Leases 2.0: Is your company ready for ongoing compliance?

Accounting Standards Codification Topic 842 on leases requires companies to elevate virtually all of their leases out of footnotes and on to the face of the balance sheet beginning Jan. 1, 2019, for calendar-year public companies. That means first-quarter filings will begin reflecting the new accounting rules, grossing up balance sheets for the first time with what are expected to be trillions of dollars in new assets and liabilities.

“There’s still some scrambling going on,” says James Barker, senior consultation partner at Deloitte, especially with respect to determining the incremental borrowing rate that should be applied. “We are still getting questions in that area.”

The standard requires companies to use a rate implicit in a lease contract as the discount rate for calculating the lease liability, but it leaves companies to determine exactly what that rate should be. That has led to a great deal of research and questions about how to determine the appropriate rate.

Beyond determining that rate, most companies have gathered their lease data and worked out how they will reflect leases for the first time, although they may still face additional work throughout 2019 to refine their processes before their first year-end reporting, says Barker. “Many of them are going to work out the kinks over the course of the year, and they’ve got some time to improve as they go through the year of adoption before they are audited for the first time,” he says.

“My impression is that most of the companies for whom this will be a relatively significant matter—meaning they have significant right-of-use assets they are adding to the balance sheet—are aware and are having discussions about this.”

Scott Muir, Partner, KPMG

Some companies are also still raising questions about how to handle sale-lease back transactions and build-to-suit transactions, says Anastasia Economos, a partner at EY. The accounting for such transactions is different under ASC 842 than under historic rules, so companies are still working to get that right upon adoption. And then there are disclosures, says Economos. “There are still a lot of systems challenges out there in terms of functionality and disclosures,” she says.

One of the ongoing accounting implications companies will face as they move past their first-quarter reporting is an impairment analysis of the new assets now moving on to the balance sheet. Companies are required under ASC 360 to regularly assess the value of the long-lived assets on their balance sheet and determine if any of them are “impaired,” or have diminished in value and therefore should be marked down.

The impairment analysis compares the carrying value, or the value on the balance sheet, for an asset to the undiscounted future cash flows associated with the asset, plus the eventual recovery amount on disposal of the asset. If the carrying amount is greater than the expected cash flows and recovery amount, then the asset is considered impaired and must be marked down. 

The new leasing standard under ASC 842 doesn’t change the longstanding impairment requirements for long-lived assets under ASC 360, says Scott Muir, a partner at KPMG. Instead, it exposes new assets to the impairment rules by requiring companies to put new assets on the balance sheet.

“My impression is that most of the companies for whom this will be a relatively significant matter—meaning they have significant right-of-use assets they are adding to the balance sheet—are aware and are having discussions about this,” says Muir.

Significance will vary, of course, depending on how many such new assets will be added to the balance sheet, and therefore subject to the impairment analysis. “Impairment testing is definitely one of the bigger issues companies will face,” says Angela Newell, national assurance partner at BDO USA. “I’m not sure companies have fully internalized this issue yet. We’ve seen a lot of companies that have not had the time or have not taken the time to implement a system that will help them manage the accounting moving forward.”

Companies that have dealt with any significant number of capital leases under historic accounting rules are likely to be quite familiar with the process, as capital leases already appear on the balance sheet and are subject to impairment testing. Leasehold improvements have also been subject to impairment analysis, whether the lease itself was on or off the balance sheet.

Companies in the retail sector are probably more familiar with the impairment analysis, says Newell. “Not every store they open turns out to be a winner,” she says. “That’s life for those industries. In other industries, where impairments may not be a fact of life, this may be a little bit of a sleeper issue.”

In fact, some companies may even be facing the impairment issue in their first period of reporting if they are adding leases to the balance sheet that already show signs of impairment, says Barker. “There are some situations, although rare, where companies might have to take impairments when they adopt the new guidance,” he says.

Some refer to those as “hidden impairments,” says Economos. “Did you have an impairment? Does it still exist? Did it exist prior to the effective date, and does it exist afterward?” It’s important to identify those issues at adoption, she says, because the effects can flow through equity at adoption rather than through earnings.

Beyond the impairment analysis, companies will also need to assure they are monitoring their lease obligations in light of new guidance in ASC 842 for ongoing compliance, says Sheri Wyatt, a partner at PwC. That includes, for example, considering the term of the lease in light of business decisions that might suggest the company plans to exercise a renewal even if it hasn’t already done so.

“The new standard requires an evaluation of whether the facts and circumstances have changed that could result in a change in lease term,” says Wyatt. If, for example, a company performs a significant leasehold improvement before exercising a renewal option, that’s a good indicator that the company will likely extend the lease.

Companies generally applied the necessary focus to get the opening balance sheet adjustments required to adopt the standard, but that kind of analysis will need to continue in subsequent periods to assure lease obligations are reflected appropriately, says Wyatt. “That’s going to require good communication with the accounting and the business people who are working closely with the asset,” she says