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As many financial executives begin to get over the hump with regards to the implementation of Accounting Standards Codification (ASC) 606, “Revenue From Contracts With Customers,” they are being tasked with tackling another new standard, ASC 842, “Leases.” Financial executives are beginning to attend training sessions and read articles on the impact of the new standard, and two things are becoming apparent: ASC 842 will have organizations report operating leases on the balance sheet, and some kind of accounting software might be needed.
What is not immediately evident is the impact the standard will have on organizations’ lease origination and modification processes. The new standard requires that organizations know not only what all their leases are, including embedded leases, but also the organization’s point in the lease life at any given time. Entities that relied on decentralized operations and reporting of operating expenses will have to either centralize their lease process or provide each of their individual operational units the ability to account for leases under the new standard, which might include training for new software. With this understanding, organizations should begin assessing their current processes and existing leases to verify they can adequately address every portion of the standard and have completeness, clarity, and control over implementation.
FASB Topic 842/IFRS 16, “Leases”
In 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-12, “Leases (Topic 842).” The International Accounting Standards Board (IASB) issued International Financial Reporting Standard (IFRS) 16, “Leases,” which is converged with the FASB standard with respect to recording all leases on the balance sheet. The new lease accounting standard is effective in 2019 for public companies, not-for-profit entities that have conduit debt obligors, or employee benefit plans that file with the Securities and Exchange Commission. All other entities must comply in 2020. The new standard will affect any entity that enters into a lease.
Virtually all companies will need to consider the effect of the standard – which could be substantial – on their accounting policies, procedures, controls, and systems. The standard’s effect on an organization will depend on the nature of its leasing activities and the structure of its existing leases. For most organizations, the primary impact will be related to operating leases that must be recognized on the balance sheet for lessees. In addition, the new lease standard could affect organizations that measure compliance with debt covenants that are based on certain financial statement metrics, given that balance sheets will be grossed up for operating leases by lessees.
Opportunities to Transform the Lease Accounting Process
For many organizations, accounting for leases is a manually intensive process conducted outside the core enterprise resource planning system (usually using basic spreadsheet software). This is a result of many factors, which can include:
- Limitations in the abilities of systems to recognize the requirements of finance and operating leases, which can limit the capacity to parse and create appropriate financial statement entries
- Changes in the types of business conducted
- The need for organizations to negotiate complex, customized leases and debt covenant arrangements
In these situations, the new standard presents an opportunity to transform the lease accounting process from end to end – creating a systematic, scalable, and automated system that can manage the complex lease agreements and record lease activity. Organizations’ processes will need to capture all their leases and provide control over the review of potential lease contracts. Employees must be adequately trained and able to provide the clarity required in the organizations’ policies and procedures.
Recap of Leasing Changes
Reporting. Nearly all leases will go on the balance sheet as a result of the changes in the standard. Companies no longer will be able to establish a lease and then never revisit it. Ongoing and regular consideration of the accounting surrounding leases will be required to monitor modifications and any potential impairment issues.
Transactions. Standard changes will affect numerous business and accounting requirements, which may drive companies to maintain significant additional data. Companies should reassess lease-and-buy policies as well as processes for future leases.
Monitoring. Establishing a formal monitoring process and structure can be a challenge for organizations, especially considering that resources may be limited as companies implement the new lease accounting standard within a specified time frame. This formal process and structure, including protocols such as establishing project plans and monitoring implementation, may be a significant effort for some companies.
It is vital to establish a project plan that can be reviewed and approved by stakeholders. Steps for creating such a plan include:
- Confirm the overall approach.
- Identify stakeholders and contacts.
- Identify and catalog the leases and items affected by an increase of assets and liabilities (such as debt covenants).
- Identify additional information needed and its source.
- Gain an understanding of the existing policies and processes surrounding the company’s lease accounting practices.
- Continually develop details of the project plan as necessary.
Start Now
The implementation of ASC 606, revenue recognition, proved to require far more resources and time than many organizations anticipated, resulting in companies being challenged through implementation and spending excess time and resources. For the lease standard, companies can get a start and avoid the same issues.
- Completeness. Companies need to begin assessing their current lease processes to verify they can identify all their leases and know at what stage each lease resides.
- Clarity. Those individuals responsible for lease initiation and modification need to begin learning the standards and be able to identify what leases qualify under the new lease classification rules.
- Control. Management needs to confirm that existing processes allow for a complete accounting of leases and that every transaction is recorded in the lease accounting software.
For more information on ASC 842 and what your organization can do to implement the new standard, visit the Crowe Lease Accounting Resource Center and access the helpful insights and resources available there.