Taking stock of new ASC 842 lease accounting standards

The transition to new lease accounting standards provides an opportunity to tap cash you otherwise might not know you have and help your organization survive the downturn, says Matt Waters, lease accounting director at commercial real estate data company Co-Star Group. 

The Financial Accounting Standards Board (FASB), under its ASC 842 standard, requires all organizations to disclose operating leases on their balance sheet, both as an asset and a liability, in the same way as capital leases. It is no longer permissible to disclose leases as expenses on the income statement and in the footnotes to the financials.

Public companies began transitioning to the new standard late last year. Private companies and nonprofits were slated to start at the end of this year, but FASB pushed it to the end of next year to provide flexibility while they grapple with the impact of the pandemic on their operations.

Waters recommends starting the transition process as soon as possible, even with the delay. Public companies' experiences have shown it takes longer than expected.

“I hear over and over and over again they wished they had more time," Waters said last week in a CFO.com webinar.

But there's also cash to be discovered, he said, as accounting or lease administration teams identify all the leases under management, analyze their terms and amendments, and get everything into a single database for proper reporting. 

Many leases no longer needed

The first thing organizations are discovering is they often don't need as many leases as they thought they did, especially for real estate, Waters said. 

Stay-at-home mandates have shown it can be possible to do the same amount of business with less space. Many people can work from home, saving office costs, and sales can be done online, saving transaction costs. 

"Companies are discovering the transition is giving them an opportunity to streamline and rightsize their lease portfolios," he said. 

Refundable security deposits

For leases you keep, it's not uncommon to discover you’re owed a security deposit. As you go through your leases, set aside the ones in which you’re owed a deposit and submit a request to get your money back. 

"Especially now, if you're looking for a cash source, it’d be nice to know how many of these refundable security deposits are out there," he said. 

The deposits are easily overlooked because accounting or lease administration teams often get too busy to keep track of when they’re supposed to be returned for each lease.

"They're all different," he said. "With some, you get it back after a year or after just a few months. With others, they're not due until the end of the lease."

It's typically up to the lessee to ask for the deposit back. "The lessor is not going to just cut you a check," he said. 

Unpaid tenant improvement allowances

For many real estate leases, a landlord commonly provide some type of incentive, called a tenant improvement allowance (TIA), often in the form of a reimbursement, for the tenant to make improvements to the asset.

Lease admin teams tend to track these arrangements more closely than security deposits because they typically involve higher amounts, but they also slip through the cracks. 

"Many times, companies are not reimbursed fully," Waters said.

Rent overpayments

Waters said he hears from many companies that they're discovering they've been overpaying on leases.

"It was only when they started consolidating data into one location, putting them into the database, and tracking the clauses associated with leases, that they could identify that rent had been overpaid," he said. 

What typically happens, he said, is that accounting teams that have a rent roll will apply what they paid last month to this month and keep rolling it forward rather than go into each lease and see if the terms have changed. 

"There's a high probability you have one or two or even many that have been overpaid," he said. 

Like other matters involving leases, it is typically up to the lessees to initiate the remedy.

"It's not something lessors typically will notify you of," he said. "A large, sophisticated lessor might, but many lessors are small operations."

CAM reconciliations

Another overlooked area is the common area maintenance (CAM) fee lessees often pay as part of their lease payment. These can change over time, and lessees need to determine whether any money is due. 

"[This portion of the agreement] is complicated," he said. "But I’ve seen this as a source of extra cash."

Co-tenancy violations

If the lease amount you're paying is tied in any way to the presence of an anchor tenant or that a minimum occupancy level be maintained — relatively common arrangements in retail settings — you might be owed money if the anchor tenant leaves, or goes bankrupt, or if occupancy otherwise falls below the agreed-upon threshold.

"You can receive some money back from the lessor or in the form of reduced rent going forward," he said. "Sometimes, companies switch to flat revenue sharing or a percentage rent agreement, in the case of a co-tenancy violation."

Evergreen fee avoidance

With equipment leases, once the asset reaches a certain point in its lifecycle, your lease moves into what's known as evergreen status and you start paying on a month-to-month basis until you return the asset. Some agreements don’t require you to return the asset at the end of the term. In these cases, it's not unusual for accounting teams to keep paying the lease even after the asset’s no longer used. 

"Companies often find they’ve been paying month-to-month status for years on an asset they don’t even use anymore," he said.

Force majeure clauses

If your lease agreement includes a force majeure clause, it’s possible the pandemic is the kind of event that's recognized as a trigger, depending on how the language is written.

If, in going through your leases you discover agreements that include the clause, it could be written in such a way that the clause can be exercised. 

Taken together, the lease clauses can amount to a significant inflow of cash if you use the transition to the ASC 842 standard as an opportunity to dig into your lease terms.

The operational challenges of transitioning to new lease accounting standards, ASC 842, have been reported widely, but there’s another hurdle companies could face: loan performance. 

Loan covenants typically require borrowers to meet specific performance measures, such as debt-equity and debt-service ratios. Failing to meet the measures can cause a loan to go into default — a growing possibility as companies meet the new ASC requirements by including operating leases on their balance sheets.  

Whenever you have a change that directly impacts debt, it's going to funnel its way through to those covenants, says Jon Eilertsen, managing director, accounting and reporting advisory services with BDO.

“From a ratios’ perspective, if you have both the asset and the liability side, those would typically net each other out," he says. "However, for some ratios, your current ratio, for instance, you're bringing in more of your current liabilities but the (lease’s) right-of-use asset is a non-current asset that would not be impactful. So, you absolutely have impacts to a lot of your ratios here.”

End-of-year deadline

The new lease accounting standards were years in the making. They require organizations to identify regular and embedded operating leases and start reporting them on the balance sheet in the same way as capital leases. Additional calculations include the right-of-use and liability values needed for financial statements. 

The changes are significant. Deloitte estimates the new standard will drop about $2 trillion of lease liability into S&P 500 companies’ balance sheets.

The new rules went into effect for public companies for fiscal years beginning after December 15, 2018 (January 1, 2019, for calendar year-end companies). Private companies and nonprofits must comply for fiscal years beginning after December 15, 2021 (January 1, 2022, for calendar year-end entities).

Frozen is good

The good news for some organizations is that while ASC 842 will affect their financial ratios negatively, the changes might not trigger debt covenant violations.

Walker Wilkerson, managing principal of assurance strategy with CliftonLarsonAllen, notes that some companies’ debt agreements include GAAP-freeze or semi-freeze clauses. In a contract with a “frozen GAAP” clause, changes to financial ratios that result from changes in GAAP should not cause a violation of financial covenants. Under a “semi-frozen GAAP” clause, the borrower and lender agree to renegotiate the loan covenant if the new GAAP rules change the financial ratios used in the agreement.

If there is a freeze or semi-freeze in place, the metrics “will still be able to be viewed and measured under the historical GAAP or the GAAP that was in place at the time it was frozen,” says Wilkerson. “But we do see a lot of agreements that don't have that.” 

There is a caveat, though, he notes: If the organization signs a lease agreement during the year when the new GAAP is being implemented, the new GAAP rules apply.

Lines of communication

Determining debt contract provisions means reviewing the underlying documents for GAAP-freeze clauses, says Patrick Farrelly, partner, UHY, LLP. That review will facilitate projections of changes to the relevant metrics and debt covenants. CFOs should also start working with the organization’s bankers so both parties are in sync over the changes’ impact, Farrelly recommends.

Lenders working with public companies will have gone through a similar process already, so it won’t be new territory for them. And it’s very unlikely that a lender would dissolve a relationship with a good customer and call in a loan due to a technical default caused by a change in accounting principles, Farrelly notes. “What I've seen from my standpoint is people working together to try to make sure that both sides are happy and that everybody comes out with the original agreement and the emphasis of the original agreement,” he says.

Eilertson says that from the lender’s perspective, it’s the borrower’s business health and financial performance that influence loan risk. Accounting changes that result in less favorable metrics don’t change anything from a business perspective and are less likely to influence a lender’s determination of a borrower’s credit worthiness.

Where’s my bonus?

Executive compensation packages that contain performance awards based on the organization’s achieving specified financial metrics also could be adversely affected by the new rules.

According to the Harvard Law School Forum of Corporate Governance “CEO and Executive Compensation Practices: 2019” report, in 2017, “performance-based stock awards surpassed 50% of the total long-term incentive award value for the first time ever among the Russell 3000, increasing to 51% from 48% in 2016. In 2018, performance-based awards jumped even more significantly, to 57%.”

Organizations that use this approach should review their metrics-based compensation arrangements to determine how ASC 842 might influence employees’ pay, Wilkerson suggests. 

He cites the example of bonuses being influenced by the company keeping leverage ratios below certain levels. If the change in GAAP rules pushes those ratios beyond their upper limits with a resulting cut to anticipated bonuses, staff morale likely will suffer. 

“They really need to understand how it's going to impact any of their bonus packages or other compensation packages inside of their companies, as well,” Wilkerson says.

Companies won’t have to recognize day-one losses on assets they make available under variable-payment, sales-type leases under Financial Accounting Standards Board (FASB) standards.

FASB rules require companies that enter into contracts to lease out assets such as printers to account for the transaction as a loss at the beginning of the lease period, called a day-one loss, even if the contract is expected to make the company money over the life of the contract.

The rule stems from sweeping lease accounting changes FASB approved years ago, known as ASC 842, that took effect for public companies in 2019. Those changes require companies to show operating leases on their balance sheet, rather than in a footnote to their financial reports, the same way they do capital leases. Private companies and nonprofits were to make the changes in 2020, but FASB delayed implementation to 2021 because of the pandemic. 

Last week’s rule change removes the requirement companies recognize a day-one loss on new sales-type lease contracts with variable payments. 

“I think this … actually conforms us to what the practice was pre-842,” FASB chair Richard Jones said.  

Critics wanted the rule changed because the loss was a bookkeeping one only and could confuse analysts and investors.

“The approach is a practical solution that would result in financial reporting outcomes that more faithfully represent the economics of the transaction,” FASB staff project manager Bobbi Gwinn said. 

The new rule, which takes effect for the fiscal year beginning after Dec. 15, 2021, aligns the standard with the International Accounting Standards Board. Companies that have already implemented the broader lease accounting changes under ASC 842 can implement the new rule prior to that date.

Access FASB's meeting material on this and other issues.   

Private companies and nonprofits have leeway to choose the discount rate they use in calculating the value of their operating leases under new lease accounting standards, the Financial Accounting Standards Board (FASB) decided this week.

The decision is intended to make it easier for organizations to comply with the new standards, known as ASC 842, which take effect at the end of this year. ASC 842, which requires organizations to recognize operating leases on the balance sheet in the same way as capital leases, rather than in the footnotes to their financials as operating expenses, is already in effect for public companies. 

This week’s change permits organizations to choose between a discount rate such as the incremental borrowing rate and a risk-free rate such as Treasury bills for certain types of leases. Prior to the change, organizations had to choose one type of rate and apply it to all of their leases. Now they can choose one rate for one class of leases and another rate for another class.

The new flexibility is expected to lower compliance costs, since computing present value using something like the incremental borrowing rate, although it can be highly accurate, requires a complex and costly calculation that is probably unnecessary for non-material leases. The risk-free rate, by contrast, is simple to use, but because it tends to be lower than what’s produced by more complex calculations, can increase lease liabilities. 

Given these differences, organizations might choose a more complex calculation for high-value leases, such as those for commercial property, and a risk-free rate for lower-value leases like those tied to office equipment.

“I might have something like a whole group of immaterial computer equipment individually that I’m leasing and then I might have a material piece of computer equipment,” said FASB Vice Chair James Kroeker. “I think if you look at asset class, it may well be you can designate these as different asset classes, so I think it does provide you, if not flexibility at the individual lease level, [then] in what asset class you do or don’t have.” 

The new lease standards take effect December 15. The option to use different discount rate calculations for different asset classes doesn’t apply to public companies, which are assumed to have the resources to use the more accurate calculations for all of their leases.

The following is a contributed article from Mark Betesh, CEO of Visual Lease. Views are the author's own.

Companies have been deep into transitioning their accounting practices to meet the new lease accounting standards issued by the Financial Accounting Standards Board (FASB) several years ago. 

Under the change, operating leases have to be disclosed on your company balance sheet, both as an asset and a liability, the same way you treat capital leases. That marks a sea change from the way you traditionally show operating leases: as expenses on your income statement and in the footnotes of your financials. 

FASB and the International Accounting Standards Board (IASB) adopted the new standards after it became clear in the early 2000s that more transparency was needed to help investors and regulators know how much liability a company had beyond what was shown on its balance sheet. Without full disclosure of these obligations, companies can look healthier than they actually are, and only people with the accounting chops to identify and quantify them can get a complete picture of a company's financial health.

For the past several years, CFOs of public companies have been living through adoption of the new standards. Financial professionals with these companies have been scrambling to meet their reporting requirements. Private companies and nonprofits were given more time.

Here's a quick overview of managing the transition. But remember, the rules are 200+ pages long and require numerous decisions and calculations.

To accurately report your leases in your financial statements, you first have to catalog and physically locate the leases themselves. This can be one of your biggest challenges, as it's not unusual for a midsize company to have hundreds and even thousands of real estate and equipment leases sitting in file drawers for years. Big companies can have tens of thousands of them scattered around the organization.

You also have to capture service contracts for copiers, data centers and other assets that contain financial arrangements that make them "leases" for purposes of the rules. For example, a three-year copier service contract that gives you a machine plus regular maintenance visits by technicians, toner supplies and on-call servicing contains a lease that has to be reported. Similarly, a data storage service agreement in which you control servers residing in a data center could have a lease embedded in it.

Second, whether it's a regular or embedded lease, you need to identify and collect all of the relevant documents that make up the transaction, including amendments, supplemental letter agreements and notices that affect its terms. This is the most obvious but can be most challenging. Lease files often are missing amendments or have other documentation failures.

Third, you have to extract the specific data needed for your lease accounting calculations. If you have a lease management system, you need to enter the data into that system (the vendor should provide you with the relevant fields to extract). If you do not have a system, you need to determine the data elements and find a place to store them. Depending on the number of contracts you have in file drawers throughout your offices, it can take months and thousands of staff hours to collect and go through them. There are lease abstracting services available in the market for this (we provide this, as well).

Finally, you need to calculate the right-of-use (ROU) and liability values needed for your financial statements. If you have a lease management system, it should do this for you. If not, you need to develop the formulas and values needed for your disclosures. This is quite complex, as it requires year-by-year comparisons of finance vs. operating term lease expenses, short-term lease expense, variable expense components, gains and losses on sale-leasebacks, weighted average remaining lease terms and discount rates, maturity analyses and much more.

Whether you do all of this manually or use a system built for that purpose, you have to start this project soon. As we have seen with the public companies, this will take much longer than you can imagine, and you'll find yourself staring down the barrel of the deadline before you know it. Learn from the public company experience: proceed deliberately but swiftly, and be ready when your first reporting deadline arrives.

Although this undoubtedly will be a significant project for the real estate, asset and finance teams within your organization, one of the key side benefits will be that when you're done, you'll be much better positioned to manage your leases. Certainly from a strategic standpoint, you're able to make better decisions about them going forward. You'll have all of your documents in one place, know what they say and be able to control your obligations. You'll stay ahead of options and deadlines. You'll be able to trend and manage your costs. You'll be better able to decide whether you should lease or buy, or whether you should extend the service contract for that copier or just buy it and pay for maintenance separately.

Due to changes in international and U.S. regulations (the new IFRS 16 and ASC 842 lease accounting standards), a large accounting firm needed to help its customers disclose their operating leases on their balance sheet. 

The customers — mostly large enterprises — have thousands of lease agreements, each of which must be scoured for relevant information. The task was difficult to automate because lease agreements aren’t standardized, so the same type of information can be expressed using different terms. That reduces the effectiveness of keyword-based search systems.

A semantic folding approach

To address the challenge, the accounting firm integrated into its contract-processing workflow a solution based on what’s called semantic folding, a form of AI-based, natural language processing (NLP) application in which words are rendered in binary terms.

The solution enabled the firm’s subject matter experts to define and refine the extraction models quickly by annotating as few as 50 sample lease agreements, a process that in the past has taken thousands of samples. 

Once the extraction models were in place, the firm was able to extract and classify the relevant information from the lease agreements at a precision level that would have been difficult to achieve at scale manually. Meanwhile, the subject matter experts improved the extraction process over time by verifying, correcting, and adding targets.

Impact

The end result was a review and data extraction time that was 80% faster than a manual process, much more accurate, and that automatically assisted the subject matter experts in preparation of their clients’ balance sheets. As a result, expensive human resources were freed up to focus on more business-critical tasks.

At the core of the solution’s success is its ability to define what it’s looking for, classify clauses and the agreements they’re in accordingly, and then extract from scanned agreements precise lease data, such as amounts, dates, and addresses. 

As part of this process, the solution is able to use other pieces of data to infer information that’s not explicitly stated in the agreement, feed extracted information into the client firm’s lease-management tool, which in turn fills a summary sheet with data for each agreement and then displays each summary sheet beside the corresponding agreement for review. It also highlights the extracted information in the displayed agreement.

What to look for

If you’re gearing up to comply with the new lease standards, based on the success the accounting firm had in helping its clients, here are a few capabilities you might look for as you evaluate solutions: 

• NLP contract analysis based on meaning. NLP contract analysis software leverages a unique, meaning-based approach to help review contracts more rapidly and accurately.
• AI contract analysis without the need for AI experts. Some contract analysis software has been specifically designed for subject matter experts, who can train new models for any document type starting with as few as 100 documents — no data scientists required. 
• Large scale insights through automated contract analysis. Contract analysis software should be easily integrated with contract management solutions and business intelligence tools, and deliver valuable information to better assess risk exposure, recognize trends and generate new revenue opportunities.

One of the most challenging aspects to the new lease standards is simply identifying the leases, which tend to be embedded in hard-to-search agreements. NLP contract analysis is one way to overcome that challenge in a quick and precise way.