After years of discussion and a host of draft documents, in January of 2016 the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) each released new mandates related to accounting for leases. While companies have always had to disclose their lease data, they’ve done so only in the footnotes of their financial statements. The new lease accounting rules move lease information to the balance sheet. The Wall Street Journal predicts this will increase the stated liabilities of public companies by at least $1.5 trillion.
Off-balance sheet accounting for leases has been a subject of controversy since the late 1990s. In 2005, the SEC decided companies needed a new approach for reporting for leases. FASB, IASB, and GASB set out to address it. In 2010, the Boards considered significant changes to the way companies report leased assets.
The Boards issued a proposal that moves all lease agreements - other than leases with a duration of less than 12 months - onto the balance sheet. All leases will be considered “right-to-use” assets and a lease liability to make future payments. The new mandate gives potential investors a more accurate view of the company’s assets and liabilities (lease payments and obligations).
"Leasing is an important source of finance to business. Therefore, it's important FASB accounting for leases provides users of financial statements with a complete and understandable picture of an entity’s leasing activities.”
-FASB Discussion Paper
The Boards issued two exposure drafts, the first in 2010 and the second in 2013. Following the release of the drafts, the Boards undertook extensive outreach. They completed fieldwork meetings where members of the Boards and staff visited financial statement preparers, both public and nonpublic, lessees and lessors.
After years of rumors of an imminent announcement, on January 26, 2017, the Boards released the new standards - FASB ASC 842, IASB IFRS 16, and GASB 87.
For public companies, the new FASB mandate applies to financial statements for reporting periods after December 15, 2018. For private companies, the rules apply to reporting periods following December 15, 2020.
The implementation date for IASB is January 1, 2020. The GASB (Government Accounting Standards Board) standards changes apply to reporting periods that begin after December 15, 2020.
*Note: It was initially assumed companies would have to provide two years of look-back financials, essentially making compliance required for public companies in 2017. However, late in November 2017, FASB issued a proposal to eliminate the look-back requirement.
FASB has retained a two-part classification for leases – finance and operating.
Leases are considered finance type if:
All other leases would be considered Operating Type Leases.
The IASB and GASB have decided to account for all leases more than 12 months as finance type leases.
Real estate agreements are an obvious form of lease financing for companies. Other lease types are included in the mandate, too. You must also consider equipment leases, vehicle leases, embedded leases, and master leases of more than 12 months.
All public and private companies will be required to follow the new lease accounting standards. Those with many leased assets will see the biggest impact. Although real estate leases are often the largest line item, companies may have many more equipment, technology, vehicle and other lease contracts. If you're in the retail, healthcare, financial services, and telecommunications industries, for example, you probably have relatively large real estate lease expenses. These will need to be capitalized. But even businesses without leased real estate will need to address the new standards.
Yes. Many companies will view the standards change as an opportunity to review and update leasing practices from stem to stern.
In some cases, the new standards will impact the buy vs. lease decision. Lease negotiators may want to move away from gross leases. Instead, they'll call out service rent and other charges that don’t need to be capitalized.
The practice of lease accounting will come under higher scrutiny by auditors and financial managers than ever before. These governing bodies will most likely implement new levels of review and audit trails.
The short answer is right now.
According to the Journal of Accountancy, “Almost one-fourth (23%) of companies surveyed... said they hadn't started their lease accounting adoption efforts yet... 31.4% of more than 2,150 executives said their organizations were unprepared to comply with the new standard.”
We've written all about the inevitable shortage of software vendors if you want to check it out.
The SEC’s Division of Corporate Finance selectively reviews filings made under the Securities Act of 1933 and the Securities Exchange Act of 1934 to monitor and enhance compliance with applicable disclosure and accounting requirements.
If a public company is selected, the cost associated with the following should deter companies from misstating their financials:
Compliance with the new standard is required for private companies starting with reporting periods that begin after December 15, 2020 (meaning 2021 for organizations that operate on a calendar year basis). However, private companies with public debt, such as many hospital systems may be compelled to report based on the time frame for public companies. If you are unsure, please consult your CPA or audit firm.
Every organization will need to develop its own project plan, but there is a basic path that most will follow.
A smooth transition will require a cross-functional team working together to cover all aspects of compliance. The corporate finance and real estate teams will ultimately do much of the heavy lifting when it comes to preparing for and complying with the new FASB standards; but it is an effort that spans multiple departments and functions.
The IT staff will often be involved in the process to implement controls over relevant lease data that is needed to comply with the new standards, as well as controls related to judgments, estimates, and management reviews.
Procurement and facilities teams will also be involved because non-real estate leases such as office and manufacturing equipment will be included in the new calculations.
Investor relations, PR, and legal professionals will also need to be informed about the impact of the new lease accounting standards on the balance sheet. HR also needs to be involved, as the company may need to ramp up staffing or redeploy existing personnel to meet project deadlines. Executive compensation tied to financial performance may also need additional review and potential revision.
Most organizations will need to make additional technology, services and/or human resources investments in order to comply with FASB 842 or IFRS 16. A key component of compliance will involve IT spending. The vast majority (92 percent) of respondents from The Great Accounting Challenge: KPMG’s 2016 Accounting Change Survey believe they will need to upgrade their IT system or invest in new technology because of the new lease accounting guidelines. In addition, 77 percent say that technology represents the most challenging part of compliance.
In addition to the technology, companies will need to budget for implementation, training, and post-installation follow-up.
Many organizations have a management system of some sort for real estate leases, but equipment and other lease contracts may be scattered throughout the organization. The first step to compliance is identifying every lease and assessing the accuracy of lease data in existing systems.
There is a wide range of data that is needed from any lease agreement in force for 12 months or longer in order to make the correct classification and complete the calculations. Some information is not commonly abstracted into lease accounting systems today, so organizations will need to determine if internal resources or a professional services partner will do this abstraction.
We’ll cover this more in-depth in the lease accounting compliance technology section of this page, but in most cases, existing technology will not be sufficient to support the new lease accounting standards. Some companies will need entirely new lease administration software, while others will need to purchase additional asset management technology from current vendors. In either case, the decision should be made early in the process so that data acquisition and implementation can begin quickly.
Certain lease terms may be better for organizations under the new standards. For example, some leases include service rent, which does not have to be included in the capitalization schedule, but don’t say exactly how much of the gross rent is service rent. Leasing teams may want to request more clearly defined lease terms in the future and may even want to renegotiate existing agreements. As we mentioned, the practice of leasing will receive greater attention and audit review, so approval requirements and internal audit plans may need to be revised.
Smart finance and real estate professionals see the new standards as a strategic opportunity to optimize lease accounting practices. Centralizing lease agreements provides the opportunity to use the consolidated lease data, improve capital project management, streamline operational maintenance, and optimize space planning, among other areas.
This is the perfect time to revisit the organization’s overall approach to lease management.
With Microsoft as an exception, not many companies have chosen to implement the new leasing standards early. However, many are far along the path to compliance. Those we’ve worked with have pointed to a few unexpected risks and challenges. Here are the potential points of failure to consider.
Some organizations have relied on the assumption that because they have software for managing real estate leases, they were prepared for compliance. What they failed to realize is that much of the information required for a correct lease classification is not usually abstracted from the lease today. In addition, much of the required information, like the net present value of the asset, or borrowing rates, isn’t in the lease at all. The bottom line is that collecting, and auditing required lease data is likely a bigger challenge than expected. Getting to work on it soon is essential.
Real estate leases may represent the highest dollar value, but often equipment and other leases, like embedded leases, far outnumber them. Equipment leases are less likely to be centrally managed if they are even tracked in a system at all. In some cases, many department-level managers can approve non-real estate leases, and each may be operating under a different set of controls. Enough time should be allotted to evaluating non-real estate leases and putting systems in place to administer them in alignment with the compliance requirements.
Because the road to compliance runs through a variety of different functions, organizations must take great care to engage in information sharing and involve the right subject matter experts. The most successful organizations define each role carefully and set up internal communications plans to keep everyone informed and on task.
The clock is ticking and time is running out to achieve compliance for public companies and private companies with public debt. Those who haven’t started yet have cause for concern. In addition to the strain that waiting until the last minute will put on internal resources, finance leaders should be aware that software vendors and professional services firms will be stretched thin as the deadline approaches.
Compliance with the new lease accounting standards is not a one-time event. Finance teams should review all ongoing leasing practices in order to minimize the balance sheet impact and make continued compliance seamless.
Choosing the best solution to support the new lease accounting requirements is the key to a successful transition. Each of the following capabilities and solution attributes should be considered.
Some vendors are offering a bolt-on FASB calculator that sits between the lease administration system and the accounting solution or ERP. This is a high-risk approach because many day-to-day leasing activities will trigger a schedule reassessment. For example, exercising a renewal, accepting tenant improvement allowances, or any change to rent payments will require a schedule revision. Since these activities are managed in the lease administration solution, an integrated compliance and management approach makes the most sense.
Compliance with the new leasing standards is complex, and there are many opportunities for incorrect calculations. The best vendors have partnered with CPA firms to ensure accurate calculations and the appropriate application of the rules.
Most organizations will need support for both real estate and equipment leases. Embedded leases and master leases are also common and should be considered. In addition to the asset type, look for a solution that supports both lessees and lessors. Even if you aren’t a landlord today, you may want to sublease space at some point, so it pays to invest in a solution that can handle this and other complex leasing scenarios.
It will be increasingly important to know who made changes to lease data and why. You’ll also want a record of when transactions are posted and by whom.
Once the lease administration solution makes the correct calculations for the capitalization schedule, it will need to send the appropriate journal entries to your accounting or ERP system.
Security has always been an important lease accounting consideration, but new mandates make it even more of a concern. Consider only vendors that conduct SSAE 16 audits, and offer three-factor authentication to ensure that your system is accessed by only those authorized to do so.
You may not know from the beginning how much help you will need implementing your new technology and getting ready to comply with the new lease accounting standard. Most vendors will provide technical implementation services, but the best partners also have a team of experts that can help with lease abstraction, data migration, and operational consulting.