With work winding down to get ready for the massive shift in how to recognize revenue, the next major accounting change exercise still awaits—lease accounting.
Accounting Standards Codification Topic 842, which contains the new rules that bring virtually all leases onto corporate balance sheets, takes effect Jan. 1, 2019. Staff members at the Securities and Exchange Commission are practically pleading with preparers to make progress sooner rather than later, so that any accounting or systems issues can be raised and addressed along the way.
At a recent national accounting conference, Sagar Teotia, deputy chief accountant at the SEC, said companies really need to dig into their lease contracts, and even executory or other service-oriented contracts, and figure out where the provisions of Topic 842 apply. “Doing that work will let you know how much more work you have to do,” he said, such as whether a given company can handle the new accounting with existing systems or will need to invest in new technology.
The SEC, the major accounting firms, and the Financial Accounting Standards Board are standing by to answer questions and address problems, said Teotia, but they can’t address them if they aren’t alerted to them, he said. “I would encourage preparers to flush out their questions now,” he said. “Look at your leases. If you think there’s an accounting question in them, take them to your accounting firm, to us, to FASB.”
FASB recently signaled that it plans to give companies some major relief to ease their transition to the new accounting rules, which require companies to bring leased assets and their related liabilities into accounting systems with greater precision than they’ve perhaps used in the past. Leases have always been subject to footnote disclosure, but now companies need to add them to the balance sheet and reflect the cash flow effects in the income statement.
“I would encourage preparers to flush out their questions now. Look at your leases. If you think there’s an accounting question in them, take them to your accounting firm, to us, to FASB.”
Sagar Teotia, Deputy Chief Accountant, SEC
While the adoption of any new accounting standard would normally involve the application of the new rules to all periods presented in the primary financial statements, FASB is planning to change the lease rules to permit companies to adopt the new accounting beginning in 2019 without requiring restatement of historic periods. Investors would have to rely on historic footnote disclosures, as they do currently, to understand a company’s lease obligations.
“We screamed with joy when we realized the possibility” of such relief, said Adena Lerner, controller at General Dynamics Mission Systems, at the same accounting conference. The joy was short-lived, however, as the task at hand was still daunting enough, she said.
General Dynamics has 26,000 leases throughout its “highly decentralized” organization, said Lerner. Each one must be read and analyzed, looking for any number of dozens of terms and conditions that must be reflected under the new accounting. The relief proposed and likely to be approved by FASB “simplifies the dual reporting,” said Lerner, “but we are not taking our foot off the gas.”
With the relief from historic period recognition, FASB also is proposing to simplify the accounting for lessors, dropping a requirement to separately recognize lease and non-lease components in rental agreements. Cathy DeGenova, director of SEC reporting and technical accounting at Avis Budget Group, said she was “still smiling” over that additional planned modification of the original requirements.
SEC consultations on lease accounting questions
Minimum Rental Payments
The first transition topic I will discuss relates to the lessee’s determination of remaining minimum rental payments for purposes of the lessee’s transition entry upon the adoption of ASC 842, for arrangements historically accounted for as operating leases.
The transition guidance in ASC 842 requires the lessee to initially measure the lease liability using the remaining minimum rental payments (as defined by ASC 840). One accounting question raised to the staff related to whether the lessee’s initial lease liability recognized in transition should include or exclude the portion of the fixed, gross rental payments that represent executory costs, such as insurance, maintenance and/or taxes. Registrants sought clarification from the staff on this issue as the measurement of the lease liability recognized in transition is directly impacted by the entity’s determination of remaining minimum rental payments.
It was observed that under existing GAAP, some lessees currently account for the entire rental payment as a minimum lease payment while others exclude from the minimum lease payment the portion representing executory costs connected with the leased asset. Some registrants concluded that executory costs should be included in minimum rental payments in transition consistent with their existing accounting policy to include executory costs as a portion of minimum lease payments under ASC 840. Those expressing this view asserted that “remaining minimum rental payments” should be derived from the definition of “minimum lease payments” in ASC 840, which they historically viewed as inclusive of payments attributable to executory costs as the guidance in ASC 840 refers to executory costs as a portion of minimum lease payments. Alternatively, others concluded that executory costs should be excluded from minimum rental payments consistent with their existing accounting policy to exclude executory costs from minimum lease payments under ASC 840. Those expressing this view generally agreed that the “remaining minimum rental payments” should be derived from the definition of “minimum lease payments” but concluded that executory costs were excluded from minimum lease payments as they viewed the guidance in ASC 840 as emphasizing the exclusion of executory costs from minimum lease payments.
In considering each view, the staff observed that the term “minimum rental payments” is not explicitly defined in ASC 840. As a result, the staff did not object to registrants consistently applying their historical accounting policy conclusions regarding the composition of minimum lease payments when concluding whether executory costs should be included in remaining minimum rental payments for purposes of establishing the lease liability in transition.
Incremental Borrowing Rate
The transition guidance for lessees clearly states that upon adoption, the lessee should measure the lease liability using the discount rate established as of the beginning of the earliest period presented in the financial statements or the commencement date of the lease, if later. However, registrants observed that the transition guidance does not specify whether the discount rate selected should be based on the original lease term or the remaining lease term.
Some registrants concluded that the lessee should select a discount rate based on the original lease term as they believe that rate better reflects the borrowing rate embedded within the contract when the lessee entered into the arrangement. Other registrants concluded the lessee should select a rate based on the remaining lease term as they believe the rate more accurately reflects the rate applicable to the remaining lease liability recognized in transition. The staff observed that the transition guidance does not specify the lease term that should be used to determine the discount rate and further observed that either rate used in transition may significantly differ from the rate that would have been determined at commencement of the lease (i.e. the original commencement date of the lease).
The staff concluded that the selection of either of these rates, that is either the rate based on the original lease term or the remaining lease term, is reasonable and ultimately did not object to a registrant’s consistent application of either approach to determine the lessee’s lease liabilities in transition.
Source: SEC staff speech by Michael Berrigan
Neither accommodation, however, will alter Avis’ planned implementation, DeGenova said. “It simplifies it a bit but it does not alleviate the effort to comply,” she said. “The timeline won’t change.”
Avis began its implementation activity in August 2016, said DeGenova, by assessing its global lease population, which consists of 4,000 leases. The company gathered lease information from its asset registers, spreadsheets, and its profit and loss information.
The company began with the “gorilla leases,” said DeGenova, or the obvious ones that were most critical in the company’s portfolio. Then it worked through the P&L and accounts payable systems from a materiality perspective to find more and more leases. Through the process, the company centralized and digitized its leases, “which was a very helpful process,” she said.
The process involved a good dose of education within the organization to assure accounting and real estate professionals understood the technical requirements of Topic 842, said DeGenova. It also involved some outreach to folks in operational roles as well. “It was important to convince others of the value of this project,” she said. “Historically accounting change projects are handled from accounting, but there are operational benefits to have leases handled from a central process. This project is critically dependent on other people.”
At General Dynamics, the biggest challenge in preparing for the new lease standard has been the gathering up of all leases, the data collection, and the centralization of the process, said Lerner. “Finding all the leases was one thing, but then you have to get the actual document,” she said.
Are they legible? Are they in a foreign language? The company opened a cloud-based platform into which lease data could be input and assembled, Lerner said.
If the initial push to gather lease data wasn’t enough, the company also needed to establish a way to assure new lease data would continually be added to the system as it is created. “That’s constantly in the back of my mind,” said Lerner. “Who are the touch points? We have to ensure they’re comfortable that this is not a one-time call for data. It’s ongoing.”
Resource constraint has been a big concern at General Dynamics, said Lerner. “We heard a quote in 2016 that for every lease it would take two to three hours of analytics to get the terms into the system,” she said. “Sadly, that held true.” The company had to engage outside help through PwC to achieve the task, she said.
General Dynamics has also made a push to educate those in procurement and legal functions who are entering into lease arrangements on behalf of the company to understand the accounting implications of what they establish, said Lerner. Those negotiating terms and conditions need to understand the positive and negative implications to the company of agreeing to certain terms, she said.
Michael Berrigan, professional accounting fellow at the SEC, said at the conference it’s important for companies to engage in “thoughtful planning and timely implementation” of the standard. Just as with the revenue recognition implementation, companies need to give themselves plenty of time to apply the new requirements and arrive at the necessary judgments, not to mention establish the necessary internal controls.
“Identification of contracts that represent or contain a lease is a key step,” said Berrigan, necessary to fully assess the scope of contracts that are subject to the new standard. “Once the complete inventory of contracts is identified and analyzed, I believe a company can, among other things, better assess the additional levels of effort required for implementation.”
James Barker, a senior consultation partner at Deloitte & Touche, said the relief provisions FASB is preparing represent “a big deal” for companies in transitioning to the new lease accounting. But they should not slow their implementation efforts as a result of it. “Don’t take this as a gift as if things will magically come together,” he said.
He sees many companies underestimating the effort that will be necessary to collect lease data and aggregate it into a centralized system, not to mention determining whether they have adequate systems to accomplish the new accounting or they may need to invest in something new. “All of those things are still out there,” he said.