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Accounting Alert: Accounting for Leases Under ASU 2016-02, Leases

08.22.2018

Public companies and public business entities (PBEs) are quickly approaching the implementation date for ASU 2016-02, Leases, and thus should be well on their way toward capturing the corresponding lease activity affected and working through the mechanics and corresponding impact. Although nonpublic business entities have a bit more time, all organizations should know this endeavor could require significant effort and attention to ensure that the accounting records and corresponding reporting are properly updated to avoid financial and regulatory reporting deficiencies.

Effective Dates and Transition:

  • Public companies and public business entities (PBEs):
    • Annual and interim periods in fiscal years beginning after December 15, 2018
    • Broker-dealers meet the definition of PBEs
  • Nonpublic business entities:
    • Fiscal years beginning after December 15, 2019
    • Interim periods in fiscal years beginning after December 15, 2020
  • Transition:
    • Reporting should transition utilizing a modified retrospective approach. Full retrospective adoption is prohibited.
    • Comparative period presented must be restated.

The following changes should be noted:

For operating leases, a lessee is required to:

  • Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial condition.
  • Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis.
  • Classify all cash payments within operating activities in the statement of cash flows.

For finance leases, a lessee is required to:

  • Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial condition.
  • Recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income.
  • Classify repayments of the principal portion of the lease liability within financing activities, payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows.

Qualitative and quantitative disclosure requirements for a lessee:

  • Qualitative
    • The nature of lease agreements
    • Leases that have been executed, but yet to begin by the end of a reporting period
    • Variable payment arrangements
    • Options: renewal, termination, or purchase
  • Quantitative
    • Lease costs: operating, variable, or short-term leases
    • Future lease commitments (five years and beyond)
    • Lease liability maturity analysis
    • Amortization and interest on financing leases

The following areas will be under particular scrutiny:

Related party leases:

  • This standard applies to both related parties as well as leases with third parties.
  • Entities must consider if an IMPLICIT lease exists with related parties (Note: This also applies to third party leases, however is less common due to terms typically being more adequately defined).
  • Some example considerations for a related party lease arrangement that should be evaluated:
    • Is there a lease arrangement included within an expense sharing agreement with the parent company or another affiliated entity?
    • “Substance Over Form” - Could the entity continue to operate without the space being occupied that a related party currently pays for on behalf of the entity, that may be explicitly or implicitly included as part of an expense sharing agreement?
    • What are the contract terms (i.e. length, options, etc.) if not explicitly stated in a lease or expense sharing agreement? Do these terms align with the original lease agreement with the owner of the space? If not, is a lesser/greater term reasonable and supportable? As a caution, entities should not structure lease agreements to avoid reporting under the new lease accounting rules (i.e. structuring a short-term lease agreement when it is clear that the entity has intent to renew the lease and/or has no substantiation to move operations to a new location).
  • Regulators have represented that it is better to have documented and supportable agreements and that now is the appropriate time to consider updating lease agreements and/or expense sharing agreements to clarify lease terms to support their position.

Another area that will likely receive scrutiny under the new lease accounting standards will be structured leases whereby the underlying intent of the reporting entity would provide for a longer lease term than what is defined in an executed lease agreement. If it is determined that the goal of structuring the corresponding terms of the lease agreement is an attempt by the reporting entity to minimize or eliminate the impact of the new lease standard, auditors and regulators will likely be in a position to propose audit adjustments which could lead to deficiency communications to those charged with governance. This will be a particularly sensitive area that will require thoughtful evaluation.

For securities broker-dealers qualifying as PBEs, these changes are effective for fiscal years beginning after December 15, 2018.

In a no-action letter dated November 8, 2016, the SEC provided clarification pursuant to their position on lease treatment resulting from ASU 2016-02, Leases. This no-action letter was in response to the Securities Industry and Financial Markets Association (SIFMA) outline which provided key issues and likely impacts to the broker-dealer industry as a whole. Within the SEC’s no-action letter, the SEC indicated that they would not recommend enforcement action under SEC Rule 15c3-1 if:

  • A broker-dealer computing net capital adds back an operating lease asset equivalent to the associated operating lease liability.
  • A broker-dealer determining its minimum net capital requirement using the aggregate indebtedness standard does not include in its aggregate indebtedness an operating lease liability to the extent of the associated operating lease asset.

While the SEC has agreed not to enforce these provisions from a regulatory perspective, they did not express views with respect to legal ramifications a broker-dealer may face from state and federal governments or self-regulatory organization rules.

To evaluate the impact of the new accounting standard on leases for your business, please contact Lincoln Gray, Partner, Audit Services at lgray@bswllc.com or Tommy Hill, Manager, Audit Services at thill@bswllc.com.

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