Ready, Set, Implement: Changes to Lease Accounting Rules
Under existing lease accounting rules, companies have 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 leases get recorded on the balance sheet because of what critics call “bright lines” in the accounting rules that let companies arrange deals as simple rentals — commonly referred to as “operating leases.” Critics of the current accounting have long complained that, if an obligation isn’t recorded on a balance sheet, a business looks less leveraged than it really is.
The FASB responded to these criticisms by issuing Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) Section A — Leases: Amendments to the FASB Accounting Standards Codification. The updated standard will require businesses to record leased real estate, vehicles and equipment as assets and the payments for them as liabilities. It also calls for more detailed disclosures about lease obligations.
The updated standard defines a lease as a contract or part of a contract that conveys the right to control the use of a rented asset. The concept of control is a key change from the definition of a lease. It refers to the customer’s right to substantially all of the asset’s economic value and to direct its use.
Contracts that have been treated as leases will be accounted for the same way with the new standard. But other arrangements that haven’t been classified as leases are expected to be captured by the new definition of a lease.
Complying with the new standard will take substantial effort for companies with significant leased assets. Management will need to:
- Identify all leases and locate lease documents,
- Review lease agreements to determine the commencement date, renewal options, residual guarantees and any other purchase options,
- Enter the information into software systems that aren’t yet commercially available, and
- Maintain a central lease database, which will evolve as some leases expire, others get renewed and new lease contracts are signed.
Although big-ticket real estate leases may be fairly easy to centralize, smaller equipment leases may be scattered around a company’s reporting units, requiring significant time and effort to identify. Another stumbling block for adopting the lease standard is the landmark update to the revenue recognition rules: Companies are currently so focused on how to recognize revenue under the new principles-based guidance that many have put lease accounting on the back burner.
Relief for Easements
The utilities and oil and gas industries are especially concerned about the level of effort needed to adopt the changes to the lease accounting rules. On July 11, the American Petroleum Institute, a trade group representing the oil and gas industry, sent a letter to the FASB, requesting a two-year delay.
After discussing the issue at its July meeting, the FASB unanimously agreed to release a proposal for public comment to insert a limited amendment to the lease standard that would exempt certain contracts, called land easements, from the standard if they weren’t previously accounted for as leases. Board members felt that the cost of evaluating these existing contracts wouldn’t be worth the benefits realized from making the accounting changes.
Easements are specialized property contracts that let the customers use all or part of a piece of land. They’re a common means for oil and gas pipeline owners and electric utilities to connect pipelines and power lines. Easements are pervasive in these sectors. For example, a pipeline operator may have more than 100 easements for a single pipeline.
FASB members characterized the proposed amendment as an optional shortcut, or “practical expedient,” to make it easier for a narrow subset of businesses to make the transition to the new lease standard. Without the proposed change, land easements would have to be evaluated to determine whether they contain a lease and follow the new guidance.
Start Preparations Early
Balance sheets for many types of companies — including airlines, retailers, telecom companies, banks, and hotel and restaurant chains — are expected to swell as they scramble to evaluate leases for such assets as stores, warehouses, operating and office equipment, and vehicles.
Besides the narrow-scope exception for land easements, however, the FASB hasn’t proposed any additional industry- or asset-specific exemptions. In light of the pervasiveness of operating leases today, it’s important to start the implementation process as soon as possible.