After years of reports that entities would one day be required to reflect all of their lease obligations on the balance sheet, companies finally have a major new accounting standard to adopt that will bring all but the tiniest assets and liabilities arising from lease contracts onto corporate balance sheets.
The Financial Accounting Standards Board has published its long-awaited Accounting Standards Update No. 2016-02 to require companies to book an asset and a liability for any lease obligation that stretches for more than 12 months. That’s a sea change for companies who have followed historical rules since 1976 that have required only capital leases, or those treated like the purchase of an asset, to be reflected on the balance sheet. More than 10 years, ago, the Securities and Exchange Commission estimated some $1.25 trillion in assets escaped public company balance sheets as a result of that treatment.
Now the work begins for companies to learn the requirements, determine the impact, plan for adoption, and prepare for the fallout consequences of bulking up the balance sheet with assets and liabilities that have long been reported only in footnote disclosures. The standard takes effect for public companies in 2019, with three years of comparative data required at that time. That means lease information beginning in 2017—10 months from now—will need to reflect the new standard when it is reported in 2019.
“For years, our focus has been on analysis of the proposals and trying to influence the direction of the standard,” says Ralph Petta, president and CEO of the Equipment Leasing and Finance Association. “Now we’re pivoting to educating our people about what they need to communicate to anybody related to the acquisition of an asset and how you book the asset.”
The first step, say partners at KPMG, is training and education. “You have to start with training in the organization so you have an understanding of what the new requirements are,” says Kimber Bascom, partner and global leasing standards leader for KPMG. “Until you do that, it’s hard to react to them.”
“For years, our focus has been on analysis of the proposals and trying to influence the direction of the standard. Now we’re pivoting to educating our people about what they need to communicate to anybody related to the acquisition of an asset and how you book the asset.”
Ralph Petta, President and CEO, Equipment Leasing and Finance Association
Training must extend well beyond the accounting department, adds Dean Bell, a partner and leases implementation leader at KPMG. “You need a team that incorporates the entire company,” he says. “You will need a lot of collaboration in the overall approach. People have to understand this is not just a finance issue.
FASB’s new standard retains many of the concepts and principles around lease accounting that are present in current accounting standards. Today, companies have two types of leases—operating or capital—with the classification driven by a handful of bright-line, prescriptive tests. Only capital leases are required to be added to the balance sheet.
The new standard retains the same basic classifications, but it requires both types of leases to be reflected with an asset and liability added to the balance sheet. Even the income statement effect from current GAAP will be carried into the new standard. Capital leases, or finance leases as they are called under the new standard, will be recognized with amortization and interest expense reflected in the income statement. Operating leases will be recognized on a straight-line basis, as they are today, as if they were a rental agreement.
Below FASB explains what the new guidance hopes to achieve.
Under the new guidance, a lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months.
Consistent with current 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. However, unlike current GAAP—which requires only capital leases to be recognized on the balance sheet¾the guidance in the ASU will require both types of leases to be recognized on the balance sheet.
The ASU permits private companies to use risk-free rates when determining the present value of lease liabilities.
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. These disclosures include qualitative and quantitative requirements, providing additional information about the amounts recorded in the financial statements.
As previously indicated, the accounting by organizations that own the assets leased by the lessee—also known as lessor accounting—will remain largely unchanged from current GAAP. However,
the ASU contains some targeted improvements that are intended to align lessor accounting with the lessee accounting model and with the updated revenue recognition guidance issued in 2014.
What About Transition?
The ASU requires reporting organizations to take a modified retrospective transition approach (as opposed to a full retrospective transition approach). The modified retrospective approach includes a number of optional practical expedients—which are described in the final standard—that organizations may apply.
An organization that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with current GAAP unless the lease is modified. However, lessees are required to recognize on the balance sheet lease assets and lease liabilities for operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under current GAAP.
“The accounting itself is not that hard,” says Michael Keeler, CEO of LeaseAccelerator, a software provider. “If companies do capital leasing today, this is maybe a quarter step in terms of the difference. What is important here is the magnitude of the impacts.”
Moving today’s operating leases from footnotes to the face of the balance sheet will heighten the examination on the data, the disclosures, and the controls, says James Barker, senior consultation partner for leases and real estate with Deloitte’s audit practice. “The scrutiny is going to be stepped up,” he says. Systems and processes will go under the microscope to assure the population of lease obligations is complete, that the data is accurate, and that the internal controls over that information are sound, he says. “From a systems standpoint, that means making sure you have the right capability to capture that information and provide it in the right format.”
That will include assuring companies have fully captured lease obligations that might be embedded in other service agreements, says Barker. Companies often have service contracts with vendors that might include use of equipment. Under the new leasing standard, those arrangements might include a leased asset and liability that must be added to the balance sheet, he says.
“In the past, the distinction between the equipment lease and the service arrangement was less significant,” says Barker, because both elements of that contract would flow through the income statement as expense to be recognized as incurred. “Under the new standard, if you don’t identify that lease, you’ve misstated your balance sheet.” Companies will need to establish controls to call out such arrangements and assure they are added to the lease portfolio.
As companies study the new accounting requirements and consider how they will meet them, they likely will have to consider whether they need new IT systems, says Sheri Wyatt, managing director in PwC’s assurance practice. “We are talking to companies about devising plans for how they will accumulate the data,” she says. “It’s still questionable whether spreadsheets used today will suffice. From a control and change management perspective, using spreadsheets to manage the asset and liabilities that will go on the balance sheet may become cumbersome.”
The analysis will depend, says Ryan Brady, senior manager in the accounting principles group at Grant Thornton, on the size of the company and the extent of its lease portfolio. “A lot of companies today don’t have a dedicated lease accounting system,” he says. “It may be more of an ad hoc process. A lot of companies are ramping up to provide those solutions, and a lot of companies are probably going to need to implement new systems.”
KPMG’s Bell says the key message for now is for companies to get started. “I don’t think it’s healthy for anyone to wait,” he says. “This is not going away, and it will take some time to implement the standard well.”