Lease Accounting: What Are the New Challenges for Lessees?

Why the new lease accounting standards pose major challenges

Prior to the announcement of new lease accounting standard requirements, most companies did not find it essential to pay close attention to leases within the financial reporting process. As companies adopt the new pronouncements, that sentiment will change – drastically. Companies will need to record all leases on the balance sheet, which, for public companies, has resulted in an average liability increase of 1,475%.

Transitioning to these new standards is a monumental task, in correlation with the significant change to the face of the financials. LeaseQuery published a survey of accountants in 2019 and found that most public companies who expected a relatively smooth transition experienced an implementation that was far more time consuming and complex than they anticipated. Even considering the amount of time companies have left to comply by the deadline, the above context would indicate that companies should put this project at the top of their to-do list.

The impact of failing to comply

Most organizations do not inherently have processes in place that can seamlessly facilitate full compliance with these new standards. Additionally, there are many obstacles preventing accountants from beginning the implementation process. These include day-to-day tasks, budget and resource restrictions, as well as an incomplete understanding of what is required for compliance. All of these obstacles put companies at risk.

Failing to comply can have wide-ranging implications, varying from material audit findings to sinking stock valuations. The following could also potentially result from non-compliance:

• Job loss and damaged reputation for senior leaders
• Loss of investor confidence
• SEC scrutiny
• Increase in audit costs

Individuals need to push back against these hurdles to ensure compliance holds top priority. Regulators have made clear the importance of adopting new accounting pronouncements appropriately, as the overarching result leads to transparent and comparable financial information.

Why the boards updated the standards – it’s all about transparency

After the financial scandals of the early 2000s, regulators and legislators issued numerous regulations and laws to reduce corporate fraud; however, lease obligations remained opaque. During The Great Recession of 2008, several firms with major leasing liabilities went bankrupt, despite a balance sheet that appeared clean. With operating lease liabilities not recognized on the balance sheet, investors did not have an all-encompassing picture of a company’s obligations.

Under the legacy ASC 840 standard, leases are classified as capital leases or operating leases. While the assets and liabilities related to capital leases are recognized on financial statements, lessees with operating leases would only recognize an expense over the lease term with limited balance sheet impact.

The Financial Accounting Standards Board (FASB) worked in conjunction with the International Accounting Standards Board (IASB) to develop the new standards to provide more transparency about all leases.

As a result, FASB released Accounting Standards Codification (ASC) 842 and IASB released International Financial Reporting Standards (IFRS) 16.

How ASC 842 and IFRS 16 will improve financial reporting:

• Offers fewer opportunities for organizations to manipulate lease transactions to avoid recognition on the balance sheet
• Provides a more comprehensive insight into a lessee’s obligations, which eliminates the need for investors and stakeholders to compensate for the lack of financial visibility by adjusting the recognized amounts on the financial statements
• Aligns lessor accounting and sale/leaseback transactions guidelines with the comparable 2014 revenue recognition standard, ASC 606
• Exposes lessors’ credit and asset risk as a result of leasing
• Clarifies the definition of a lease and how to specifically identify an embedded lease asset within a contract

Lessee accounting: What has changed?

As mentioned above, the legacy guidance shows that a clear distinction exists with how lessees record operating and capital leases. Operating leases are off-balance sheet items and capital leases get recorded as a liability and capital asset at present value.

Under the new standards, the classification of leases has changed, along with their placement on the balance sheet. Other changes and common challenges addressed include:

• The definition of a lease
• How initial direct costs (IDC) are defined
• More extensive disclosure requirements
• The treatment of lease and non-lease components

Lease accounting under the old standards, ASC 840 and IAS 17

Lease accounting under the new standards and major differences

Who is affected by the new standards?

All companies that lease assets are affected by the new standards. Some considerations exist within both ASC 842 and IFRS 16 to omit specific types of transactions from capitalization (i.e. short-term leases). However, all companies that have the right to use at least one in-scope asset that qualifies as a lease will need to apply the new standard.

Industries that are most affected by the lease accounting changes

The changes under ASC 842 and IFRS 16 will have wide-ranging effects across most industries.

Why embedded leases are a particular challenge

One of the biggest challenges companies face today involves identifying their embedded leases. A typical real estate lease can require legwork to gather the appropriate data, but the process of identifying the lease itself does not provide immense difficulty.

Embedded leases, which refer to leased assets provided within service, outsourcing, and maintenance contracts, require additional work. Examples of contracts that may contain embedded leases include:

• Warehousing contracts – although typically outsourced, these agreements may contain language that meets the definition of a lease.
• Security contracts – these types of services may also contain access to scanners or equipment, which could qualify as a lease under the standard’s definition.
• Transportation contracts – depending on the terms, the vehicles used for transport could qualify as a lease asset
• Data storage contracts – much like security contracts, these agreements could include embedded leases for both the servers or the space the servers occupy.

Departments responsible for procurement will not typically have a comprehensive understanding to know whether the contract includes any assets that qualify as an embedded lease. The process of dissecting each contract for embedded lease assets might just earn the title of the most daunting exercise that the lease accounting transition requires.

Common lease accounting errors under ASC 840 that could impact your transition

Beyond what’s required when adopting the new accounting standards, there are many additional errors that are common within current lease accounting. One of the initial steps in ensuring compliance with the new standards is, of course, to ensure that no current errors exist within lease accounting today. Any such errors in your current accounting will present additional challenges when your organization is transitioning.

For example, there exists a practical expedient under ASC 842 that allows for the grandfathering of lease classification. Sounds great, right? Keep in mind that this practical expedient can only be applied if there are no errors associated with the classifications of your current leases. Are you sure that you applied the capital lease criteria correctly for each one of your leases?

Below, we’ve noted six common errors in lease accounting and provided links to some additional articles that will help you find and apply the right solution.

1. Incorrect lessee accounting for tenant improvement allowances

When a lessee receives a tenant improvement allowance (TIA), they often do one of two things, both of which are incorrect: they either do nothing or they reduce the value of the leasehold improvement by the amount of the allowance. This is common in situations where the landlord pays a contractor directly for the improvements rather than paying the tenant.

Neither of these methods are correct under ASC 840, however, and they will cause accounting problems. They could understate the value of a leasehold improvement as well as the associated depreciation expense, impacting EBITDA.

2. Accounting for tenant improvement allowances when a lease is renewed or modified

Another common error associated with TIA accounting is related to leases that are renewed or modified. Often, lessees will simply do nothing at all to compensate for these changes. However, this is incorrect. When a lease is renewed or modified prior to the end of the initial lease term, the lessee should reassess the straight-line reduction in the incentive liability account based on the new lease terms.

When companies do not make any changes to the TIA amortization schedules after a lease is renewed or modified, then rent expense is understated in some years and overstated in others. This can also impact EBITDA.

The previously-referenced article on TIAs contains a full example on the correct guidance for this issue. Additionally, to learn more about lease modifications, read the following articles:

3. Accounting for deferred rent balances when a lease is renewed or modified

When a lease is renewed or modified prior to the end of the initial lease term, any deferred rent from the prior lease should be included in the calculation of straight-line rent expense for the new lease term. However, a common error is to make no adjustments to the deferred rent recorded from the prior lease. In this case, the liability is simply left on the books and keeps increasing as leases are renewed or modified.

Lessees should include the existing deferred rent balance in the reassessment of the straight-line expense calculation. If deferred rent represents amounts already expensed but not yet paid, lessees would not want to recognize that expense again!

Additionally, there has been a change to deferred rent under ASC 842 that many accountants find confusing. Under ASC 842, prepaid/deferred rent is not accounted for in a separate account anymore. These balances need to be rolled into the opening balances of the related right-of-use assets upon transition to ASC 842.

To learn about the correct treatment for deferred rent under ASC 840 and ASC 842 with examples, read the following articles:

4. Incorrectly determining the lease start date

It’s common for companies to assume that the lease amortization schedule should always begin on the date the lease contract states as the commencement date. This, however, is not always true. For a better understanding of how to assess the appropriate lease start date, read our article, “Lease Commencement Date: How to Know when a Lease Starts.”

5. Accounting for asset retirement obligations (removal expenses associated with a lease)

An example of an asset retirement obligation (ARO) is when a lessee must return a leased asset in a specific condition, or rather, at its initial condition, at the end of the lease term. This is very common with leasehold improvements and it particularly impacts companies in industries such as oil, energy, and gas.

There’s a common error associated with these obligations. When companies construct these leasehold improvements that they are legally obligated to remove, they do not anticipate and accrue the removal costs. Rather, they expense those costs when incurred, which is incorrect.

To learn the correct method of ARO accounting with a full example, read our article, “Asset Retirement Obligation (ARO) Accounting Example under ASC 410 and ASC 842.”

6. Accounting for partial terminations

Vacating a portion of leased space or discounting the use of some of a leased asset may result in partial termination accounting. To record a partial termination, the reduction to the lease liability and underlying asset are calculated separately. Applying the same adjustment to the lease liability and lease asset is incorrect. This treatment could cause misstatements in rent expense and errors in prepaid/deferred rent or the lease liability and lease asset on the balance sheet.

To learn the correct treatment for lease terminations and for partial lease terminations, read the following articles:

Why Excel isn’t the right solution for the challenges in lease accounting

Accountants love to use Excel. Excel offers the ability to achieve nearly any result desired – or so many think. However, for compliance with the new leasing standards, Excel simply won’t cut it. Too many opportunities exist to make mistakes.

Excel has limitations when considering the complexity of ASC 842 and IFRS 16. When considering the practical expedients offered by the boards, Excel does not offer the capabilities of building those elections into a spreadsheet. This is one of the reasons why audit firms suggest using software for compliance.

Additionally, housing all leases within a central repository provides access across an entire organization, rather than only to contract owners. Ideally, this central repository will provide access to the document, amortization schedules, critical date alerts, journal entries, and footnote disclosures all at once.

To comply, companies need a purpose-built solution

To address the complexity of the new standards, companies must look to software solutions that have specific functionality built for IFRS 16 and ASC 842. The software should address the accounting, reporting, and document management needs your company, auditors, and regulators require.

Considering the judgmental nature of these new standards, companies should ensure they have lease accounting experts at their disposal to assist in navigating the complexities and nuances of the standards.

Choosing the right solution

Implementing a lease accounting solution should not happen overnight. When comparing solutions, companies should consider:

• Whether the software supports its internal controls
• Whether the provider completes a system and organizational controls audit of both design and operating effectiveness
• User reviews – and what specific role the reviewer has within their organization

While budget constraints may make pricing an initial glaring decision factor, evaluating on price alone will only lead to costly headaches in the long run.

The same goes for choosing a lease management software that was not originally architected for accounting compliance. Many lease management companies have added accounting modules to their software; however, those programs often include shortcomings, as the product teams usually lack the expert guidance of lease accountants.

The hidden benefits of the new accounting standards

One silver lining of implementing the new standards is that the departments in your organization will begin working together more seamlessly to manage and account for leases. Transitioning to the new standards provides an opportunity to integrate processes and tools so all stakeholders have the same understanding of lease agreements and how the contracts affect the business.

Many public companies that have already implemented lease accounting solutions have found that their facilities, procurement, and other leasing departments now provide more complete data when entering into new contracts. This results in fewer accounting hours spent gathering information and more time devoted to achieving core business goals.

Even further, compliance with the new standards provides exactly what the FASB and IASB are designed to ensure: financial comparability and transparency amongst organizations across all industries and sizes!