Lease Accounting- Avoiding a False Start

With the initial transition date for the new Lease Accounting Standards less than two years away, a large number of companies are already in their comparative “look back” period. For US based, calendar year, public companies, the period of dual tracking between the current and future standards commenced January 1, 2017. For many of the most highly impacted retailers who operate on a fiscal year, that comparative period began on February 1st of this year.

Most companies with over 500 leases are contemplating or implementing new systems and processes to manage under this new standard. However, software providers are still finalizing their last releases to meet the requirements, so there are very few companies that are fully ready at this point in time. As time marches on, it is critical for companies to have a change management methodology in place so they can accurately reconstruct their 2017 and 2018 lease activity when they present their financials in their first fiscal quarter of 2019. Here are five tips that companies should consider:

1.      Make sure that at the beginning of your look back period (or soon thereafter) you have a mechanism in place to manage changes in leases. In many existing lease administration systems for operating leases, people will often overwrite data on a single lease record. This may not allow the company to track Balance Sheet and Expense calculations accurately when they do their transition or comparative reporting. It is important to have a snapshot of the current state of terms each time that there is a change from this point forward. Companies may have a lease in 2017 that gets renewed in 2018 or 2019 and needs to be reassessed.

2.      For companies that currently manage leases on a decentralized basis, it is critical to have a central control point for change documents that will affect the leases during the look back period. This will be necessary from both an audit and SOC control standpoint to support the new calculations. As companies evaluate a single vs multiple system approach, the volume, materiality and turnover of leases should be a major consideration. Going forward, the timing of renewal decisions close to the end of a quarter or within a currently budgeted fiscal year could yield unintended consequences. Where feasible, a centralized control point will be more reliable than decentralized.

3.      Most companies are still wrestling with the “Likely Term” decision under the new Standards. In modeling various scenarios, using only term certain dates will reduce the Balance Sheet values and maintain a lower straight line rent expense, while incorporating additional option periods will increase both the Balance Sheet values and initial expense values. However, particularly during the look back periods prior to the transition dates, there could be 20% to 30% of the leases that will expire, and managing to when the decision is made to renew will be a difficult task to recreate. It would be much cleaner to use assumptions on renewals (assuming there is a high likelihood of renewing) that carry the lease beyond the end of 2019 or FY 2020 to reduce the headaches and potential misstatement of those first reports.

4.      For international companies that need to report under both IFRS 16 and FAS ASC 842, there could be large variances in the reported expense numbers. For US companies, there will be a net income pickup on consolidation in the early years compared to the IFRS expense profile. However, the IASB is not requiring comparative presentation in the transition year. Their “cumulative catchup” approach will start every lease as of the transition date. For companies that measure performance of regions, divisions or executives based on EBITDA or Net Income, there could be some material differences based on the new lease accounting. Some effort may be required to normalize these numbers.

5.      One of the biggest changes under the new Standard is the requirement to reassess or recalculate the values related to a specific lease anytime that there is a change in terms or circumstances. More importantly, the reassessment is to be done when the business decision is made, not at the effective date of the new term as is the case today. This change will dramatically affect the timing of the recalculation and will also be a significant internal control point. Developing a consistent, cross-functional methodology and strict decision and approval protocol will be the only way to ensure that there are not erratic spikes in expenses or potential restatements down the road.

As the deadline for the initial report gets closer all companies should pay very close attention to the quality of the data they will use and the change management process. Once the data is clean and accurate to meet compliance requirements, the real work of analysis and strategy will begin.