Q2 2019 - ASC Topic 842, Leases: Considerations

FASB issued ASC Topic 842, a new lease accounting standard that fundamentally changes the accounting guidance governing all leases. For most entities, this will have an impact on equipment and real estate leases. The goal of ASC Topic 842 was to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the statement of financial condition and disclosing key information regarding leasing arrangements.

This new standard will have an impact on a firm’s accounting and financial reporting functions and may require an investment in software solutions to assist in the cataloging and maintaining the relevant information for the required accounting presentation and disclosures.

The effective date for ASC Topic 842 for the new standard is as follows:

Public Entities – Fiscal and interim years within those years beginning after December 15, 2018. For public entities with calendar year-ends, the adoption date is January 1, 2019. Full retrospective application is prohibited. An entity can choose to apply the provisions at the beginning of the earliest comparative period presented in the financial statements or at the beginning of the period of adoption.

All Other Entities – Fiscal years beginning after December 15, 2019, and interim periods within those fiscal years beginning after December 15, 2020. For all other entities with calendar year-ends, the adoption date is January 1, 2020. Full retrospective application is prohibited. An entity can choose to apply the provisions at the beginning of the earliest comparative period presented in the financial statements or at the beginning of the period of adoption.

Some keys changes under ASC 842 are as follows:

1. The definition of what constitutes a lease has changed.
2. For lessees, all leases longer than 12 months will be recognized on the balance sheet as either an operating or finance lease.
3. Classifications as either an operating lease or finance lease will have impacts on the Statements of Operations and Cash Flows.
4. Lessees must apply certain criteria to determine whether leases include a lease and one or more non-lease components, which should be allocated.

Accounting Treatment Components:

For a Finance Lease:

1. Right to use asset and lease liability (Statement of Financial Condition).
2. Amortization and interest expense (Statement of Operations).
3. Cash paid for principal and interest payments (Statement of Cash Flows).

For an Operating Lease:

1. Right to use asset and lease liability (Statement of Financial Condition).
2. Single lease expense on a straight-line basis (Statement of Operations).
3. Cash paid lease payments (Statement of Cash Flows).

Initial Steps

1. Understand that the definition of a lease has fundamentally changed. Under current GAAP, determining whether a lease is on or off the balance sheet is relatively straightforward and leases can be structured in order to achieve either outcome. Under ASC Topic 842, Leases, all contracts meeting the definition of a lease will be presented on the balance sheet, even if the lease meets the criteria of an operating lease.
2. Evaluate how the new rules could impact existing leases and affect current agreements that were not previously considered a lease and new lease agreements.
3. Assess the impact on the internal control process.

Potential Challenges

1. Gathering an inventory of all lease agreements, vendors, and monthly payments. Assess whether your entity has the resources and technology to capture all necessary data.
2. Maintaining the assembled inventory for any expired or new leases on an ongoing basis.
3. Determining if an embedded lease exists, which requires a thorough understanding of all agreements with vendors.
   Potential challenge: If an entity controls an asset (an asset is specifically designated for the entity), you may have an embedded lease. For example, if an entity contracts with an outsourced information technology provider and requests a dedicated server, this would potentially be categorized as an embedded lease and the new leasing requirements would apply. If the arrangement with the information technology provider does not require a dedicated server in this example, then ASC Topic 842 does not apply. In addition, if categorized as an embedded lease, determining the applicable interest rate (incremental borrowing rate) to be to be applied could be challenging, especially, if the entity has not recently entered into a financing arrangement.
4. If there are numerous leasing arrangements (more than 20), an entity should consider purchasing a software solution to assist in the maintaining the lease inventory and the accounting entries.

As with most accounting rule changes that impact an entity, if you fail to plan, you plan to fail. As such, if you have not commenced the gathering of information exercise and assessed the accounting implications, there is still time left to be in a position to be in compliance upon the effective date.

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