WITH GE CAPITAL’S MONEY GONE, YOU JUST MIGHT NEED A COWBOY.
The new lease accounting rules – ASC Topic 842 were signed in 2016 with a long implementation window such that public companies must transition to the new rules in 2019. And while 2019 seems distant, many actions should begin now. The presentation requirements are to show 3 year’s P&L (2017, 2018, & 2019) and 2 year’s balance sheets – 2018 and 2019 and every operating lease with a term longer that one year has to be capitalized. The FASB kept the classification tests in place and kept the straight line P&L rent expense for operating leases with one big change – capitalizing operating leases–to give users better information. Keeping most of the framework in place was done with the lessee preparers in mind to make compliance easier. The real issues for lessees are the work involved to transition existing leases to the new rules and to set up a process to account for new leases in the new environment.
What You Should be Doing Now?
Planning
- Set up a planning team – Include staff from the controllers department, treasury, systems, business management (who use the leased assets) and purchasing. Companies with large amounts of real estate leases already have a lease administration who must also be on the team.
- Develop a list of actions, assign target dates and responsibility. The lease team has to read and understand the new rules.
Systems
- Ideally the lease accounting and management system should not only capture booking and accounting information for the leases, it should serve as a tickler file (critical date system) to warn of future events–like when a lessee must give notice to the lessor. It should also produce disclosure information–including a table of future rent obligations, weighted average term and weighted average discount rate.
- Decide if you can develop a system in-house, though it is likely too late.
- Identify commercially available systems providers that can account for both equipment and real estate leases.
- Test the systems.
- Buy the system that suits your needs.
Data Accumulation and input
- Retrieve lease documents for all existing leases. Find the business units that manage and account for the leases. Operating leases may be located by using the information the controller’s department uses to develop the operating lease payments footnote. You should also check the source of all entries to rent expense as a means of finding all your operating leases. Finance leases are grandfathered, but for ongoing implementation, you have to include all leases in your new process.
- Develop a list of the information the transition team needs to extract from each lease document including:
- Contractual lease term
- The timing and amount of contractual rents payable
- Options to purchase or renew must also be captured. They are included as a lease payment only if their exercise is reasonably assured, but even if they are not reasonably assured of exercise they should be captured by the lease accounting system for future use. Those that manage the use of the leased assets must decide if any renewals should be included in that lease term based on whether it is reasonably assured they will be exercised.
- Residual guarantees (common in fleet and synthetic leases) must be captured and assessed as to whether a payment is expected to be made. That amount (the amount that the guarantee is “in-the-money”) is included in the lease payments to be capitalized. The valuation of residual guarantees is a trouble spot as lessees may have difficulty finding expected values. It should be the responsibility of the business unit that uses the leased assets to determine if it is likely that a payment will be made under any residual guarantees. The residual guarantee has to be reviewed for adjustment whenever the lessee issues financials to the public.
- An indication of gross/bundled billed full service or net lease should be captured by the system:
- If gross or bundled billed the lease and non-lease components must be separated as only the lease component is included among the payments to be capitalized. A lessee can elect not to separate non-lease components but that is not desirable as it would result in a large overstatement of the capitalized amount. The business unit that manages the lease must separate the components of a gross billed full-service lease
- To separate the components, the lessee needs information that could be obtained by asking the lessor for a breakdown. If the lessor does not provide the information, the lessee can estimate the components by using available market pricing and information. It remains to be seen what auditors will accept as support for estimates.
- Variable rent clauses must be captured by the system
- Rents based in indexes like CPI or a rate like LIBOR must be accounted for using the spot rate at the date of booking.
- Other variable rents are accounted for as incurred unless they are considered “disguised lease payments” (meaning the contractual rents are below market and the variable rents are reasonably assured of being incurred) and in that case, an estimate must be capitalized). Other variable rent expenses must also be captured for disclosure purposes.
- Determine a discount rate for each lease to calculate the present value of payments to capitalize the lease. That discount rate is the lower of the lessee’s incremental borrowing rate (supplied by Treasury based on the lease term) as of the date the lease is being booked or the implicit rate in the lease (if known – it is typically only known in synthetic leases and split-TRAC leases where the lessee knows the lessor’s residual assumption). For floating rate leases use the rate in the deal (usually LIBOR/CP plus a spread) to develop the projected payments (the amount capitalized is the unamortized lease balance).
- Identify any unamortized IDC, unamortized landlord allowances and any accrued rent payable associated with each lease in existence during the transition financial reporting periods. Those amounts are elements (sub accounts) of the ROU lease asset and should be input into the lease accounting system. To ease the compliance burden, the FASB allows the lessee a transition relief package to continue using existing GAAP/definitions for items like IDC, lease classification, sale treatment in a sale-leaseback and leases embedded in contracts. At this point, the lessee has all the information needed book all existing operating leases.
- Input the information into your system for each lease. Test the results.
- An indication of gross/bundled billed full service or net lease should be captured by the system:
Process for New Leases
The new rules will require a new process to book leases that will involve the participation of several disciplines in the lessee organization. The process must be developed with documented internal controls. That process should include:
- The accounting department must receive and review every new lease, any modification (including trade-ups) to an existing lease and every new agreement that involves the use of assets as it may have a lease embedded in it. The terms and lease payments have to be extracted and input as described in the transition section above.
- The treasury department must provide information on incremental borrowing rates to book the new leases and modifications. For leases with variable payments based on an index or rate, Treasury must provide information on changes in CPI and any interest rate for floating rate leases. To ease the complexity the FASB allows a lessee to hold off on rebooking a lease with variable rents based on a rate or index where the rate or index changes the contractual rents. The lessee need only rebook when the lease is modified or when the lessee does something that changes the assumptions. This presents an issue – do I rebook anyhow or do I track the “un-booked” variable rent changes as they must be disclosed and they must be paid and expensed (the system has to have the ability to track “un-booked” variable rents).
- The accounting department must classify the lease as an operating lease or finance lease using the appropriate discount rate, the lease term and the lease payments (including interim rents and any other payments the lessor can force the lessee to pay) for the PV classification test, the useful life for the term vs useful life test, and whether there is an automatic transfer of title or a bargain purchase option. The accounting department must then record the lease.
The ongoing accounting is complex, so a lessee accounting system is recommended with all the controls, history, report generation capability, etc. The days of managing operating lease accounting using an Excel spreadsheet are over.
About the Author:
Bill Bosco is the Principal of Leasing 101, a lease consulting company. Bill has over 40 years’ experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the Equipment Leasing and Finance (EFLA) accounting committee since 1988 and was chairman for 10 years. He is a frequent author and speaker on leasing topics. He has been selected to the FASB/IASB Lease Project working group as a representative of the ELFA. He can be reached at wbleasing101@aol.com, www.leasing-101.com or 914-522-3233.
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