Many SOEs have now completed their second year of lease accounting under ASC 842, and the effective date for private enterprises is fast approaching.
The new lease accounting rules have a significant impact on the way companies, both public and private, account for their lease portfolios and have far-reaching implications across the balance sheet. For the first time, most operating leases must be reported on the balance sheet, resulting in significant increases in the balance of reported liabilities for many companies.
As the LeaseQuery Rental Bond Index report shows, public companies have seen an average increase in lease obligations of 4 times and private companies that have already adopted have seen an increase of 13 times.
A critical step in adopting the new ASC 842 guideline is understanding its impact on your company’s financial statements and anticipating how to manage that impact. As the experience of public companies demonstrates, adopting ASC 842 brings about substantial changes not only to the balance sheet, but also to an organization’s accounting and lease management processes.
The immediate goal for businesses is adoption and accounting from day one, but it’s important for businesses to recognize – and plan for – the long-term impacts that will extend into the future.
There are three key areas for businesses to consider as they prepare for successful adoption:
Identify all rental contracts
With operating leases now recognized on the balance sheet, it is imperative that companies correctly identify all leases, as missing them will have a direct impact on the financial statements.
Many companies are compiling a list of entity-wide lease portfolios for the first time, prompting them to change their current lease management processes to ensure they support compliance with the new standard . The end-to-end leasing process requires the collaboration of multiple departments within an organization, including legal, treasury, purchasing, and accounting.
Identifying critical people and points of contact within the process will help businesses more effectively collect the rental data needed to properly measure new rental liabilities and asset balances.
Companies can take the following steps to help identify a complete and accurate list of rental agreements:
- Get a list of recurring payments from the A / P service, as these often indicate a rent payment structure for a rented property
- Review supplier contracts maintained by legal and procurement teams to determine which ones represent a lease
- Request lists of leased assets from business associates with direct knowledge (for example, a plant manager)
- Review general ledger data in rental expense accounts to identify important provisions
Having a complete list of rental contracts allows businesses to better understand their rental business. This new and more detailed information can aid in budgeting and financial analysis.
During the COVID-19 pandemic, many tenants have looked for ways to save costs, including working with their landlords for rent concessions, such as deferrals and reductions in payment.
Properly maintaining the lease portfolio list going forward is a powerful tool that businesses can use to help identify opportunities to cut costs or renegotiate lease agreements to offer better terms.
Understand the impacts on financial statements
As companies record a new lease liability balance on their adoption date, significant increases in balance sheet liabilities are expected to result.
As a general rule, the greater the operating leasing activity of a business, the greater the increase in liabilities will be. While the immediate impact of adoption is on financial statements, there are several other impacts that companies should think about ahead of time.
For example, most debt commitment agreements use metric calculations that include a company’s liability balances. As a result, a business may want to contact its banks and lenders to determine how the new lease liability balance affects these metrics and whether changes to covenant agreements are needed. Communicating this possibility to the treasury department upstream will allow them to have these critical discussions upstream and reduce the risk of surprises later.
Another potential impact of the new rules for accounting for leases relates to the lease-to-own analysis of a business.
Historically, many companies have taken advantage of operating leases as a way to secure the capital assets needed to operate without spending large sums of money or incurring large debts up front. The original operating lease structure was an added benefit, as these agreements were off-balance sheet transactions, meaning there was no direct impact on the balance sheet in the form of a liability.
However, with the adoption of ASC 842, the off-balance sheet benefits for operating leases will no longer exist. As a result, many companies are rethinking their sourcing decisions, such as buying an asset rather than leasing it or structuring an arrangement as an operating or finance lease.
Communicating with other departments, such as legal and purchasing, and educating them about the impacts of ASC 842 provides these teams with the best information needed to determine if the change in rental activity can be beneficial to the results.
Collaboration with external auditors
The new lease accounting standard has not only had an impact on the finances and internal processes of companies, but also on the external auditors and their substantive checks and tests.
There are new lease-related balance sheet accounts that auditors need to consider in their audit scope and may result in more extensive testing of leases than before.
The best approach for a seamless transition to ASC 842 is to work with the external audit team early in the process. This reduces the risk of surprises during the subsequent audit.
Auditors will review both a company’s initial implementation process and apply new audit procedures regarding lease agreements in the future.
A company that keeps its auditors informed throughout implementation and helps them understand any new policy and process changes will be better prepared for the year-end audit.
ASC 842 impacts more than financial statements
In summary, ASC 842 has already had major impacts on financial statements – but companies would also be wise to consider the ripple effects that the new standard may cause far into the future.
It is essential to develop a comprehensive understanding of the adoption process now, examining past adoption and immediate impacts, as well as future challenges and changes to policies, infrastructure and processes.
Companies that think about all the potential impacts now will be in a better position to take advantage of the benefits later… And find ways to make the adoption process work for them in the meantime.