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The Most Common Lease Accounting Pain Points Under ASC 842
Much has been said about the new lease accounting standards, including from your friends here at Embark. While some make ASC 842 seem like the accounting equivalent of Godzilla, others say it's more like a cuddly little financial puppy that just needs a bit of attention. The truth – at least how we see it – exists somewhere between the two.
If your organization is still trying to figure out how to deal with the new lease accounting standards, we suggest starting with our previous thoughts on ASC 842. Today, however, we're going to look at some of the most common and significant pain points during implementation. Equal parts heads-up and best practices, keep these four points in mind as you integrate the new standards into your accounting processes.
Lease Identification Process
The most obvious hurdle in implementing the new lease accounting standards for US GAAP also happens to be the most time consuming one – identifying what qualifies as a lease under ASC 842. However, establishing a complete lease population is the cornerstone to a successful implementation process. Therefore, whether it takes a day, a week, or a month, identifying all of your lease obligations is a critical first step.
Much of the difficulty in the lease identification process stems from embedded leases within service contracts, so an organized and deliberate approach can be a lifesaver in streamlining that time-consuming process for you. Take the time to first identify all of your embedded leases, then analyze each one to determine if it qualifies as a lease under the new standard. Not too bad, right? See, we told you so.
Embedded Lease Example
Let's say your company uses a leased copy machine that you previously recorded as a monthly expense when you received the bill. Under the new lease accounting standards, you must begin the lease identification process by determining the level of control you have over the copier. For instance, can you determine how much you use it in a day? Or can you leave it idle whenever you want?
Control is a critical determining factor in the new accounting standards. Simply put, if a supplier can substitute the asset at any time and benefit from the substitution, then you don't have sufficient control and it's not considered a lease. However, in our copier example, if you answered yes to those questions, than the copier likely meets the qualifications for control and must go on the balance sheet as an operating lease.
In fact, the copier would go on the balance sheet even if you improperly classified it as a service contract under ASC 840. That's one of the most significant differences in the lease accounting changes, where before, operating leases and service contracts had the same P&L impact, so it didn't matter how you classified that copier. The new guidance draws a clear distinction between the two, again reinforcing the importance of your initial lease identification process.
Lease Identification Best Practices
As you can imagine, going through several service contracts like our copier example can consume quite a bit of time and effort. Therefore, streamlining your efforts along the way will be very helpful in maintaining everyone's relative sanity. Here are a couple of best practices to keep in mind.
- Use your accounts payable ledger as a guide, looking for any vendors with recurring invoices that you pay each month, quarter, or year. This simple trick will help you identify all of your service contracts and give you a nice head start in the process.
- Sit down with people from your different departments – accounting, finance, IT, procurement, internal auditors, tax, and treasury – and ask for their inputs on the different service contracts they use. Getting all of the stakeholders involved will minimize the chances of anything slipping through the cracks. For example, ask IT for a list of the different software subscriptions they use. Chances are, they're going to give you a pretty lengthy list, along with all of your other departments as well.
Lastly, remember that the lease term is required to calculate the present value of the lease, making it another potential pain point for your team. We understand that such calculations are exactly no one's favorite thing to do, but that doesn't make it any less important. Just be sure to document all of the choices you make for the calculation – ex. justifying why you chose a six-year life for a three-year contract that goes month-to-month after the initial term – keep those choices reasonable, and you’ll be fine.
Day One Accounting Balance Sheet Entry
Building on that last point, there are obvious balance sheet implications with the new lease accounting standards. Most of the associated balance sheet pain points concern the inputs for use in the day one-present value calculation for the right-of-use asset and the lease liability. Those inputs include:
- The lease term
- The discount rate
- Upfront payment information and any initial direct costs affecting the present value calculation
Discount Rate Calculation
In another example of something important for ASC 842 but usually low on an accountant's list of favorite things to do in life, the discount rate calculation has been known to induce mild panic attacks. As you know, it’s not that the calculation itself is terribly complicated, but it’s just not something that’s a part of the average accountant’s daily routine. That said, Embark has a few more best practices to help smooth things out for you.
- Look for an implicit rate within the lease. If there isn't one – which is usually the case – then you must calculate the incremental borrowing rate.
- Your incremental borrowing rate is the rate of interest that you, as the lessee, would pay on a collateralized basis for a similar term and in a similar financial environment across equal payments.
- Don't be scared to ask your finance department for help. While this might add a bit more time and complexity to the process, it's more than worth it if it means getting the calculation correct.
- Sometimes public companies have publicly traded debt they can use for the incremental borrowing rate. If that doesn't fit you, then you have to calculate the rate for each lease.
- The incremental borrowing rate is specific to every company. Therefore, it doesn’t matter how similar the company down the street is to your own. Their discount rate is different than yours, and vice versa. In other words, eyes on your own paper.
- If you are a private company, and you are choosing to use the risk-free rate, you must choose the risk-free rate that corresponds with the lease term. For example, with a three-year auto lease, you would use the risk-free rate for a three-year treasury bill. Otherwise, your discount rate is the incremental borrowing rate you would pay to borrow an amount equal to the total lease payments for three years.
Transition Relief Package
The good folks at the Financial Accounting Standards Board (FASB) understand that the new lease accounting standards present a significant change for many companies. For that reason, they've provided some practical expedients through ASU 2018-11 to help with the transition, but even those can present certain problems.
For example, as an accounting election, by asset class, you can opt not to record leases 12 months in duration or shorter on the balance sheet. However, if you use this election, then you must still disclose the cash flows related to the leases. Therefore, it's important to start tracking those leases from day one to make sure you have the correct year-end information for all of the required disclosures. As a best practice, it's helpful to flag such payments as a lease in your AP system to keep those year-end disclosures neat, tidy, and accurate.
Of course, that's just one of the many expedients available. We won't take a deep dive into all of them, but a high-level glance can at least give you an idea of what to look out for.
- As a lessee, you can elect not to separate nonlease components from lease components. Instead, you can account for each as a single lease component.
- You may also elect not to reassess initial direct costs for existing leases. Whether or not you capitalized those initial indirect costs under the old guidance, you would still qualify for capitalization under ASC 842.
- You must apply the hindsight practical expedient to all leases in order to use hindsight in determining the lease term. In plain English, that applies when you're considering options to extend or terminate the lease and to purchase the underlying asset. This is also applicable when assessing impairment of the entity's right-of-use assets.
- The modified retrospective approach allows you to apply the old standard in the comparative periods. However, opting for this approach means that you must provide the disclosures required by ASC 840 for all periods that you continue to present in accordance with the older standard. Also, you must recognize the effects of applying ASC 842 as a cumulative-effect adjustment to retained earnings as of the effective/adoption date.
When determining whether or not to use any of these expedients, remember that some are industry-specific, so it's essential to understand how the new lease standards relate to your business entity.
From a reporting perspective, we've previously discussed how technology can provide many benefits as you transition to the new lease accounting standards. When deciding if you need designated lease accounting software rather than just sticking with Excel, use the number of leases you have as the determining factor.
As a rule of thumb, companies with more than 50 leases should consider using a designated system since the time and effort involved in manually processing everything could strain your resources. Remember, ASC 842 requires a new financial statement footnote on leases, making systems that automatically track the required disclosure numbers especially attractive for reporting purposes.
On the audit side of the reporting fence, you're now required to prove that your lease population is complete. Your audits will check the accuracy of your present value inputs when calculating lease values, and will also test your day-one lease values. Once again, it's critical to properly document every choice you make in those calculations to ensure your audits are as smooth as possible.
Lastly, you must also maintain separate general ledger accounts for your operating and finance lease right-of-use assets and liabilities rather than combining them into the same accounts. These four data points are separately disclosed in the lease footnote.
We understand that's an awful lot to take in, but just like the changes to rev rec or any other accounting standard, it's just a matter of time until ASC 842 becomes commonplace to you and your accounting function. Take an organized approach to the new leasing standards, use the practical expedients if they make sense for you and your needs, and rely on technology solutions whenever possible to streamline your implementation. If you happen to have a global footprint, not to worry because we even have you covered on the differences between IFRS 16 and ASC 842. In other words, whether its insights or hands-on help, Embark is always here to lead the way.