On July 30, 2018, the Financial Accounting Standards Board (FASB) issued ASU No. 2018-11, an update to pending changes in lease accounting standards, in a move to reduce costs and ease implementation. The update provides a new transition method (something that has been on the FASB agenda since the end of 2017) and a practical expedient to separating contract components as required by the new standard, which is scheduled to become effective for public companies in fiscal years beginning after December 15, 2018 (i.e., effectively January 1, 2019, for calendar year companies), and for private companies a year later.
“The targeted improvements in the ASU address areas our stakeholders identified as sources of unnecessary cost or complexity in the leases standard,” said FASB Chairman Russell G. Golden. “They represent the FASB’s commitment to proactively address implementation issues raised by our stakeholders to ensure a successful transition to the new standard without compromising the quality of information provided to investors.”
- Cumulative adjustment – Under ASU 2018-11, an entity applying the new lease accounting standard may record a cumulative adjustment to the opening balance of retained earnings in the period of adoption, instead of having to restate comparative results, as initially required. An entity that elects this transition method must provide the required Topic 840 disclosures for all periods that continue to be in accordance with Topic 840 (the current FASB standard for lease accounting).
- Separation of contract components – The amendments in ASU No. 2018-11 provide lessors with a practical expedient, by class of underlying asset, to not separate non-lease components from the associated lease component and, instead, to account for those components as a single component if the non-lease components otherwise would be accounted for under the new revenue guidance (Topic 606) and both of the following conditions are met:
- The timing and pattern of transfer of the non-lease component(s) and associated lease component are the same.
- The lease component, if accounted for separately, would be classified as an operating lease.
An entity electing this practical expedient (including an entity that accounts for the combined component entirely in Topic 606) is required to disclose certain information, by class of underlying asset, as specified in the ASU, which can be reviewed in its entirety at www.fasb.org.
The amendments in this new ASU relate to separating components of a contract affect the amendments in the prior issued ASU No. 2016-02, which are not yet effective but can be early adopted. These are:
- For entities that have not adopted the new lease accounting standard (Topic 842) before the issuance of this ASU, the effective date and transition requirements for the amendments in this update related to separating components of a contract are the same as the effective date and transition requirements in ASU No. 2016-02.
- For entities that have adopted Topic 842 before the issuance of this ASU, the transition and effective date of the amendments related to separating components of a contract in this update are as follows:
- The practical expedient may be elected either in the first reporting period following the issuance of this update or at the original effective date of Topic 842 for that entity.
- The practical expedient may be applied either retrospectively or prospectively.
All entities, including early adopters that elect the practical expedient related to separating components of a contract in this new ASU, must apply the expedient, by class of underlying asset, to all existing lease transactions that qualify for the expedient at the date elected.
How We Got Here
As detailed in our Flash Report issued on March 1, 2016, ASU No. 2016-02, published on February 25, 2016, revolutionises lease accounting by requiring lessees to recognise a lease liability and a right-of-use asset for all leases (except for short-term leases; i.e., duration of less than one year) as of the date on which the lessor makes the underlying asset available to the lessee (the commencement date):
- “Lease liability” is the lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis.
- A “right-of-use asset” is an asset that represents the lessee’s right to use, or control the use of, a specified asset during the lease term.
With regard to income statement amortisation for lessees, the FASB retained a dual model, requiring leases to be classified as either operating or finance. Operating leases will result in straight-line expense recognition, while finance leases will result in a front-loaded expense pattern. Classification will be based on “consumption” of the asset, meaning that leases of property (i.e., real estate), which is typically not consumed during the lease period, will follow straight line amortisation and leases of non-property (e.g., office equipment), which is typically consumed during the lease period, will follow an expense pattern similar to current capital leases. Conversely, the International Accounting Standards Board (IASB) elected a single model whereby all leases, regardless of asset class, are considered financing.
In effect, because the new guidance requires lessees to recognise lease assets and lease liabilities, off-balance sheet financing – at least through the use of lease transactions – is taken off the table. Thus, accounting for sale and leaseback transactions has been simplified considerably.
For lessors, accounting for leases is substantially the same as in the past. The only changes result from some very specific adjustments to align the lessor accounting model with both the lessee accounting model and the revenue recognition standard to get the principles underlying the accounting in sync.
For public companies, the new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (thus, calendar year reporting companies must adopt the standard effective as of January 1, 2019). For private companies, the new standard is effective for fiscal years beginning after December 15, 2019 (thus, calendar year reporting private companies must adopt the standard effective as of January 1, 2020). Early adoption is permitted for all companies, public or private. For leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, lessees and lessors may apply a modified retrospective transition approach or may record a cumulative adjustment to the opening balance of retained earnings in the period of adoption, as discussed above.
As with recent changes to the revenue recognition standard, the new lease accounting standard is the result of a collaborative effort by the FASB and International Accounting Standards Board (IASB) to agree on a global standard based on common principles that can be applied across industries and regions. While the FASB and IASB are aligned on most key decisions, some important U.S. GAAP/IFRS differences remain in the new lease accounting standard, such as the classification and amortisation differences discussed above.
Our Point of View
The relief granted, with the targeted improvements discussed above, while promised and expected, should be considered a “win” for companies preparing for the lease accounting standard. Yet it is clear that many public companies are still struggling to meet the deadlines. Common transition issues continue to be assessing the validity, completeness and accuracy of the company’s existing lease portfolio; challenges in prior lease classification; and identifying and quantifying the pool of embedded leases (i.e., various service type arrangements that may have equipment embedded in them and need to be separated, quantified and reported separately in the financial statements).
Additionally, the proper identification and availability of information technology systems and the time necessary to execute the new standard through new applications, as well as the human resources needed to implement them, have been challenges throughout the lease accounting standard adoption process.
That said, our point of view continues to be that as long as companies follow a complete, thoughtful documented lease transition roadmap (see Figure 1 on following page), pursue the work diligently, and have the affected financial statement changes auditable, they should be able to execute the transition to the new lease accounting standard. Further, in regard to technology, we have seen that there is a sufficient spectrum of available systems such that companies should be able to identify and deploy the technology that meets their needs, as long as the IT change management programme is as diligent and robust as the financial reporting transition process.
Figure 1 – Lease Transition Roadmap