The New Era of Lease Accounting and Why You Should Prepare Now

Overview

In addition to the required implementation of ASC 606, the new Revenue Recognition accounting standard (currently in progress for privately-owned organizations), now a seismic change in the way leases are accounted for, must be implemented.

For many years there has been agreement about the deficiencies associated with reporting the distinction between operating leases, which are expensed currently (resulting in off-balance-sheet financing), and capital/financing leases, which are capitalized on the balance sheet as assets and obligations, and are eventually amortized. After years of debate about how leases should be better accounted for, the new era has arrived.

In 2016 the Financial Accounting Standards Board (FASB) issued Accounting Standards Update number 2016-12, “Leases (Accounting Standards Codification topic 842, or ASC 842)". Contemporaneously, the International Accounting Standards Board (IASB) issued International Financial Reporting Standard (IFRS) 16, ”Leases”, which also requires capitalization of all leases. In short, GAAP now requires that all leases that span more than one year in duration must be capitalized as right-of-use assets and related liabilities.

The new lease accounting standard must be implemented beginning January 1, 2019 for public companies and certain special purpose entities; and other entities beginning January 1, 2020. 

Technical difficulties

The effect of this standard will vary by entity, depending on the nature of the leasing activity, the structure of the leases and the extent of decentralization relative to the new accounting requirements. In many entities, this represents far more than a different way to account for and report on the same information.

Compliance with ASC 842 involves a myriad of new technical considerations. Among many other factors, organizations must address the following: the new definition of a lease, whether assets associated with leases are explicitly or implicitly identified, separation of lease and non-lease components and rights to control the use of and obtain substantially all of the economic benefits of identified assets.

With respect to classification for reporting purposes, there is extensive guidance, and ASC 842 and IFRS 16 have differences to be addressed. ASC 842 requires lessees to classify a lease as either a finance lease or an operating lease (both of which are capitalized), while lessors will classify a lease as either a sales-type, direct financing or operating lease. Under IFRS 16, lessees will account for all leases in a manner similar to finance leases, while lessor accounting is virtually unchanged. 

The journey

As companies begin the journey, many realize it is more complicated than imagined. The new standard requires tighter integration between lease administration, lease commitment and lease accounting, together with more robust policies, processes, systems and reporting. Organizations will no longer be able to enter into a lease of any type and dismiss it from central consideration. Ongoing monitoring is necessary, including consideration of possible impairment. Significant additional data must be maintained.

A project plan and an implementation monitoring processes are critical to successful compliance in the time allotted.

Such a project plan should include:

  1. Identify the current state of leasing activities and the stakeholders involved;

  2. Pinpoint impacts and changes resulting from the new standard;

  3. Design solution to capture new lease data requirements and address financial statement impact as well as other impacts (debt covenants, financial ratios, lease or buy decisions);

  4. Implement new accounting policies, processes, controls, systems and reporting; and

  5. Finally, transition to the new standard.

Technical accounting expertise is necessary to interpret and report in compliance with the new standard. This is a different skill set than is required to transform the organization in light of the standard. There is a need to develop a strategy and an implementation roadmap in order to effectively accomplish a challenge of this magnitude.  

Public companies still in the process of implementing the new standard will likely need additional resources to comply by January 1, 2019. Now is the time for all other organizations to begin the process of implementation.

Challenges and complexity

As planning for ASC 842 begins, examples of the challenges organizations may face are:

  1. Manual lease tracking and/or disparate systems of record;

  2. Quantity of unidentified/untracked leases, like equipment leases and embedded leases (the right-of-use assets embedded in other contracts, like the outsourcing of IT infrastructure);

  3. Implementation of a sustainable solution prior to the deadline;

  4. Negative impact on key financial metrics and debt covenants;

  5. Need for broad organizational involvement and lack of resources to execute; and 

  6. Lease-or-buy decision making may need change

The transition to the new standard can be complex. Dimensions of impact to be considered include:

  1. The effect on internal and external stakeholders;

  2. The effect on operations;

  3. New policies, processes and systems;

  4. New internal and external reporting;

  5. Need for program management; 

  6. Training and knowledge sharing; and

  7. Details must be considered in each dimension of impact.  

In summary, the standard requires tighter integration between lease administration, lease commitment and lease accounting, together with more robust policies, processes, systems and reporting. 

Data is a critical gap

Data is a critical gap. Today 84% of organizations manage leases in Excel, 70% extract key terms manually and only 10% utilize lease management systems. Companies will need to collect a significant amount of data, modify or implement new lease-management software and update their business processes accordingly. 

To comply with the new standard, all real estate, equipment, embedded and other leases must be identified. Then, a significant amount of new information must be collected, formatted, integrated with core financial systems and reported. 

The new process will involve the cooperation of accounting with those procuring the leases. Where there are more than 200 leases involved, a software application or an upgrade of existing software will enhance the capability of the organization to implement and sustain compliance with the standard. This will require the cooperation of IT stakeholders with respect to the IT infrastructure as well as the reporting and analytics layer. 

There are a growing number of specialized software applications that facilitate the new accounting for leases. The alternatives differ by size of organization they serve and to the extent of which they handle the end-to-end process.  The decisions to select, implement and learn to maintain such new or improved, specialized software are complex. The time constraint imposed by the compliance deadline increases the challenge even more. 

Lease accounting transformation leverage

 

Many organizations realize that ASC 842 compliance requires a transformation in the way leases are accounted for. After implementation of the new Revenue Recognition Standard (ASC 606), they understand the excess time and resources required for success. They recognize that involvement on the front end of an outside-specialized-strategic resource can significantly increase the likelihood of success, while minimizing the distraction from core business priorities.

Third party strategic leadership in transformation planning, technical accounting decisions, performance management, data and digitization and program and project execution can make the difference between success and failure in this important endeavor.

Tatum Performance Optimization (TPO) consulting is the answer. A robust, streamlined, sustainable approach is offered, driven by deep strategic and technical expertise and capabilities spanning the entire lease accounting journey. For more information on ASC 842 and what your organization can do to implement the new standard, visit our website here to learn more about our TPO lease accounting services. The Managing Director of TPO, Tony DellaTorre, has more than 25 years of consulting services experience within the office of the CFO and is available for immediate assistance. His email address is tony.dellatorre@tatum-us.com. His direct phone number is 404-418-4215.



 


about the author

Jim Swartz - Southeast Managing Partner

Prior to joining Tatum, Jim spent seven years leading his own consulting company and started and co-led an RPO firm in New York. Earlier in his career, Jim was CEO of Talent Tree and COO of Romac International, the predecessor of Kforce. Previously, he was a CFO in the real estate industry and began his career at KPMG. Jim holds a BBA in Accounting from Georgia State University and he is a CPA.