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By Jeffrey Ellis
Jeffrey Ellis is a Senior Managing Director at FTI Consulting and is based in Chicago. He has extensive experience advising clients on the accounting for complex transactions and identifying alternative structures to meet client business needs and accounting objectives. Mr. Ellis has assisted law firms on a wide range of matters involving accounting issues, including investigating financial statement restatements and examining structured transactions to determine if the accounting violated generally accepted accounting principles, assisted companies in implementing new accounting standards, and provided advice to companies on financial statement restatements and conversions to international financial reporting standards. In addition, Mr. Ellis has testified as an accounting expert in disputes over leveraged lease transactions.
This article is the fifth and the final in a series of articles exploring the new guidance on accounting for leases (ASC 842) issued by the Financial Accounting Standards Board (“FASB”) in February 2016. This article discusses the effective date of and transition requirements under ASC 842.
Topic 842 is effective for public business entities, not-for-profit entities that have issued or are conduit bond obligors for securities that are traded, listed, or quoted on an exchange or an over-the-counter market, and employee benefit plans that file or furnish financial statements with or to the Securities and Exchange Commission in financial statements for periods beginning after Dec. 15, 2018, including interim reporting periods within those fiscal years (for a company with a calendar year end, Topic 842 will be effective beginning Jan. 1, 2019). For all other entities, ASC 842 is effective in financial statements for fiscal years beginning after Dec. 15, 2019 and for interim reporting periods beginning after Dec. 15, 2020 (for a company with a calendar year end, Topic 842 will be effective beginning Jan. 1, 2020).
Note: At its Nov. 29, 2017 meeting, FASB tentatively decided to allow reporting entities to adopt Topic 842 by recognizing a cumulative effect adjustment on the effective date of the new guidance (i.e., Jan. 1, 2019 for a public company with a calendar year end). FASB will issue a proposed Accounting Standards Update with the alternative transition method for comment. The change to the transition approach in Topic 842 will likely be finalized during the first quarter of 2018. Any further FASB discussions on the practical expedients in Topic 842 is not expected to be affected by the board’s decision to permit an additional transition method. Further, reporting entities will continue to have the option of applying the modified retrospective approach, although once the board finalizes the amendment to permit adoption by the cumulative effect approach, it is unlikely reporting entities will elect the modified retrospective approach.
FASB decided to require a modified retrospective approach to transitioning to Topic 842 because modified retrospective is less onerous to reporting entities than a full retrospective approach. As discussed in previous articles in this series, Topic 842 makes a number of changes to the guidance applicable to accounting for leases. A full retrospective transition would have been time consuming, particularly for reporting entities with a large volume of leases. A modified retrospective approach is less complicated, but provides users with the improvements in financial reporting made by the new standard in the reporting entity’s comparative financial statements. In applying the modified retrospective approach to adopting Topic 842, reporting entities will adjust equity at the beginning of the earliest period presented in financial statements issued subsequent to the effective date. In addition, a reporting entity may be required to adjust income for periods subsequent to the beginning of the earliest period presented. Both adjustments are determined as if the reporting entity had always applied Topic 842 to its leases.
To further reduce the cost of transitioning to Topic 842 for reporting entities, FASB provided certain practical expedients. The practical expedients that will have the greatest mitigating impact on the transition to topic 842 are discussed in paragraph 1(f) of ASC 842-10-65, which states:
An entity may elect the following practical expedients, which must be elected as a package and applied consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor), when applying the pending content that links to this paragraph to leases that commenced before the effective date:
If a reporting entity decides not to apply those practical expedients, it will be required to apply Topic 842 to determine:
The most significant issues in transitioning to Topic 842 for a lessee, assuming the lessee elects the practical expedients discussed above, relate to accounting for operating leases, sale-leaseback transactions that didn’t qualify for sale-leaseback accounting under Topic 840, and build-to-suit leases where the lessee was deemed to be the owner of the asset under construction. Each of those issues is discussed further below.
A lessee is required to record a right-of-use asset and lease liability for all operating leases at the later of the beginning of the earliest period presented (Jan. 1, 2017 for a public company with a calendar year end) or the commencement date of the lease. The lease liability that a lessee is required to record will be the present value of the remaining “minimum rental payments (as defined under Topic 840)” and any amounts that are probable of being paid under a residual value guarantee, determined using the incremental borrowing rate at the later of the beginning of the earliest period presented or the commencement date of the lease. While Topic 842 doesn’t indicate whether the lessee should use a discount rate that corresponds to the original term of the lease or the term remaining at the date the lessee measures the liability (if shorter than the original term), we believe a reporting entity should determine the incremental borrowing rate based on the remaining term. That approach is consistent with the FASB’s conclusions on Issue 3 of Part II of the proposed ASU Technical Corrections and Improvements to Recently Issued Standards issued Sept. 27, 2017.
Although the guidance in Topic 842 refers to the definition of “minimum rental payments” in Topic 840, there is no definition of “minimum rental payments” in Topic 840. The definition of “minimum lease payments” in Topic 840 makes it clear that “minimum lease payments” exclude the lessee’s obligation to reimburse the lessor for executory costs. Paragraph 6 of ASC 840-10-25 states that “minimum rental payments” are a component of “minimum lease payments.” Therefore, minimum rental payments to be used in measuring the lease liability on transition to Topic 842 should be the amount remaining after deducting the portion of the total payment attributable to executory costs, along with a profit thereon. However, we understand that FASB staff believes it would be acceptable for a reporting entity to use the amounts it has included in the disclosure of future lease payments, even if those amounts had not been reduced by the portion of the total payment attributable to executory costs. For operating leases that include a residual value guarantee, the lessee should include the expected deficiency that it was recognizing as rent expense in accordance with the guidance in paragraph 1 of ASC 840-20-35 in measuring the lease liability. The right-of-use asset recognized in transition will equal the lease liability, plus the remaining amount of initial direct costs, plus or minus any deferred rent that resulted from differences between cash payments and rent expense determined on a straight-line basis, plus or minus any intangible asset or liability recorded for an operating lease with off-market rents assumed in a business combination.
Finally, Topic 842 doesn’t address how a lessee should account for a lease denominated in a foreign currency in transition. Based on discussions with the FASB staff, if the lease is denominated in a foreign currency, then consistent with the guidance on the incremental borrowing rate to be used in transition, the lessee should use the exchange rate at the later of the beginning of the earliest period presented or the commencement date of the lease. In subsequent periods, the exchange rate used to remeasure the right-of-use asset into the lessee’s functional currency in transition to Topic 842 will be used to remeasure the right-of-use asset, while the exchange rate at the date of the financial statements will be used to remeasure the lease liability. The difference between the rate used to remeasure the asset and liability will result in a lessee recognizing exchange gains or losses in income.
Failed Sale-Leaseback Transactions
For any sale-leaseback transactions that didn’t qualify for sale-leaseback accounting under Topic 840 and continue to be reported as a financing at the effective date of Topic 842, a lessee is required to determine whether the transfer would have been a sale in accordance with paragraphs 1 through 3 of ASC 842-40-25 at any point on or after the beginning of the earliest period presented. If the transfer qualifies as a sale under Topic 842, the lessee would account for the leaseback as an operating lease or capital lease based on the classification determined in accordance with Topic 840 at the inception of the lease. This guidance would also apply to failed sale-leaseback transactions arising out of the application of the provisions of Topic 840 addressing build-to-suit lease transactions when the construction was completed prior to the beginning of the earliest period presented.
If a lessee was deemed to be the owner of the asset to be leased during the construction period under Topic 840 and the construction period ended between the beginning of the earliest period presented and the effective date of Topic 842, the lessee is required to derecognize the asset and liability recognized at the later of the beginning of the earliest period presented and the date that the lessee was determined to be the owner of the asset.
If the construction of the asset to be leased is ongoing at the effective date, we believe a lessee should consider whether it is the owner of the project in accordance with the guidance in paragraphs 3 through 6 of ASC 842-40-55. However, the transition provisions in Topic 842 do not address the accounting for a build-to-suit arrangement where construction has not been completed, so a reporting entity could elect to apply the general transition guidance discussed above.
If a lessor elects to apply the practical expedients discussed above (determination of whether an arrangement is a lease, lease classification and initial direct costs), we won’t expect to see it recognize any significant transition adjustments.
As part of preparing for the adoption of the new standard, reporting entities will identify new processes necessary for requirements of Topic 842 that weren’t present in Topic 840 (for example, the requirement that a lessee periodically assess whether to remeasure the lease liability) and processes that require revision based on changes to the guidance in Topic 840 (for example, determining which costs qualify as initial direct costs), and they will need to develop or revise controls around each of those processes. For reporting entities that elect to apply the practical expedients, the new processes and controls will only apply to leases with commencement dates after the effective date of Topic 842.
In addition to processes and controls over the accounting requirements of Topic 842, reporting entities will also need to ensure they have controls over determining the transition adjustment. While the measurement of the lease liability and the right-of-use asset to be recognized in transition may be determined by a software solution, a reporting entity will need to have controls around the development of the incremental borrowing rate at the beginning of the earliest period presented that will be used to measure the lease liability for leases that commenced prior to that date and identifying lease payments to be used in recording the asset and liability for operating leases (particularly where the entity did not retain the inputs used to assess lease classification under Topic 840). Further, if a reporting entity has not maintained a centralized repository of its leases, it will need to develop controls around ensuring that it has identified all material leases prior to calculating the transition adjustment.
While reporting entities are required to adopt Topic 842 using a modified retrospective approach, the practical expedients FASB provided should simplify the process of transitioning to the new guidance. Even with the practical expedients, operating leases of lessees will require the most effort in transitioning to the new standard, at least for leases with commencement dates that precede the beginning of the earliest period presented. However, assessing whether agreements for the purchase or sale of goods or services contain leases and determining the classification of leases should not require a significant amount of time during the transition to Topic 842 as each of those activities were required by Topic 840.
The views expressed herein are those of the author and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
Copyright © 2018 Tax Management Inc. All Rights Reserved.
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