In 2016, the Financial Accounting Standards Board (FASB) issued a new lease accounting standard, Accounting Standards Update (ASU) No. 2016-02, “Leases (Topic 842)”. It becomes effective in 2019 for public companies, not-for-profit entities that have issued securities that are traded on an exchange, and employee benefit plans that file with the Securities and Exchange Commission. All other entities must adopt in 2020. The new standard will affect any entity that enters into a lease. Additionally, the International Accounting Standards Board issued International Financial Reporting Standard (IFRS) 16, “Leases,” which follows concepts similar to the FASB standard with respect to recording all leases on the balance sheet.
Virtually all manufacturing and distribution companies will need to consider the potentially substantial impact of the standard 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.
Learn From 606 “Revenue From Contracts With Customers”
Many organizations are feeling the strain of implementing Accounting Standards Codification (ASC) 606, “Revenue From Contracts With Customers” (IFRS 15), just as they are expected to take on another similarly large and complicated standard, ASC 842, “Leases” (IFRS 16). While each standard deals with very different portions of the financial statements, the adoption of ASC 606 taught many organizations important lessons on what must be considered when implementing a complex new standard.
As organizations planned, and some scrambled, to implement ASC 606, several best practices became evident that will be equally important in ASC 842 adoption.
- Have a clear and thoughtful approach. Many organizations went into revenue recognition thinking the standard would have a minimal impact or it would be easy to gather the information needed to complete the assessment. Instead, many organizations were left struggling to find the information they needed to gain assurance they had considered all the aspects of the standard. When these organizations finally approached their auditors, they struggled to show how they reached their conclusions. Leasing could present similar challenges. Organizations will need to show the auditors – in a thoughtful and concise manner – that they considered all potential sources of leases as well as the aspects of the standard that would affect them.
- Know your controls. Auditors will be expecting organizations to clearly define how they became comfortable with all the leases they recorded and to show that ongoing processes should result in a controlled environment for recording both new leases and changes to existing leases. As organizations go through the process of adopting the standard, they should know what controls they will implement to ensure they are recording complete and accurate lease information.
- Get help. Similar to ASC 606, ASC 842 is more than 300 pages long and still does not have all the information or examples needed to provide organizations with clear-cut guidance for how leases should be treated. Many organizations do not have the resources or time to have one or more individuals familiarize themselves with the entire standard and then figure out which parts apply to their organization. A professional services firm can assist in determining the provisions that apply to a specific organization and help formulate required estimates and policies. These firms see many different scenarios in the market and have the tools to help organizations establish sound policies and processes.
- Use technology. Unlike with revenue recognition, many organizations will utilize software to assist with the implementation of the leases standard. The new standard requires that organizations report not only the expense associated with leases but also the corresponding right-of-use asset and lease liability. Organizations with 15 or more leases may need a software solution to measure and track these assets and liabilities. The implementation of new software needs to be considered in the budgeting process, and software selection should occur well before the deadline for adoption. While revenue recognition was a change in accounting policy for most organizations, leases will become a change in processes overall. Companies will need to consider how their current lease initiation and modification process will be affected by the need to track each and every lease. Many organizations will find that having business units engage and modify leases on their own will not work under the new standard and that these processes need to be centralized.
- Communicate. Organizations’ internal departments will need to communicate to the accounting department on a regular basis. Revenue recognition requires that sales and marketing communicate far more with accounting regarding pricing techniques and understand the implications of revenue recognition. Leasing will require groups such as procurement and facilities management to communicate their expectations to accounting. For example, the new standard requires an estimate of the likely life of the lease, which will require accounting to understand the options and nuances of the leases adopted by the procurement team – for example, whether the lease will be for two years or if it is reasonably certain that the company will elect the three-year extension.
Organizations need to learn from the pain points of revenue recognition implementation and be proactive in addressing these for leases. They need to ensure they start the process early and address the items discussed here to ensure they are not wishing for more time at year-end.
Simon Little and Luis Lopez Garay are CPAs at Crowe LLP. William Watts is a principal in risk consulting at Crowe LLP.