How to Handle New Lease Accounting Standards
It's tax season.
Amid the collective groans from business firms and individuals alike, there are also some new standards that will affect private companies and non-profits with a lot of leased space on the books. The new standards are already in effect for publicly held corporations.
Updated standards were originally timed to become effective in December 2019 for all business entities, but the target date for implementation by private firms is now the first fiscal reporting year after December 15, 2020. Even with the year-long reprieve, the change may well be burdensome, according to some tax accountants.
Affected businesses must treat operating leases as liabilities, according to the Financial Accounting Standards Board (FASB), under the new rules. The change is expected to add a layer of complexity to record-keeping and reporting. It's not a "lease Armageddon," according to Matthew Derba, a director in the New York office of CohnReznick. He adds that there is much new information to digest, and the new standards pose a more difficult challenge than originally expected. But he remains optimistic that "leasing will thrive" and the new deadline is reasonable and achievable.
An Overview of Change
The new standards were first ratified in 2016 by the FASB, following a long period of consideration. The FASB is the non-profit oversight group that oversees GAAP, the gold standard of Generally Accepted Accounting Practices. New standards, known as ASC842, apply to leases of more than one year, and became effective for corporations on December 15 of last year. However, the bulk of American companies are not corporations. It is estimated that the standards will affect more than six million private businesses, in contrast with just 4,000 public companies.
A Deloitte poll in February 2019, approximately 10 months prior to the implementation deadline, found that fewer than seven percent of public companies felt unprepared. The picture was much different on the private side: Only 17% of company executives felt prepared for the change, while 33% reported feeling unprepared. That was enough, apparently, to offer a time extension.
In addition, implementation has proved to be more time-consuming than expected for the public companies. One of the difficulties was in underestimating the length of time needed to review leasing contracts and identify specific leases that fall under the aegis of the new FASB standard. Calculations are complex, according to MRI Software Senior Vice President of Occupier Solutions Mandira Mehra. Traditionally, there has been a separation of duties between the property team that deals with property leases and the financial department that handles balance sheet reporting. Mehra cites a need for closer collaboration in order to adhere to new standards.
Lease terms and conditions that can affect the reporting include such provisions as free rent, other types of dollar credit, materiality, operating clauses, and even the actual definition of what kinds of agreements between parties actually constitute a lease. LeaseCrunch CEO Ane Ohm points to the healthcare segment as an example of businesses that "embed" leases in what are termed service agreements. A physical asset can be considered leased property, she notes, and it would count as a lease to be reported under the new standards even if it isn't specifically called a lease.
The Benefits of Technology Tools
Lease accounting compliance is made easier, according to the experts, with software specifically designed to track leasing obligations. Mehra notes that, when it comes to compliance, there is no margin for human error, and that even with targeted lease-accounting-specific software, preparing for the reporting change is no walk in the park. Private companies, in particular, have been slow to move in the direction of such specific software. The Deloitte survey found that more than half of public companies use such specific program, but less than 13% of private firms have adopted such tools. It was found that about 44% still rely on manual accounting practices, patchworked into existing accounting software.
A recent article in Accounting Today forecasts that by the deadline, more than $3 trillion in lease liabilities will have been reported on the balance sheets of private companies and non-profits. It should be noted that firms do not have to wait for the deadline to implement the changes, and some forward-thinking businesses have already done so.
Deloitte audit and assurance partner Mark Jacobs notes that this is the first major change in accounting practices in nearly 40 years, and, although the learning curve may be steep, there are some benefits. He suggests studying the lessons learned by early adopters of ASC842.
Some major takeaways, in his opinion, include:
- Technology solutions are necessary, but the time frame to switch from manual record-keeping may be extended;
- More coordination will be required to properly identify, manage, record and "account for" leases under the new standards;
- Leases must be recorded on the balance sheet using a "collateralized incremental borrowing rate," and that can be complicated;
- Existing processes and controls will almost certainly need to be examined, and probably upgraded;
- Compiling lease data will require thought and judgment; reportable leases may exist across many individual business departments; and
- Most importantly, some leases are not clearly labeled as such.
Outlook for Property Managers and Leasing Agents
Clearly, the new standards affect property leases. Commercial real estate companies, in particular, have a vested interest in assuring that both leasing agents and financial managers have available all the guidelines, tools and information sources necessary to ensure the standards are understood and applied correctly.
"A carefully thought-out ASC 842 implementation can yield enhanced analytics, modeling and forecasting capabilities," Deloitte audit and assurance partner Mark Davis wrote in Accounting Today. "At the same time, new lease accounting processes can jump-start related initiatives such as procurement or real estate management and optimization, contract management and compliance and contract digitization."
Many questions exist, both for lessors and lessees.
Savills Managing Director Nate Brzozowski notes that a company's leasing activities impacts many areas of operation, and that the variables are almost unlimited. But, he also doesn't think that leasing behavior will be altered dramatically by the new reporting requirements. Strategic planning, he notes, has always involved weighing pros and cons, and that will continue to be the way future leasing decisions are made.
Other analysts point out that leases will add debt to a company's balance sheet, and that may lead some companies to seek alternatives such as co-working spaces, short-term leases, or purchasing property. Such decisions must always be made based on individual circumstances. The new standards may add another consideration to the mix, but the consensus is that they will not reach the status of a deciding factor.
So, chances are high that, come next year, not much real change will be felt in the leasing community.