When the very first IKEA store came to the United States in 1985, there were signs and billboards two years beforehand declaring, “IKEA is coming!” I lived in Plymouth Meeting where it was built, saw the signs, and heard the news. Still,
I had no idea what this store was about, let alone whether it would catch on. In my professional life, the new lease accounting standards exposure draft was issued in 2010, and we have long endured the “New lease accounting is coming!” promotions.
Finally, it is here: Accounting Standards Codification (ASC) 842 is in effect for 2019 for public companies and 2020 for nonpublic companies. Some early adopters are already up and running. This is bigger than IKEA.
From a balance sheet view, this will be a radical change. A great many CPAs were thinking this would essentially be a fixed-asset accounting parallel, so there is a big surprise in store for them. ASC 842 absolutely is not fixed-asset accounting. There
are a great many assessments to be done, software tools to be considered, modifications to financial loan covenants to be negotiated, and several accounting policy elections to be weighed and elected (or not elected) that will have substantive implications,
and may require forward-looking assessments of what all this means for the company’s financial statement presentations.
This discussion will focus on the implementation issues that need to be considered, which are so much more complicated than fixed-asset accounting. While I will cover some ASC 842 guidance and differences from lease accounting under ASC 840, the primary
purpose is to initiate some of the assessment of the business and business operating structure, evaluate adoptable practical expedients, and address requisite transition determinations that, before we know it, will be dropped on businesses like a
ton of bricks.
Do You Have a Lease?
In keeping with ASC 606 revenue recognition, a lease is now defined as a contract or part of a contract that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. This nuance
may get complicated, and may vary from how arrangements are viewed as the aspect of “control” (which is much more than a right to use) adds expanded judgment to transactions. Under U.S. generally accepted accounting principles (GAAP),
companies may have had lease components in their service contracts, and never addressed them or considered extracting them because, as “operating leases,” there was no balance sheet implication and expense recognition was connected to
the service arrangement. These leases must be identified and addressed under the new lease accounting standard.
Enforceability of rights, substitution of assets used, and physical distinctness may be among the factors as to whether ASC 842 applies and how accounting will be applied, measured, and presented in financial statements. Further, attributes that may change
during the course of the term of the arrangement may result in there being a lease contract only for part of the period stipulated by the transaction. So, not only will a thorough review of all existing leases need to be done, but also evaluations
of whether all leases would still be leases under ASC 842, whether transactions not previously reflected as leases now constitute a lease under ASC 842, and whether those determinations impact the reporting entity. These assessments will influence
the considerations of practical expedients or accounting policy elections considering whether to grandfather all previous lease determinations into ASC 842 characterization upon implementation. (More on this later.)
Managing Third-Party Expectations
Third-party financial statement users – such as bankers or bonding underwriters – may have expectations that will be rocked by ASC 842. Placing a discounted economically valued intangible asset on the balance sheet may create confusion and
concern regarding meaningful financial ratios, but adding the debt of lease liabilities … well, that will have significant ripples and create unprecedented doubts and uncertainties as to the predictive metrics and benchmark analyses of performance
results. Debt-to-equity ratio triggers will explode, and every entity with a recordable ASC 842 lease will lose current ratio and working capital position. Preparing all third parties for the impact will be an essential preadoption implementation
practice. This will be essential in assessing another expedient opportunity related to which transition implementation alternative to apply:
- A company will retrospectively apply to each prior reporting period presented in financial statements with the cumulative effect of initially applying ASC 842 recognized at the beginning of the earliest comparative period presented, or
- A company will retrospectively apply to the beginning of the implementation (current) year with cumulative adjustment.
If the first transitional option is elected, the application date will be the later of the beginning of the earliest period presented and the commencement date of the lease. Accordingly, comparative financial statements will restate a prior year and present
comparable reports as if ASC 842 had always been the accounting election method. However, this greatly increases the time, effort, and cost of implementation. Cost versus benefit will be greatly influenced by the assessments of the leases reported
previously in ASC 840 versus the new ASC 842 definition and framework of applicability.
Package of Practical Expedients
Of the available practical expedients (lessee accounting), the first three are an all-or-nothing package deal, in that they are all adopted or none of them are adopted.
- A reporting entity will not have to reassess whether any expired leases or existing contracts are, or contain, a lease.
- A reporting entity will not have to reassess the lease classifications for any expired or existing leases. Accordingly, ASC 840 operating leases become ASC 842 operating leases, and ASC 840 capital leases become ASC 842 financing leases.
- A reporting entity will not have to reassess initial direct costs for any existing leases.
This might suggest that what was past is prologue, and that a huge weight of the reassessment burden has been relieved. But this expedient only applies to the extent that there were no “errors or omissions.” That is, if certain lease contracts
or components were missed or otherwise misclassified, the expedient doesn’t permit any “Oh, well” situations. Missed or misclassified lease transactions will be outside the grandfathering.
Companies have been predisposed to “steer” a lease transaction toward operating lease status to avoid the balance sheet impact, so judgments and subsequent information could suggest another determination. Further, ASC 840 allowed for allocation
of internal expenses to initial indirect costs, as contrasted with ASC 842 defining costs as those that would not have been incurred if the lease had not been entered into.
Electing the package expedients has an allure, in that it should reduce the time spent reevaluating and assessing leases. If third-party users were comfortable with the presentation and decisions that had been conveyed within previous financial statements,
why open a Pandora’s box of second-guessing and explaining why assessments or classifications are being altered or changed. On the other hand, certain fact patterns may allow for changes in lease classifications or presentations that are more
representative, or even more beneficial to the reporting entity.
Lease and Nonlease Components
Under ASC 840, nonlease components were relatively insignificant, particularly since operating leases never really hit the balance sheet (save for straight-line recognition accruals/deferrals), and capital leases were more akin to actual fixed asset/property,
plant, and equipment (PP&E) transaction. ASC 842 requires nonlease components to be accounted for separately from lease components unless the practical expedient is to combine the lease and nonlease components and account for the entirety as the
lease contract consideration. A determination assessment is needed as to whether there is a transfer of a separate good or service to the lessee. So, maintenance and utilities are separate services and would be considered nonlease components, whereas
property taxes or insurance would be lease components because there is no transference of any good or service to the lessee. Further, contract considerations must be allocated to lease and nonlease components based on the relative stand-alone prices
of each component. If stand-alone pricing is not available, the lessee is required to estimate the stand-alone prices used by related and observable inputs as available.
Separating lease and nonlease components requires documentation of the entity’s internal lease accounting policies, by class of asset, and needs to be disclosed in the financial statements. The practical expedient might be elected when the nonlease
components are significant when compared with the lease components or the company’s lease accounting policies are weak or inadequate. ASC 842 does permit a portfolio approach to aggregate leases.
The election of the expedient to combine would provide simplification and eliminate the stand-alone pricing allocation (such as copier leases), and permit the entire lease payment as the lease consideration. Thus, it would be a time-saver and more simplistic
in application and disclosure. However, the more components that comprise the lease, the larger the value to be discounted and capitalized on the balance sheet as the right-of-use asset and the lease liability. While the profit and loss implication
may be nominal, the balance sheet implication will be more significant. The larger lease value (lease and nonlease components) is more likely to push a lease from “operating” to “financing,” as the present value of the sum
of the lease payments (and any residual guaranteed by the lessee not already reflected in the payments) are more likely to equal or exceed substantially all of the fair value of the underlying asset. Finally, there is the consideration that right-of-use
(ROU) will be subject to impairment. Since the underlying identifiable tangible property that is the controlled asset component upon which the lease is assessed and valued, this may be a difficult aspect in applying the impairment assessment provisions
against the carrying value of the amortized ROU asset without a corresponding impact to the recorded and carried lease liabilities.
Lessors may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and, instead, account for each separate lease component and the nonlease components associated with the lease
components as a single lease component, if both of the following are met:
- The timing pattern of revenue recognition for the lease component and nonlease component associated with that lease are the same.
- The combined single lease component is classified as an operating lease.
ASC 842 offers an expedient to use hindsight in determining the lease term (hindsight assessments of renewal options may differ from what was initially expected or thought) and in assessing impairment of ROU assets when a company transitions to ASC 842.
That is, the entity may consider actual knowledge or current revised expectations, as well as up-to-date factors as of the effective date, to make assessments and evaluations. If adopted, it must be applied to all leases with a “fresh take”
point of reference, which could impact or affect the packaged expedients (discussed earlier) of carrying forward all previous assessments and determinations. Applying this expedient requires numerous considerations, including contract, market, underlying
asset, and entity factors. These documented evaluations may require a significant time investment that could outweigh the benefits.
These influencing factors apply only at the transition. Changes that occur after the effective date would not be reflected in the assessment. Further, the entity would not apply the hindsight practical expedient to retrospectively reflect the terms of
a contract modification in its initial accounting for a lease under ASC 842 transition provisions – only options that were part of the contract as of the application date of ASC 842 can be assessed under this expedient.
Most practitioners are excited that, under ASC 842, a lessee may make an accounting policy election to forgo the ASC 842 guidance to short-term leases, which is a lease that has a term of 12 or fewer months at commencement and does not have a purchase
option that the lessee is reasonably certain to exercise. If a lessee makes this accounting policy election, no transition adjustment is required and the lease is accounted for in the same manner as under legacy GAAP. Note, application of the hindsight
practical expedient could have an impact on short-term leases at implementation, and these arrangements will still need to be disclosed. However, there could be some time-savings if these leases don’t need to be assessed and capitalized.
It is relatively infrequent to have the rate implicit in the lease readily stated or determinable, which then moves the entity to using either the incremental borrowing rate applicable for similar assets and terms. If the entity has portfolios of leases,
the determined incremental rate can be applied to the entire portfolio. The result would not be significantly different than individual lease discount rates (an assessment that should be documented to meet compliance). There is, however, a private
company option to use a risk-free discount rate (generally federal funds rate) for the lease.
The considerations here offer the incremental borrowing rate, which could vary throughout a reporting year for different types of leases for different types of underlying assets. This direction will make things a little more involved. Specialized ASC
842 software1 should be used to manage the extent, complexities, and variances of lease inventories. Conversely, using a risk-free rate, while providing more uniformity and simplicity, has the following drawbacks:
- The smaller the discount rate, the higher the capitalized value put onto the balance sheet, creating an even heavier liability on the books.
- The much higher discounted and calculated value is more likely to instigate lease test No. 4, triggering financing lease rather than operating lease accounting.
- The larger amounts capitalized as ROU assets could increase the potential for impairment issues for the carrying value vs. fair value of the underlying leased assets.
- Since this election is only available for private companies, if there is consideration of an IPO or an acquisition by a public company, the carrying values of lease assets and liabilities would be nonconforming.
The fact that, generally, an entity is not required to apply U.S. GAAP to immaterial items, and many entities have accounting policies establishing a materiality threshold for capitalizing fixed assets/PP&E, the question of whether such considerations
could be applied in ASC 842 accounting become prevalent.
ASU 2016-02 does include the following: “The Board observed that, in addition to accounting for some leases at a portfolio level, entities will likely be able to adopt reasonable capitalization thresholds below which lease assets and lease liabilities
are not recognized, which should reduce the costs of applying the guidance. An entity’s practice in this regard may be consistent with many entities’ accounting policies in other areas of GAAP (for example, in capitalizing purchases of
property, plant, and equipment).” However, caution is raised not to uniformly apply fixed-asset thresholds to leases because of the following:
- Fixed-asset capitalization thresholds do not likely include the effect of the additional asset base that was introduced by ASU 2016-02. Aggregated amounts may become material.
- Existing capitalization threshold for PP&E would not likely consider the liability side of the balance sheet. Under the new standard, if an entity wishes to establish a threshold that will be used to avoid accounting for both ROU assets and lease
liabilities on the balance sheet, it must consider materiality, in the aggregate, of all of its ROU assets and related lease liabilities that would be excluded as a result of its adoption of such a threshold.
In addition to looking at both asset and liability thresholds and opting for the lesser trigger, another approach gaining traction is applying a capitalization threshold to the asset/ROU side, below which the amount would be immediately expensed, but
still recording the related lease liability.
Some are looking to International Financial Reporting Standards (IFRS) 16 materiality thresholds, which suggest an amount less than $5,000 alone or in the aggregate would fall into a de minimis level for nonrecognition. Since the lease standard was the
accounting principle that effectively ended the official GAAP-IFRS convergence, adopting an IFRS standard for capitalization threshold may not get automatic approval in peer review.
ASC 842 requires related-party leases to be accounted for by the lessee and lessor based on legally enforceable terms and conditions of the lease contract more so than the substance of the arrangement. Accordingly, related-party leases should be accounted
for in the same manner as leases between unrelated parties, while considering the disclosure requirements conveyed in ASC 850, Related Party Disclosures. This differs from guidance contained in ASC 840, which indicates that related-party leases should
be accounted for on their substance rather than their form.
The manner of presentation and disclosure may have been ramped up with the issuance of ASU 2018-17, Targeted Improvements to Related Party Guidance for Variable Interest Entities (Consolidation Topic 810), which expands and, essentially, supersedes ASU
2014-07 to provide exemptions from variable interest entities consolidation for more than just leasing arrangements, placing more emphasis for specific transaction identification, accounting, and disclosure.
Where it potentially can get tricky is in those situations where the actual leases are month-to-month, and the assessment of whether an argument for short-term lease treatment can be sustained despite the long-standing “exercised renewals”
weighed against the challenge of what possible lease term could be justified as the basis for capitalizing the lease.
Care for Your Independence
There are a great many business and accounting policy determinations, assessments, lease analyses, financial considerations, and so on to be made. Professional assessment as to which attributes apply, which considerations or options should be elected,
and how the entity wishes to present and position itself are decisions for business ownership and management. ASC 842 lease accounting will be much more involved and complex than maintaining “client depreciation schedules.” Accordingly,
implementation and application of ASC 842 by an external CPA will constitute a significant (and quite valuable) nonattest service that may be complex enough that management and owners cannot assume full responsibility for the accounting principle
compliance (lacking sufficient skills, knowledge, and expertise). The service provided by an external CPA could impair that CPA’s independence, especially since a significant part of implementation of any meaningful GAAP standard is the establishment
of internal controls over the process. So, an external CPA who provides attest services may find impairment threats for which there are no sufficient safeguards, presenting a prohibition from providing either the nonattest service or the attest service.
For CPAs who do U.S. GAAP-based financial reporting, the summer and fall of 2019 will be jam-packed with last minute revenue recognition (ASC 606) pre-year-end reviews (yet another area where auditor/reviewer CPA involvement would likely impair independence),
along with substantive planning with those GAAP clients to prepare for the 2020 responsibilities, analyses, considerations, and decision-making needed for applying ASC 842. You will want to get started sooner rather than later, or a ton of bricks
falling on you may seem like the less daunting option by comparison.
1 ASC 842 lease accounting software options are beyond the scope of this article. The mechanics of the lease inventories and amortizations of ROU assets and the related lease liabilities is beyond traditional fixed-asset accounting and the simple Microsoft Excel worksheet.
James J. Newhard, CPA, is a sole practitioner in Paoli, a CPE presenter for Loscalzo-Kaplan, and a past president of PICPA’s Greater Philadelphia Chapter. He serves on numerous state and chapter technical committees, and is a member of the
CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org or on Twitter @CatalystJimCPA.