Private companies can learn from public companies in this difficult rules implementation process.
Company financial reporting personnel are accustomed to hearing that they need to start early in the implementation of new accounting standards. The expert advice on FASB’s new lease accounting standard (Accounting Standards Update No. 2016-02, Leases (Topic 842)), though, comes with extra urgency
“Just starting early doesn’t make this easy,” Brian Satenstein, CPA, CGMA, said in December at the AICPA Conference on Current SEC and PCAOB Developments.
Satenstein is controller and principal accounting officer of Tapestry, a global house of brands including Coach, Kate Spade, and Stuart Weitzman. Like many public companies, Tapestry is in the process of implementing the lease accounting standard, which took effect at the beginning of this year for public companies.
But private companies are scheduled to implement at the beginning of 2020, and their finance staffs can be better prepared if they pay close attention to the challenges public companies faced. And there were plenty of challenges.
A PwC survey conducted in the fourth quarter of 2018 showed that:
■■ More than half (58%) of public companies said they were implementing new systems for lease accounting, and another 17% said they were modifying or upgrading existing systems (see the chart, “The Tools of the Trade”).
■■ Nearly one-fourth of all companies reporting systems changes had doubts that their systems would be live before the effective date.
■■ A substantial majority (87%) of respondents said the combined task of implementing standards for lease accounting, revenue recognition, and other topics was somewhat or very difficult.
The challenges have been so pervasive that FASB Chairman Russell Golden was asked at the AICPA’s SEC/PCAOB conference whether the board was considering delaying the effective date to give panicked finance departments time to catch up. FASB doesn’t plan to postpone the deadline, although the board has issued numerous clarifications and practical expedients — and engaged in numerous educational efforts — to make implementation easier.
“At this point, we’re anticipating an on-time implementation,” Golden said in December.
LOCATING YOUR LEASES
The most challenging aspect of the lease accounting implementation for many companies is actually locating all of the company’s leases. More than three-fourths (77%) of the PwC survey respondents rated ensuring the completeness of their lease population as somewhat or extremely difficult.
Private companies may have an advantage with this over public companies, which were more likely to have their lease agreements scattered in multiple locations across the globe and tracked with many kinds of systems. But private companies also may go into this implementation with processes that are less formalized, which can create problems. Satenstein said that mature and well-defined procurement policies, processes, and teams can assist in locating the company’s full lease population; private companies with less mature process- es may have to work harder to find all their leases. As a result, educating personnel throughout the company on what’s needed during the lease accounting implementation may be the first step toward success.
Cheryl Levesque, CPA, a partner in Dixon Hughes Goodman LLP’s Risk Advisory group, is advising clients to hold formal working sessions with key people from departments throughout their organizations to describe what types of contracts qualify as leases under the accounting standard. Satenstein said that the creation and distribution of specific questionnaires throughout a company, tailored to the accounting guidance, is a simple yet effective starting point in helping to identify embedded leases. It’s fairly easy for people to identify when real estate, car fleet, and copier contracts are considered leases. It can be a bit more difficult to identify embedded leases in situations where a right to use exists in areas such as billboard advertising or certain outsourced IT services. In general, an embedded lease exists in a contract when it conveys the right to control the use of identified property, plant, or equipment. Almost three-quarters (72%) of respondents in the PwC survey said identifying embedded leases was at least somewhat difficult.
“We actually walk [company personnel] through examples and say, ‘Here’s an example contract, and this is what you’re looking for, this is why it would meet the criteria of a lease,’” Levesque said at the AICPA conference.
The new lease accounting standard puts more emphasis on identifying embedded leases, Satenstein said, because the previous lease accounting rules expensed operating leases and service contracts in a similar fashion. A search for embedded leases may focus on a number of areas, such as:
■■ IT contracts such as server arrangements or cloud computing arrangements.
■■ Manufacturing agreements, especially those with customized tooling.
■■ Advertising contracts.
“Obviously, all your contracts won’t just say ‘LEASE’ in big, bright letters at the top of those agreements,” Satenstein said. “So having a very structured and formalized process to help identify them as leases is going to be very important.”
A company’s legal counsel also may be able to help finance understand which contracts might contain an embedded lease. Companies may also choose to start with their commitments and contingencies tables in their search for lease components. Working backward from there to determine what the company’s costs are, and then understanding the underlying arrangements for those costs, can help the finance department locate liabilities and assets associated with leases.
INTERNAL CONTROL CONCERNS
Once a company locates all its leases and gathers them into a central repository, it’s necessary to extract the data from them that are needed to comply with the accounting standard. This also is a challenge; 69% of the PwC respondents said extraction was at least some- what difficult. This is because a company may have thousands of lease contracts from which data must be extracted before calculations can be made. Some companies have turned to software that uses artificial intelligence (AI) to “read” large numbers of similar contracts and input the data into the accounting system.
Regardless of whether AI is used, companies need to have internal controls over the extraction processes to ensure the correct numbers are being used for the lease accounting. With the lease accounting implementation overall, Levesque said, companies need to have two sets of internal controls. Transition or pre-implementation controls help the company make sure that it has effective processes for changing over its lease accounting from the old standard to the new standard. The post- implementation controls are designed to keep the lease accounting processes running effectively in the future.
According to Levesque, the pre-implementation controls include controls over:
■■ The completeness and accuracy of the lease population, including embedded leases.
■■ The discount rate for each lease, which for lessees is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate, which is the rate of interest a lessee would have to pay to borrow, on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment. Private companies also can make an accounting policy election to use a risk-free rate.
■■ The implementation of a new software system (if one is being installed) as well as over the migration of data into that system.
Post-implementation controls include controls over the information that will be presented in the disclosures, which have been expanded under the new standard.
Controls also are needed to ensure that new leases that the company agrees to in the future are added to the population that is being accounted for under the new standard. This includes a process to determine whether any new contracts contain embedded leases, and once again a process with the procurement department may provide the appropriate control for this purpose.
Controls over calculations also are important.
Levesque said companies that decide not to use soft- ware for their lease accounting need controls to make sure their formulas don’t change and that the information being used for the calculations is kept up to date. “Even if you are using a software solution, how are you getting comfortable that the software is calculating everything correctly?” she asked. “… You start feeling warm and fuzzy because you have this nice little SOC report that’s going to get you there, and then when you actually open it up, you’re like, ‘Wait, it’s not going to give me everything that I was going to rely upon.’ So, it’s really important to look at that.”
Satenstein added that during a software implementation, manual calculations and checks will be important to ensure the software is calculating the impact correctly. He said that this is a short-term calculation check that should not need to continue once the company is comfortable that the software is working correctly, but it’s nonetheless an important control as the new systems are implemented.
SYSTEM CHOICES
There’s no correct answer for whether a company should purchase and install a new system to comply with the lease accounting standard. Although three- fourths of the public company respondents in the PwC survey were implementing new systems or modifying existing systems, 53% of private companies planned to use desktop applications such as spreadsheets. Al- though there’s a chance some private companies will change their minds after they get further into the implementation process, new systems may not be necessary for companies that have a small population of leases.Even companies that are purchasing new systems are taking a variety of approaches, Levesque said.
THE TOOLS OF THE TRADE
Public companies were more likely than private companies to be purchasing new software tools for implementing FASB’s new lease accounting standard, according to a PwC survey in the fourth quarter of 2018.
PUBLIC COMPANIES
■■ Implementing new lease accounting software .......... 58%
■■ Modifying/upgrading existing systems ...................... 17%
■■ Using desktop applications such as spreadsheets ... 22%
■■ Other .......................................................................... 3%
PRIVATE COMPANIES
■■ Implementing new lease accounting software ........ 33%
■■ Modifying/upgrading existing systems ............. 9%
■■ Using desktop applications such as spreadsheets .. 53%
■■ Other ................... 5%
Source: PwC’s 2018 Q4 accounting change survey.
Some companies — particularly those with many leases — intend for their new software to do everything associated with leases, including paying them, keeping the inventory, and performing the accounting. Other companies plan to continue paying leases and keeping track of them through their existing processes, and they are purchasing systems just to perform the accounting and give them the information for their disclosures related to lease assets and liabilities.
“Some companies just don’t want to change their current manual process,” Levesque said. “It was less disruption for them to just have the accounting come out with a new solution and continue under their old process. Now generally … that’s usually companies that have a smaller number of leases.”
Other tips from experts on the lease accounting implementation include:
■■ Look for opportunities for improvement. Implementing the lease accounting standard provided Tapestry with an impetus to build upon its existing processes and educate personnel. “It’s going to be helpful for us internally,” Satenstein said. “Hopefully then it’ll be helpful for our auditors externally. Then, indirectly, helpful for our audit fees eventually, as well.”
■■ Mind the transition provisions. “The transition provisions were surprisingly complex,” Mark Barton, CPA, a partner with EY’s National Professional Practice
in Washington, said at the AICPA conference. “… There’s a lot of transition guidance to work through.” Nonetheless, Barton said, the transition will be more difficult than applying the standard on a go-forward basis.
■■ Fully document everything. “The external auditors are going to want to see that,” Levesque said. “Your internal auditors are going to want to see that. So, documentation is huge. The process of completeness and accuracy, how you got information to the soft- ware, why you chose certain elections — document as much as you can. It’s only going to help as you work with the auditors to get through this process.” Ultimately, though, the success of this implementation for many companies is likely to hinge on the number of resources they devote to it. For companies with a lot of leases, this transition may be tedious and painstaking, and the assistance of a third party can be beneficial. Satenstein added that considerations given to resource requirements for this project have been fluid, and “as the project has advanced, we’ve right-sized, rationalized, and readjusted some of those resources to make sure that we are ultimately in a good place.”
3 important lease accounting considerations
The pervasiveness of leases across a wide variety of companies and business models makes FASB’s new lease accounting standard a high-profile implementation item for a large number of organizations that use GAAP for their financial reporting.
Although FASB has made a significant effort to keep the new accounting for leases straightforward and simple, the sheer volume of leases at many companies — and the fact that it’s rare for any company not to make at least some use of leases — makes this implementation a challenge. Here are three things for companies to consider as they adopt the standard:
Keep the audit committee informed
Audit committees play an important oversight role in the implementation of any accounting standard, and the lease accounting standard (Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842)) gives them plenty to think about.
Committees should be prepared to evaluate:
■■ Management’s impact assessment. GAAP users are spending a great deal of resources evaluating the effects of the new standard. For instance, Walmart estimated in its quarterly report issued Nov. 30 that as a result of the new standard, its total assets and liabilities will increase between $14.5 billion and $16.5 billion upon adoption before considering deferred taxes. (The retailer also noted in the filing that it was implementing new lease systems in connection with ASU 2016-02, but the systems were still being developed to comply with the rules and, “as a result, the company has implemented a temporary solution for initial adoption and until these systems are fully implemented.”) The effect of adding leases to balance sheets can be huge, and therefore the impact should be considered carefully by the governance body as well as the finance team.
■■ The implementation plan. Keeping tabs on who at the company is involved in the project, as well as inquiring about how milestones are established and monitored, is important for the audit committee. Many organizations find they need a team with personnel from throughout the organization with considerable expertise. CVS Health Inc., for example, disclosed that its implementation was being handled by a cross-functional team and that it would implement a new lease system that would produce the data to perform the accounting and disclosures.
■■ The disclosures. Leading up to the time of adoption, it’s important for management to disclose the anticipated effects that the new lease accounting standard will have on the financial statements. Disclosures have been quantitative for some public companies and qualitative for others while they were still evaluating the impact of the standard, and either way the information is important to give investors an idea of what to expect from the new standard.
For more information on audit committees’ responsibilities related to the new standard, see the Center for Audit Quality’s tool Preparing for the New Leases Accounting Standard at tinyurl.com/ya5navms.
Choose the right transition method
Companies need to decide whether to elect the optional transition method that allows them to initially apply the new lease accounting standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption.
This option was offered by FASB in ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, in July 2018. Prior to that, the new lease accounting standard required companies to initially apply the new lease accounting standard at the beginning of the earliest period presented in the financial statements. Using that modified retrospective transition method, lessees are required to recognize lease assets and liabilities for all leases even though they may have expired before the effective date of the new standard.
Preparers found that the comparative period reporting requirements were creating unanticipated costs and complexities, so FASB provided relief with the optional transition method described in ASU 2018-11.
Some public companies, such as CVS Health Inc., have disclosed their intention to adopt the standard on a modified retrospective basis. Others, such as Johnson & Johnson and Walmart, have disclosed their intention to apply the standard at its adoption date rather than at the earliest comparative period in the financial statements.
Monitor debt covenants
As lease obligations move onto company balance sheets, they have the potential to negatively affect covenants that organizations have with their lenders. Companies that find themselves in violation of their debt covenants as a result of leases coming onto their balance sheets may need to renegotiate with their lenders. As this is an issue that many companies are facing, lenders aren’t likely to be surprised when clients ask to renegotiate. ■
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