Preparing to implement the new Lease Accounting Standard – ASU 2016-02, Leases (Topic 842)
The FASB’s lease accounting standard change, ASU 2016-02, Leases (Topic 842), presents dramatic changes to the balance sheets of lessees. With the effective dates quickly approaching for public and private companies, now is the time to prepare for implementation of the new lease standard. Our comprehensive guide is designed to help mitigate operational challenges as implementation teams grapple with the complexities of the new standard.
Effective Date
It is time to focus on implementing the FASB’s new leases standard; ASC Topic 842 is effective as follows:
- For public business entities, the standard is effective for annual periods beginning after December 15, 2018 (i.e., calendar periods beginning January 1, 2019), and interim periods therein.
- For all other entities, the standard is effective for annual periods beginning after December 15, 2019 (i.e., calendar periods beginning January 1, 2020), and interim periods after December 15, 2020.
Early adoption is permitted for all entities.
Overview of the New Lease Standard
The most significate difference between Generally Accepted Accounting Principles (GAAP) prior to the new lease standard compared to after is that all leases with terms of over 12 months will now be recorded on the balance sheet.
Under the new standard, leases will now be classified as either an operating or financing lease and accounted for as a “right-of-use asset” on the balance sheet. Lessees will also record a lease liability associated with the right-of-use asset at the commencement of the lease, based on the present value of future lease payments discounted using the rate implicit in the lease. The lessee is also allowed to use its incremental borrowing rate if that rate is not provided in the lease agreement. The new standard permits the lessee to exclude the recognition of right-of-use assets and lease liabilities for leases with a term of 12 months or less.
Under the new standard, a lease is classified as a finance lease if any of the following criteria applies, otherwise the lease is classified as operating lease:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date of the lease falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purpose of classifying the lease.
- The present value of the sum of lease payments and any residual value guaranteed by the lessee not already reflected in lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
The new lease standard defines a lease as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration.” Therefore, companies will need to review all their contracts to determine whether or not they contain a lease and, if so, the company will segregate the lease components from the contract and recognize a right-of-use asset and lease liability.
Transition
The new guidance became effective for public business entities, as well as for certain not-for-profit entities and employee benefit plans, for annual periods beginning after December 15, 2018 (i.e., calendar periods beginning on January 1, 2019) and interim periods therein. For all other entities, the ASU is effective for annual periods beginning after December 15, 2019 (i.e., calendar periods beginning on January 1, 2020), and interim periods thereafter. Early adoption is permitted for all entities.
Companies may implement the new lease standard using the retrospective approach or using the additional transition method, permitted by ASU 2018-11, Leases: Targeted Improvements, issued in July 2018, and recognize a cumulative-effect adjustment in the period of adoption.
Steps to Consider
Entities will most likely need to implement new, or change existing, business processes and internal controls to ensure compliance with the new guidance. The following considerations should be taken into account as you begin the transition.
#1 Understand the impact of the new standard:
Recognize how the changes will affect not only accounting policies, but also the systems used to manage leases. Consider other ramifications of applying the new lease standard beyond the organization’s financial statements, such as the impact on key financial ratios included in debt covenants or key performance indicators used to manage the company.
#2 Gather information:
Obtain current and in-process lease agreements as well as relevant policies, procedures, data and systems involved.
#3 Evaluate the impact:
Establish a cross-functional team, inclusive of accounting, tax, purchasing, IT, and legal, to evaluate the impact across the entire organization.
#4 Select a transition approach:
Plan for required system enhancements, such as updating financial accounting software and purchasing add-on solutions.
#5 Design a solution:
Develop a project plan and timeline and secure necessary resources to meet the effective date.
#6 Implement and monitor:
Execute the project plan, monitor status, and communicate with relevant stakeholders.
It’s important to note that the implementation timeline for your organization will vary depending on the industry or industries in which you operate, the number and types of contracts in question, existing systems and processes in place, and the amount of resources dedicated to the transition plan.
The implementation of the new revenue standard is an ongoing process that will require involvement of stakeholders throughout the organization. Further, while the initial steps of an implementation plan logically focus on the technical accounting issues, other aspects of the project can occur contemporaneously. As certain technical conclusions are reached, tax and IT/systems implications can be assessed, internal training can begin, and pro forma impacts can be modeled.
McConnell & Jones knows that a delay in implementation is be the biggest risk of all and we work to deliver tailored solutions to efficiently address each of our clients’ needs when transitioning to the new standard. Contact our team today with your questions – we’re ready to help.
Johnson Olatunji, CPA
Senior Assurance Manager
Public Assurance Services
Marlon Williams, CPA
Assurance Partner
Public Assurance Services