Many public companies have now finished their second year accounting for leases under ASC 842, and the effective date for private companies is quickly approaching.
The new lease accounting rules significantly impact the way companies—both public and private—account for their lease portfolios and have wide-reaching implications across the entire balance sheet. For the first time, most operating leases are required to be reported on the balance sheet, resulting in material increases to the reported liabilities balance for many companies.
As shown in LeaseQuery’s Lease Liabilities Index Report, public companies saw an average increase in lease liabilities of 4x and private companies that have already adopted have seen an increase of 13x.
A critical step in adopting the new ASC 842 guidance is understanding how much it will impact your company’s financial statements and anticipating how to manage that impact. As evidenced by the experience of public companies, adopting ASC 842 results in substantial changes not only to the balance sheet but also to an organization’s lease accounting and management processes.
The immediate focus for companies is on day-one adoption and accounting, but it’s important for companies to recognize—and plan for—the longer-term impacts that will stretch into the future.
There are three key areas of consideration for companies preparing for a successful adoption:
Identifying all lease arrangements
With operating leases now reported on the balance sheet, it is imperative that companies properly identify all lease arrangements, since missing any will directly impact the financial statements.
Many companies are compiling an entity-wide lease portfolio listing for the first time, pushing them to make changes to their current lease management processes to ensure it supports compliance with the new standard. The beginning-to-end lease process requires the collaboration of several departments within an organization including Legal, Treasury, Procurement and Accounting.
Determining the critical individuals and points of contact within the process will help companies more efficiently collect the lease data needed to properly measure the new lease liability and asset balances.
Companies can perform the following steps to assist with identifying a complete and accurate listing of lease arrangements:
- Obtain a list of recurring payments from the A/P department as these often indicate a rental payment structure for a leased asset
- Review vendor contracts maintained by the legal and procurement teams to determine which ones represent a lease
- Request listings of leased assets from company associates with direct knowledge (e.g., a plant manager)
- Review general ledger data in rent expense accounts to identify material arrangements
Having a complete listing of lease arrangements gives companies a more in-depth understanding of their leasing activity. This new and more detailed information can assist with budgeting and financial analysis.
During the COVID-19 pandemic, many lessees looked for ways to capture cost savings, including working with their lessors for rent concessions, such as payment deferrals and decreases.
Properly maintaining the lease portfolio listing into the future is a powerful tool companies can use to help identify opportunities to reduce costs or renegotiate leasing arrangements to offer more beneficial terms.
Understanding financial statement impacts
Given that companies record a new lease liability balance on their adoption date, it’s expected that material increases in liabilities on the balance sheet will result.
Generally, the greater a company’s operating lease activity, the greater the liability increase will be. While the immediate impact of adoption is to the financial statements, there are several other impacts companies should think through ahead of time.
For example, most debt covenant agreements use metric calculations that include a company’s liability balances. As a result, a company may want to reach out to its banks and lenders to determine how the new lease liability balance impacts these metrics and if any modifications to the covenant agreements are needed. Communicating this possibility to the treasury department early on will allow them to have these critical discussions in advance and reduce the risk of surprises later.
Another potential impact of the new lease accounting rules is to a company’s lease-versus-buy analysis.
Historically many companies have leveraged operating lease arrangements as a way to obtain the fixed assets needed to operate without expending material amounts of cash or taking on material amounts of debt upfront. The original operating lease structure was an added benefit, as these arrangements were off-balance sheet transactions, meaning there was no direct impact to the balance sheet in the form of a liability.
With the adoption of ASC 842 however, the off-balance sheet benefits for operating leases will no longer exist. As a result, many companies are rethinking procurement decisions such as whether to purchase an asset rather than lease it or whether to structure an arrangement as an operating or finance lease.
Communicating with and educating other departments, such as Legal and Procurement, about the impacts of ASC 842 arms those teams with the best information needed to determine if changing lease activity can benefit the bottom line.
Collaborating with external auditors
The new lease accounting standard has not only impacted companies’ financials and internal processes, but also external auditors and their controls and substantive testing.
There are new lease-related balance sheet accounts that auditors need to factor into their audit scope and might result in more extensive testing of lease arrangements than before.
The best approach for a seamless transition to ASC 842 is to collaborate with the external audit team early on in the process. This reduces the risks of surprises popping up in the audit later.
Auditors will both review a company’s initial implementation process and perform new audit procedures around lease arrangements into the future.
A company that keeps its auditors updated throughout implementation and helps them understand any new policy and process changes will find themselves 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 the new standard can cause, far into the future.
It’s critical to develop a fulsome understanding of the adoption process now, looking past adoption and immediate impacts, and toward future challenges and changes to policy, infrastructure and processes.
Companies who think through all of the potential impacts now will be better positioned to take advantage of the benefits later…and find ways to make the adoption process work to their advantage in the meantime.
