ASC 842 - Lease Accounting

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ASC 842LEASE ACCOUNTING HANDBOOKImplementing processes,controls, and systems to achieveand maintain compliance withthe lease accounting standardA12020 Guide for Lessees

ContentsIntroduction to the ASC842 lease accounting standard. 3Why the standards were introduced. 3Knowing your deadline. 3The major changes. 4Exhibit 1: executive summary of the lease accounting rules. 5I. The lease accounting standard: timing, key provisions, and changes in direction. 6Key changes of the standard. 6Exhibit 2: Lease accounting under the standard: a real-world example of key issues. 9Regarding lease payments. 8Impact of the standard. 11To meet the timetable for implementation, lessee companies must begin preparing now. 12Setting objectives and defining compliance and ROI success. 13Sale-Leaseback Transactions. 16II. Transitioning to the standard: how to meet the new requirements and drive savings and ROI. 17Introduction. 17Transitioning to the standard: a comprehensive 8-step process .17Keeping internal groups up-to-date. 21The bottom line: if you haven’t already, start now . 22You may already be behind. 22Consider lease lifecycle automation software. 23Consider outsourcing: drive maximum savings quickly. 24Summary. 242

Introduction to the ASC 842accounting standardIn 2019, the latest FASB lease accounting standard, ASC 842, began to go intoeffect for public company filers. Other entities, including private companies,have more time to prepare for adoption. However, lessons learned from earlyimplementation projects demonstrate that ASC 842 often requires more effortthan companies originally anticipated. Developing a strong understanding of thecompliance requirements for the latest standards is crucial for lessees to adopton time and without material weakness.Why the standardswere introducedThe change to lease accounting rules comes withmany other accounting standard updates, allcreated with the purpose of closing loopholes inaccounting guidance that could potentially allowcompanies to mislead financial statement usersas to the true nature of the company’s financialstate.ASC 842 closes the lease accounting off-balancesheet loophole which allowed corporations toreport their operating leases, often a majorportion of the lease portfolio, in the footnotes offinancial statements. Under the standard,companies are required to capitalize operatingleases on the balance sheet — reporting them asright-of-use assets and lease liabilities. As a resultof the shift, operating lease obligations faceincreased auditor scrutiny, pushing companiesto focus on ensuring accuracy and completenessof what they report as well as leading to greatercomparability of financial statements.3Knowing your deadlineThe following is a table showing when privatecompanies need to transition to the new rules:If Your Year End Is:You Must Transition ToThe New Standards By:December 31January 1, 2022March 31April 1, 2022June 30July 1, 2022September 30October 1, 2022Early adoption is permitted for all organizations, butvery few major public companies elected to earlyadopt. It is expected that private companies willfollow the same pattern. This is primarily becausethe transition process is a huge undertaking.Organizations with sizable lease portfolios shouldmake use of all the time between now and thedeadline to identify leases, extract data, inputdata into a lease accounting system, and test thesystem under the standard’s rules, among othersteps.

The major changesThe FASB lease classification testis as follows:The most notable change is the capitalizationA lessee shall classify a lease as a financeof operating leases, which occurs underboth FASB’s ASC 842 and the InternationalAccounting Standard Board’s IFRS 16.However, the FASB and IASB split on howto classify operating leases, with the FASBdeciding to keep the dual classification modelof operating and finance leases, and the IASBdropping the operating classification so thatall leases greater than 5,000 in value andlease if the lessee effectively obtains controlof the underlying asset as a result of thelease. A lessee effectively obtains controlof the underlying asset when the leasemeets any of the following criteria at leasecommencement:a. The lease transfers ownership of theunderlying asset to the lessee by the end oflonger than 12 months in length are classifiedand accounted for as finance leases.Under finance lease accounting, an asset andliability are recorded at the present value ofthe lease payments on the balance sheet. Onthe income statement, the lease is recordedas a straight-lined depreciation expense plusa front-loaded interest expense.the lease term.b. The lease grants the lessee an option topurchase the underlying asset that thelessee is reasonably certain to exercise.c. The lease term is for substantially allof the remaining economic life of theunderlying asset.d. The sum of the present value of the leasepayments and the present value of anyUnder FASB’s operating lease accounting,residual value guaranteed by the lesseeoperating leases are capitalized but accountedamounts to substantially all of the fair valuefor differently from finance leases (previouslyof the underlying asset.called capital leases. The present value of thee. The underlying asset is of such a specializedoperating lease payments is recorded as anature that it is expected to have noseparate asset and liability and the profit andalternative use to the lessor at the end ofloss (P&L) expense remains as the straight-the lease term.line average expense.When determining lease classification, oneMost notable is that the operating leasereasonable approach to assessing the criterialiability is not be classified as a debt, butfor c and d would be to use the “bright line”rather as an “other” operating liability. This istests of ASC 840 to determine how to definesignificant as it does not impact debt“substantially all”covenants that limit debt.The FASB allows a short-term lease (12months or less exemption, but not anexemption for leases less than or equal to 5,000 in value.a. Seventy-five percent or more of theremaining economic life of the underlyingasset is a major part of the remainingeconomic life of that underlying asset.b. Ninety percent or more of the fairvalue of the underlying asset amountsto substantially all the fair value of theunderlying asset.4

Exhibit 1:Executive summary of the lease accountingstandardTimeline: The final standard was issued in 2016. Public companies began transitioning to the standard January 1, 2019. Private companies transition starting January 1, 2022.Lessee accounting standard summary Capitalize all leases (except those exempted as noted above) at the present value (PV). For the IASB, all capitalized leases have a P&L pattern that is front-loaded (rent expense replaced bystraight-line amortization of the asset and imputed interest on the liability). The initial measurement of variable lease payments included in lease assets and lease liabilitiesincludes only variable lease payments that depend on an index or a rate, measured using the indexor rate at lease commencement.Variable rents based on a rate (e.g. LIBOR) or an index (e.g. CPI) are booked based on spot rates. Variablerents based on usage or lessee performance (e.g. sales) are not booked unless intended as a tool to avoidcapitalization (also known as disguised minimum lease payments which have to be estimated andcapitalized).For the FASB, one should reassess and book variable lease payments that depend on an index or a rateonly when the lessee is reassessing the lease liability for other reasons (e.g., when there is a changeto the lease term upon the occurrence of a significant event or a significant change in circumstanceswithin the lessee’s control). The changed lease payment (due to changes in the rate or index) stillneeds to be tracked to provide footnote disclosure of future lease payments. The IASB voted to requirereassessments whenever the reference index or rate in a variable rent cause changes the future ofcontractual rents. For the FASB, short-term leases (with terms of 12 months or less), including renewals where thelessee is reasonably certain to exercise to renew, can be accounted for under the off-balancesheet method with additional disclosure. For the IASB, short-term and low dollar value leases of 5,000 or less (even if material in the aggregate) can continue to be accounted for off-balancesheet if so elected.5

SECTION IThe ASC 842 lease accountingstandard: timing, key provisions,and changes in directionKey changes for the latest standardFor US lessees, adoption of the rules creates a(and thus must be recognized) only upon thesignificant change from ASC 840 reporting whereoccurrence of a significant event or a significantoperating leases are off-balance sheet.change in circumstances that is within thelessee’s control.Leases capitalized:The rules require a lessee to capitalize allTransition:leases longer than 12 months. While leased assetsExisting capital leases are grandfathered underare capitalized normally, lease obligationsASC 842.should be recorded using the lease term andlease payments based on assumptions related toFor the FASB, lessees may choose betweencontractual rents, including:two available transition methods. The first is a“modified retrospective” approach where alloperating leases existing at or entered into after Bargain or compelling renewal rent andthe date of initial application are booked onpurchase options where the lessee isa prospective basis, but those that expire in thereasonably certain to exercise the optionsperiods of comparative statement will not Variable (contingent) rents Likely payments under residual guaranteeshave to be rebooked. The asset and obligationare booked at the PV of remaining rents atthe earliest date presented in the financialstatements.Estimates of lease term and lease payments:For purchase and renewal options,a lessee should reassess whether the exercise ofan option is “reasonably certain”The second transition option is a practicalexpedient that was approved in 2018 which allowscompanies to “recognize a cumulative-effectadjustment to the opening balance of retainedearnings” at their adoption date. Both transitionmethods must be applied in the same way.6

Present value calculation:The Profit & Loss statement:The lessee calculates the PV of the estimatedFor finance leases, the asset is amortized as anlease payments using the implicit rate in theexpense in the P&L over the estimated leaselease, if it is known to the lessee, or the company’sterm on a straight-line basis (SL) Interest expenseincremental borrowing rate (the interest rate theis imputed on the lease liability The sum of thelessee would incur to borrow under a securedinterest and amortization creates a front-loadedloan with terms similar to those of the lease) Thelease expense pattern. Capitalized operating leasesimplicit rate is defined as follows in the FASBcontinue to use the straightline average rent as thestandard:expense, and operating lease assets and liabilitiesare reported separately from capital lease assets“The rate of interest that, at a givendate, causes the aggregate presentvalue of (a) the lease paymentsand (b) the amount that thelessor expects to derive from theunderlying asset following the endof the lease term to equal the sumof (1) the fair value of the underlyingasset minus any related investmenttax credit retained and expected tobe realized by the lessor and (2) thedeferred initial direct costs of thelessor ”The PV is considered to be both (1) the value ofthe right to use the leased asset (ROU asset), and(2) the “principal” balance of the obligation to payrent (lease liability) This amount is recordedas both an asset and a liability7and liabilitiesLease payment breakdown:Under the standard, the lease payment fora finance lease is broken down into: (1) aninterest component (charged to P&L), and (2) aprincipal componentLease cost for operating leases:The reported lease cost for those leases thatqualify as operating leases is the same as it isunder current GAAP, that is, the straight-lineaverage of the lease payments reported as rentexpense The “rent expense” is the sum of theimputed interest on the liability and amortizationof the asset

Exhibit 2:Lease accounting under thestandard: a real-world exampleTable 1. PC Lease example: assumptions and calculationsAssumptionsOperating lease example:Rent in advance 1,700Here’s an example of how the lease accountingTerm in months36standard under the FASB’s approach would workIncremental borrowing ratefor an operating lease based on provisions of theFair value of leased assetsstandard.5.50% 65,000CalculationsPV of payments - Inception 56,557rent is 1,700 a month for 36 months ( 61,200 inPV of payments - Year 2 38,729total). Under the standard, this lease would likelyPV of payments - Year 3 19,896be considered an operating lease as the PV is lessTotal rent 61,200A company leases several PCs for three years. The87% of 65,000 FVthan 90% of the fair market value. Thus, the leasemust be capitalized and reported as a rightof-useasset and liability on the balance sheet.At a 5.5% incremental borrowing rate, the presentvalue of the rental payments is 56,557. This is theamount that is capitalized on the balance sheet.The lessee’s initial balance sheet entries are:Table 2. Annual journal entry summaryAssumptionsROU asset 56,557Capitalized operating leaseliability 56,557Entry to record first year’s liability activity Debit Right-of-Use Lease Asset 56,557 Credit Capitalized Lease Obligation 56,557Rent expense (imputedinterest)LiabilityOn the P&L, the first year’s imputed interestCashexpense is 4,425 and the amortization expense isEntry to record asset sctivity 15,975. Together, these two items total 20,400Rent expense (amortizationof asset)for the first year’s lease expense. Under thecurrent GAAP standard, the rent expense wouldtotal 20,400 on a straight-line basis.8Asset 2,572 17,828 20,400 17,828 17,828

Finance lease example: Below is an exampleTable 1. IASB method PC lease exampleof the IASB’s approach for the same lease as inassumptions and calculationsthe example above.A company leases several PCs for threeyears. The rent is 1,700 a month for 36months ( 61,200 in total). Under IAS 17, thisis considered an operating lease, as the PVof the payments is less than 90% of the fairvalue of the assets and is accounted for as anoff-balance sheet transaction. Under theIASB standard, the lease must be treated asAssumptionsRent in advance 1,700Term in months36Incremental borrowing rate5.50%Fair value of leased assets 65,000CalculationsPV of payments - Inception 56,557Total rent 61,200a finance lease. That is, it is capitalized andreported as an asset and liability on the balancesheet with interest expense and amortizationTable 2. Annual journal entry summaryexpense reported on the P&L statement.Entry to capitalize the lease at inceptionAt a 5.5% incremental borrowing rate, theROU assetpresent value of the rental payments isCapitalized operatinglease liability 56,557. This is the amount that is capitalized 56,557 56,557on the balance sheet. The lessee’s initialEntry to record first year’s liability activitybalance sheet entries are:Imputed interest expense 2,572Liability 17,828 Debit Right-of-Use Lease Asset 56,557Cash Credit Capitalized Lease Obligation 56,557Entry to record first year’s asset activity 20,400Amortization expenseOn the P&L, the first year’s interest expense 18,852Accumulated amortization 18,852is 2,572 and the amortization expense is 18,852. Together, these two items totalTable 3. I ncome statement impact of 21,425 for the first year’s lease expense.Front-ended lease expenseUnder the current IASB standard, the rentexpense would total 20,400 on a straightlineEntry to capitalize the lease at inceptionbasis. Thus, capitalizing the lease hasYearincreased the company’s lease expenseby 1,025 in the first year. The cross-overpoint occurs in the second year of the lease,when the total lease expense under thestandard would be less than the expenseunder the current IASB standard.9123FASB method 20,400 20,400 20,400IASB method 21,425 20,419 19,357IASB B/(W)than FASB( 1,025)( 19) 1,043-5%0%5%%

Evolution of key issues regarding leasepaymentsLease term Variable lease payments that are “disguised”The FASB and IASB decided that the lease termminimum lease payments based onis defined at inception as the contractual term plususage of the underlying asset or on lesseerenewal or purchase options, where the lesseeperformance—in other words, paymentsis “reasonably certain” to exercise the option tothat are “reasonably certain,” in which caserenew or purchase. This is essentially a reversionan estimate of the expected rents must beto ASC 840. Under ASC 840, a renewal or purchasecapitalized.option is included in the lease term if there arebargains or if there is “compulsion” to exercise--- where the lessee would incur an economicpenalty for failure to exercise the option. Underthe standard, for purchase and renewal options, alessee should reassess whether the exercise of anoption has now reached the level of “reasonablycertain” (and thus must be recognized) onlyupon the occurrence of a significant event or asignificant change in circumstances that is withinthe lessee’s control. The FASB and IASB agreedthat the term “reasonably certain” is a high hurdle.Variable Lease PaymentsOnly certain variable lease payments areincluded in the lessee’s lease capitalization,including: Variable lease payments that depend on anindex (like the CPI) or a rate (like LIBOR, usingthe spot rate at lease inception for floatingleases).Change in required adjustment of variablerentsLessees are required to reassess index- orratedependent variable lease payments only whenthey are reassessing the lease liability for otherreasons. For example, reassessment may berequired when there is a change to the lease termupon the occurrence of a significant event, orwhen there is a significant (but controllable)change in the lessee’s circumstances. Do notoverlook the requirement to disclose future leasepayments, meaning that although a FASB companyis not required to rebook when variable rentschange, it is required to disclose the adjustedpayments.Residual guaranteesLessees need only include the likely paymentunder a residual guarantee in the lease paymentscapitalized – not the full amount of the residualguarantee. Residual guarantees are common insynthetic leases, TRAC leases, split TRAC leases, 10and open-ended fleet leases.

Impact of the ASC 842 standardFinancial impact – significant, but less thancode for leases are entirely independent ofthe accounting treatment. Regardless of whatchanges take place, there is expected to be noimpact on taxing in these jurisdictions. As such,the lease versus buy decision is not impactedby taxes. In the same jurisdictions, however,the changes to lease accounting for IASBcompanies may increase the administrativeburden with regards to tracking differences,which are expected to occur under capitalizedoperating leases. IASB companies also have totrack operating leases for personal propertytax purposes, as they are not taxable for thelessee. The difference in administrative cost oftracking tax treatments that differ from booktreatments is not expected to be material forcompanies with an Enterprise Lease LifecycleAutomation platform that has strong accountingand reporting capabilities.originally envisioned:For many US companies, the overall financialimpact of the lease accounting changes is not asgreat as originally thought. Certainly, the impactof capitalizing leases is significant, as it puts newassets and liabilities on the balance sheet. However,due to the FASB decision on the operating leaseexpense pattern, the impact on profitability formany companies is not significantly differentfrom what was true under the existing standards.Some financial ratios and measures are impacted.However, IASB companies are seeing much moresignificant changes including higher debt amounts,permanent lost capital, new permanent deferredtax assets, and temporary reduced earnings.For most leases, the amounts capitalized aregenerally the same as the estimates used by In other taxing jurisdictions, and as sometimesseen in Europe, the tax code makes referenceto or uses the accounting treatment for thepurposes of calculating taxable income withoutany adjustments. The new standards may infact impact the amount of taxes paid in thesejurisdictions. However, there are certain taxingjurisdictions taking action to ensure that suchaccounting changes do not impact taxes byrevising the tax code to be consistent withthe existing standards. Again, where timingdifferences occur, you are required to trackdeferred tax amounts. Personal property tax and sales tax couldpossibly be impacted in some taxing jurisdictions.Ordinarily, the responsibility to pay theseamounts is determined by the legal substanceof the lease contract or within the lease contractterms, The accounting treatment would notimpact either the amount or responsible party forthese payments. Nevertheless, companies shouldconsult with their tax departments to ensurethere are no tax consequences as a result of thelease accounting changes in all of the countriesand taxing jurisdictions in which they transact or anexus exists.major ratings agencies. For IASB companies, theincrease in liabilities classified as “debt” due tocapitalizing operating leases may result in debtcovenant breaches that requiring negotiationand adjustment. US bankruptcy laws do notconsider operating lease obligations as debt, asdo many other countries, so the FASB decided toclassify operating lease obligations as non-debt“other” liabilities. Also, financial measures likereturn on assets, liabilities to et worth, etc., maychange, so a lessee should make pro formacalculations to determine if loan covenants, othercontracts, or internal performance and incentiveplan measures using those measures are affected.Tax impact — minimal, depends on jurisdiction:Lessees should investigate the following areasfurther with their tax departments to determine ifthere are any tax changes that may result with thestandard: 11In many taxing jurisdictions, typically in NorthAmerica, the income, sales, and property tax

Operational impact — substantial increasein administrative burden:The ASC 842 lease accounting standardincreases a lessee’s administrative burden dueto the required increase in process controls;data collection, analysis, and maintenance;To meet the timetablefor implementation,lessees must preparenowmonitoring; internal reporting systems; and,most importantly, audit scrutiny. Here aresome of the key factors contributing to theadded burden. There is an expanded definition of what isincluded in lease payments – in particularvariable payments and expected paymentsunder residual guarantees. Data to calculate payments come formseveral sources in the organization. Calculation of lease payments is complex. Non-lease components in gross or bundledbilled payments must be separated (unlessthe practical expedient not to separate isselected for all asset classes). Calculation of some payments involvesjudgments and estimates. Calculations to determine the amountsto record in order to capitalize operatingleases are complex. Financial disclosure requirements areexpanded. Income tax reporting and accounting maybe more complex. For most companies, the scale of theadministrative requirements meansadditional systems and tactical support.12For those lessees that have not alreadyadopted, it is critical to not underestimate thetimetable for implementation. This is especiallytrue if a company’s lease portfolio includesmany lease schedules with multiple assets,non-homogeneous assets, lessors, countries,or languages.It is likely to take more than twelve months forsome companies to fully overhaul the leaseaccounting processes, systems, and controlsthat are required to comply with the standard.Companies must: (1) understand the rules todetermine compliance requirements, (2) startand complete a transition process, and (3)develop an ongoing process for complying withthe new standard beginning on the effectivedate.The lease accounting rules are complex andlessees must read them in detail to understandhow to comply and what the implications are.

Setting objectives anddefining complianceand ROI successSee the metrics you can employ tomeasure how well you achieved theobjective.To address the lease accounting changes,Metrics example:companies have to change how they manageWe know we have been successful intheir leasing activities. Accounting for operatingmeeting this objective because:leases was relatively simple, since those leaseswere treated as operating expenses. Accounting We can generate reports with the push of abutton, quickly and easily, for:for capitalized operating leases, however, requiresa much more rigorous approach, given the increase in risk and complexity. Such complexityThe lease accounting changes that reflectthe final lease accounting standard.issues include the impact of estimation errors as well as the increased compliance requirements ofPreparation of our financial reportingdisclosures, including SEC-requiredthe Sarbanes-Oxley Act.comparable, with full audibility. As with any change-management project, youInternal management of a all lease termsthat require timely decision making.should start by defining the objective, scope, and strategy of the project or process. See an exampleAll stakeholders who use the data, trustthe data.of an objective that you might establish for yourcompany’s transition to the standard. It is All stakeholders in the leasing processdeliberately stated in past tense as if it has alreadyreceive timely, accurate, and completebeen accomplished. The objective is not exclusivelyreporting and notifications, especiallyfocused on compliance. Instead, it is designednotifications about the end of term.to yield financial returns from the investmentin compliance by improving the financialperformance of your leasing process and portfolio. The financial performance of our leaseportfolio, process, and people is measurableand continuously improving. For example, weknow quantitatively how much money we areObjective example:By the implementation deadline for the leaseaccounting changes, we will have developed,saving by easing rather than buying. And weknow how much money we could be savingif specific underperforming people andgroups managed their leases assets at thedeployed, documented, and iteratively refinedend of term more effectively and returneda leasing process that is compliant with theassets on time. We can provide those under-lease accounting standard. This process willperformers with the automated notificationsbe well-controlled, auditable, automated, andand scorecards that they need to improvescalable, and we will be able to demonstrate thattheir performance quickly and easily.we made good economic decisions throughoutthe lease lifecycle.13

SECTION IITransitioning to the standard: howto meet the requirements whiledelivering savings and ROIIntroductionThe remainder of this handbookstandard, it is also an investmentLease versus buy:provides comprehensivein managing the company’sReview of your leasing policiesguidance on implementingleasing activities more efficientlyincludes reviewing your leasethe ASC 842 lease accountingand effectively. Therefore, ifversus buy (LvB) analyses.standard. The transition processproperly implemented, thePreviously, LvB analysisrequires the collaborationprocess will pay for itself andand decision making wereof many individuals andbring continuous, sustainable,primarily based on economics,departments within yourand annual returns.as operating leases werecompany. At the same time, theoffbalance sheet and treatedprocess we recommend hereWe recommend an 8-stepas an operating expense. Nowdelivers major efficiencies inpr

Under finance lease accounting, an asset and liability are recorded at the present value of the lease payments on the balance sheet. On the income statement, the lease is recorded as a straight-lined depreciation expense plus a front-loaded interest expense. Under FASB’s operating lease accounting

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