An Intro to ASC 842
Historically, the prevailing standard for lease accounting was ASC 840. Under this standard, lessor and lessee could circumvent the exclusion of an asset or liability for a capital lease by structuring their transaction as an operating lease. For operating leases and other asset contracts, the asset and liability could be excluded from the lessee’s books. The effect of not recording the asset and liability was that the financial statements of an entity that entered into operating leases with a term of greater than one year were understated because such transactions were not recognized. In general, the lease terms under ASC 840 provided an incentive for the lessor and the lessee to enter into operating leases since that would avoid the requirement to record the asset and liability on their respective balance sheets.
The objective of ASC 842 is to record leases on an entity’s balance sheet and to replace ASC 840, Leases. This is meant to provide comparability between entities that do not use leasing transactions and those that do, and, as a result , to improve the financial reporting of leasing transactions. The staff believes that the capitalization criteria in ASC 840 did not produce timely information about the amount, timing, and uncertainty of cash flows arising from leasing transactions, which is necessary for investors and other financial statement users to understand the cost of those transactions.
ASC 842 changed the type of lease an entity must record on its books analyzed by the term of the lease and the risk of the asset to the lessee. For finance leases, the lessee must recognize the lease liability (the present value of the lease payments not yet made) and the right-of-use (ROU) asset (representing the lessee’s right to use the asset for the lease term). For operating leases, the lessee must recognize a lease liability (the present value of the lease payments not yet made) and either (1) the right-to-use asset (representing the lessee’s right to use the asset for the lease term), or (2) net present value of the total lease payments, or (3) the ROU asset and the lease liability adjusted to reflect the lease costs, adjusted for impairment.
Key Disclosure Obligations
ASC 842 introduces several new disclosure requirements that are designed to provide a comprehensive overview of an entity’s leasing activities and the impact on financial statements. The disclosures are intended to provide additional transparency by clarifying the amount, timing, and uncertainty of cash flows from leases and the nature of an entity’s leasing transactions. The disclosures are to supplement the recognition, measurement, and classification.
For lessees and lessors, ASC 842 requires disclosures of lease obligations, right-of-use assets, and other impacts on the Statement of Operations, Balance Sheet, and Cash Flow Statement. In addition to the specific measurement and classification requirements for lessees, the entity should also provide qualitative and quantitative disclosures.
The qualitative disclosures should describe how the recognition and measurement of leases affects the entity’s financial position, cash flows, and results of operations in the period. Disclosures should include the nature and extent of leasing arrangements including policies for determining whether a contract contains a lease, the significant judgments and assumptions (including the discount rate used) in applying ASC 842, and residual value guarantees, options to extend or terminate leases, restrictions imposed by a lease, and how the entity determines variable lease costs.
ASC 842 contains a number of quantitative disclosures that generally align with existing guidance under U.S. GAAP: ASC 842 requires specific disclosures of lessors for sales-type leases and direct financing leases that are in addition to the disclosure requirements for operating leases. For lessors, ASC 842 requires:
EMB has created an easy to read, comprehensive summary of all the new disclosure requirements for lessees and lessors.
Comparison with ASC 840
When comparing ASC 840 with the current leasing standard (ASC 842), there is a marked change in the disclosure requirements. The changes span both the qualitative and quantitative information that must be disclosed, as well as the frequency with which certain information must be disclosed.
In general, the former standard under ASC 840 required a number of both mandatory and voluntary disclosures. However, the disclosure requirements under the new standard are significantly more extensive. The new disclosure requirements for lessees relate to the nature of their leasing arrangements, the costs for such arrangements, and significant assumptions and judgments made during the process of accounting for the leases.
ASC 842 expands upon ASC 840 by requiring companies to disclose exit costs associated with terminating or modifying leasing arrangements. The disclosure of the costs for leasing arrangements must include the location and amount of each of the asset classes within the leasing arrangement that it will retain (or not retain) after the termination or modification, and the estimated costs associated with the termination or modification. In keeping with this information, the company must also disclose the estimated completion date and future cash flows related to the costs. In addition, companies must explain the significant assumptions and judgments used to determine the costs of the termination or modification, including key assumptions regarding lease term. Similar disclosures are required for leases that are contingent upon a sale that will likely occur.
The new standard is substantially more extensive in relation to both the qualitative and quantitative disclosures which are required.
Implementation Pitfalls
Moving from an analysis of why ASC 842 disallows broad categorical disclosures in a previous piece, here’s a look at some practical issues I’ve encountered in talking to companies preparing to comply with the new rules.
Interestingly, data gathering is the most common implementation challenge people mention. The problem is compounded by the size and scope of the data in the lease portfolio. Related to this information, but on a slightly different track, the organization’s system upgrades are not something they seem to be ready for to support the requirements of the new standard, particularly when it comes to identifying lease portfolio changes. Compliance costs are not insignificant, and are increasing for many companies. A major component of compliance costs involves tracking down the huge amounts of specific data required by the new standard. ASC 842 requires companies that lease assets and liabilities (largely real estate) to gather extensive amounts of specific data. Such data can be housed in numerous places. There’s a big downside: it’s not centralized. It may be stored in various places within the finance and IT sections as well as in other departments such as procurement, operations, facilities management, and real estate. It is not just the absence of centralized data storage that poses a problem. It’s the fact that the data is scattered across the organization’s many systems, many of which need expensive upgrades to comply with the new standard. Many of these costs will not be expected by the purchasing department, so it’s a good idea to make them aware of the additional charge for the comprehensive information. After gathering the extensive amounts of specific data, another huge challenge lies in updating systems so they can handle mass changes across the lease portfolio. Some organizations think they can manage the data via spreadsheets. This may work for a number of smaller real estate leases but transporting that to thousands of small leases, including leases for equipment, is mostly not going to work. Fortunately, the cloud is set up for processing mass amounts of data. It is good to know that this workable solution is available, both for the processing of data and centralizing the storage of files.
With an Eye toward Best Practices
The following best practices can help companies to comply with ASC 842 disclosure requirements:
Leverage technology. Technology solutions can enable a consistent, enterprise-wide approach to ASC 842 compliance. They can help you to efficiently assess the operation of your current leases and the sources and quality of data, and then determine where disclosure gaps exist. Some enterprise resource planning (ERP) and accounting software systems will come with built-in capabilities for ASC 842 compliance, but others may require supplemental software or transitioning to a new system.
Take a "big picture" approach. A number of companies may end up providing one set of ASC 842 disclosures for the initial period (full-year or quarterly) and another , more robust set for the next period. You can avoid this disruption by taking a big picture approach to compliance. Consider how your company expects to grow in the next few years and how lease acquisitions and dispositions could impact future disclosures.
Consider disclosure implications when making policies. Many updates and changes in accounting policies have disclosure requirements. Making judgment calls now about arrangements that involve variable lease payments, renewals, purchase options, discounts and other issues can affect the disclosures required for both current and future leases, and conversely, disclosures can help inform your decisions.
The Impact on Financial Statements
The most immediate area of accounting that ASC 842 will have an impact on is a company’s financial statements. The new leasing standard requires a full disclosure of all leases. It is supposed to improve the financial reporting and consistency of accounting for leases. In particular, it will provide financial statement users with transparent financial data about a company’s performance, cash flows, obligations and use of assets.
Companies can expect that the new disclosures will offer an improved ability to assess the amount, timing and uncertainty of cash flows arising from the entity’s leases. The disclosures are also intended to help users assess: ● the amount, timing and judgements made in applying lease criteria to leases, including significant judgments and changes in judgments regarding recognition, measurement and cash flow presentation ● any uncertainties surrounding the amount of liabilities resulting from judgements made ● the lease assets and liabilities arising from both finance leases and operating leases ● the lease expenses ● supplemental or transitional disclosures in the initial reporter’s first annual disclosures to comment on the new requirements.
The disclosures are intended to be presented in a way that will provide users with relevant data to evaluate a company’s cash flow and liquidity. The new standard has four primary objectives: Although the overall financials will change, some of the line items will remain the same:
Balance Sheet Changes Under the previous GAAP, lessees applying the new GAAP transition date of Dec. 15, 2018, will make the following balance sheet adjustments upon implementation of the new standard: As the new GAAP primary balance sheet changes may not significantly impact a company’s true liquidity, below are the specifics of expected impact to current assets or liabilities, and future year income statements.
Income Statement Changes ASC 842 will require companies to recognize rent expense over the term of the lease (or combined lease term for related-party operating leases) using the effective interest rate method or amortization method. The lease payments will be recorded as interest expense and principal reductions.
Examples & Case Studies
The adoption of ASC 842 at over 5,000 public companies and 175,000 private companies has prompted enough success stories that we can now provide readers with some real world examples highlighting how companies in several industries have planned and effectively implemented strategies to address and reduce the costs of implementing ASC 842.
In July 2018, Jacobs, a Dallas-based engineering company with $15 billion in revenue, was one of the first public companies to file its quarterly report (Form 10-Q) for the period ended June 29, 2018, prepared using ASC 842. The 10-Q also included the Company’s condensed consolidated financial statements prepared using the five-step ASC 606 revenue recognition standard. Jacobs was able to implement ASC 842 by re-using the core ASC 606 implementation team to adjust its technology to support the new ASC 842 standard. The core team met weekly to design and test the technology, while special teams focused on the manuals needed to support the new standard.
In response to ASC 842, Jacobs was able to retain existing software – SAP – it had already been using for years. Jacobs approached the in-scope contracts in an incremental manner that gave space for input from accounting, tax, and legal departments on the most significant contracts during January 2018. The in-scope group, which included IT, payroll, and HR professionals, defined the contracts and created the policy, which was then provided to the executive team before being presented to the audit committee for review.
Jacobs star team was able to efficiently implement the new standard and to continue its wide-ranging support of this transition by creating a "hub" for the new accounting and reporting principles which encompassed multiple topics including ASC 842, ASC 606, leases, tax, goodwill impairment, and share-based compensation.
Keep It Simple. One of the country’s largest insurance brokers with more than 10,000 employees and over $4 billion of revenue, Barnett Vivekananda & Bolin, Inc. (BV & B) , was able to leverage its existing contract management system, and its implementation of the ASC 606 revenue recognition standard, to address ASC 842’s lease liability requirements. BV & B created an inventory of its leases and entered into a contract management system its internal data elements including terms, termination clauses, escalation clauses, and other key contracting information. BV & B was able to integrate its reporting capabilities into its contract management system, creating a single view of leases from any angle and enabling management to quickly identify patterns and trends across multiple leases and line items. This allowed the company to best determine when they should purchase a lease, negotiate discounts or incentives in exchange for signing longer term leases, and seek to negotiate buyout options for leases in which the projections are less favorable over the course of the contract.
Success Through Keep It Simple. In December 2017, we shared Precise Surgical, Inc.’s story of cost-effective and timely implementation of ASC 606. Precise, a startup, was able to apply the same time and effort and methodology to ASC 842. From the start of 2017, the company understood the requirements of both 606 and 842 were significant. Precise only contracts with hospitals and distributors, however its contracts were more bifurcated than its competitors. Rather than spend an exorbitant amount of money for a solution to incorporate its entire set of contracts, Precise worked with its auditors to evaluate materiality and then focused on the contracts with the most significant liabilities and revenues. The company adhered to the "keep your eye on the prize" philosophy and initially limited its focus to contracts which had a $250,000 – $6,000,000 range. It then expanded its focus to its healthcare provider customer based contracts. Although Precise ultimately needed additional functionality to address its long-term supply agreements with the government, the company was able to use the same provider as it had for both ASC 606 and 842.