In case you haven’t heard, there are massive changes coming to how leases are accounted for. While I was doing some research into the changes, I noticed that a lot of companies that will be affected haven’t begun to take them seriously or think it won’t cause too much disturbance. While this is partially true, as the effects can be minimal if thorough preparation is done, the preparation is a whole job in itself. One of the departments I’ve spoken with have even hired a temp solely to input all of their lease data and make sure it’s up to date!
When speaking with me about the changes, Jennifer Hannah from Richey May said that “if you don’t understand what the changes mean, you cannot prepare properly.” So, before we get into how to prepare, let’s get a clear understanding of what the changes are.
Previous Standards
While under the 40-year-old ASC 840 standards, leases were categorized as operating or capital, and only capital leases were required to be recorded on the income statement and balance sheet. Operating leases were reported in the footnotes of the financial statements, easily lost in the jumble and causing an issue with transparency. As Jennifer mentioned in our discussion, if someone did their due diligence looking into a company’s financials, they would find this information, but it shouldn’t be as easily masked.
New Standards
The new ASC 842 standards kept the dual classification model that the ASC 840 had, however the criteria and nomenclature for those classifications have changed slightly.
To classify as a Finance Lease, at least one of the following criteria must be met:
-Lease transfers ownership of the asset at the end of lease term to the lessee
-Lease provides the lessee an option to purchase
-The lease term is for the majority of the remaining economic life of the asset, unless the commencement date falls at or near the end of the economic life.
-The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all the fair value of the asset
-The asset is so specialized that only the lessor has no use for it at the end of the lease term
An Operating Lease is simply any lease that does not fall into the Finance Lease category.
These new classifications aren’t the only change, however. Both Finance and Operating Leases are required to be capitalized on the balance sheet. The exception to this rule would be short-term leases that are less than 12 months. In addition to the balance sheet, both types of leases will be reflected on the income statement, though in different ways. Interest and amortization are combined into a single line item for operating leases, meaning they will have a straight-line cost profile. Finance leases, on the other hand, should see interest and amortization recorded separately and will have a front-loaded cost profile.
What will these changes look like?
At first glance, these changes may look similar to deferred rent calculations, but it’s more than that. A much more manual process, Jennifer Hannah said it’s like “adding another layer” to those calculations. It will also cause a lot more administrative work, logging the leases into whatever system you are using, keeping lease agreements up to date, and running the correct lease calculations. In addition to these time intensive projects, accounting departments will also have to consider branch turnover and how the subleases are affected, whose name is on the leases, and what the fair value of the assets are.
What’s next?
The changes to the ASC 842 standards do not take effect for private companies until January 1st, 2020, but this does not mean companies should wait until the fall to start taking the changes seriously. If you and your department haven’t already, begin preparing as soon as possible. How might that look?
1) Start with a blank slate.
Don’t try to build on current deferred payment schedules and sheets. Wipe the slate clean and gather all of the lease agreements.
2) Assign a person or people to sort through your lease agreements.
The amount of people on this task will most likely be determined by the number of leases your company currently holds. Maybe you give the task to a few people you already employ or hire a temp to sort and categorize the leases. It’s also imperative that the most current lease agreements are used.
3) Figure out the correct calculations for your leases.
Knowing and understanding the interest and amortization on leases is important, especially how to calculate them. All the preparations will mean nothing if your equations are incorrect.
4) Start tracking your leases per the ASC 842 standards as soon as possible.
By following the standards sooner, rather than later, your accounting department can work out the kinks in the process. This way, when the standards do go into effect, your department will not only be ready, but will understand how it affects the day-to-day and month-end processes.
Another important step in transitioning to the new standards is to talk to your auditors. I didn’t include it in the steps above because it should be an ongoing task, from the beginning of your research throughout the process of transitioning to the new standards. Your auditor(s) will know the best way for your department to handle the changes and can help verify that you are taking the proper steps.
Don’t let the changes scare you
As in any area of life, change is difficult. However, preparation and a consistent, honest conversation with your auditor can get you through the changes. And remember, the more work you put into the transition now, the easier it will be later.
Sources
ASC Topic 842: Lease Accounting [PDF]. (n.d.). Moss Adams.Ellis, J. (2017, June 08).
Lease Classification Under ASC 842. Retrieved from https://www.bna.com/lease-classification-asc-n73014453094/
Leases (Topic 842). (2016, February 02). Retrieved from https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176167901010&acceptedDisclaimer=true
Santanelli, P. (2019, May 05). Lease classification: Implementing the new leases accounting standard. Retrieved from https://www.bakertilly.com/insights/lease-classification-implementing-the-new-leases-accounting-standard/
A special thank you, also, to Jennifer Hannah of Richey May, Dan Humphrey of Norcom Mortgage, and Toni White of Sierra Pacific Mortgage for lending their time and knowledge. ASC Topic 842: Lease Accounting[PDF]. (n.d.). Moss Adams.Ellis, J. (2017, June 08). Lease Classification Under ASC 842. Retrieved from https://www.bna.com/lease-classification-asc-n73014453094/Leases (Topic 842). (2016, February 02). Retrieved from https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176167901010&acceptedDisclaimer=trueSantarelli, P. (2019, May 05). Lease classification: Implementing the new leases accounting standard. Retrieved from https://www.bakertilly.com/insights/lease-classification-implementing-the-new-leases-accounting-standard/
About the Author
JORDAN PAVELKA
Jordan is the Marketing and Communications Manager at Loan Vision. A rookie in the mortgage industry, she is constantly looking to learn everything she can while lending her expertise of the marketing world.
