here are five things that your company can do to prepare for implementation:
1. Determine the impact to the company’s balance sheet.
- Identify the company’s leases. This may seem simple at first, but the mere right to use an asset is considered a lease and, as a result, the new lease accounting standard may impact accounting for many types of arrangements that may not seem like leases.
- Understand the classification criteria used to determine whether a lease is a finance or operating lease under the new guidance. The criteria to determine if it is a finance lease are similar to the four historical lease capitalization criteria, with some modifications. First, if the leased asset has no alternative use to the lessor at the end of the term because of its specialized nature, then it is considered a finance lease under the new standard. Second, there are no bright lines for the economic life criteria (previously 75 percent) or payments representing substantially all the fair value of the asset (previously 90 percent). As such, there is some flexibility with the percentages that can be chosen for your accounting policy, but the expectation is that you will use the same percentages or something very similar.
- Accumulate information about the cash flows associated with all of your leases.
- Perform a present value calculation of the future payments.
- Evaluate the results and the impact on both the balance sheet and financial ratios.
2. Develop an implementation strategy.
- Identify available resources. The effort required may be substantial and may require outside assistance if existing team members do not have sufficient time to devote to implementation of the new standard.
- Evaluate whether software is needed in order to track leases. Many companies plan to use spreadsheets; however, this may become problematic for companies with a high volume of lease transactions.
- Consider accounting policy elections, including available practical expedients. For example, in some situations the new standard allows companies to choose not to capitalize an asset or record a related liability for leases with terms of 12 months or less (short-term leases).
- Determine how you will present financial statements in the initial period of transition. The standard allows companies to recognize and measure leases at the beginning of the earliest period presented OR to account for the change as of the beginning of the period in which the standard is adopted (with a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption).
3. Evaluate new leases and upcoming lease renewals.
- Consider whether terms can or should be modified to change the accounting treatment.
4. Evaluate third-party agreements, such as those with banks or others that have clauses related to the balance sheet.
- If the mere adoption of the new standard could trigger violations, consider addressing those issues with counterparties sooner rather than later.
5. Consider how related party lease arrangements will impact your financial statements.
- For example, if your financial statements include consolidated real estate entities, the amounts recorded on the operating company’s balance sheet related to leases with the consolidated entity will be eliminated/reversed in your consolidated financial statements.
If you start working on lease accounting implementation now, you will have a better understanding of the financial statement impact as well as more time to evaluate and update your internal controls, systems, and processes. It will also provide a greater opportunity to proactively negotiate modifications to agreements with third-parties to avoid unwanted surprises down the line.
Mark A. Guillaume can be reached at Email or 215.441.4600.
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