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Accounting

Companies Must Forge Ahead with Lease Transition—Unpacking the FASB’s Fall 2020 Roundtable


by Jennifer Booth

The feedback from adopters can provide private companies with insight into the complexities of transition and a roadmap to follow that will hopefully minimize the complexities of compliance.  

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Given the significant amount of effort public companies expended on adoption to the new lease standard, coupled with the significant changes to the balance sheet as a result of the adoption, the Financial Accounting Standards Board (FASB) recently hosted a meeting to discuss potential changes to the standard that might ease the compliance burden for private companies.

Overall, there seemed to be a consensus against making major changes to ASC 842, Leases; however, there were robust conversations about ways to ease the accounting for lease modifications, lessee allocation of fixed and variable payments, embedded leases and lessee use of the incremental borrowing rate (IBR). Public companies complied with the transition date to ASC 842, but many are still struggling to deal with the “Day Two” challenges of accounting for these arrangements, which was reflected in the nature of many of the topics addressed. The Roundtable conversations underpin some of the ongoing challenges facing public companies, while also highlighting the challenges private companies will face upon adoption.

A couple of the key takeaways from the Roundtable discussion are highlighted:  

  • Lease Modifications – Lease modifications were a hot topic at the Roundtable meeting. A lease modification occurs when there are contractual changes to a lease agreement that are not accounted for as a separate contract and result in the re-evaluation of the lease classification, identification of a new discount rate and the recalculation of the corresponding lease liability and right-of-use assets.

Accounting for lease modifications, including terminations, is a very technical topic. In the Roundtable meeting, there appeared to be general support for changes to the lease modification guidance to simplify the accounting. We have seen the FASB support this concept, as 1) earlier this year, the FASB issued a Q&A allowing companies the option of choosing not to account for lease concessions stemming from COVID-19 as a modification and 2) in mid-October, the FASB proposed an Accounting Standards Update (ASU) for three targeted improvements to the leases standard.
One of the proposed targeted improvements relates to accounting for modifications and is a proposal to ease accounting for terminations of one asset within a contract that does not materially impact the remainder of the assets accounted for in the same agreement (i.e. termination of one vehicle within a 25 lease master lease arrangement). Stakeholders are able to provide comments until December 4.

These topics received general support, especially regarding re-evaluating the lease classification upon modification since the change in the lease classification can be driven by the timing of when the lease term in the contract is modified. Companies should stay tuned to this topic as a future standard setting regarding modifications is likely.

  • Lease Allocation of Fixed and Variable Payments The concept of identifying and accounting for fixed and variable payments is a complex element within the standard. Given the complexity of the standard on this point, there is a high probability that many lessees that are accounting for lease and non-lease elements separately are doing so incorrectly. Because of a practical expedient that allows lessees to elect to account for lease and non-lease components as a combined lease component, the details of this accounting approach have not been addressed.
    Given the practical expedient available to combine the lease elements, there was a general discussion about whether standard setting in this area would have a significant impact to ease the overall complexity of the new lease accounting standard. Public companies resoundingly noted that they did not want changes to the standard, since they had completed their compliance and did not want to re-address the accounting. Further, there was a caution that the impacts of the change would need to be closely evaluated since this is an area where there is convergence with certain areas of revenue recognition guidance under ASC 606.
  • Incremental Borrowing Rate (IBR) IBR is the interest rate a lessee would pay in order to borrow funds to use the asset in a similar economic environment over a similar term. Given that the inputs to calculate the rate implicit in the lease are often not available to a lessee, many companies that have transitioned to ASC 842 have appropriately utilized the IBR as the discount rate when accounting for the lease liability and asset.
    Many public companies established processes to work with their treasury or other departments to appropriately identify the inputs (i.e. consideration for collateral, etc.) for the incremental borrowing rate under ASC 842. As a result, while it was a time-consuming process initially (and sometimes expensive as many public companies obtained assistance initially from valuation specialists), these public companies now feel like they have a repeatable process in place.
    The standard provides private companies the option of using a risk-free rate instead of determining the IBR. Because this rate cannot be used for public companies, and because the risk-free interest rate has been so low due to economic conditions, there was a proposal discussed at the Roundtable meeting about whether a different interest rate should be used (for example, AA rate). Some participants felt the additional interest rate options discussed would be arbitrary, and overall, the suggestion seemed to be that with the risk-free rate already available, perhaps standard setting was not needed in this area.
  • Embedded Leases – Embedded leases are lease agreements that exist within service contracts (i.e. copier, IT server leases, etc.). The guidance has not changed, as these embedded leases were leases under ASC 840 and continue to be under ASC 842. However, given many of these service contracts are operating leases, the expense treatment under ASC 840 was similar to whether companies accounted for these as service contracts or lease arrangements. Therefore, many companies did not identify all of their operating lease arrangements under ASC 840. It is necessary to identify these lease arrangements under ASC 842 because the lease liability and ROU asset must be recorded on the balance sheet. Companies must ensure they have a complete inventory of lease arrangements identified in order to ensure their financial statements are materially accurate.

Given the large volume of these service contracts, the process of identifying and accounting for embedded leases has proved to be a time-consuming process for many public companies. The lease asset within these service contracts has proved to be of a small-dollar in many of these arrangements, and some public companies have utilized capitalization thresholds to avoid having to identify and account for each of these arrangements.
Discussion at the Roundtable meeting addressed possible updates to easing the compliance of accounting for embedded leases, such as establishing a quantitative or qualitative threshold. However, there was general consensus that since the capitalization threshold is available under GAAP to allow an entity to only account for material transactions, private companies should utilize the capitalization threshold concept, similar to the approach that public companies have taken, rather than request the FASB to incorporate standard setting in this area. Individuals also mentioned that this might result in more accurate financial statements since the capitalization threshold is evaluated and identified as appropriate for each company, rather than set an arbitrary quantitative threshold.

Staying the Course for Compliance

The FASB Roundtable served as part of the Post-Implementation Review process for the new lease standard, ASC 842, and allowed companies, accounting firms and other relevant parties the opportunity to discuss some of the areas that were complex and time consuming on adoption. The appetite for standard setting was focused on a couple of areas. The feedback from adopters can provide private companies with insight into the complexities of transition and a roadmap to follow that will hopefully minimize the complexities of compliance.  

As the economic issues related to the pandemic impact companies and finance organizations, it may be even more difficult for organizations to find the resources to devote to the lease accounting implementation. Public companies consistently advise that the process took longer to complete than expected and they wish they had started earlier. Therefore, while private companies should continue to monitor future standard setting from the Board, it is important for private companies to continue identifying and accounting for its lease inventory and avoid delays in the transition process.

Jennifer Booth is the Vice President of Accounting at LeaseQuery.