Public companies have already passed the FASB’s (Financial Accounting Standards Board) deadline for implementing the new lease accounting standards. The board has been discussing tentatively deferring the deadline for implementation which would move this from 2020 to 2021. However, the deadline will still approach quickly and many companies have not started or are still at the beginning stages of the implementation and identification process. Here you will find some insight to what your company should be doing now to prepare.
What is ASC 842 and how does it apply to your business?
ASC 842, which is the codification of ASU 2016-02, is replacing the outdated ASC 840 leasing standard implemented over a few decades ago. The ASC 842 requires companies to identify if a contract contains, or is a lease when the contract is initiated and provides some guidance for the identification process. This will rectify the ASC 840 issue pertaining to off-balance sheet operating leases. Businesses will need to classify leases as operating or finance, and most leases will now be required to be reported on the balance sheet. Operating and finance leases will differ in the recognition of expense sequences.
Per ASC 842, a contract “is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).”
Take note of the key words that will apply to your business which are “the right to control”. Having the right to control the identified asset means that your company would substantially assume all the potential economic benefits from using the asset and be able to direct the use of the asset throughout the terms of the contract. Some leases will have exemption from the capitalization requirement if they are short-term leases (less than or equal to 12 months in length). Therefore, it will be vital to sit with all department heads to discuss what your company currently utilizes, that would fall under a lease contract. While you will want to make sure someone is leading this implementation process, this should not be a solo task for one person or even one department.
Breaking down the identification of a lease
While some leases are easily identified, the trickiest issue is going to be found in contracts that don’t necessarily spell out “lease.” As mentioned above, it is important to collectively identify what could be a lease through your officers and your department heads. Often, service contract and lease negotiations are handled by multiple departments. Marketing, warehousing, I.T. departments are where you might find some of these leases hiding as simple service contracts. Typically, when we determine a lease, we recognize the obvious, like property and vehicles. However, often what you would envision to fall under a service only contract, if it specifies any assets explicitly or indirectly, the contract may technically still be a lease. Such assets could be a dedicated server, billboard, manufacturing equipment, a taxi tent, even security equipment, but again, this really depends on whether your company has the right to control the asset. This is why it is crucial to go through identification processes collectively and with a fine-tooth comb.
Best practice for implementation of ASC 842
First, the best thing to do is get started right away. Scrambling near the cut-off date will increase room for error. Hold a discovery session with your decision makers in the company and perhaps include a few select employees that have demonstrated thinking outside the box. They may be the ones who spot the hidden leases, since they typically view things in a different perspective than what is in black and white. While you might want to consider lease accounting software, this alone takes a vast amount of time and you should at least start with manually tracking your finds in a spreadsheet or other means, rather than waiting through the process of software selection and implementation. This doesn’t mean do not start reviewing accounting software options for all future contracts and leases, but the lack of such software should not prohibit you from getting the ball rolling.
Have your team explain in as much detail as possible how, with each service contract or lease, your company controls the asset, and does it obtain substantially all the economic benefits from use of the asset. Have your legal department review all of your contracts and agreements, identify any recurring expenses in your ledger to inspect for possible leases, do a physical walk through to spot any assets that would have probability to be part of a lease, create a risk assessment system on a scale basis, (i.e. 1 - absolutely not a lease through 5 - definitely a lease) that you can document as your trying to identify embedded leases. Then revisit any items with a rating 2 through 4 that may be questionable, look for any exempt leases that are 12 months or less but document them, and lastly, consider using outside resources for assistance.
Here is an example of identifying an embedded lease:
Let’s say your company uses a contracted manufacturing facility to make your vegan soap products. Because you must comply with regulations in order to label your soaps as vegan, the manufacturer must use dedicated equipment specifically for your soap. Your company also controls the amount manufactured and substantially gains the economic benefits from the equipment. This contract contains an embedded lease for the manufacturing equipment used for your product.
Final Thoughts
The implementation of ASC 842 is not going to be a simple process and time is of the essence. The original deadline for ASC 842 will be effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. However, as mentioned, the FASB have tentatively discussed changing this date providing an additional year, but this process will still be very time consuming and your business should start preparing now.
Document all processes and procedures. When speaking to your team, don’t always use technical and financial jargon. Even with its complexity, you do not want to shadow the process with undue stress from misunderstandings. Again, seek outside resources, if necessary. Since this affects so many industries, reach out to your business network for insight and to discuss helpful methods of implementation. Remember, we’re all in this together.
