10 observations for private companies’ lease accounting

David WentzelDan EdwardsLuis Lopez Garay
10 observations for private companies’ lease accounting

After years of preparation and deferrals, the final effective date of the FASB’s new lease accounting standard is now imminent for private companies. For those that have yet to adopt, here are some valuable observations.

The new lease accounting standard from the Financial Accounting Standards Board (FASB), Accounting Standards Codification (ASC) Topic 842, “Leases,” requires organizations to record most leases on their balance sheets. Public companies and early adopting private clients have implemented the standard, and now it’s time for private companies to follow suit. As with any major standard adoption, many factors should be considered and assessed, including the lessee’s discount rate, embedded leases, software tools to assist with tracking and accounting for leases, and process changes. The experiences of adopters have revealed several important lessons and key takeaways about adopting and applying this complex lease accounting standard.

Here are 10 observations that might benefit private companies as they embark on adopting the standard.

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Observation 1: Lease contracts are everywhere

The lease accounting standard requires companies to record on their balance sheets leases embedded into contracts. This means private companies need to determine their obligations arising from lease and service contracts that involve the use of fixed assets.

Many companies underestimate the effort it takes to collect lease information and organize it in a uniform format. They might be surprised by the number of things they lease – from coffee makers and copy machines to building space and cars. The problem is that companies often are not tracking smaller assets (like printers, for example) because the dollar amount isn’t as significant as it is for other assets such as real estate. The value of a handful or more of smaller, seemingly insignificant items adds up, however. And tracking these and other leased items takes time.

Observation 2: Complexity abounds

Lease contracts aren’t one-size-fits-all. Contracts for car leases might be straightforward while land, equipment, and office leases can be rife with complexity. In order to enter, calculate, and report accurate information, companies need to have the right information, which involves going back and carefully reviewing the terms of every lease, including amendments. The relevant terms needed to calculate the ASC 842 impact can reside across multiple documents, and tracking changes across several amendments can be difficult.


Observation 3: Accounting will be stretched

The new lease accounting standard adds more requirements for accounting teams. This might mean adding accounting resources or outside advisers to assist with the implementation and ongoing data gathering, accounting, and financial reporting for leases. How far to stretch the budget depends on the organization. For example, if a company has 20 office leases and each is a 20-year lease, one accountant might suffice. But if a business has hundreds of leases and anticipates more leased assets, it might need to consider adding to the accounting team. Remember, the lease accounting software a company chooses is an enabler, not an end-all solution.

Observation 4: Other departments should be involved

Private companies need to make sure personnel with responsibilities such as legal, purchasing, IT, and real estate are engaged with accounting during the transition process. This means accounting is going to have to ask others within the organization, “What leases are you aware of that we don’t know about?” This outreach can help form a more comprehensive understanding of the company’s leases, as critical lease contract information often resides outside of accounting. Bridging this disconnect can be a challenge, but a proper project plan and team commitment can help the implementation and keep all departments involved on the same page.

Observation 5: Accounting for related-party leases will be a change in practice

Observation 5: Accounting for related-party leases will be a change in practice

Prior to applying ASC 842, entities accounted for related-party leases based on their economic substance, which can be complex given the unique nature of related-party leases. In contrast, ASC 842 requires entities to account for related-party leases based on their legally enforceable terms and conditions, which is intended to simplify applying the leases guidance and will be a change in practice for many entities. However, stakeholders have raised questions about how to apply this guidance. As of the time of this publication, the FASB has proposed amendments to the standard to ease the application of the legally enforceable terms and conditions concept and to amend the subsequent accounting for leasehold improvements in an effort to reduce diversity in practice.

Observation 6: Private company lessees have a choice when it comes to the discount rate

In most cases, private company lessees will have a choice to use either their incremental borrowing rate or the risk-free rate as the discount rate for a lease. This accounting policy election can be made by class of underlying asset. Many companies have found that determining the incremental borrowing rate can be unexpectedly complex and can make it difficult to create consistent processes for the future. On the other hand, using the risk-free rate as the discount rate is easier to apply, yet it typically results in a larger lease liability and right-of-use (ROU) asset.

Observation 6: Private company lessees have a choice when it comes to the discount rate
Observation 7: Transition practical expedients will make adopting the standard easier

Observation 7: Transition practical expedients will make adopting the standard easier

The new leases standard comes with a package of three transition practical expedients that companies can use to ease their initial application of the standard. Most companies likely will elect to use the package of transition practical expedients, namely so that they do not need to reassess the classification of leases existing at the transition date. The practical expedients allow the same classification of leases assuming they were originally classified correctly under ASC 840.

Observation 8: The transition adjustment is largely a balance sheet gross-up

Given the modified retrospective transition method, it might be surprising that many entities will not have a cumulative effect adjustment to make upon adopting the standard. While the situations that call for such an adjustment are limited, an example of when a cumulative effect retained earnings adjustment might be required is if a sale-leaseback gain was deferred under ASC 840 but qualifies for recognition under ASC 842. Entities with significant balances of lease incentives, deferred rent, or ASC 420 obligations at the transition date should keep in mind that these balances are, in most cases, merely reclassified on the balance sheet in establishing the initial ROU asset. That is, in most cases, the balances are not derecognized or adjusted through a cumulative effect adjustment to equity.

Observation 8: The transition adjustment is largely a balance sheet gross-up
Observation 9: Companies downsizing their real estate footprint can expect changes from past practice

Observation 9: Companies downsizing their real estate footprint can expect changes from past practice

Changes in the way (and where) people work in recent years have drawn many companies to either reduce their real estate risk by entering into sale and leaseback transactions or reduce their leased real estate footprint. In either case, applying ASC 842 changes the accounting for these events.

For example, ASC 842 has less restrictive rules relating to sale and leaseback transactions involving real estate. Consequently, more sale and leaseback transactions involving real estate are likely to result in gain recognition. However, entities should be aware of guidance involving off-market terms. For example, often in these transactions, the sale price and leaseback rentals are negotiated together – that is, if the sale price is above fair value, the corresponding lease payments also typically will be above market rent terms. When performing their accounting analysis, companies should not assume that either the selling price or lease payments (or both) are at market terms.

Private company lessees that expect to downsize their lease footprint should be aware that they might need to consider if ROU assets (along with other assets in an asset group) have been impaired by applying guidance in ASC 360 relating to testing long-lived assets for impairment.

Observation 10: A software solution should be considered

Acclimating to the new lease accounting standard means companies should make an honest assessment of their existing processes and capabilities for capturing, tracking, and reporting lease data. Unlike past practice, after adopting ASC 842, entities need to establish processes that enable them to continually report accurate lease-related balances. Companies should consider if existing processes allow for efficient data collection and can be easily integrated with, or embedded in, existing company systems. Companies with more than a few leases should challenge themselves to consider if a software solution might be better suited than existing spreadsheet systems to address these concerns and to perform the following ongoing tasks after initial adoption of the standard:

  • Compiling lease data from multiple sources
  • Performing multibook accounting under parallel standards (for example, International Financial Reporting Standard 16, “Leases”)
  • Making midlife adjustments automatically after lease modifications or lease reassessments
  • Tracking variable lease payments
  • Creating a full suite of reports to satisfy disclosure requirements
  • Providing a centralized point of control around lease information

Contact us

No matter where you are in the implementation process, our team of specialists can help you understand how the new lease accounting standard affects your business and what you can do to get your company ready.
Simon Little
Simon J. Little
Office Managing Partner, Dallas and Plano
David Wentzel
David Wentzel
Partner, National Office