For private companies, a new era of updated lease accounting standards is becoming real. Better known as ASC (or Topic) 842, it impacts what is typically one of a company’s largest long-term expenses and obligations: commercial real estate leases.
For fiscal years beginning after Dec. 15, 2021, ASC 842 requires private companies to more rigorously recognize the future costs of such leases on the balance sheet, a onerous change with a price that may seem shockingly high for the C-suite. As they begin to tackle delivering the first financial reports under the new standards, many private companies are finding that the work required to comply is more complicated than expected. “I would think about ways to speed up the process,” said Joe Fitzgerald, senior vice president of lease market strategy at Visual Lease, a lease accounting software company.
Basically, under the new standards, the Financial Accounting Standards Board (FASB) wants all companies to record operating leases over one year on their balance sheets as both an asset and a liability, the same way capital leases have always been. checked in. It is no longer permitted to recognize only operating lease expenses in the income statement and to disclose future operating lease obligations in the notes to the financial statements. Users of financial statements have long believed that operating leases give rise to assets and liabilities for tenants, so logic dictates that actually recording them on a company’s balance sheet is a good thing for some parties. stakeholders.
A complicating factor is that the Financial Accounting Standards Board (FASB) is about to make another attempt to update a small portion of the existing lease guidance related to lease accounting, which would clarify how a parent and subsidiary should determine if a lease even exists that needs to be considered.
No reprieve likely but surprises are
But despite these changes on the horizon, it is not safe to count on a reprieve from the new rules. Public companies have already transitioned, but for private companies the requirement has already been extended twice due, in part, to complexities related to the COVID-19 pandemic. “Another delay seems unlikely at this point given the FASB’s unanimous decision against further delay only about 10 months ago,” said Scott Muir, partner in KPMG US’ professional practice department.
A potential catch for companies looking to implement ASC 842 for the first time is that the definition of leases is broad. According to KPMG, leases under this guideline and previous guidelines (ASC 840) could include or be integrated into sales contracts, supply contracts, dedicated manufacturing capacity and “as a service” contracts. arrangements that may not immediately come to mind when thinking about leases.
In a white paper, KPMG identifies instances where leases may exist or arise unexpectedly, for example from a shuttle service set up on a corporate campus where the company pays a fixed fee each month to Services. “There’s a lot to prepare for these changes,” said Renee Minchin, former chief financial officer of 2account, a virtual financial accounting and executive firm.
For professionals, the pressure is high: failing to properly apply this new standard could lead to increased audit costs and fines, potential legal action and loss of credibility. Visual Lease found that a staggering 99% of senior and financial professionals admit to fear of potentially misrepresenting information. Fears include: increased audit costs and fines (51%), damage to a company’s credibility (49%), risk of legal action (48%) and reputation of the professional (44%).
It doesn’t have to be that way. Here are six steps CFOs of private companies can take now to ensure a smooth transition to the new normal:
- Complete inventory of the lease. Ensuring a complete inventory of leases is something that cannot be done quickly. “Make sure all your leases are identified. Don’t wait until 2023,” Muir warned. “Take the opportunity now to ensure you have that full rental inventory.” When it comes to integrated leases, companies should think broadly about what will qualify, including leases that may arise from unexpected or hidden lease elements. “We’ve had customers who have been surprised,” Fitzgerald said. “They found real estate leases they didn’t know they had.”
- Remember to align the terms. When dealing with leases between a parent company and a subsidiary, it is useful to ensure that the lease and all improvements are for the same term, Fitzgerald said, adding that the accounting treatment of leasehold improvements between entities is complicated. “The question is how long to amortize the improvement, if the intercompany lease has a significantly different term than the leasehold improvement,” Fitzgerald said. “Aligning the two terms minimizes the impact of the question.”
- Strengthen record keeping. Not all leases are identified as such and many companies have decentralized administrative processes. Work now to make sure you have all of your rental agreements and related documents needed to complete the new accounting and make the new required disclosures.
- Adjust staffing levels. Don’t underestimate the task. Make sure you have enough team members and recognize that this isn’t just a “bookkeeping” team task. Identifying leases and obtaining contracts and other documents will often require buy-in and assistance from legal, purchasing, operations and other departments, Muir advised.
- Consider necessary changes. “The new rules can be complex, so it’s important to take the time to fully understand them,” Minchin said. “That way, you can determine their impact on your specific leases and make any necessary changes.” Once you understand the new rules and their impact on your leases, you can make the necessary changes. That can include renegotiating rental terms or changing your accounting methods, she said.
- Allow time for complications. Finally, as surprise leases emerge and accounting becomes apparent, some companies are encountering issues that could create ripples leading to areas such as debt rating. “These changes may cause headaches with existing banking covenants and agreements,” one accounting firm noted. Once companies “dive into it, they realize how complicated it is, not just from an accounting standpoint, but also from a practical implications standpoint,” Fitzgerald pointed out.