Lease accounting changes keep on coming
Private companies are facing a deadline on implementing the new lease accounting standard, but recent updates in the rules could make an impact on their financial statements and disclosures.
Last month, the Financial Accounting Standards Board issued an accounting standards update to help lessors account for variable lease payments (see story). FASB also proposed changes in June in the discount rate guidance for lessees that are not public businesses, such as private companies, not-for-profits and employee benefit plans (see story).
Other changes could be coming with the goal of easing the transition for private companies, which have until 2022 to implement the standard. Public companies already needed to begin implementing the standard in 2019, but private companies were given an extra two years, as FASB often does with major new standards, but more time was added after the outbreak of the pandemic last year. The standard will bring operating leases onto the balance sheets of companies for the first time, but in some ways, it’s a moving target.
“There are significant challenges, especially from the private entity side,” said Jon Eilertsen, managing director of BDO’s accounting and reporting advisory services practice. “FASB is continuing to release updates, modifications and changes to the standard.”
Courtesy of GASB
Companies are turning to their accountants for help in getting ready for the new standard, but they are far from ready. “It’s such a significant change in accounting standards so what we’re seeing is that a lot of entities that maybe do not have the resources or bandwidth inhouse to implement such significant standards are seeking professional advice from professional services firms like BDO to help them with the adoption,” said Eilertsen.
Other firms are assisting their clients with the leases standard as well. “We are seeing an uptick in companies asking questions and taking a look at it,” said Heather Winiarski, a shareholder at Mayer Hoffman McCann. “A lot of it is still evaluating what their entire population of leases is, as well as how they’re going to keep track of the accounting. Can they continue to use the same system they had before, which was perhaps Excel, or do they need to invest in software specifically to track all of the leases and the accounting for them?”
Some private companies will need more help than others. “You’re going to have those that are just completely buttoned up and they’re ready, and those are the ones that probably won’t need the handholding, but you’ve also got a pretty good subset of companies that typically wait until close to the end are going to get caught with needing a bunch of help,” said Frank Balestreri, consulting partner-in-charge at Sensiba San Filippo. “I look at this as just a big project. Where some of these companies really need help is with project management and helping them get over the finish line.”
Jan. 1, 2022 is the effective date of the new standard for private companies, so for many of them it will be showing up in their Dec. 31, 2022 financial statements. “I think they got fairly lucky because what I’m seeing right now, and what’s happened over the last 18 months is a lot of leases are going through some sort of negotiation phase, so that makes it interesting from a calculation standpoint here because that’s a triggering event to reassess what your lease liability and your right of use asset is going to be, so the good news is we should get beyond this before private companies need to adopt this, but public companies obviously are smack dab in the middle of it because they’ve already adopted it,” said Balestreri. “I would expect to see a lot of adjustments coming through relative to that going forward. For our clients, what’s really going on right now is they’re in the process of trying to figure out how to tackle this. Typically what we see when there’s a new accounting standard, there’s a flurry when the standard gets released, and then it goes dormant for a little while up until the period where it needs to be implemented, and then everything heats up again. We’re heading into that period where this is going to start to get focus from people. With the impact of the pandemic, the challenge there is that a lot of the private companies have probably downsized their staff as well as their leased space or leased assets. They’re going to be trying to adopt a new standard, which is challenging in and of itself with a reduced workforce. Maybe they don’t have those technical resources still on staff that can help them. I would imagine that they’re going to need pretty significant handholding to get this over the finish line.”
Technology assistance
Around three-quarters of companies are not yet compliant with the lease accounting standard, according to a recent survey of 500 senior finance and accounting professionals by Visual Lease, a leasing software company. Even though 100% of the survey respondents acknowledged the many benefits that lease accounting can bring, 75% are not yet compliant with the new leasing standard, known as ASC 842 for its place in FASB’s Accounting Standards Codification. Nearly half (46%) said they are less than halfway through or have not yet begun the process, while one in five respondents admitted that achieving full compliance has been a low business priority for them. A high percentage of the respondents gave their own industry a grade of C or lower on lease compliance.
“In my experience in the accounting profession, private companies tend to lag,” said Joe Fitzgerald, senior vice president of lease management strategy at Visual Lease. “They’re typically less resourced. It’s not surprising to see so many not so far along that journey.”
He expects to see more companies working to adopt the standard this year and next, with many of them transitioning from Microsoft Excel to a dedicated system. “I think what will happen is a lot of it will come down to the last minute,” said Fitzgerald. “Compliance isn’t optional. At some point you have to address it. I think we’ll see a pretty busy 2022 in terms of companies getting started on the later side. Some will take shortcuts. We saw that with the public companies. We now have public companies coming back to us who adopted Excel. They realized Excel wasn’t the ideal option and so they’re back in the market.”
Technology is providing some help, as lease accounting can be complex for many companies to handle on their own. “If a company has significant IT contracts where maybe they’ve outsourced some servicing to a third party, but in order to provide that service there’s an underlying, dedicated server, that would be considered a lease,” said Balestreri at Sensiba San Filippo. “In our practice too, where we’ve got a lot of manufacturers, and some that outsource their manufacturing in a manufacturing contract, if there are dedicated assets, or if they’re taking all of the production out of a facility, then that’s considered a lease. Things are out there that I don’t think are necessarily on the radar screen of some of these private companies, and that’s where the complexity is going to be. The good news is I think this is an excellent opportunity to turn to technology to help solve it. As a firm we are big on trying to work smarter and not harder, and since this thing got extended a little bit in terms of the implementation date for private companies especially, there’s a host of companies out there that can help from a technology standpoint. Part of the challenge is the disclosure requirements that are now required to go into the audited financial statements. There’s a bunch of different companies now that will be able to accumulate the information for you. You’ve still got to input it, but they’re set up to help you with all of the different disclosure requirements that are out there. I think that’s going to be a huge help. Companies that try to do this without embracing technology are going to struggle, because this is now an every year thing. It may be easy enough if you’ve only got a couple of leases to try to do this in Excel, but I wouldn’t recommend it because you have to do this every year now, so finding a software solution really makes a lot of sense because it will save you time in the long run.”
Clients will need to weigh the advantages and disadvantages of the various systems with their accountants. “There are different products on the market that have various levels of bells and whistles, so I think that if you’ve got a handful of leases, there may be software solutions that are less expensive and also accomplish the needs of the company,” said Winiarski of Mayer Hoffman McCann. “If you start getting into a lot more leases, then there are options that have greater tracking, visualization, reminders and things like that. What we’re seeing in a lot of cases is companies are finding that a software solution is beneficial just to keep track of the amortization schedules and handle the disclosure requirements and aggregate all of that information. Companies are also refining their processes in terms of tracking contracts that get signed, having greater discussions and interconnected points between the accounting department and other groups that may be entering into contracts. There is an awareness, hopefully before the contract is signed, about whether or not there’s an embedded lease within it to make sure that the full population is getting captured.”
Accountants can help their clients evaluate the pros and cons of the different systems. “You have to vet the software providers,” said Balesteri. “We’ve looked at several and finally chose one to use in our practice, because we felt it covered the lion’s share of what you need. The challenge here is there are literally hundreds of companies that threw their hat in the ring trying to figure out how to do this. Early on, it’s like a lot of any software adoption. There are a lot of bugs in the software, and as you get more companies using it, you come up with the issues and the challenges. A lot of these are cloud-based systems now, so it’s worthwhile for companies to do their due diligence or work with a partner to try to figure out where the best software solution is and implement it. But it’s not just implementing it one time. There’s ongoing maintenance that needs to happen, perhaps every quarter or every month, depending on the frequency that you want to update. For example, if you have a bunch of variable lease payments, that needs to get tracked and reported on in your annual financial statements, so having a software package that can accumulate that information becomes very important.”
Variable lease payments
The new variable lease payment standard from FASB could be helpful for some companies as it allows companies to continue to use parts of the earlier leasing standard, ASC 840, with which they may be more comfortable. “It brings the accounting back to how it was done under 840, which would be a little more familiar for businesses in applying the changes in the update to the standard,” said Eilertsen of BDO.
The standards update helps lessors when they have many variable lease payments that aren’t tied to a rate or an index. “Those variable lease payments still go into the calculation of lease payments and all of the classification criteria, so companies are finding themselves with a day one loss because they have so many variable payments expected in the future that weren’t captured in the calculation,” said Winiarski. “It was creating this oddity in terms of the day one accounting, so I believe the accounting standards update that came out will help address that issue.”
The update came in response to comments from companies about the challenges they saw in the leases standard. “The board received feedback from stakeholders that this accounting treatment did not reflect the economics of the transactions, either at commencement or over the lease term,” said Eilertsen. “I think this change is being well received from the industry, in that it better aligns the economics of these lease agreements with what’s being put into place. For instance, when the readers of a financial statement see disclosures that there’s a day one loss associated with the recording of these leases, it doesn’t appropriately represent the underlying economics. From the reader’s perspective of the financial statements, it also provides additional clarity and information for investment decision-making purposes.”
Clients will still need to look at how to transition to the latest standards for variable lease payments. “Businesses will have to evaluate, from a transition perspective, when this is going to need to be applied for public companies as well as private companies, based on how they’re electing to apply these, whether on a retrospective basis or a prospective basis,” said Eilertsen. “You have two options for a transition there. There can be some additional disclosures that you’ll have to include from a financial reporting perspective. Those will capture the applicable transition disclosures that are required about accounting changes and error corrections.”
“FASB tried to create some practical expedient to make the transition easier,” said Fitzgerald. “They are looking to make this easier. FASB may come out with more tweaks along the way.”
Rate proposal
The recent proposal in June deals with the risk-free rate and adds further options for private companies and their accountants. “I believe that’s going to greatly help lessees that are implementing the standard that are nonpublic companies,” said Winiarski. “Right now there is a practical expedient that a nonpublic company can use the risk-free rate, but they have to make that election for all leases. The proposed change would allow that risk-free rate to be applied by nonpublic companies by class of underlying asset. What that will allow is, if a company has a lot of smaller leases, let’s say copiers, IT equipment or cars, smaller dollar amount, perhaps smaller-duration leases, they may now choose to elect the risk-free rate because it tends to be easier. The risk-free rate tends to result in a larger lease liability in today’s environment. By applying it to those smaller leases, perhaps it doesn’t have as much impact to the company, or the cost benefit of not having to determine the incremental borrowing rate makes it worth it. Then with this proposed accounting standards update, they can decide for perhaps a building lease, which is a much larger and more significant lease in terms of their balance sheet. They can apply the incremental borrowing rate if the rate implicit in the lease is not known and spend the time identifying the proper rate for the big lease and not have to spend all their time worrying about sorting out the incremental borrowing rate as well for the smaller leases that have a smaller dollar impact on the balance sheet.”
The proposed update can also help private companies with their transition to the new standard. “One of the challenges for private entities that are either beginning the process or going through their adoption, or had just recently applied or adopted the change in the standard from 840 to 842, is making sure they have included all relevant updates that have been released by the FASB,” said Eilertsen. “As it relates to general challenges that they’re facing, this is a significant change from 840 to 842, so it will have significant impacts for private entities.”
The extra guidance from FASB should help companies transition to the new standards. “Anytime they put more guidance out, it’s typically helpful,” said Balestreri. “The good news is we’ve extended this for such a long period of time, having the public companies go first gives the private companies the opportunity to look at disclosures. Interestingly enough, I don’t believe there were a lot of comments from the SEC relative to the lease disclosures that they saw as this was implemented. That to me is a pretty good sign that the accountants and the companies are getting it right. So there hasn’t needed to be a lot of course correction along the way. That should help. We’ve got good examples of the disclosures and the accountants are getting more comfortable with how to actually do this. The software programs are getting better, so you’ve got all this coming together at one point in time, which I think is going to be really helpful.”
More work to do
Many private companies may now be playing catch-up from the impact of COVID-19, with more than two out of five respondents (43%) to the Visual Lease survey noting that their organization’s process has been delayed due to the global pandemic. With the deadline for private companies approaching soon, 40% of the respondents said they are only somewhat, not very, or not at all confident about their organization being ready to reach full compliance with ASC 842. More than two in five (42%) of the respondents admitted that the ASC 842 compliance process has taken more time than expected, which puts those who have not started the process at serious risk. That figure is particularly concerning considering the average anticipated staff hours to gather all the necessary lease information to fully adopt ASC 842 is 1,334 hours, equivalent to more than 33 weeks of full-time labor for a highly skilled worker.
More than one out of three (36%) of the senior finance and accounting professionals polled said they don’t have the right people, technology and tools in place. High on the list of items they consider to be essential in the process are implementing new (48%) or upgrading existing (51%) lease management and accounting software.
Compliance officers and accounting firms can help guide clients through the transition, but it will be an ongoing process even after the new standard has been adopted. “It’s good to have a compliance officer guide you through the process and navigate through a lot of the intricacies of the changes in the standard to help you get that adopted well,” said Eilertsen. “I think one of the big challenges that we’re seeing in our client base is once the new standard is adopted and implemented, you still have to understand what sort of changes in policies and procedures moving forward you’re going to need to implement in order to maintain adherence to the change in the standard. Whether that’s a new lease checklist that is implemented, or whether there’s changes to internal controls that are put into place, it’s really just understanding changes in the lease framework that they have, whether it’s new leases, terminations, modifications to existing leases that could cause reassessments, understanding how to apply that standard to their population moving forward I think presents a lot of challenge.”
Companies will have to evaluate their internal resources, Fitzgerald noted. Some are bringing in third parties such as accounting and consulting firms to search for leases, while others are bringing in partners who offer lease management as an outsourced managed service, especially as a day one option.
Reaching ASC 842 compliance in time for the standard’s effective date is only part of the battle. Ninety-nine percent of respondents to the Visual Lease survey anticipate they will face ongoing challenges maintaining compliance after the 2021 deadline. Among the most anticipated challenges include accurately tracking and managing future modifications to leases, adopting new technologies to optimize the process and continuing to train and educate staff.
Companies may decide to buy instead of lease some assets as a result of the new standard. “I think there’s an added element of lease vs. buy determinations that are being made from an operational strategy side, in that because all of these right of use asset, lease liability numbers from operating leases are being brought onto the balance sheet, there’s additional scrutiny as to operating leases that you have,” said Eilertsen. “We’re seeing a lot of our clients spending more and more time on evaluating whether it’s in the best business sense to continue to lease these assets or to purchase them since they’re being brought onto the balance sheet.”
Clients will also need to take a closer look at their debt covenants with lenders. “Maybe another challenge is from a debt covenant perspective,” said Eilertsen. “By bringing the additional debt onto the books from the lease liabilities, are there debt covenants in place where the addition of these new liabilities could bring into jeopardy some of the covenants and ratios presented in your debt agreements? Understanding how those changes impact your debt agreements is equally as important to ensure that if there are any changes or modifications to the debt agreements that need to be put in place to account for the update or the changes in the accounting standard, we’re seeing a lot of our clients having discussions with their lenders to make necessary updates because the economics of the business haven’t changed. The numbers are being updated to reflect the changes in accounting standards. Ensuring that the debt agreements are inclusive and incorporating these new accounting changes are some of the requirements that are equally as important and create new challenges for a lot of our clients. They’re navigating all of the different areas in which the standards are impacting their business.”