Microsoft Excel is a powerful spreadsheet program that many companies utilize for their data analysis and documentation.
The new FASB lease accounting guidelines put operating leases front and center.
In preparing for the transition to the new lease accounting standard, most of the focus has been on the changes to the actual accounting for leases. In a nutshell, virtually all leases with terms over 12 months are required to be recognized on the balance sheet with an ROU asset and corresponding lease liability. For private companies, the deadline is January 2021.
But there’s another change within the 400-plus pages of FASB 842 that organizations also need to pay close attention to from the get-go.
And that’s the ASC 842 disclosure requirements under the new lease accounting standard.
Reporting entities should be aware that the new disclosure requirements have expanded significantly over the old guidance for both lessees and lessors. This increase in what’s required means you need to consider all the disclosures early in your implementation process--even before settling upon an automated lease accounting software solution.
Why did FASB increase the disclosure requirements?
In keeping with the overall objective of the new FASB lease accounting rules to bring transparency, insight and clarity to a company’s financial statements, the Board also revised what it expected entities to disclose regarding their leasing commitments.
According to FASB ASC 842, the disclosures should “enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases.”
So to satisfy this objective, lessees (lessor disclosures will be discussed at a later date) must disclose information about their leases that’s both qualitative and quantitative as well as explanations about the assumptions used in the process.
In the absence of hard and fast “bright lines,” the new guidance allows a reporting entity to apply judgment when it comes to how much detail to include in its disclosures and how much emphasis each of the various requirements receives.
“A lessee shall aggregate disclosures so that useful information is not obscured by either the inclusion of a large amount of insignificant detail or by aggregating items that have different characteristics.” In other words, lessees should provide information that is neither extremely detailed nor overly high level but simply enough to present a straightforward understanding of its current and future leasing obligations.
Furthermore, the disclosures of companies with extensive leasing activities are expected to be more comprehensive than those of a company with fewer leases.
Before getting into the new disclosures for lessees, you should know that FASB eliminated some of the current disclosures:
- The total of minimum rentals that are to be received on noncancelable subleases in the future. This applies to both operating and capital leases as of the date of the financial statements.
- For each financial statement presented, the gross amount of assets recorded under capital leases by major classes.
- For sale-leaseback transactions when the seller-lessee applied the deposit or financing method, the future minimum lease payments and minimum sublease rentals aggregated at the date of the financial statements and for each of the five succeeding fiscal years.
One of the topics in the new FASB guidelines getting a lot of attention these days involves ASC 842 embedded leases--those provisions that are often hidden or buried in a larger service or supply contract that grant a lessee the right to use an asset for a specified term.
In fact, in a 2018 KPMG poll, over 60% of respondents indicated that the most significant challenge they encountered in ASC 842 implementation was identifying embedded leases.
The requirement to identify embedded leases is not altogether new. Under ASC 840, embedded leases, like operating leases, were to be included only in the footnotes. And because they had little impact on financial statements, many companies may not have been diligent in their efforts to identify all their embedded leases.
However, the new lease accounting standard calls for virtually all leases over 12 months to be recognized on the balance sheet with a right-to-use lease asset and lease liability.
It doesn’t matter if an embedded lease is classified as an operating lease or a finance lease, the accounting for it must happen on the balance sheet.
The recognition of embedded leases has financial professionals concerned for several reasons:
- As noted above, these types of leases were often overlooked as simply part of a service agreement or treated as operating leases--which up till now were accounted for off-balance sheet. There could be a myriad of embedded leases that need to be discovered.
- Locating them is difficult, partly because many contracts with an embedded lease may not even contain the words “lease” or “rent.”
- Failure to include an embedded lease could possibly have a material impact on a company’s financial statements.
Private companies in the midst of implementing the FASB guidelines for compliance, need to take the identification of all their embedded leases seriously.
The buzz surrounding the new lease accounting rules generally focuses on operating leases. All those leasing arrangements that were previously buried in the footnotes of a company’s financial statements are now required to be recognized with a lease asset and lease liability on the balance sheet.
No doubt about it. That one change is definitely buzzworthy. After the FASB announced its plans, financial forecasters estimated that singular move could increase balance sheets of U.S. publicly traded companies by as much as $2 trillion and could make many of them appear more leveraged than under the legacy guidance.
But before you can begin the new--and somewhat complicated--accounting for those operating leases, you have to complete the classification of all your leases--including any contracts that may contain an embedded lease.
The FASB’s legacy guidance uses a two-model approach: operating leases and capital leases. FASB ASC 842 also uses a dual model approach: operating leases and capital leases with a new name--finance leases.
Regarding capital leases, the FASB did more than change the name. They made slight changes to the four criteria used to determine whether a lease is a finance lease or not and added a fifth one.
The actual accounting for finance leases under the new lease accounting rules is not much different from the way capital leases were handled under the old standard.
So if the accounting for a finance lease is practically the same as it has been and virtually all leases over 12 months have to be recognized on the balance sheet, should it really matter how your leases are classified?
Yes. Because the correct accounting of a lease begins with the correct lease classification.