June 16, 2016 Dallas Marriott Las Colinas • Irving, TX New Lease Accounting Standards: What You Need to Know
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June 16, 2016
Dallas Marriott Las Colinas • Irving, TX
New Lease Accounting Standards: What You Need to Know
What We Learned
On behalf of the FEI Dallas Chapter, I am pleased to share that Financial Executives International (FEI) held a successful financial reporting conference on the new leases standard in Dallas on June 16, 2016.
As many have heard, the new leases standard issued early in 2016 by the Financial Accounting Standards Board (FASB) will change the way leases are accounted for decades to come. Its impact will be sweeping across industries and organizations. With the adoption date looming, the importance of utilizing the time we have between now and the adoption date cannot be overstated.
With this in mind, our first preparer-focused conference brought financial executives together to get a head start on planning for the adoption of the new standard and to better understand its impact on their organizations.
We could not have pulled this off without the help of our expert session leaders who traveled across the country to convene at our conference, and who provided valuable advice and insights during our learning sessions. We are grateful for their support and the support of our event sponsors and their generous contributions to what was no doubt the best leases conference in the country.
Most of all, we thank the 250-plus attendees who were treated to a truly comprehensive overview of the new standard. You now have valuable insights to take back to your organizations to ensure successful implementation of the new standard. This was a conference to remember.
As the association of choice for CFOs and senior-level financial executives, FEI is committed to bringing you the latest in thought leadership, advice and insights. To that end, we’d like to share our edition of What We Learned: Lease Accounting Standards Conference — June 2016.
If you missed our event, please look for additional education opportunities from FEI in the future. This is only the beginning.
Lista Lista Hightower2015-2016 FEI Dallas Chapter PresidentChief Financial Officer, Mothers Against Drunk Driving
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Thank you to our event sponsors.
June 16, 2016 • New Lease Accounting Standards: What You Need to Know
Table of Contents 4 New Lease Standard — Technical Accounting Session (U.S. GAAP)
9 IFRS 16 — Compare and Contrast Difference From FASB Standard
12 Adoption, Timing and Planning
15 ICFR Data Expanding Under New Lease Standard
16 Where’s the App? Emerging Lease Management Technologies
18 Implications from a Business Strategy and Operations Perspective
20 Ask the Experts: Capital Markets and Investors Answer Your Questions on What They Expect From Companies
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What We Learned
New Lease Standard — Technical Accounting Session (U.S. GAAP)Scott Muir, Partner at KPMG led a technical accounting session covering the new standard from a U.S. GAAP perspective.
What we learned …
Lease IdentificationWhile the new lease accounting standard brings big changes to the balance sheet, Muir eased some concerns about the scope of the changes, noting “you should expect that the vast majority of your leases today will be leases tomorrow.” Therefore, what’s most important now is to make sure you have a complete population of leases.
Muir did caution, however, that a closer look into the control criteria in the new standard would generally be necessary for those leases that meet the current definition of a lease in ASC 840, solely because of the third control criterion (criterion c) in ASC 840-10-15-6 (formerly EITF 01-8) — a nod to the fact the new guidance could, in some cases, change the conclusion because it now requires that the customer have the right to direct the use of an identified asset (a “power” element of control) for there to be a lease, not just the right to obtain substantially all of the output or other utility from the asset.
Muir explained there are three “legs” to the definition of a lease under the new standard:
1. There must be an identified asset, which means there is an explicitly or implicitly specified asset and the supplier does not have the substantive right to substitute that asset for another asset. A substitution right is substantive only if the supplier can practically effect that substitution and would benefit economically from doing so (i.e., the incremental revenue that can be derived as a result of the substitution exceeds the costs of effecting that substitution — e.g., transporting and installing the replacement asset).
2. The customer must have the right to obtain substantially all of the economic benefits from use of the asset during the period of use in the contract. Economic benefits goes beyond solely the capacity or direct output from the asset to include things like by-products (e.g., steam from a production facility that can be sold or used for power production) or renewable energy credits generated by use of the underlying asset.
3. The customer must be able to direct the use of the underlying asset, which generally refers to the customer’s ability to direct (and change) how, and
[ Figure 1 ]
for what purposes, the asset will be used during the period of use in the contract (e.g., when, whether, where, and/or for what the asset will be used). The presence of mutually agreed restrictions on use of the asset generally will not, in isolation, preclude the customer from having the right to direct the use of the asset.
The three legs of the lease definition were presented by Muir in Figure 1 above.Once one or more leases have been identified, lessees and lessors must
appropriately identify any other components of the contract. Components include all of the goods (including leases) or services provided by the lessor to the lessee. Many leases will include non-lease components (e.g., maintenance or operations services). Components do not include activities that do not transfer a good or service to the customer or that simply reimburse costs of the lessor that would be incurred irrespective of the lease (e.g., property taxes and insurance on the leased asset).
Lessees and lessors will generally allocate the consideration in the contract between those components on relative standalone price basis, with the amounts allocated to lease components driving the lessee’s new lease liabilities and right-of-use assets. However, Muir noted lessees are permitted, as an accounting
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
policy election made by class of underlying asset, to forgo this exercise and accept a larger lease liability by choosing to not separate lease from non-lease components, and instead account for all of the payments associated with the lease contract as lease payments.
Key Definitions and Lease ClassificationIn determining the initial recognition and subsequent measurement under the new standard, Muir noted certain definitions are key to getting the accounting right.
Lease term includes (a) noncancelable periods, (b) optional renewal periods (if lessee is reasonably certain to exercise), (c) periods after optional termination date (if lessee is reasonably certain not to exercise), and (d) optional periods to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. However, Muir noted the “determination of the lease term under the new leases standard will remain substantially unchanged from current U.S. GAAP. ”
The determination of what make up lease payments, as noted by Muir, is important because it determines what ultimately becomes the lease liability. The new guidance requires lessees to record a right-of-use (ROU) asset and corresponding liability for all leases in scope other than short-term leases. The lease liability is measured on a discounted basis and based on the identified lease payments.
In accordance with the new standard, lease payments include (a) fixed payments (including in-substance fixed payments, less lease incentives paid or payable to the lessee), (b) termination penalties (when the termination options is assumed to be exercised in determining the lease term), (c) exercise price of purchase options (when reasonably certain of exercise), (d) residual value guarantees (amount probable of being owed) — lessees only, and (e) variable lease payments (based on an index or rate at lease commencement).
The discount rate, by definition, is the rate implicit in the lease if that rate is readily determinate. However, because the rate implicit in the lease will very rarely be readily determinable, lessees will generally use their incremental borrowing rate to discount the lease payments in the contract.
For lessees, the new standard will still distinguish between capital leases (which will be referred to as “finance leases” in the new standard) and operating leases with the classification test remaining largely unchanged as shown in Figure 2 (right). When speaking about classification between operating and finance lease treatment Muir noted “the vast majority of your operating leases today will be operating leases
tomorrow.” Likewise, “the vast majority of your capital leases today will be finance leases tomorrow.” However, Muir did caution that where some small measure of change is likely, that is most likely to be a small portion of operating leases becoming finance leases under the new standard as a result of factors such as the new alternative use classification test, elimination of a couple of exceptions that exist in current GAAP, and changes to what get characterized as lease payments compared to today.
Lessee Accounting: Recognition And MeasurementLessees will recognize and measure a lease liability and a right-of-use (ROU) asset for all leases other than short-term leases (i.e., those with a lease term of 12 months or less) at the lease commencement date.
Measurement of the lease liability will not be affected by lease classification — that is, the lease liability is measured in the same way regardless of whether the lease is a finance lease or an operating lease. The measurement of the lease liability at commencement and subsequently “will always equal the present value of the unpaid
[ Figure 2 ]
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What We Learned
lease payments” Muir said. Initial measurement of the ROU asset is also the same regardless of lease classification. The ROU asset begins with the lease liability, to which the lessee adds any initial direct costs and prepaid lease payments, and subtracts lease incentives received. Because of these adjusting items, the ROU asset will often not equal the lease liability either initially or at other points during the lease term.
However, the subsequent accounting for the ROU asset will be driven by whether the lease is classified as a finance lease or an operating lease.
n FInAnCE LEASE TREATMEnTFor finance leases, a lessee will record interest expense (under the effective interest rate method) on the liability component and amortization/depreciation expense on the ROU asset, which are, like today for capital leases, presented separately in the income statement (consistent with how other interest expense and amortization/deprecation expense are presented). The combination of generally straight-line ROU asset amortization and interest expense will result in increased (or front-loaded) interest expense for entities in the early years of a lease, based on the use of the
effective interest rate method applied to the liability component. However, while finance lease accounting is substantially similar mechanically
to capital lease accounting, new definitional differences (e.g., lease payments vs. minimum lease payments), changes to the separation and allocation guidance for components, and significant changes resulting from the new reassessment requirements and the new lease modification guidance mean the accounting for many finance leases will be different from the accounting that would result from capital lease accounting today.
n OPERATInG LEASE TREATMEnTFor operating leases, lessees will record lease expense on a straight-line basis over the term of the lease as a single line item, consistent with the income statement effect of operating leases today. Muir shared two approaches (Method 1 and Method 2) for measuring the operating lease ROU asset after lease commencement, each of which would result in the same measurement:
In Figure 3 (left), Muir illustrated each method, and demonstrated how the differing mechanics of the two methods would produce the same results.
Reassessments And ModificationsMuir described the circumstances under the new standard that require a lessee to remeasure its lease liability, as well as how to account for a remeasurement.
At a high level, the lease liability should be remeasured when there is a change in a. the lease termb. exercise of a purchase optionc. the amount probable of being owed under a residual value guarantee, or d. performance and use contingencies associated with a variable lease payment
that subsequently becomes fixed after resolution of the contingencyImportantly, Muir noted “the reassessment of the lease term or purchase option
exercise will only occur upon the occurrence of a triggering event that is within the control of a lessee” (e.g., the lessee decides to build significant leasehold improvements that compel it to extend the lease term or enters into a sublease that requires exercise of a renewal option to fulfill).
In addition, the lease liability is remeasured when there is a modification to the lease. Muir noted the modification guidance under the new standard is substantially different from the relatively limited modification guidance in current GAAP (ASC 840).
Reassessment and remeasurement is a done on a generally prospective basis.
[ Figure 3 ]
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
That is, with only limited exception, the change in the lease liability resulting from a remeasurement is offset by an equal adjustment to the associated ROU asset.
Lessor Accounting ChangesThe headline here is that “lessor accounting is not being fundamentally changed,”
Muir noted. Current accounting under U.S. GAAP can result in four different models (sales-type, operating, direct financing, and leveraged lease) compared to the IASB’s two-model approach (finance and operating). The new FASB model eliminates the “leveraged lease” classification prospectively (leveraged leases that commence before the effective date will continue to be accounted for as leveraged leases unless they are modified after the effective date) and results in more leases qualifying as either sales-type or direct financing leases. Operating lease treatment will still be maintained. There are, however, some less-dramatic, but important, changes that will affect lessors.
Figure 4 (left) illustrates some of the key changes applicable to lessors.
DisclosuresUnder the new standard, there will be more disclosure requirements for lessees and lessors. The objective of the disclosure requirements is to provide more transparency around leasing activity, particularly for lessees, to enable investors and other users of financial statements to assess the amount, timing, and uncertainty of cash flows
[ Figure 4 ][ Figure 5 ]
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What We Learned
arising from leases more accurately. The new standard’s disclosure requirements are highlighted in Figures 5 (previous page) and 6 (above).
Effective Dates And TransitionThe effective date of the new standard was delayed until 2019 for public companies and 2020 for non-public companies, partially to allow enough time for preparers to adopt the new revenue recognition standard first. However, preparers have the option to early adopt the new leases standard at any time, either before or concurrent with their adoption of the new revenue standard. Muir said some lessors may find adopting the new revenue and leases standards concurrently may be beneficial because of the interrelationship between many of the concepts and requirements.
Figure 7 (right) lists the effective dates of the new standard and describes the required transition method.
Some lessees may choose to early adopt, for instance, if they have existing issues resulting from failed real estate sale-leaseback transactions or build-to-suit leasing transactions because the transition provisions may alleviate some of those issues.
Slides courtesy of KPMG. © 2016 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG international Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
For lessees, the new standard will still distinguish between capital leases (which will be referred to as “finance leases” in the new standard) and operating leases, with the classification test remaining largely unchanged.
[ Figure 6 ] [ Figure 7 ]
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
IFRS 16 — Compare and Contrast Difference From FASB StandardThe discussion of differences between the new IFRS leasing standard and the FASB’s final standard was presented by James Barker, a Deloitte partner.
With the new standard, many had hoped both the new IFRS version (IFRS 16) and the FASB standard (ASC 842) would be the same. While largely converged in terms of moving to a balance sheet approach for all leases, including operating leases, there are several major differences.
ScopingScoping will be different. ASC 842 only includes property plant and equipment (PP&E), which is similar to today’s standard. However, the scoping under IFRS 16 will be much broader as it is not limited to PP&E. Additionally a company can make an election for lessees to apply guidance to intangibles, a provision that does not exist in the U.S. standard. “Once you get through scope, the definition of a lease will be the same between the two standards,” Barker stated.
MaterialityUnder ASC 842, there will be no exemption for lower value items, although some preparers may achieve a similar result through accounting conventions and/or capitalization policies. Barker did caution that a discussion with your auditors may be necessary when finalizing this decision.
According to Barker, “Under the ASC 842, although there is not an explicit exemption amount, companies should consider materiality,” noting that IFRS 16 will provide for a scope out for “small ticket” values under $5,000. Both standards will also scope out short-term leases with terms of 12 months or less.
Figure 8 (right) illustrates some of the key scoping and materiality differences.
ExpensesUnder U.S. GAAP, the boards retained the distinction between an operating and finance lease, whereas the model under IFRS 16 will follow a single income statement approach following a “finance lease” approach. That is, companies will still go through a lease classification test to determine what type of lease they have, Barker noted, adding while the U.S. model may be more complicated, “it is something the preparer community really wanted and the FASB ultimately accommodated them.” Barker also
stated that “this is likely the most significant difference between the two standards.”
Lease Paymentsnoting another difference, Barker commented on variations in the reassessment triggers for variable lease payments based on an index or rate.
Under ASC 842, those types of variable payments would only be reassessed when a lease obligation is reassessed for other reasons. Under IFRS 16, that reassessment and re-measurements will occur whenever there is a change in contractual cash flows. “From a remeasurement standpoint or leases that have frequent changes to them, this is significant” stated Barker. “The FASB, from an implementation viewpoint, was trying to make this issue a bit simpler,” he noted.
Figure 9 (next page) further illustrates the expense and lease payment differences.
Lessor AccountingLessor accounting will largely remain unchanged under both standards, with the boards deciding to leave most key aspects of lessor accounting as they are currently. Current accounting under U.S. GAAP can result in four different models (sales-type, operating, direct financing, and leveraged lease) compared to the IASB’s two-model approach (finance and operating).
[ Figure 8 ]
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What We Learned
These differences in lessor accounting and subleases accounting are illustrated in Figure 10 (above).
Sale And Leaseback ArrangementsThe sale/leaseback model is changing under the new standard, including how we think about repurchase options. In addition, the new standard will require companies to go through an analysis under the new revenue standard (ASC 606 or IFRS 15) to determine whether the conditions to qualify as a sale have been met. However, U.S. GAAP contains a restriction that if it is determined that the lease is a finance lease it cannot qualify as a sale. This restriction does not exist in the international standard.
Gain recognition is also different under both standards. with U.S. GAAP allowing for immediate recognition upon a sale, versus a deferred model under IFRS 16 with a portion of the gain related to the residual portion of the asset being recognized immediately and the remainder being deferred over time.
Early AdoptionSome companies may want to consider early adoption, particularly lessors, Barker noted. The U.S. standard does not require adoption of the new revenue standard at or before adoption of the new leases standard. On the other hand, the international
The new FASB model will bring U.S. GAAP closer to IFRS by eliminating the “leveraged lease” classification (existing leveraged lease transactions will continue to be accounted for as leverage leases unless modification results in a new lease), resulting in more leases qualifying as either sales-type or direct financing leases. The IASB model will remain largely unchanged with lessor leases qualifying for finance or operating treatment.
“When it comes to sales-type and direct finance leases, it is important to note that under the U.S. standard, we still have the two types of leases. Under the international standard we don’t,” stated Barker. That is, lessor accounting under ASC 842 companies could have a sales-type lease or a direct finance lease depending on the lessee’s control of the asset. However, under IFRS 16, there will be no distinction between a sales-type lease and direct finance lease. The dealer’s profit for a finance lease is recognized up front without regard to IFRS 15.
SubleasingAcknowledging that “conceptually” the international standard might be more sound than the U.S. GAAP version, practically the FASB standard “makes a lot more sense,” Barker stated.
[ Figure 9 ] [ Figure 10 ]
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
standard does not allow earlier adoption of the new leases standard. Barker did point out, however, that because certain elements of the new
leases standard are dependent upon conclusions reached under the new revenue standard, the FASB has preliminarily stated that for U.S. GAAP purposes it would be appropriate to early adopt those aspects of the new revenue standard for purposes of lease adoption to the extent the leases standard is adopted prior to the new revenue standard.
Figure 11 (above) illustrates key differences in sales and leaseback transactions and adoption considerations.
Slides courtesy of © Deloitte Development LLC. All rights reserved.
[ Figure 11 ]
Under U.S. GAAP, the boards retained the distinction between an operating and finance lease, whereas the model under IFRS 16 will follow a single income statement approach following a “finance lease” approach.
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What We Learned
Adoption, Timing and PlanningThe discussion on the practical side of the implementation timeline and adoption process was presented by Anastasia Economos, Partner, EY, and John Bober, Managing Director, Global Technical Controller, General Electric.
OverviewThe basis for this discussion was a survey and subsequent report titled Paving a path to success: preparing for new lease accounting standards. The survey was conducted by EY and Financial Executives Research Foundation (FERF) during March and April 2016 to assess the readiness of approximately 125 companies across a wide variety of industries. Respondents were generally CFOs and other high-level executives within accounting and finance functions.
A unique aspect of the new standard is that compliance is going to require a cross-functional effort to understand where data is coming from. Accountants are going to have to understand why their organizations lease assets, and potentially step out of their own function to do so. Bober stated that “leasing is not an accounting activity, it is a business activity. Companies tend to lease non-ordinary assets, which are managed by specialized asset managers.”
One of the factors financial statement preparers will have to understand as they launch a lease accounting compliance effort is the business reasons underlying their companies’ leases. For instance, Bober said, companies may enter into leases for financial or tax reasons, to address short-term needs for assets, or to take advantage of expertise in areas such as real estate management.
Understanding the motivations behind these leases can be helpful in collaborating with business-unit managers and identifying the company’s lease inventory.
Current StatusCiting the report, Economos said nearly half of responding companies have started a lease accounting assessment effort. “Most of the steps companies have taken so far have been diagnostic,” she noted. “Companies are forming cross-functional working groups to understand their inventory of leases, the data’s that available to assess what they’re doing currently, and to identify what they’ll need to start doing differently.”
Unlike the new revenue recognition standard, where companies are determining if their current process will change, with the new lease standard most companies will have to update their systems and re-write their current policy, and aren’t likely to have
processes, systems or data in place to be in compliance. Figure 12 (above) illustrates the actions taken by companies.“Lease analysis is in early days and, as when companies started complying
with the revenue recognition standard, there are a number of interesting scenarios they may not have comprehended,” Bober said. “There are going to be surprises as companies look at their own transactions.”
Implementation ChallengesAs companies begin to prepare their compliance efforts, Bober said, one of the early challenges is understanding the number and types of leases they have. “Those permutations are going to add complexity to your accounting, as well as your ability to design the processes and tools you’re going to need to complete your calculations.”
Economos went on to say, “You’ll need to capture those permutations so you can design an effective process.” From an audit perspective, the issue of completeness will be significant. “How will you know if you have your full population of leases?” Economos discussed certain tactics companies could potentially use to tackle this completion issue including
• Assigning a “super user” for all line items in the P&L which could facilitate how
[ Figure 12 ]
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
companies reconcile rent expense of all leases, as rent can be many lines. • Identify technology to begin data mining text. • Data cleansing even if a lease administration system exists. According to the survey, almost 80 percent surveyed believe that identifying the
complete population of real-estate leases will not be difficult. However, when it comes to non-real estate leases, only 43 percent gave the same answer.
Over 70 percent of respondents stated developing and implementing new policies, processes and controls would be a challenge. Economos added, “This is a new area where journal entries have not been posted, and accounting decisions/ judgments have not made. All of these must be thought through, documented and controlled. Additionally, from a process perspective, companies must have a good way of recognizing when reassessment and remeasurement should occur such as when payments change and leases are modified.”
Other significant challenges include getting through the first-year audit, internal education, managing differences between U.S. GAAP and IFRS, and ensuring the company has created an inventory of all the necessary data points.
“It will be important to explain these concepts to business people and help them
understand what they need to know,” Bober said. “Your accounting team can help your real estate professionals understand what’s important, but won’t be able to embed your accounting people in your real estate team.”
Figure 13 (above left) illustrates the areas of difficulty companies may encounter during adoption.
Areas Of ImpactThe new standard will impact several areas. According to the survey, the balance sheet impact will be the most significant followed closely by key financial ratios changing, IT system impact and financial statement disclosures.
According to Bober, “There are several new and voluminous disclosures with the new standard, but many were also requirements of the old FAS 13.” Describing a company’s leasing activities and the disclosure of contingent rent were examples he pointed out of what will be required under the new standard.
Most companies will likely have to prioritize their processes and compliance approach according to the types and values of various assets. Bober cited the example of a Fortune 200 company whose initial analysis identified about 700 real estate leases,
[ Figure 13 ] [ Figure 14 ]
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What We Learned
TOP 10 ACTIONS TO CONSIDER
1 Enhance understanding of the new standards and raise internal awareness
2 Establish cross-functional project team
3 Inventory lease types across the business
4 Perform gap analysis
5 Develop initial implementation plan and evaluate synergies and interdependencies
6 Make accounting policy elections
7 Determine transition date
8 Perform an impact assessment
9 Update and implement transition plan
10 Communicate to key stakeholders
15,000 leased vehicles and 44,000 pieces of equipment such as computers, copiers, phone systems and servers.
“As you get into those smaller and mid-value leases, you’re going to have to develop processes and systems to account for changes in that pool of transactions. That’s going be new ground for most organizations,” he said.
Figure 14 (previous page) illustrates a sample population and potential accounting implications.The specialized nature of varying leased assets means it’s going to be challenging to find a single technology tool capable of collecting and tracking all of the required data effectively.
“As you identify your population, don’t jump into a system because real estate will likely require one type of system, vehicles a different type of system, and equipment will vary according to what you consider relevant for the standard,” Bober said.
Slides courtesy of EY. All rights reserved.
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
ICFR Data Expanding Under New Lease StandardSean Torr, Director at Deloitte, and Ruth Uejio, Professional Accounting Fellow, Office of the Chief Accountant, U.S. Securities and Exchange Commission (SEC), led a discussion on internal controls over financial reporting (ICFR) considerations and potential impacts companies should evaluate as they plan to adopt the new lease accounting standard.
Data Collection And CompletenessUnder the new standard, companies will add new data points as leases become a more significant part of the balance sheet. Some companies may not have a robust system of controls and, in some cases, will be using a lease sub-ledger for the first time. “This is a hot issue for both the SEC and PCAOB, who will be focusing on controls around the lease standard on upcoming reviews,” stated Torr.
One of the key challenges he also noted is capturing complete and accurate data, as lease information will need to be housed in one location. Existing data can come from many locations across different functions, and controls will need to be established as to how data is compiled in a company’s sub-ledger.
Internal Controls And Risk AssessmentCompanies must also consider the internal control framework, including the control environment and risk assessment, and must evaluate potential implications of the standard across each area. Torr added, “When establishing an internal control environment, steering committees and the project management office need to establish accountability to get through the next two years of implementation.” Risk assessment, for instance, must address the risk of material misstatements in the financial statements among other issues.
IT Access And Change ManagementCommenting further, Torr noted, “Controls surrounding IT computations, access and change will also be an area of concern.” From a business perspective, proper segregation of duties, review and approval must be established. Companies need to leverage technology fully. According to Torr, “Fortunately most IT solutions we are seeing have controls built in, but access controls must be established.”
At the back end of the process, lease modification controls — currently handled outside the corporate accounting function — must be looped in.
Similarly, outside service providers must have controls around them. Companies need to know exactly what controls are in place and establish appropriate management reporting oversight.
SEC PerspectiveSharing her SEC perspective, Uejio noted: “It’s a good time for companies to focus on investor outreach and education so that investors can sufficiently understand the impact of the new leases standard.”
Commenting further, she noted, “it’s imperative that controls, processes and technical resources are properly calibrated to execute on the successful implementation of the new standard,” adding that “the successful implementation of the new standard is also dependent upon the role of the audit committee oversight and dialog with external auditors and to the application of ICFR.”
n SAB 74 DISCLOSURESWhen speaking about disclosure controls, Uejio noted the SEC staff has long advised that companies should provide disclosures to investors about the impact of recently issued accounting standards they will adopt in the future. Without these disclosures, investors won’t be prepared to understand the impact upon adoption. It is a company’s responsibility to notify the reader a new standard has been issued, and to assist the reader in understanding the potential impact of the new standard.
n AREAS OF JUDGMEnT“Well-designed controls support the process by which accounting judgments and estimates are made and the resulting quality of financial reporting,” stated Uejio while adding, “Application of the new leases standard requires preparers to make judgments. Ensuring documentation and rationale for conclusions are in place and the importance of ICFR cannot be overlooked given the level of judgment required.”
While a bright line standard, she noted the new standard brings certain areas of judgment including scoping (i.e., what contracts are within the scope of the new standard), the right to direct the use of an asset (i.e., under the new standard, a customer must have the right to direct the use of an identified asset for there to be a lease), and determining the proper accounting lease term.
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What We Learned
Where’s the App? Emerging Lease Management TechnologiesThe differing types and locations of lease-related data means some of the biggest challenges companies face in their effort to implement the new standard are systems and technology-related.
Jason Josko, Director, Advanced Risk and Compliance Analytics at PWC, led a discussion with Peter Graham, Director, Finance Solutions and Mobility, SAP Labs LLC, Michael Keeler, CEO of Lease Accelerator, and Chris Smart, Manager, Product Management, Accruent LLC, covering the available systems, tools and applications to assist in the adoption and ongoing administration of leases and the required data collection.
Josko opened the session with an overview of a PWC survey of 500 business executives. In the finding, 75 percent of respondents said systems would be the number-one issue from an implementation perspective.
Currently, only 10 percent of the respondents have selected a software solution. Over 60 percent of the companies surveyed say they are currently tracking their leases only on spreadsheets, and many of these companies are only now beginning the data extraction necessary to comply with the new standard.
Adding to the complexity is the fact that extracting lease-related data is expected to require a manual process, according to over 80 percent of respondents.
“[Executives are saying] ‘it’s a challenge in that we haven’t selected a system yet, we’re not sure the data is good and we’re not sure how to get it, and we need to start now,’” Josko said.
A starting point in confronting the challenge of data management is defining the project’s scope and identifying existing agreements. Many companies currently house their lease contracts in a combination of lease management systems, spreadsheets, PDFs and file cabinets. Companies must consider how to get all of their diverse lease information in one place.
Additionally, the roll-out of a single global process may be another significant hurdle, especially for companies that must be SOX-compliant. Moving forward, reliable process owners must be identified to maintain the organization’s leasing data.
“Many companies are finding it easier to identify process owners of real estate contracts as they tend to be owned by treasury or real estate,” Keeler said. “Real estate makes up the majority of the dollar amount of leases.”
However, some panelists suggested, the bigger challenge lies in equipment
contracts because most companies lack centralized administration of non-real estate leases.
This lack of central administration means identifying the process owner and the central source of data is more difficult. “The likely solution will be a cross functional effort including but not limited to the controllership, treasury, real estate, FP&A and procurement,” noted Keeler. “Someone needs to become the owner of each of these sub-processes if you’re going to get the data you need.”
Accruent’s Smart said discovering equipment lease data often involves a blend of spreadsheets and individual procurement contracts before companies can evaluate the types of data they need to track.
SAP’s Graham said they’ve worked with companies ranging from 100 lease contracts to thousands of agreements covering billions of assets, with similarly divergent administrative approaches.
“not much has happened in lease accounting for a long time, and the last time the standards changed, people were using pencil and paper,” Graham said. “We’ve talked to companies with 700 departments around the world with leases and, guess what, they’re using pencil and paper still. You’re going to have disparate sources of information that you’ll have to get into one place.”
Adding to the complexity is trying to coordinate a leasing standard compliance effort with adoption of the revenue recognition standard.
Making A ChoiceWhen it comes to making a software solution decision there are many factors that must be considered. The solution needs to represent the business workflows, corporate hierarchies and ERP system or the company. Stakeholder involvement up front is also very important and will assist with identifying what the long-term goals of the company are.
Smart recommended companies look beyond the immediate data and compliance challenges to consider the long-term, strategic implications of improving their leasing processes and administration.
“While [the new standard] is reason enough to move, you need to understand the software provider’s approach and roadmap, and make sure those align with your business,” Smart noted. “This should be a partnership that you’ll be involved with for some time, so make sure your organizations are aligned.”
Keeler said software tools should address the different natures of real estate and
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
equipment leases, since most real estate leases will have individual contracts and single equipment contracts may cover a broad number of leased assets. In addition, equipment leases often include purchase and early termination options that will have to be accounted for.
Given the diverse nature of equipment and real estate leases, Graham said SAP chose to address those as separate components within a lease administration suite.
Managing RiskRisks also must be identified early in the process and mitigated. Determining what data is critical for an organization is of utmost importance. The company must understand the provider and everyone in the room must voice their opinion on what success will look like.
Companies should designate an executive sponsor who is aware of the company-specific challenges and milestones that can own the implementation process and see it through to the end.
“A formalized assessment should be conducted by the company prior to selecting a software vendor and implementation,” Keeler stated. “An effective assessment should bring to light any unexpected issues that could come up. From a controllership perspective, the bottom line is the data must be accurate and reliable. Accuracy, or the best way to abstract and normalize the data, along with getting the information into a system where the data is testable on a go-forward basis, will be a challenge.”
Other implementation challenges include finding a solution that will work with the company’s existing ERP. Most contracts take a minimum of a few hours to review manually, so companies should consider using a standard equipment leasing contract to enable software to review contracts quickly and extract key terms. Moving away from spreadsheets and toward automation will reduce control risk going forward.
Over 60 percent of the companies surveyed say they are currently tracking their leases only on spreadsheets, and many of these companies are only now beginning the data extraction necessary to comply with the new standard.
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What We Learned
Implications from a Business Strategy and Operations Perspective Shauna Watson, Global Managing Director, Finance and Accounting Practice, RGP, led a presentation along with panelists Brant Bryan, Managing Principal, Cresa, and Marc A. Maiona, President, LeaseCalcs, Inc., discussing the impact the new standard may have on business decisions and strategy.
Bryan noted that the factors driving one company may not be important to another, making it important for financial leaders to ask the following questions:
• What is the company trying to do? • What financial statement line item is most important to stakeholders? • Is the company balance sheet-driven or P&L-driven? • If the company is P&L-driven, are stakeholders more concerned with net income
or are they really concerned with EBITDA?“How decisions are driven should be the starting point when beginning
negotiations,” Bryan noted.
Finance Lease Transition WallCompanies that report in IFRS will hit what is called a “transition wall,” noting that the overwhelming majority of real estate leases are operating leases under IFRS, but will become finance (previously referred to as “Type A”) leases under the new standard.
For a finance lease, an entity will incur interest expense that will impact earnings. Bryan explained that for an individual lease, the expense profile could jump as much as 20 percent when a lease goes from operating to finance under the new standard. Companies will expect to get relief toward the tail end of the lease as interest will be front-loaded with the finance lease model. However, many leases are renegotiated toward the end of the term and the asset is re-recorded, and the interest amortization begins again. With proper strategy, the impact of the “wall” can be reduced significantly.
According to Bryan, “an organization needs to understand the entire financial statement impact, not just discounted cash flows.” Leases with identical cash flows can hit the balance sheet differently, and when this occurs, the impact to the income statement can also be different.
Maiona provided an example comparing the accounting impact of a gross lease1 versus a net lease2 (generally referred to as “triple n” or “nnn”). In a gross lease arrangement, “taxes and insurance are capitalized as per the rules of the new standard.” A company seeking to minimize what is recorded on the balance sheet and thus ultimately impacting the income statement could negotiate a net lease and pull out those additional costs. Bryan stated, “With the new standard, it’s expected that net leasing will increase and will be easier. It’s up to the lessee to know what embedded expenses are on day one.”
Unintended ConsequencesMaiona also discussed the subjective nature of certain elements within the new standard, noting that in his opinion the subjectivity allows for two leases that are identical to have very different financial statement outcomes — which may be contrary to what the FASB and International Accounting Standards Board (IASB) intended.
Companies will still need to go through a series of assessments and apply them consistently to comply with the new standard and to get through an audit. “Many companies may not view things exactly the same,” Maiona said.
Speaking of unintended consequences, Bryan noted that for sale and leaseback arrangements, companies should be aware of a number of potential implications. For example, the existence of a repurchase option may prevent a sale from occurring. In addition, certain gains that were deferred previously may require earlier recognition. In certain scenarios, this could alter the income statement profile of the “leaseback” significantly, and may cause a deal to be untenable from an earnings-per-share or EBITDA perspective, Bryan suggested.
What Companies Need To Do To PrepareSpeaking on the issue of preparation, Maiona noted, “In order to achieve the company’s desirable outcome, adequate preparations must be made.” Discussions must be held regarding establishing “reasonably certain” and “significant economic incentive” in an objective manner on a portfolio-wide basis. A company must understand the value, life and specialized nature of improvements they make to leased properties. Additionally, the company must understand the strategic implications to the business for each deal in terms of location and purpose.
1 A gross lease is a commercial lease where the landlord pays for the building’s property taxes, insurance, and maintenance.2 A net lease is a lease agreement that designates the lessee (the tenant) as being solely responsible for all of the costs relating to the asset being leased in addition to the rent fee applied under the lease. The structure of this type of lease requires the lessee to pay for net real real estate taxes
on the leased asset, net building insurance and net common area maintenance. The lessee has to pay the net amount of three types of costs hence the term “net lease.”
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
Decisions TimeWith the new standard, there are more “levers” that can be pulled, suggests Maiona, adding that tenants will have opportunity to design transactions for an optimal balance sheet or income statement result if they are willing and able to concede ground elsewhere.
“A company that is more concerned with the balance sheet can restructure rent to burn the liability quicker,” he stated. They can also renegotiate terms to switch from a gross to a net arrangement and manage shareholder impact.
Rent payments are key in negotiations. For instance, escalating payments may not be beneficial and it may be better to smooth out payments over the full term of a lease. To maximize EBITDA, a company may want to structure the deal as a capital lease, extend the term, or include a term extension option.
Discussions must be held regarding establishing “reasonably certain” and “significant economic incentive” in an objective manner on a portfolio-wide basis. A company must understand the value, life and specialized nature of improvements they make to leased properties
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What We Learned
Ask the Experts: Capital Markets and Investors Answer Your Questions on What They Expect from CompaniesBetty Davis, Partner at EY, led a Q&A session along with panelists Kevyn Dillow, Vice President — Senior Accounting Analyst at Moody’s, Shripad Joshi, Senior Director, Corporate and Government Ratings at Standard and Poors (S&P), Ken Katz, Deputy Chief Credit Officer at Wells Fargo, and Jon Tkach, Director at Barclays, discussing the effect of the new standard on capital markets, lending practices and credit ratings methodologies.
Ratings MethodologyDespite operating leases being off balance sheet under current U.S. GAAP, it is common knowledge that rating agencies view the differences between the accounting for capital and operating leases as substantially artificial, despite differences in rating methodology.
In fact, when rating agencies are assessing a company’s financial position to assign a rating, they typically “add back” some amount for off-balance sheet operating lease liabilities. In general, the ratings agencies view leases as contractual debt-like obligations for the use of assets. According to Joshi, “the new standard will mimic S&P’s approach, making life simpler.”
Elaborating further, Dillow noted the new standard is a step closer to how investors and ratings agencies view contractual lease obligations, but adjustments will still be necessary. For example, global ratings will continue to require adjustments for differences between IFRS and U.S. GAAP. While the current plan is to keep Moody’s methodology the same, Dillow acknowledged that if, after making adjustments it determines that the calculated liability using Moody’s methodology is not materially different from the recorded liability of a company, Moody’s could make the future decision to use the recorded liability rather than calculating its own.
DisclosureA concern some have expressed is whether
the data that has been disclosed in historical financial statements and used in many estimation methods is as robust as it needs to be for reporting on the balance sheet. With the new guidance, there is a hope these concerns will be eliminated, however, it does beg the question whether current disclosures are sufficient enough to understand what’s going on the balance sheet upon adoption.
Joshi noted, for instance, that the new standard will bring more definitional changes moving from a “risk and reward” approach to more of a “right to control,” which will bring additional disclosures. That is, more information will be required to be disclosed, increasing transparency for investors.
Impact On LendingWhen speaking about the impact on lenders, Katz noted changes to the new standard are not likely to change the decision-making process of the lender, noting in theory that, “The economic cash flows really don’t change. The accounting changes but the cash flows do not.” In fact, most sophisticated lenders calculate leverage by putting leases on the balance sheet.
Tkach echoed those sentiments, noting in the context of credit and underwriting decisions most regulated institutions are making lending decisions evaluating a borrower’s lease-adjusted leverage. “We’re capitalizing the annual lease expense and appropriate multiple for the industry,” Tkach stated, noting there would not be a change in credit worthiness unless there is new information in the disclosures.
Addressing additional lending concern, Davis noted “as I talk to clients about the new lease rules many do express a concern as to what impact they will have
on their debt covenants and various performance ratios.”
In response, Tkatch noted lenders are not seeing significant changes currently in decision-making by companies to maintain compliance with their debt covenants since operating leases are coming on the balance sheet. “It’s early, but I have not seen much in terms of changes. Some companies may take on more debt, but others may not as they would like more flexibility and do not want to be highly leveraged.” When it comes to From left: Betty Davis, EY; Kevyn Dillow, Moody’s; and Shripad Joshi, S&P.
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June 16, 2016 • New Lease Accounting Standards: What You Need to Know
actual debt covenants, “Most covenants in the U.S. are not GAAP based, but based on secured debt,” noted Tkatch.
One metric of note that will be affected is the debt-to-EBITDA ratio, noted Joshi, although he does not expect material changes in EBITDA. He said, “There will be movement between depreciation and interest but overall the number should not be materially different.”
Acknowledging differences in decision-making, some companies may take action to manage certain balances and metrics in their financial statements, according to Katz. “Different transactions can be structured differently to keep items off the balance sheet, for example changing terms to less than 12 months,” but he also noted this ultimately depends on the goals of the decision-makers.
The accounting profession is also not seeing much in terms of changes. According to Davis, “most companies are not giving up economic flexibility for accounting.” Tkatch added that in credit underwriting, the capacity to repay is of utmost importance, meaning the more flexibility the better. “Binding yourself economically for better accounting will hurt.”
Despite operating leases being off balance sheet under current U.S. GAAP, it is common knowledge that rating agencies view the differences between the accounting for capital and operating leases as substantially artificial.
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