Lease Accounting Reform Takes Hold
The journey from issuance of a new standard to implementation
September 2021 | Originally posted in Integra International's Audit & Accounting Alert
Back in 2006, in response to increasing criticism at the inadequacy of lease accounting and reporting, the FASB and IASB launched a joint project to rectify the situation. The United States Securities and Exchange Commission had estimated in 2005 that $1.25 trillion in off-balance sheet lease obligations were held by public companies alone. (Today, lease liabilities are approaching $3 trillion).
After a discussion paper, two exposure drafts drawing over 1,700 comment letters, hundreds of meetings and workshops, the IASB and FASB, early in 2016, issued International Financial Reporting Standards 16 Leases (IFRS 16) and Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), respectively. The significant change from prior accounting was that now most leases with terms of more than twelve months would be reported on the balance sheet as right-of-use assets with corresponding lease liabilities. While the standards from the two boards were generally comparable, a basic distinction was that the ASU differentiated between operating and finance leases, while the IFRS treated all leases as financing. The expenses for finance leases were broken down between amortization and interest, while operating leases combined the expenses into amortization.
The original standard stated the purpose of the new accounting model as "to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements." With companies anticipating some cost to implement the standard, the FASB minimized that expectation by noting that the new model utilized methods already in use. That expectation proved to be grossly underestimated.
Though the standards would not be effective until 2019, by 2017 troublesome issues and questions had already arisen. In the first Swenson Advisors (Swenson) article in the November 21, 2017 JofA, Practical considerations for lease accounting, the original sense that the new standard was intended to "simplify lease accounting" was quickly followed by the reality that "These lease accounting changes are substantial and will require in many cases a significant investment of time and effort." The article proceeded to give twelve specific planning and technical tips and helpful pointers for addressing the breadth and depth of the task at hand.
Recognizing the complexities of the new standard, the FASB in 2018 issued some practical expedients and targeted improvements. These addressed areas such as retaining existing land easement treatment, making the provisions prospective, and not requiring non-lease items to be separated from lease components.
In July, 2019, with public companies having implemented the standard, a JofA Swenson article, Lease accounting: A private company perspective, turned attention to non-public entities, who at the time were scheduled for adoption in 2021. Ten of the hard learned lessons from working on public company implementation were laid out to help prepare the private sector for what they were up against. The standard was lengthy and complex, so additional time was necessary at the front end. Fully understanding the technical definition of what constituted a lease was essential in order for identification within client contracts and agreements, all of which needed to be reviewed. The comprehensive nature of the standard became even more apparent, requiring analysis of debt covenants and internal controls, as well as considering more robust software solutions and outside help from auditors and national firm publications.
Expanding on the challenges in identifying leases where least expected, Swenson released a September 19, 2019, JofA article, Hidden in plain sight: Accounting for embedded leases. The article offers several steps to aid in raising management's awareness to these types of leases and how to recognize them within existing arrangements.
The year 2020 was the first year when the new lease standard became subject to audit for public entities. With that in mind, the Swenson March 1, 2020, JofA article, Lease accounting standard requires new auditor judgments, offered insights for consideration both by internal and external auditors. Entity policy and procedural updates would need to be evaluated, along with the completeness and accuracy of identifying and accounting for leases. For example, lease terms now called for additional scrutiny, since lease extension options that were considered "reasonably assured" required capitalization on the balance sheet, accompanied by their corresponding liabilities.
As if the complexities of the new standard were not enough to deal with, the coronavirus created totally unanticipated consequences for lessees and lessors alike. The April 16, 2020 Swenson article, Pandemic alters lease accounting landscape, analyzed the situation, describing how the FASB was reacting. With no time to wait for the normal standard-making deliberative process, FASB staff provided a reasonable approach to handling nominal lease concessions which would not require revisiting every lease. (The IASB issued an amendment in May 2021 of a similar nature). Where the amounts involved changed substantially, then the lease modification provisions in the standard would be applied, requiring remeasurement of assets and liabilities. As predicted in the article, the FASB did, on June 3, 2020, expeditiously issue ASU 2020-05, extending the effective date for private entities by a year, generally to 2022.
The new lease standard continues to present challenges. In addition to the several updates discussed, the FASB staff have responded to 300 technical inquiries. In June 2021, an FASB Exposure Draft, Discount Rate for Lessees That Are Not Public Business Entities, proposed a change to allow more flexibility in setting discount rates. At a September 15, 2021, meeting, the FASB approved the change and is drafting the update. Also, while most of the issues have affected lessees, the recent July 19, 2021, ASU 2021-05, Lessors Certain Leases with Variable Lease Payments, was issued to rectify an unintended outcome for lessors. The latest Swenson article, Lease accounting: Private companies on the clock after delay, published September 9, 2021, pulls things together after the COVID disruption, reiterating implementation lessons learned, coupled with suggested and necessary actions requiring timely consideration. Also, the article notes that the Government Accounting Standards Board (GASB) Statement 87, Leases, which generally treats all capitalized leases as finance leases, will be applicable for fiscal years beginning after June 15, 2021.
Further details can be found at FASB's post-issuance activities and amendments related to the amendments in Accounting Standards Update No. 2016-02, Leases (Topic 842) and IFRS 16 Leases.