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The New Lease Accounting Rules and Small Business

By Evan Scarbrough, CPA
June 1, 2019
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The newly updated lease accounting standard is likely to affect most small businesses that follow GAAP or IFRS.

 

The new accounting rules for leases go into effect for private companies’ annual reporting periods on December 15, 2019, for U.S. Generally Accepted Accounting Principles (GAAP) and January 1, 2020, for International Financial Reporting Standards (IFRS). If your small business or nonprofit organization follows GAAP or IFRS, then the new rules—Accounting Standard Codification (ASC) 842 and IFRS 16—will impact the definition of a lease, what leases are reported, and the differences between an operating and a finance (or capital) lease. The Governmental Accounting Standards Board also has issued GASB Statement No. 87, Leases, which is very similar. Thus, changes will be felt throughout all areas of accounting.

 

Early adopters report that implementing the new lease accounting rules is a very time-consuming and costly process. In part, this was because there were few software vendors with adequate products and services to meet their needs at the time. While software companies will catch up eventually, the products that initially will be available for your small business will have had limited implementation in real-world situations and will likely need major upgrades in the near future, further slowing down the implementation process.

 

Essentially the new leasing rules involve three significant differences from the previous rules:

 

  1. They put all leases, whether finance or operating, on the balance sheet (unless the lease term is less than a year).

 

  1. They require a judgment call to determine if a contract is an operating or finance lease. Capital leases were determined by yes-or-no questions: “Is the lease for 75% of an asset’s useful life?” and “Is the present value (PV) of lease payments 90% of an item’s cost?” Those have changed into “Is the lease a major part of the asset’s life?” and “Is PV of lease payments substantially equal to the item’s cost?”

 

  1. They add the element of control as part of the definition of a lease. Control is subjective, so some items that are currently classified as expenses should be reclassified as liabilities and amortized over time.

 

These new standards were put in place because companies were playing games with lease terms (such as leasing an asset for 74% of its useful life) in order to keep items off the balance sheet. Another reason is that this change puts ASC 842 and IFRS 16 in line with the already adopted ASC 606 and IFRS 15, Revenue from Contracts with Customers.

 

IDENTIFYING CHANGES

 

Other than having to meet additional disclosure requirements, lessors are relatively unscathed. The rules do include guidance, however, on recognizing revenue and expenses for taxes that landlords collect from lessees, lessor expenses paid by lessees, and variable payments with nonlease elements.

 

The major changes that these standards have enacted affect lessees. The most time-consuming part of these new rules won’t be adding already identified leases onto the balance sheet or determining whether already identified leases are classified as operating or finance. While these issues will take time, the biggest drain on time will be identifying items currently identified as expenses that should instead be classified as a lease, added to the balance sheet, and amortized. Previously, operating leases were expensed when the monthly invoice came in and frequently not recorded as a liability.

 

The new rules around embedded leases are among the trickiest components of the standards. An embedded lease exists if there’s an implicitly or explicitly identified asset in the contract and the customer controls the use—i.e., gains all of the substantial economic benefits—of an asset. Under GAAP, these standards state that an asset must be tangible, while IFRS allows for intangibles. Under both standards, leased employees aren’t allowed. An asset might be explicitly stated, such as a car with a specific vehicle identification number (VIN), whereas in other cases, the asset might be implied in the contract.

 

For example, a retailer or manufacturer has a contract with a supplier for all of its products. That supplier only has one factory that produces the items in response to the customer’s orders—in other words, the customer controls production. Since the retailer controls what’s produced, it’s considered to be leasing the factory, which is classified as an implicit asset. Changing certain contract terms may alter whether an arrangement contains an embedded lease.

 

For a variation on the example, assume that the supplier has multiple factories and the contract allows the vendor to substitute one factory’s output for that of another factory. This scenario would be a “substantial substitution right,” changing this agreement from a lease to a supply contract because the retailer actually has no control over the factory, as the asset was able to be swapped out. Going through old contracts to determine if there was an embedded lease and reviewing current contracts to see if they’re leases are the major time-consuming parts of implementing these standards. Embedded leases primarily occur in logistics, transportation, warehousing, and data center service contracts.

 

HOW TO PREPARE

 

To prepare for these changes, you must understand the accounting requirements thoroughly, as well as the landscape of your leases. Pick a random sample of your contracts with vendors and determine whether there are hidden leases embedded in the contracts.

 

The next step is to determine if your system has all the required data points needed to ascertain whether a contract is a lease. If not, then you may need to track down a hard copy of the contract to get the information.

 

After that, assess the capabilities of your company’s existing technology. Are your technology capabilities adequate to store lease data and perform calculations? After you know what your system can do and what data still needs to be recorded, you can determine if an upgrade to your lease system is all that’s required or if a complete overhaul is needed. Data collection and aggregation increase for companies with multiple locations and technology platforms. Make a plan using the prior steps as a guide. Document every step of this process for your auditors.

 

There are two considerations to keep in mind as you proceed:

 

  1. Financial ratios will be affected, which could affect other contracts, such as debt covenants.

 

  1. While you’re adopting these standards, the business doesn’t stop, and your lease population is changing with the business.

 

The Financial Accounting Standards Board (FASB) allows three options to make the transition easier for small businesses. First, nonlease and lease components can be combined to be recognized together as a single lease, although changing lease classifications requires consent from the Internal Revenue Service (IRS). Second, entities can elect to not apply the standards for comparative periods. Third, organizations don’t have to reclassify already identified leases. Applying the new rules requires accountants to use their best judgment based on multiple data points from various sources of information. Professionals with the CMA® (Certified Management Accountant) credential have the proven technical knowledge to interpret data to properly allocate revenue and expenses. If you’re a leader, not a robot, then your small business will be able to adapt seamlessly.

 

Evan Scarbrough, CPA, is an auditor for the City of Detroit, Mich., a governor with the Stuart Cameron McLeod Society, and a member of IMA’s Ann Arbor Chapter. You can reach him at eascarbro@gmail.com.
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