The Days of Excel Are Done: Lessees Prepare for the New Accounting Rules

by Bill Bosco March/April 2016

Bill Bosco reviews the changes that lessees will encounter while preparing for the new FASB lease accounting rules. He encourages lessees to utilize a lease accounting system and outlines the information that lessees will need to research and enter into the new system.

Bill Bosco,
Principal,
Leasing 101

The FASB designed the new lease accounting rules to be as neutral as possible to companies’ financial results. It maintained the current risks and rewards framework for classification, separately reporting the operating lease asset and liability, and kept the profit and loss (P&L) and cash flow presentation unchanged. The goal was to continue providing users with the information on finance and operating leases that they need to make decisions. In fact, most of the key financial ratios, measures and debt covenants are not affected. With lessee preparers in mind, the new rules should also make compliance easier. The real issues for lessees will be the work involved to transition existing leases to the new rules and create a process to account for new leases in the new environment.

Working Toward Transition

Work is the issue and lots of it. Large companies have thousands of equipment leases, and lessees like retailers and banks have hundreds to thousands of real estate leases. Under the current rules, the only requirement for operating lease financial reporting is to report future operating lease rents in tabular form in the footnotes. The straight-line average rent is currently reported as a P&L statement expense, and the cash paid for rent is reported as an operating cash outflow on the cash flow statement. Since the future rent obligation numbers are in the footnotes, the auditing is not as rigorous as it is for on-balance sheet items, and the internal control process is not a big concern.

All operating leases with original terms greater than 12 months that will exist during the reporting periods in transition must be capitalized. This will raise the level of audit focus. The transition year for public companies is 2019. The SEC reporting rules require three years of P&L and two years of balance sheets. This means that 2017 will be the first year to report under the new rules for public companies. Private companies must transition in 2020. Private companies have no rules for comparative financial statements, but the custom is to provide at least two years of comparative statements. To insure a successful transition to new accounting, especially when high volumes of transactions and complexity are involved, companies typically run parallel systems and test results before going live with the new reporting. This means most lessees have an immediate need to buy a lease accounting system.

The next step in the transition process will be to retrieve documents for all leases in existence, read the leases and extract the data needed to capitalize and account for the leases. Some calculations will be involved to determine the payments to be capitalized. The data that must be extracted from the lease documents and input into the lease accounting and management system includes:

  • Contractual lease term
  • Contractual rents payable: Timing and amount
  • Options to purchase or renew: Although included as a lease payment only if exercise is reasonably assured, these should be captured for future use even if their exercise is not assured.
  • Residual guarantees: Assessment is necessary to determine whether a payment is expected. The amount that the guarantee is “in-the-money” is included in the lease payments to be capitalized. Valuation of residual guarantees will be a trouble spot as lessees may have difficulty finding expected values.
  • Indication of gross/bundled billed or net lease: If gross or bundled billed, separate the lease and non-lease components. Only the lease component is included among the payments to be capitalized. A lessee can elect not to separate non-lease components, but that would result in a large overstatement of the capitalized amount. To separate the components, the lessee needs information. Ask the lessor for a breakdown, or estimate the components using available market pricing. It is unclear what auditors will accept as support for estimates. This will be a major issue in time spent, materiality and uncertainty of outcome.
  • Variable rent clauses: Account for rents based in an index like CPI or a rate like LIBOR using the spot rate at the date of booking. Account for other variable rents as incurred unless they are considered “disguised lease payments” (contractual rents are below market and the variable rents are reasonably assured of being incurred). In that case, an estimate must be capitalized.

Ideally, the lease accounting and management system should not only capture information for booking and accounting for the leases, it should serve as a critical date system to warn of future events such as when a lessee must give notice to the lessor. The system should also be able to produce disclosure information as to a table of future rent obligations, weighted average term and weighted average discount rate.

The lessee will also have to identify any unamortized IDC, unamortized landlord allowances and any accrued rent payable associated with each lease in existence during the transition financial reporting periods. Those amounts are elements (sub accounts) of the ROU asset and should be input into the lease accounting system.

The lessee will have to choose a discount rate for each lease to calculate the present value of payments to capitalize the lease. That discount rate is the lower of the lessee’s incremental borrowing rate (as of the lease booking date) or the implicit rate in the lease, if known. Often lessees do not know their incremental borrowing rate as they do not borrow medium-term fixed rate money. A proxy for the incremental borrowing rate is the lessees’ revolver rate swapped to fixed using the swap rate reported in the Federal Reserve’s H15 screen that most closely matches the term of the lease.

To ease the compliance burden, the FASB allows the lessee a transition relief period to continue using existing GAAP definitions for items like IDC, lease classification and sale treatment in a sale-leaseback. At this point, the lessee has all the information needed to book all existing operating leases.

Process For New Leases

The new rules will require a new process to book leases that will involve several disciplines in the lessee organization. The process and its internal controls must be documented.

The accounting department must receive and review every lease. The lease payments must be extracted as previously described.
Several items will require judgment of the business unit responsible for the leases:

  • Gross/bundled billed: The unit responsible for negotiating the lease must provide information to separate the lease and non-lease components.
  • Renewal or purchase options: The unit responsible for the lease must determine and document whether or not the options are reasonably certain of exercise (and thus considered a lease payment).
  • Residual guarantee: A residual guarantee must be compared to the estimated value of the asset at lease expiry to determine if a payment expected. That amount is a lease payment. The residual guarantee must be reviewed for adjustment whenever the lessee issues financials to the public.

The treasury department must provide information on incremental borrowing rates to book the leases. For leases with variable payments based on an index or rate, the treasury must provide information on changes in CPI and any interest rate for floating rate leases. To ease the complexity, the FASB allows a lessee to hold off on rebooking a lease with variable rents based on a rate or index if the rate or index changes the contractual rents. The lessee need only rebook after modification of the lease, or when the lessee does something that changes the assumptions (the best example is incurring significant leasehold improvements that make renewal options reasonably assured of exercise). This presents an issue: Rebook anyway, or track, pay and expense the “un-booked” variable rent changes as they must be disclosed?

The accounting department must classify the lease using the appropriate discount rate, the lease term and the lease payments (including interim rents and any other payments the lessor can force the lessee to pay). The accounting department must also record the lease.

The ongoing accounting is complex, so I recommend a lessee accounting system with all the controls, history and report generation capability available. The days of managing operating lease accounting using an Excel spreadsheet are over.

Good luck lessees — it’s showtime in the new world of lease accounting.

I’d like to thank Alan Bushell, co-founder and head of Development of ProLease for reviewing and providing commentary for this article.

4 Replies to “The Days of Excel Are Done: Lessees Prepare for the New Accounting Rules”

Avatar
Avatar
Avatar

Leave a comment