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Companies will have the option—but not the requirement—to recast their comparative financial statements when they adopt the new leasing rule in January 2019 under a decision by the Financial Accounting Standards Board. James Barker, partner with Deloitte LLP, discussed this and other developments in an interview with Bloomberg Tax during the AICPA’s conference on Current SEC and PCAOB Developments.
Barker also said FASB will allow easements—provided they existed prior to the adoption of ASC 842 and are not modified—to be grandfathered, thus negating requirements to be accounted for as a leased asset and liability. While this may not be a game changer for all companies, accounting departments of affected companies are breathing a sigh of relief. The grandfathering will greatly reduce the work required to identify the full population of leases as they transition to the new rules. Notable industries include power and utilities, oil and gas, railroads, and telecom.
While ASC 842 will tend to have a bigger impact on lessees than lessors, Barker cited favorable developments from the lessor standpoint. Lessors were “struggling with the idea that under this new standard you would have to separate the common area maintenance (CAM) from the lease of a building, because [under the new standard] those are two different things: one is a lease, and one is more of a service” and the standard does not allow you to combine them as a single revenue line item.
Lessees have an option under the new rules to combine lease and non-lease— service—components, but lessors were not afforded the same opportunity. In their Nov. 29 meeting, FASB decided to provide some relief in these situations, which would allow accounting for the combined arrangement as a lease, provided certain conditions are met. Barker emphasized that this favorable decision doesn’t relate purely to CAM, but may also extend to other services that may be offered by lessors, such as equipment maintenance. Lessors will have the option, but not the requirement, to combine these revenue sources as a single lease component “if both of the following conditions are met (1) the timing and pattern of revenue recognition for the lease component and non-lease component(s) are the same, and (2) the combined lease component is classified as an operating lease,” according to FASB meeting notes.
An edited transcript of Barker’s interview follows:
I understand the FASB issued some guidance via a practical expedient to help companies with their leasing. Can you explain what happened at their Nov. 29 meeting?
With the required effective date of ASC 842 approaching, the FASB has been receiving feedback from preparers that they are concerned about their ability to adopt on time. The reasons for that vary but I’d say the top two are concerns about lease software availability and insufficient time to focus on ASC 842 given all the attention required by the new revenue standard. The FASB heard those concerns, but are very reluctant to defer the effective date of ASC 842. Instead, they are asking preparers how they can make the standard easier to adopt and the decisions from their recent board meeting reflect some of that feedback.
So what specifically did the FASB do to make adoption easier for preparers?
There were really three main developments or discussion areas. The first one has to do with easements. It would provide a practical expedient for companies that have easements in their portfolio today, and have historically accounted for those easements as something other than a lease. Those companies are going to be able to grandfather that accounting treatment for their existing easements and not have to perform an analysis of those arrangements under ASC 842.
This is a pretty big deal for heavy users of easements. You can imagine that a lot of companies like electric and gas utilities have thousands of easements to support their electric transmission and distribution systems or to pave the way for underground pipelines. So this was a very positive development.
What should companies consider with their easements?
New, or modified easements after you have adopted the new standard will need to be assessed under the new leasing rules. The grandfather clause is just for existing easements. For any new, or modified easements after you adopt the leasing standard you would need to at least run that through the [lease determination] model to see if the easement is a lease.
Many easements provide for joint use between the landowner and the easement holder. For example, a farmer uses the land to grow crops while a utility is allowed to run transmission lines overhead. Those arrangements often won’t convey the type of control that the new leasing standard requires the customer to have, so our expectation is that many of them will not be leases. The point is that for any new or modified easements you will have to go through the exercise of assessing whether they are leases. In the past, US GAAP was not clear on that point, so a lot of companies did not think about whether their easements were leases or not.
You said that if an easement is modified or a new one comes in it has to be put through the model to determine if it is a lease. Can you describe that model? And to take it a step further, can you clarify some of the operational challenges companies are facing as they try to ensure that all leases have been identified?
There is a set of technical criteria that we assess and those have to do with things like is there an identified asset in the arrangement? Does the customer control that asset? Do they get all the economic benefits from that asset? Those are the kind of things that the standard tells you must exist for a lease. For easements, there may be judgment required in several areas of the analysis.
From an operational perspective; many companies are still figuring out how they will extract the critical data from an agreement and run that data through the lease model. This isn’t limited to easements, but is a consideration for all potential leases. In practice, we see a wide range of capabilities in terms of how companies do that. Some companies have very good data extraction software that you can put an agreement in and it will tell you those critical terms. I would say that is the best in class, and that’s not something that we see in a lot of situations. In some cases, it is still purely a manual exercise. So it is anywhere along that spectrum.
Given that every leased asset from equipment to real estate, excluding short-term leases under a year, will have to be on the balance sheet, and that they will each have monthly journal entries under different terms, how confident are you as an auditor, when you go into a business and you read a company’s lease reports in a manually created excel mode?. What do you do in that situation?
A lot of it comes down to the nature of the lease portfolio. If it is fairly small, and not a complicated portfolio in terms of provisions, it can often be successfully managed without complex systems. I think there are a lot of companies today that are using excel for their leasing and we would expect some companies to continue doing that in the future. But the more complicated the leases get, and the more the volume of leases increases, that becomes a higher reporting risk for companies and a higher audit risk for us.
We do see a lot of companies that are planning to implement new systems as a result of the new rules. Many of your larger companies are adding a new system, an addition to the existing system, [or] a new module that has been developed by their ERP provider. I would say a significant percentage of—certainly public—companies are implementing new software solutions to deal with the standard. That’s one of the reasons it has taken a little longer for a lot of companies. You’ve seen some companies request deferral from the FASB and request other simplifications because of that.
You mentioned the FASB’s reluctance to defer the effective date. Why the reluctance?
I’m not 100 percent sure. They did defer revenue by a year and I think they are concerned that if they defer leases too, people will tend to always ask for deferrals and not pursue implementation in a serious and timely manner. Personally, I think there is a good case for deferral here since many of the FASB’s original assumptions about the landscape have changed, but they don’t appear interested in revisiting it.
What are you most concerned about next year?
My concern is that there’s been so much focus on revenue and even though it’s getting adopted in less than a month now many companies are still focused on revenue instead of leasing.
There are still a lot of companies and industries that are nailing things down for revenue recognition, and since we are so close to the effective date [of revenue recognition], clients acknowledge they have not spent the time they would have liked to on leasing at this point in the process. Accounting shops, like everyone else, have limited resources and they have to prioritize what’s immediately in front of them.
Going through and identifying leases, understanding the new standard—which does change the definition of a lease—having the system and a system vendor that has actually got a system that works and that has the resources to implement the system on time. It is one thing to find a module that works for you—and that’s been a challenge to a lot of our clients—but then once you have identified the vendor you want to use, the discussion becomes, when can the vendor implement the system and how long will it take? Anyone that has been through a system implementation knows that they are not quick. Software vendors are in demand, and they are over stretched from a resource perspective, so I continue to have concerns in this area despite some of the recent decisions to simplify adoption.
Getting back to those recent decisions, can you provide an update on the requirement around comparative period financial statements?
This is probably the biggest development and one that I expect most companies to take advantage of. The standard as written requires the company, when they adopt, to present their comparative information under the new leasing rules. For a public company you have two years of balance sheets, and three years of income statements, just like you would expect to see in a 10K. Most private companies will have one comparative period, and my understanding is some private companies could actually opt to not present comparatives depending on their specific reporting requirements. The point is that ASC 842 requires whatever comparative periods are presented in the year of adoption to be recast to reflect the new rules. If you think about it, that means that in theory public companies should have been applying the new rules starting this year on a parallel path along with their ASC 840 accounting so that when they adopt in 2019, they have the comparative financial information readily available. I can tell you that very few companies are actually doing that, and many are concerned about their ability to get that recasting right along with all the other adoption considerations.
Fortunately for those companies, the FASB has decided that recasting is not required after all. They will give companies the option to recast but will not require it. As I mentioned before, my expectation is that we’ll see the great majority of preparers choose not to recast prior periods.
Can you elaborate a bit further on what this means for a company?
So when you adopt, let’s say a public company adopts January 1, 2019, they’ll reflect the cumulative effect of adoption on January 1st and won’t touch the prior periods. They won’t worry about recasting their ’17 and ’18 numbers. They also won’t have to worry about disclosing activity related to those leases under the 842 disclosure requirements. They basically make a clean cut on the adoption date.
Even though most will take advantage of this relief, there are some companies that early adopted leasing, so they’ve already done some of the comparative work and so there will be exceptions. [But not requiring comparative financials] that’s the pervasive decision that impacts just about everybody. The easement decision was a big deal to a small number [of companies or industries] but this one is pervasive.
And lastly, can you tell us about the lessor issue?
[FASB has provided] an option or a practical expedient to lessors allowing them to not bifurcate arrangements into lease and non-lease components. The industry that pushed this one really hard was the real estate industry led by NAREIT (National Association of Real Estate Investment Trusts). NAREIT said, look, our companies are landlords. They own office buildings, and other commercial real estate, and they also provide common area maintenance to the residents or tenants, things like cleaning services and security that most tenants see as an integral part of the lease. What they’ve been frustrated with, or struggling with for a while now, is the idea that you would have to separate the common area maintenance from the lease of the building. The standard requires this because those are two different things. One is a lease, one is more of a service—from a revenue perspective you should display those differently.
[NAREIT’s position was] who’s this really helping to bifurcate my CAM and present it separately? My investors don’t want that information. They want my top line revenue, my all-in revenue for being a landlord. And if I have to bifurcate them, the standard makes me go through some fairly nuanced and complicated exercises to allocate consideration between the service and the lease. From a cost benefit perspective, they were saying it really doesn’t make sense to us that we have to do this.
These companies wanted the ability as lessors to combine the service with the lease. They wanted the same option that a lessee would have—lessees have the option to combine a lease and non-lease element. They might be reluctant to do that because combining the lease and non-lease elements and calling the whole thing a lease will increase the liability. For that reason, many lessees are probably reluctant to do it, but the standard does provide them with that option. Lessors don’t have that option under the standard as it was issued a couple of years ago. And so these companies were saying we’d like to have the same option that lessees have. We’d like to have the ability to not bifurcate our arrangements. Ultimately, the FASB did agree to provide that option, but there will be certain conditions. We don’t know exactly what the conditions will be yet, but we expect them to include a condition that the pattern of delivering the service be consistent with the pattern of delivering the leased asset. In most cases I think that means a straight-line pattern. We also understand that the combined arrangement must be classified as an operating lease, so that may rule out certain arrangements where the service is significant. For example, if the service element is too large it may cause the lease to trip the lease classification test, which compares the discounted lease payments to the asset’s fair value.
That sounds like a great benefit to lessors.
I think it is, but it won’t satisfy all of them. For example, some will provide services that don’t have the same revenue pattern as the lease so they’ll be ineligible for the relief. We also hear from a lot of lessors that have arrangements that are predominantly services—in other words, the service revenue is far larger than the lease revenue. Those lessors would like to combine the two elements and call the whole thing a revenue transaction—that is, account for it under ASC 606 instead of ASC 842—but the FASB decision would require the combined arrangement to be accounted for as a lease, irrespective of the magnitude of the lease compared to the service. I suspect that some lessors will make another run at that one, but I don’t think the FASB is likely to agree to another change.
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