This article is organized into two sections. The first provides an overview of the lease accounting changes that go into effect into 2018 and 2019, including both IFRS and FASB. In the second section, we provide a step-by-step summary of our comprehensive lease accounting transition guide for FASB ASC 842 and IFRS 16.
- Lease accounting changes in 2018 and 2019
- Step-by-step summary for FASB ASC 842 and IFRS 16 transitions
Lease accounting changes in 2018 and 2019
The world of Lease Accounting is set for a radical makeover. In January 2016, the International Financial Reporting Standards Foundation issued IFRS 16, and in February 2016, the U.S. Financial Accounting Standards Board issued Accounting Standards Update FASB 842 – both of which significantly change the way companies account for and record leases on their financial statements. IFRS 16 goes into effect on 01/01/2019, while FASB 842 kicks in for fiscal years beginning after 12/15/2018 for public companies and 12/15/2019 for all other entities. The changes are significant and time consuming to properly implement, so it’s imperative that companies revamp their lease accounting and financial reporting systems as soon as possible to be in full compliance with the new rules come December 15, 2018.
What’s Changing Under FASB 842
FASB Topic 842 requires that a lessee recognize the assets and liabilities that arise from operating and finance leases, and measure them as the present value of lease payments. The asset represents the lessee’s right to use the underlying asset (ROU asset) and the liability represents lease payments over the lease term.
When measuring assets and liabilities, the lessee (and the lessor) should also include ‘reasonably certain’ lease extension periods beyond the current lease term and ‘reasonably certain’ asset purchase options.
However, for leases with terms of 12 months or less, or where the underlying asset is of low value, lessees can elect to not recognize lease assets and liabilities but should recognize lease expenses on a straight-line basis, generally, over the term of the lease. While the recognition, measurement, and presentation of lease expenses and cash flows have not significantly changed from previous GAAP rules, the principal difference under FASB 842 is that even operating leases require recognition of lease assets and liabilities on balance sheets. Existing finance leases will continue to be treated as finance leases.
For Finance Leases: Lessees must:
- recognize interest on the lease liability and amortization of the right-of-use asset as separate line items on the income statement, and
- ii) classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows.
For Operating Leases: Lessees must:
- recognize a single lease cost allocated over the lease term on, generally, a straight-line basis, and
- ii) classify all cash payments within operating activities on the statement of cash flows.
For lessors, accounting practices remain largely unchanged. Additionally, FASB 842 outlines changes to leveraged leases, and sale-leaseback transactions.
The new lease accounting standards were jointly developed by the International Accounting Standards Board (IASB) and the U.S. FASB. As a result, there is a lot of overlap between FASB 842 and IFRS 16. Their main differences relate to how lessee’s record leases.
For instance, while FASB 842 distinguishes between finance leases and operating leases in financial statements, IFRS 16 requires that all leases be treated as FASB 842 finance leases. Hence, operating leases will be accounted for differently under GAAP and IFRS.
Here are a few other notable differences:
- IFRS 16 exempts lessees from recognizing and measuring leases valued at less than $5,000
- Under IFRS 16, lease asset values may be calculated using alternative methods other than Present Value
- Under IFRS 16, a change in lease cash flows triggers a reassessment of variable lease payments that depend on a reference index or a rate
- In sale-leaseback transactions, IFRS 16 does not specify whether the asset transfer should be classified as a sale unless the seller (lessee) has a material repurchase option on the underlying asset
- While FASB 842 allows private companies to use a risk-free rate to calculate the lease liability, IFRS 16 does not provide specific guidance
- While FASB 842 requires interest payments to be listed within operating activities on the statement of cash flows, IFRS 16 allows the listing of interest within either operating, investing or financing activities
Why Lease Accounting Rules Were Changed
Companies have over $3 trillion in leases outstanding, of which only a limited amount show up on the balance sheet. An operating lease, for instance, is not shown on the balance sheet but represents a real liability and should be clearly presented so users of financial statements can assess the amount, timing and uncertainty of cash flows arising from leases. For example, during the financial crisis of 2007, several firms with huge leasing liabilities went bankrupt even though they had clean balance sheets.
According to IASB and FASB, given the widespread prevalence of leasing, the new lease accounting rules will improve financial reporting and increase transparency and comparability across organizations while also disclosing vital information about leasing arrangements to investors. For instance, airlines that buy and own planes carry heavy debt on their balance sheets while those that lease planes have misleadingly clean balance sheets despite having materially similar lease obligations.
The new rules also address criticism of previous lease accounting rules for failing to meet the needs of users of financial statements by not always providing clarity on leasing transactions.
While companies will balk at the added cost, implementing these rule changes should give management better insight into the true extent of their lease obligations, and lead to better lease vs. buy and capital allocation decisions. Moreover, the new rules are not expected to hurt leasing companies because leases will continue to offer a very flexible way of financing and using assets without all the risk of owning them.
Why You Must Act Now To Get Ready
The impending lease accounting changes give corporations less than a year to understand the technical requirements of the new rules, take inventory of all their leased assets, accurately ascertain what their remaining lease terms are, and figure out how to value them for FASB 842 and IFRS 16. This is no trivial task.
For example, companies with large volumes of leases are finding that the initial step of identifying and locating all of their lease contracts is in itself a substantial task, particularly when lease records are not centrally maintained. Corporate accounting teams will also need time to understand contract provisions such as extension options and variable payments.
So the sooner companies get on this, the better.
Why It’s Important to Move Quickly
Here’s why: For an entity that elects to apply practical expedients to the identification and classification of leases that commenced before the effective date, FASB 842 states that “lessees are required to recognize a right-of-use asset (ROU asset) and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP”.
What this means, in simple terms, is that if a company decides to present comparative period financial statements of fiscal years prior to FASB 842’s effective date of 12/15/2018, those prior year financials will have to reflect ROU assets and lease liabilities. So if a company typically presents two prior years of comparative financials, it would have to present the impact of FASB 842 on 2017 and 2018 financials when comparatively presented with 2019 financials.
It’s imperative that companies act now to understand and account for FASB 842 and IFRS 16 on 2017 and 2018 financials. If you’re unsure how, read LeaseQuery’s Transition Guide for FASB 842 and IFRS 16, which we have summarized below.
Step-by-step summary for FASB ASC 842 and IFRS 16 transitions
Companies typically lease several items of daily corporate use, such as computers and office equipment, which are valued at less than $5,000 apiece, and accounting for all of them as ROU assets can quickly become a nightmare. While IFRS 16 allows an exemption for all “small ticket items” with a fair value of less than $5,000 each (even if, when combined, those assets could be deemed material), FASB 842 does not provide such an exemption.
However, there is a workaround, and that is to establish a written policy to exempt leased assets below a certain dollar-value threshold that you deem appropriate, with good reasoning and justification; then – this is important – present the policy to your external auditors and get their feedback and approval. If you can develop an exemption policy that your auditors approve of, you will not have to list out small ticket items, and could save yourself a lot of time and money while still being compliant with FASB 842.
Now that you have a standard lease exemption policy in place, it’s time to put together a team, across relevant departments and multiple locations, which will help your organization transition to the new rules.
Start by appointing a point person to head the transition (Transition Team Leader), ideally in the corporate controller’s office. Then, have the Team Leader identify potential departments in your company that have or know about any leases or leased assets, and assign a Transition Team point person at each department. Such departments include Real Estate (typically in larger companies), Purchasing/Supply Chain, IT, Legal, Finance, Accounting and Treasury.
Once you have your lease transition team in place, it’s time to get everyone working together on developing a list of leased assets across the organization, along with lease contract details. The list should include details such as:
- lease start and end dates for each leased asset
- monthly lease payment amounts
- the current accounting treatment of the lease
- borrowing costs associated with the lease, if any (this could help calculate ROU asset value)
- optional lease extension clauses and the likelihood that leases might be extended
- optional asset purchase clauses
- and whether the lease is embedded on other contracts, such as with IT outsourcing partners.
Aside from boiler-plate legalese, the more information you have on lease details, the better. Often, companies contract with specialized lease brokers, so your point person may have to reach out to them (and to former or reassigned employees) to get a thorough and accurate listing of all leases. So select persons with attention-to-detail and good communication skills to make sure nothing slips through the cracks.
For companies with multiple locations, the team leader should identify a “Location Leader” to collect detailed information on all leases at that location. This person should ideally be in a finance role (such as the Corporate Controller who is intimately familiar with the location’s operations and accounting details) and have a reputation for working well with other departments.
Once all locations have been identified, and point persons assigned at relevant departments at each location, your transition team is in place and ready to move ahead.
To get them all started, the Team Leader should develop a Lease Details Template and send it out to Location Leaders for further dissemination to Lease Coordinators at relevant departments at each location, along with a realistic reporting deadline.
Next, from your financial reporting department, get details on all 5-year lease commitments. These are typically disclosed in Notes to financial statements and should be fairly easy to collect, especially from 10-Q and 10-K filings for public companies.
In addition, get details on the deferred rent (straight line) schedule for each asset at all departments and all locations. Not all companies have deferred rent schedules but if they do, they are typically housed in the corporate accounting department.
Get details on rent expense for the most recently completed year-end audit. This information is required disclosure on audited annual financial statements and, in larger organizations, can be obtained from the financial reporting department.
Now that you have a fairly comprehensive list of all your leases, sort through them to identify and track down missing pieces of information and eliminate duplicates.
Also make sure all 5-year lease commitments and deferred rent schedules are accounted for in the final list.
The following is your “reasonableness test”. Here’s what you do: Use your final list to calculate straight-line rent expense on all your leases; then compare your calculated number to what was listed on your most recent, audited annual financial statement (from Step 10).
If your calculated number is significantly lower than what is in the audited financials, you’re probably missing a few leases, so try and track them down. On the flip side, if your calculated number is significantly higher, then there’s either another G/L account where rent expense is recorded, or your accounting team made a mistake in its rent expense calculations for the audited financials (it’s rare, but mistakes do happen, where leases get missed and overlooked year after year).
Upon completion of Step 13, you’re ready to select lease accounting software. Keep in mind that lease accounting software is not the same as a lease management software. Lease accounting software is developed specifically for the accounting and financial reporting aspects of leases, whereas lease management products were developed to manage the logistics of leases such as lease payments, and do not address the nuances of lease accounting.
For instance, lease accounting software can:
- distinguish between short-term and long-term deferred rent under GAAP
- handle amortization of initial direct costs and tenant improvement allowances
- handle the accounting of pre-mature lease terminations or modifications
- change borrowing rates on modified capital leases
- handle foreign currencies, and more… features and tasks that lease management software is ill-equipped to reliably handle or perform.
Moreover, a SaaS-based lease accounting system is continually updated and does the heavy-lifting to make sure your lease accounting is always in full compliance with FASB 842 and IFRS 16.