As lease rules advance, companies need to alert investors

Public companies still have several months before they are required to show their lease obligations on the balance sheet, but they should be prepared over the next few quarters to give investors increasing detail about the change that is coming.

Companies are required under Staff Accounting Bulletin No. 74, now codified under Topic 11-M, to give investors some advance warning about accounting standards that will become effective in future periods. The idea is to let investors know how the financial statements will change when they are prepared under new accounting requirements in future periods.

“It helps investors get a sense of the accounting changes that will be coming,” said Wes Bricker, chief accountant at the Securities and Exchange Commission, at a recent regional conference of the Institute of Management Accountants. “So investors have time to anticipate and build that into their evaluations. Then they don’t have to play catchup or discount their valuations until they get comfortable with the numbers.”

Bricker and his staff spent a great deal of time reminding companies of SAB 74 in 2016 and 2017 as they worked to implement Accounting Standards Codification 606 on revenue recognition. Even auditors were on notice that they should be scrutinizing disclosures as the effective date drew closer.

With that standard now in effect as of Jan. 1, 2018, the focus is turning to the next big accounting standard to be adopted, which is ASC 842 on leases. Companies are or should be working this year to prepare for that new accounting rule, which takes effect Jan. 1, 2019, for public companies.

Revenue recognition was an important standard because it had the potential to alter the top line in financial statements. New rules for lease accounting have a different profound effect, which is to gross up the balance sheet with trillions of dollars in leased assets throughout the United States that until now have shown up only in footnote disclosures.

As with the revenue adoption, experts are getting worried about the state of readiness at many companies to properly reflect leased assets and liabilities in financial statements as of the effective date. Many companies deferred implementation efforts on the lease rules, because they were consumed with preparing for revenue recognition last year.

“We are concerned some of our clients are not as far along as they probably should be,” says Angela Newell, a partner at BDO USA. Most waited to start adopting the leasing standard until after they completed revenue recognition, hopeful leases would not require as significant an adoption effort. “In some situations, that may be the case, but in others, it is not,” she says.

“Make sure the audit committee is asking the relevant questions about the company’s process and where they are in the process.”
Mark Shannon, Partner, Crowe Horwath

That may make it difficult for companies to increase their SAB 74 disclosure specificity as the year progresses, but Bricker makes it clear the staff will continue watching for incrementally more information. “SAB 74 is not binary—either I know the effect of the standard or I don’t,” Bricker said. “It’s designed to elicit a discussion of what you do know. Don’t say more than you know, but don’t say less than you know.”

There are legitimate reasons why many companies are not yet providing significant detail in SAB 74 disclosures, says Rohit Elhance, a partner at Grant Thornton. “One of the most significant impacts of the new standard is to put on the balance sheets the operating leases that are off balance sheet now,” he says. “But a lot of that information is included in filings under the existing disclosure regime.”

Companies are already required under current accounting requirements to quantify their operating lease obligations for footnote purposes, and they address lease obligations when they describe contractual obligations, says Elhance. That already tells investors more about what they can expect under the new accounting than they might typically have with other standards’ adoptions.

SEC on SAB 74 disclosures

The following disclosures should generally be considered by the registrant:
A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier. 
A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined.
A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made.
Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.
Source: SEC Codification of Staff Accounting Bulletins

Scott Muir, a partner at KPMG, says some companies are starting to advance the detail in their SAB 74 disclosures on the lease accounting standard simply by referring to those footnote disclosures. “They are letting investors and analysts know the amounts disclosed over here will effectively be coming on to the balance sheet in a future period once we adopt,” he says. “It’s sending you to a disclosure under current GAAP and saying here’s our undiscounted amount, so you should expect some discounted version of this is going on the balance sheet. We’re advising you’d start doing that as a minimum.”

Mark Shannon, a managing director at Crowe Horwath, says that’s a reasonable starting point, but there’s likely some additional analysis companies should consider as well, especially with each passing quarter. “There’s a continuum there for how easy it is for certain entities to quantify what their lease portfolio will look like at the end of the year,” he says.

As examples, the current year disclosure likely includes leases that will expire, leases that may not be renewed, or leases that may be renewed at different amounts, says Shannon. It might also include short-term leases that will not hit the balance sheet under the new accounting. The new standard also scopes in commitments that companies do not currently regard as leases, like obligations embedded in service contracts or certain types of easements.

James Barker, a partner at Deloitte, also cautions companies on simply referring investors to current footnotes as if numbers there are clear indicators of the future balance sheet appearance. “Internal controls around the preparation of SAB 74 disclosures are very important,” he says. “If companies come out with a quantitative metric for the impact of the new standard and it ends up being significantly off, they should expect to be asked why that happened. Was there a breakdown in the control framework around developing estimates? Rightfully so, companies need to be careful about what they say and when they say it.”

Shannon says he’s advising companies to be sure the audit committee is engaged and asking the right questions about the company’s implementation progress, internal controls, and SAB 74 disclosures. “Make sure the audit committee is asking the relevant questions about the company’s process and where they are in the process,” he says.