FASB New Standard Brings Most Leases Onto the Balance Sheet

After working for almost a decade, the Financial Accounting Standards Board (FASB) has annually issued its new standard on accounting for leases, ASU 2016-02.(i) The International Accounting Standards Board (IASB) issued its own version, IFRS 16, (ii) in January 2016, and although the project was a convergence effort and the boards conducted joint deliberations, there are differences. Developing an approach that requires all operating leases to be recorded on the balance sheet proved to be no small task. During the process, the boards had to grapple with questions such as (1) whether an arrangement is a service or a lease and (2) what amounts should be initially recorded on the lessee’s balance sheet for the arrangement.

Mission complete, the FASB’s new standard is now in place and introduces a lessee model that brings most leases on the balance sheet. The Wall Street Journal reports that doing so could increase liabilities of US public companies by about $1.5 trillion, according to the US Chamber of Commerce’s Center for Capital Markets Competitiveness (iii). While companies always had to disclose lease information, it was traditionally done in the footnotes of their financial statements and not in their balance sheets, where investors pay most of their attention.iv Both lessees and lessors are likely to face significant, additional reporting burdens. Being caught unprepared when standards go into effect is not an option–not in an era where strict compliance is essential. Plus, the reputational risk is far too great. But are companies ready?

It’s clear that creating a centralized, electronic repository of all equipment and real estate leases held should be a priority for companies with leased assets, given the fast-approaching deadlines. The new standard, which is effective on January 1, 2019, for calendar year-end public business entities, and January 1, 2020, for calendar year-end non-public business entities, represents a wholesale change to a company’s approach to lease accounting and financial reporting. Many organizations are spending the balance of 2016 consolidating lease data so that calculations can begin in 2017 as ultimate compliance with these new rules in 2019 will require look back reporting for 2017 and 2018. Still, despite pending deadlines, very few report they are ready.

The Time to Move Is Now
In fact, just 9.8 percent of more than 5,400 financial and accounting professionals say their companies are prepared to comply with the new FASB and IASB lease accounting standards, according to a recent Deloitte poll.(v) Moreover, only 15 percent of respondents expect compliance to be easy. Understandably, sectors with higher numbers of leases, like retail, expected the highest level of difficulty implementing the lease accounting standards.
Having a lot of leases or just a few complex leases in a portfolio can create management challenges. Companies have to decide which contracts apply to the new rules. Other difficulties can arise due to disparate tracking systems, expanding global footprints, and M&A activity.

Understanding the application of judgement and obstacles to implementation can help companies become more successful in their approach. Respondents of the poll said the top challenges to lease accounting implementation are collecting necessary data on all organizational leases in a centralized, electronic repository (33.3 percent), and instituting processes to evaluate quarterly adjustments for the balance sheet, as well as pro t and loss statements (20.5 percent).

In order to facilitate an efficient and streamlined implementation, organizations should consider developing their implementation roadmap now. Some noteworthy items to consider during the development of an implementation road map include the following:

A retailer’s judgment in distinguishing between leases and services agreements be- comes more critical under the new guidance as failure to appropriately identify a lease may result in balance sheet misstatement. By and large, in accordance with ASC 842, a lease agreement has to convey the right to control the use of an identified asset. To control the use, the lessee should have the right to direct the use of the asset over the lease term and obtain substantially all of the economic benefits from the assets use. If the company paying for the lease has the ability to control how and for what purpose the real estate or equipment being leased is used, and obtains substantially all the economic benefit of the asset used, the agreement likely belongs on the balance sheet.

For example, a retailer enters into a third-party logistics contract. The agreement includes the use of the facility and equipment that is essential for the services to be performed by the third party. The re- tailer is expected to utilize substantially all of the facility’s capacity. The retailer may decide the type of staff to be employed and may prescribe the various techniques used by management throughout the logistics process. The assessment of the arrangement may conclude that the retailer controls the use of the assets. Despite the fact that the third party is operating the facility and equipment, the control of the use of the specific assets identified would likely result in a lease that would be required to be recorded on the balance sheet under the new standards. Operational control of the facility and equipment doesn’t trump the authority that the retailer has regarding decisions affecting the use of the assets. Companies have to understand the standards and apply them to individual contracts to stay in compliance. The more contracts there are to go over, the more daunting the task.

It’s not uncommon for retailers to have numerous lease agreements at multiple decentralized locations and may, in many instances, maintain their lease data in spreadsheets or physical documents. Con- sequently, collecting and abstracting data needed for applying the lease standards may be time-consuming and resource- intensive. Even if the data is in an electronic format, it may reside in disparate systems. Furthermore, companies may need to gather required information that was never contained in the original lease agreements. Acquiring this data may be particularly challenging for multination- al retailers whose lease documentation may be prepared in a foreign language, and could also vary as a result of local business practices.

Along with data management, retailers will likely need to identify an appropriate information technology system to facilitate timely, accurate, and reliable quarterly and annual financial report- ing. The extent of such enhancements will be based on the size and complexity of an entity’s lease portfolio and its existing leasing systems. As with any change to existing systems, an entity should consider the business ramifications (i.e., the potential impact on existing processes, systems, and controls) and the requirements of system users (e.g., the entity’s legal, tax, financial planning and analysis, real estate, treasury, and financial reporting functions). Ultimately, lease administrators need to abstract and manage contract data in an easy-to-use, centralized system, based on user roles. Further, the organizations accounting and financial reporting team will need assistance with their periodic financial statement reporting and impact analyses.

To a significant extent, current lease data systems are used for operational purposes and aren’t under formal examination. Given the increased relevance of leasing data to the financial statements as a result of the new standards, organizations may face additional scrutiny from auditors and regulators regarding the design and effectiveness of controls associated with such systems. Organizations will likely need to examine their internal controls related to their processes for capturing, calculating, and accounting for their leases. If additional internal controls or processes are needed, companies may also need to issue organizational communications and establish change management and employee training programs.

While the new lease accounting standards may seem a niche accounting or nance concern, they are not. It is recommended that all leaders of organizations with real estate or equipment leases should take the time now to learn about the potentially broad-reaching impacts of these new accounting requirements. Compliance will likely require input from multiple stakeholders from different parts of the organization. Having top leaders’ support could really make a difference in successful implementation.

There are early steps to evaluate the implications of the new lease accounting standards. Here are some considerations around where to start:
• Assess your organization’s current lease landscape, discerning lease volumes and types, availability of electronic lease data and data gaps within it, as well as any potential accounting, tax, and process-related challenges.
• Develop a cross-functional project management team to coordinate implementation activities with necessary resources to support it.
• Build a granular implementation plan to manage efforts that may span various business units, file types, IT systems, languages, and geographies.
• Plan to invest time in lease data abstraction since this is a long lead time activity that likely requires a detailed plan and resourcing.

• Determine if your organization’s IT infrastructure can support compliance with the new standard(s) with which it must comply, including comprehension and management of new storage, calculation, and reporting requirements.