Armanino Blog

Are You Ready for the New Lease Accounting Standard?

by Grant Lam
January 23, 2017

The new lease accounting standard may be a bigger undertaking than some companies expect. Straightforward leases of real estate and vehicles won’t present too much of a challenge, but complex judgment calls may be required for some third-party service contracts. Here’s what you need to know about the lease standard that was issued by the Financial Accounting Standards Board (FASB) in February 2016 before it goes live in 2019 for public companies and 2020 for private ones.

Years in the Making
The FASB’s lease standard is the culmination of years of debate about how to make balance sheets more representative of companies’ financial condition. The existing lease accounting rules in U.S. Generally Accepted Accounting Principles (GAAP) require companies to record lease obligations on their balance sheets only when the arrangements are akin to financing transactions, such as rent-to-own contracts for buildings or vehicles.

In practice, few arrangements get recorded under the existing guidance because of what critics call “bright lines” in the rules that let businesses structure deals to look like simple rentals. If an obligation isn’t recorded on the balance sheet, it makes a business look like it’s less leveraged than it really is.

Investors and analysts, however, have long considered lease expenses an essential component to assessing a business’s financial health. Most use data in footnote disclosures to determine what a balance sheet would look like if the company were forced to own up to its lease liabilities.

The FASB’s final lease standard is less comprehensive than earlier drafts. But implementing the changes still will be a significant undertaking for many businesses.

Changes Underway
Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), requires companies to report on their balance sheets their leased office space, storefronts, vehicles and equipment as assets and the rent they pay for them as liabilities. The standard is expected to make company balance sheets balloon. Although the changes don’t go into effect for a few more years, companies that issue comparative financial statements will need to change their reporting processes and recordkeeping long before the implementation date.

Implementation starts by gathering all contracts and assessing who’s in control. Most businesses will know right away that they have to put their rented real estate, factory equipment and vehicle fleets on the balance sheet, but some arrangements can get more complex. For example, an oil company hiring a contractor to drill in the Gulf of Mexico and operate an oil rig could fall under the lease standard, depending on which party controls the rig.

Some U.S. businesses also must assess whether the rented equipment used by third-party overseas manufacturers will have to be accounted for under the updated guidance. The exercise of deciding how to account for the rented equipment for the third-party manufacturers will require significant research and data collection. In fact, just documenting that the standard doesn’t have an impact could be time-consuming for management.

In some cases, deciding whether to report leases on the balance sheet could require complex judgment calls. Handling lease agreements in a centralized manner may help larger companies simplify the decision-making process and lead to greater consistency across reporting units.

Helping Hand
As the effective date for the updated guidance approaches, companies should realize that implementing the FASB’s new lease accounting standard will require an effort that’s comparable to other major accounting changes. To make the changes, management must cull data not just from rental agreements for storefronts and vehicles, but also from service arrangements and third-party outsourcing contracts. For help understanding how the new standard will affect your business, contact your local Armanino expert to help perform a comprehensive review of your contracts.


Implementation Challenges: Stories from the Trenches

A year before the lease standard goes live, companies will be busy trying to implement another major accounting rule change: the revenue recognition standard. Like the lease standard, the revenue recognition standard is expected to require sweeping changes for a wide variety of businesses.

Published in 2014, Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, is effective in 2018 for most public companies and 2019 for most private companies. It replaces reams of industry-specific guidance in U.S. Generally Accepted Accounting Principles (GAAP) with a broad, principles-based method for most businesses to tally revenues. Retailers generally don’t expect to see a significant change in how or when they record revenues, because a customer buying, say, sweaters at a store is a straightforward transaction. But companies that enter into specialized, long-term contracts with customers are a different story.

Significant Work
Last November, during a panel discussion at Financial Executives International’s (FEI’s) Current Financial Reporting Issues Conference, representatives from large companies that are at an advanced stage of the implementation process issued a collective warning: Even if the new accounting standard isn’t expected to have a major effect on a company’s reported revenue, management still faces a lengthy and complicated implementation process.

“Regardless of where your end point is and what may be the financial impact this standard causes, or if this changes the timing of revenue or the amount of revenue recognized, there’s no doubt that this standard and implementation is significant,” said Christine DiFabio, assistant controller at Zoetis, a manufacturer of medicines for animals. “For those people who haven’t started or are very early [along], try to start to speed it up, because while you may not think it will have a significant impact financially, it’s a significant impact in workload—and documentation efforts as well.” She described the accounting change as “all encompassing.”

Michael Cleary, Boeing vice president of accounting and financial reporting, said the changes would be “significant” in terms of when his company records revenue. So, he formed a steering team, including officials from the communications and human resource departments, tasked solely with implementing the new standard. “One of the things we’ve learned—there are a lot of interdependencies, and it’s very important for us to understand, if we’re making a big accounting change, it’s important to understand what the other changes we are making in the company at the same time,” Cleary said. “We worked hard to keep all those things in alignment.”

Johnson & Johnson, a seller of consumer goods, doesn’t expect to experience as much complexity in implementing the revenue recognition standard as companies in other industries. But Johnson & Johnson’s worldwide senior director of financial compliance and procedures, Steve Rivera, still reportedly plans to invest substantial time going through customer contracts to assess the level of the change.

The Lesson?
As these real-life implementation stories demonstrate, complying with major accounting updates can be a time-consuming process that extends beyond the accounting and finance department. Companies that have had a late start implementing the changes may be in for some unwelcome surprises in the years ahead.

Surprisingly, the SEC reported at the recent FEI conference that roughly one in five public companies haven’t yet started to implement the revenue recognition standard. With an extra year to make the changes, even fewer private companies are likely to have started the implementation process. To help encourage timely compliance, the AICPA’s Financial Reporting Executive Committee is preparing a revenue recognition standard guide for a 2017 publication date.

January 23, 2017

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Grant Lam - Partner, Audit - San Francisco CA
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