The new lease accounting rules, ASC 842, are a major change for lessee customers. The rules are complex and will require lessees to do things they have never done before. Activity has lulled anticipating the transition occurring in 2019 for public companies and in 2020 for private companies. Although that seems a long way off, companies should consider several things now.

First, lessees must report comparative financial data — generally two years of balance sheets and three years of profit and loss statements. Lessees must account for leases in place during the first year of required reporting by inputting them into a lease accounting system.

That leads to the other big issues: locating lease documents, reading and extracting key elements, inputting them into a system, and testing and running the system.

This article covers issues lessee customers are facing and issues that will arise as lessees get into the details of transition and implementation, as well as how lessors can take many steps to help lessees.

Recommending a System

Several large companies may choose to transition to the new rules early but realize they need a system first. Finding a system that meets their needs may not allow time for early adoption. A large-ticket salesman told me several clients have asked for advice in choosing a system. Several systems purport to account for leases under 842.

I recommend Prolease. I gave them the specs for lessee accounting and tested the system so I know it works for all the requirements of the new rules. Prolease accounts for leases under FASB and IASB rules. It does transition and subsequent accounting for both operating and finance leases. It can handle modifications, interim rent, floating rate leases, CPI clauses, impairment, IDC, landlord allowances and disclosures. Prolease also serves as a lease admin system by tracking notice periods, renewal/purchase options and other lessee action items. It can handle equipment leases and real estate leases.

Covenants

To be proactive, lessors and lenders should add a “static” GAAP clause to covenants in their transactions going forward so any ratio, measure or other GAAP calculated covenant item will be based on GAAP as of the date of the lease/loan. By using this suggested clause, the parties to the transaction would agree to accept recalculated amounts for covenant compliance thus avoiding potential technical covenant violations.

This issue will be important regarding future changes to GAAP. This is a convenience for the customer, as the FASB seems bent on exploring bold new accounting concepts, going where no accountant has gone before. Accounting changes like the leases or revenue recognition rules have created new types of assets and liabilities that are not based on the traditional “risk and reward” concepts and change the accounting for costs and revenues that can change the amounts in ratios and measures specified by loan/lease covenants. With this type of clause, there is no need to renegotiate covenants because of a GAAP accounting change.

Residual Value Guarantees (RVGs)

The new rules require lessees to review all RVGs they are providing to lessors in their leases at every reporting period to determine if the RVG is “in the money” and account for the amount expected to be paid. This is not usually an issue at lease commencement as residual guarantee strike prices are typically set at or below the expected fair market value of the asset at the future date of the guarantee. The lessee must make an entry to capitalize the amount or the change in amount that is expected to be paid under the RVG. Lessees in TRAC, split TRAC and synthetic leases must complete this review, so this will be a new issue for them. They may ask their lessors for help by requesting expected future values of assets in their leases.

Lessors can suggest public sources like Kelly Blue Book, ALG and Ritchie Bros. auction results to get expected future asset values. If a lessor subscribes to services like ALG or has access to auction results, they can pass this information on to lessee customers.

Ritchie Bros.’ website lists sold equipment of all types (mostly heavy equipment like vehicles, agriculture, construction, material handling, industrial and forestry), itemizing details like age, make, model and selling price. As an example, a lessee guaranteeing a residual in a truck tractor five-year lease can find recent auction sales prices of five-year-old trucks of the same type (hopefully the same make and model) and compare the sales price to the original cost and MSRP of the truck sold. So if the five-year-old truck sold for 50% of MSRP, and the lessee is guaranteeing a 40% residual of the same type of truck at the end of a five-year lease, they should not have to make a payment under the guarantee.

Residual guarantees are included in the terms of TRAC, split TRAC and synthetic leases. Large companies can have many types of assets (mostly vehicles, often fleets of cars and trucks) under these lease types, so they will face this major compliance issue. These companies will have to set up a monitoring process to obtain expected values and compare them to their residual guarantees. They will require a lease accounting system that has the ability to capture and compare expected values to the strike price of residual guarantees and record any entry needed. This is part of the new accounting and internal control process needed to comply with ASC 842.

Incremental Borrowing Rate Calculation

This is not a new issue as lessees often use their incremental borrowing rate in classifying leases under current GAAP. Under ASC 842, the lessee will use the implicit rate in the lease, if known, or its incremental borrowing rate for both lease classification and capitalizing a lease.

In my opinion, the FASB inadvertently included the lessor’s IDC in the definition/calculation of the lessor’s implicit rate and since the lessee can never know a lessor’s IDC in the lease, the lessee can never know a lessor’s implicit rate as defined. As a result, lessees will be using their incremental borrowing rate more frequently and may ask for help as they typically have to estimate their incremental borrowing rate. Since lessees generally do not borrow on a fixed rate term basis, it is likely they do not know their fixed rate incremental borrowing rate.

As a proxy for the fixed rate incremental borrowing rate, lessees should use their floating revolver rate and swap it to fixed using the lease term as the term of the swap. In a floating rate lease, a lessee’s incremental borrowing rate is the LIBOR + spread rate.

Separating Lease Payments & Services

Lessees are required to separate the lease and service portions of bundled billed leases. They have the option of not unbundling but capitalizing the full amount of the gross payment, which is not a good choice as it overstates the capitalized lease asset! Lessors can give the lessee a breakdown of the lease and service portions, but many lessors have a policy against that, considering it proprietary information.

Lessees have the option of estimating the breakdown using market information regarding lease rates or service rates. They may not have the ability to get on-point lease portion market information, and they may not know how to estimate the lease portion. In my opinion, it is acceptable to use market information to estimate a lease rate for the asset, but I don’t know what the Big 4 auditors will accept.

You can direct lessees to a lease advisor — like me — who can provide an independent estimated calculation of the lease portion. An advisor can supply market-based support for the estimate via a letter that lessees can present to auditors.

Data to Help Book the Lease

Lessees never had to book operating leases before. If they do a high volume of equipment leases, it would be helpful for lessors to provide electronic data as to future rent payments. Lessees may ask for that information to load into their lease accounting systems. Although there is a concern about giving accounting advice, merely providing data that is derived from the terms of the lease may be acceptable.

Conclusion

It’s a whole new world now that lessees must record and account for operating leases. The compliance requirements are extensive, and I am sure lessee customers would welcome the help from lessors to get through it.