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Lessons Learned for Entities That Have Not Yet Adopted ASC Topic 842, Leases

ASC Topic 842 Background

Accounting Standards Codification (ASC) Topic 842 eliminated off-balance sheet leasing activities, thereby improving financial reporting by increasing comparability and transparency. This standard allows stakeholders and investors to fully assess the impact of lease payments on a company’s cash flow. It also gives management better insight into the full extent of their lease obligations, allowing them to make more informed decisions.

Topic 842 focuses on streamlining lease accounting under GAAP and increasing transparency into liabilities resulting from leasing arrangements, particularly operating leases. This standard applies to any business or organization that enters into a lease and applies to any assets not accounted for under other topics.

As public business entities (PBEs) were required to adopt Topic 842 for the year ended December 31, 2019, most public companies have now been accounting for their leases under the new rules for nearly three and a half years.

The effective date to adopt Topic 842 for most private companies is for annual periods beginning after December 15, 2021, or January 1, 2022. The first annual reporting date is December 31, 2022, and the first quarterly reporting date being March 31, 2023 (if required).

The following are key takeaways to help private companies prepare for the adoption and successful implementation of the new leasing standard.

It is Critical to Plan for Adoption and Identify a Complete Population of Leases

Companies should involve stakeholders from all departments within the business for the successful adoption of Topic 842. The identification of a complete population of all lease agreements to be put onto the balance sheet could be challenging due to the decentralized structure of a business. The departments which should be aligned and fully involved in implementation activities include IT, legal, procurement, treasury, and real estate – just to name a few.

Companies should look to create a cross-functional Topic 842 task force and robust implementation plan so that stakeholders across the business are fully engaged and aligned on the implementation. Training stakeholders to identify what constitutes a lease and triggers for remeasurement after initial transition is an important consideration for all companies.

The Identification of Embedded Leases is a Complex Issue

Lease agreements are not always clearly labeled as a lease agreement. Topic 842 defines a lease as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”

Leases are often embedded in IT service arrangements or manufacturing service arrangements. A careful examination of agreements currently in effect, with the collaboration and alignment of stakeholders throughout the business, is critical to the identification of all embedded leases. After the adoption of Topic 842, implementing internal controls surrounding the identification of leases within the context of the new leasing guidance for the identification of leases under the definition of Topic 842 will be an important change to consider.

Data Required for the Adoption of Topic 842 Could be Challenging to Compile

The information required for the effective adoption of Topic 842 includes lease payments, other expenses or non-lease components in the lease, lease term, and an appropriate discount rate, among others. Current lease databases maintained under the old lease standards may not be sufficient or complete to meet the requirements of Topic 842.

The original lease agreements, and possible numerous amendments will be required to be analyzed during the implementation process by the company and its external auditors. If current databases do not include the required information, the extraction of pertinent key data points will need to be performed which could require a substantial amount of time to complete. After the adoption of Topic 842, the ongoing tracking of lease terms, cancellations, modifications, etc., will be required to continue to follow requirements of Topic 842.

The enhanced disclosure requirements in accordance with Topic 842 also requires expanded quantitative and qualitative data which may not have been maintained under the old standards.

Incremental Borrowing Rates are Integral to the Successful Implementation of Topic 842

Determination of an appropriate incremental borrowing rate (IBR) could be challenging for a private company. Many companies have assumed that compiling information for the determination of an IBR would be straightforward or could be obtained from a company’s rates on its existing debt. However, this has generally not proved to be the case due to changes in the term structure of interest rates and the company’s credit worthiness between the date of placing existing debt and the measurement date for leases, as well as differences between the terms of existing debt and the required hypothetical conditions of the IBR (i.e., secured v. unsecured, variable v. fixed interest rates, remaining term to maturity, amount of debt relative to the total lease payments, etc.).

Private companies have the option to use the risk-free rate as an alternative to an IBR for the calculation of the lease liabilities; however, the risk-free rate would not be suitable if the private company were considering an initial public offering or a sale to a public company. If the private company goes public, the company will then have to reassess and calculate an appropriate IBR. Additionally, using the risk-free rate would further increase the company’s balance sheet, potentially putting them in an unfavorable position for lending negotiations and benchmarking against peers who did not make this elective.

How Centri Can Help

Companies that have not yet adopted Topic 842 should consult with Centri for a successful transition to the new standard. Centri can:

• Serve as the central point of contact for the working group, ensuring that responsibilities are clearly defined, and critical deadlines are met.
• Provide technical accounting and financial reporting support for the adoption of Topic 842, including calculation of Right of Use Assets and Lease Liabilities, appropriate classification of leases, assistance on accounting for sale-leaseback transactions, and determination of incremental borrowing rates.
• Provide audit support for companies throughout the adoption of Topic 842 and the audit process.
• Tailor on-going financial reporting requirements based on new requirements of Topic 842.