Learning Your Leases

What FASB’s new lease accounting standard means for businesses and their advisors. By JEFF STIMPSON | Winter 2018



The Financial Accounting Standards Board (FASB) has done it again. If the new revenue recognition standard wasn’t exciting enough, FASB’s new accounting standards update (ASU), “Leases” (Topic 842), should get your blood pumping — or mind numbing. All organizations that lease assets — aka “lessees” — will be required to recognize these assets and liabilities on their balance sheets. Without a doubt, this will introduce profound accounting changes. (And if you’re up to the task, it might also create some great consulting opportunities with clients looking to comply with the new standard.)

“The most significant change impacts lessee accounting, as all leases in excess of one year will be included on the balance sheet, regardless if they are a financing or operating lease,” explains Jeffery Watson, CPA, a principal of quality assurance at Miller Cooper & Co., Ltd. in Deerfield, Ill., a current member of the Illinois CPA Society’s Accounting Principles Committee and a former AICPA PCPS Technical Issues Committee member.

Consistent with current U.S. generally accepted accounting principles (GAAP), the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. But unlike current U.S. GAAP, the new ASU requires both types of leases to be capitalized on the balance sheet, resulting in a liability and a corresponding right-of-use asset being recognized. The ASU also will require disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases.

For public companies, the ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018. For a calendar year company, that means it would be effective Jan. 1, 2019.

Who’s ready? Not many, according to a recent Deloitte poll of more than 2,170 C-suite and other executives. In fact, Deloitte found only 42 percent of public companies and 33 percent of private companies are on schedule to implement their respective new standards by their effective dates.

“The clearest part about this standard is that there will be a significant change,” says Nancy Miller, CPA, senior director of technical accounting at Reynolds Group Holdings Limited in Lake Forest, Ill. “A significant amount of work needs to go into assessment and adoption of the standard — it should not be underestimated.”

THE SIMILARITIES

Both international financial reporting standards (IFRS) and U.S. GAAP require operating leases to be recognized on a reporting entity’s balance sheet, with the capitalized asset and lease liability are initially measured with reference to the fixed portion of lease payments.

Under IFRS, the capitalized asset is amortized, and the lease liability unwinds by way of interest and principal, “consistent with today’s accounting for finance leases,” Miller explains. “Under U.S. GAAP, capitalized leases continue to be classified as either capitalized operating leases or capitalized finance leases. The P&L expense associated with capitalized operating leases will be the same as today’s expense and will continue to be reported in EBITDA.”

“Although both operating and finance leases will be recorded on the balance sheet, the expense recognition pattern will differ for each,” Miller adds. Under an operating lease, a lessee would recognize a lease expense on a straight-line basis over the lease term; under a finance lease, the lessee would recognize both interest expense (by using the effective interest method) and amortization expense. “The lessee would generally recognize greater expense earlier in the life of the lease for a finance lease than for an operating lease,” she says.

Miller also points out that under both IFRS and U.S. GAAP, most variable lease payments are excluded from the measurement of the capitalized asset and lease liability. “The expense associated with these amounts will continue to be reported within EBITDA,” she says. “The new rules also call for extensive quantitative and qualitative disclosures to increase transparency related to revenues and expenses recognized, and expected to be recognized, from existing contracts. Companies will want to consider how to gather the necessary information and how to appropriately communicate with relevant stakeholders.”

THE IMPACT

Under U.S. GAAP today, operating leases are not capitalized on the balance sheet but will be in the future (assuming the lease term is more than a year). “The impact on income taxes should not be different than what’s done today for federal income taxes,” Watson says. “Although, if lease terms and conditions or accounting policies change as a result of adopting the ASU, they could lead to timing differences between book and tax that would lead entities to assess deferred taxes.”

Other tax areas impacted include state taxes, international taxes, and transfer pricing. State taxes will be impacted where certain states levy franchise taxes, which are generally based on net worth, Watson notes. Entities will need to consider how they record the right-of-use asset — that is, recorded in the same balance sheet account, or line item as other company owned property?

“For entities with international operations and intercompany transactions, financial and profitability ratios utilized to assess transfer pricing may no longer be comparable to periods presented prior to the ASU’s effective date, raising questions on the validity of the transfer pricing arrangements,” Watson cautions.

THE HELP

Considering the amount of change the new standard creates, there’s significant opportunity for advisory firms to step up to help their clients. According to PwC, businesses are likely to feel the financial impact of the new standard in several ways:

• Losing the benefit of off-balance sheet financing for operating leases could merit reassessing lease-buy decisions and trigger the need to reconsider debt covenant compliance.

• Pre-existing leases won’t be grandfathered, so most outstanding leases will come onto the balance sheet. Companies may need new processes, systems, and controls to account for current and future agreements.

• Any new lease accounting system must address taxes. The new assets recognized for operating leases will change companies’ book/tax difference computations and could affect certain state and local tax apportionment calculations and transfer pricing.

• For regulated companies, such as banks, broker/dealers, and insurers, new assets and liabilities on the balance sheet may affect regulatory calculations, in some cases requiring more regulatory capital.

Consulting and accounting firms will want to help clients get IT, tax, operations, treasury, and accounting together to ensure transition and compliance, create an inventory of lease contracts, and look at service contracts to identify potential embedded leases.

Watson thinks the latter is a potentially troublesome area. “Entities will be able to identify and catalog their more traditional lease arrangements but could forget about the balance sheet impact of embedded leases contained in service contracts,” he warns. “Even though embedded leases exist in U.S. GAAP today, often these arrangements are not bifurcated between an operating lease and service contract but instead are just recorded as a line item, such as a service contract expense, on the statement of operations. Under the new lease guidance, not bifurcating a material embedded lease from a service contract will result in the balance sheet being misstated.”

To start preparing for the new standard, Miller recommends companies identify stakeholders as soon as possible. A standard this far-reaching means many different functions, like IT, legal, accounting, procurement, real estate, operations, and so on, will need to be involved.

PwC recommends that advisory firms help clients discover if they know everything they lease by doing the following:

• Prepare an inventory of lease contracts and gather data on lease terms, renewal options, and payments.

• In a multi-asset lease, identify and account for each component as a separate lease. Gather data on lease elements and non-lease elements.

• Estimate future balance sheet amounts for operating leases. Consider whether debt covenants are affected by the addition of lease liabilities and assets to the balance sheet.

• Evaluate the leasing strategy for changes (e.g., lease-buy, shorter vs. longer terms, variable payments, or asset substitution clauses).

In other words, companies and their advisors have their work cut out for them; we’re talking about a whole new level of learning leases. “Almost everyone I know is finding out much more than they originally anticipated,” Miller says.