FASB Lease Accounting Standard

In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases, which can be found in the new Accounting Standards Codification (ASC) Topic 842. The issuance of the ASU marks the completion of the FASB’s lease project.

Effective Dates

Public Entities
Reporting periods beginning after December 15, 2018. Public entities include:

• A public business entity;
• A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed or quoted on an exchange or an over-the-counter market; and
• An employee benefit plan that files financial statements with the U.S. Securities and Exchange Commission.

All Other Entities
Reporting periods beginning after December 15, 2019. Early application is permitted.

Who will be Impacted?

Any entity that is party to a lease (either as the lessor or the lessee) is subject to the provisions of the new lease standard. The new standard does provide for limited scope exceptions. For example, this standard does not apply to leases of intangible assets, leases of biological assets (i.e. timber) or leases of inventory, among other things. Because leasing arrangements are so prevalent – leases of office space, office equipment, etc. – virtually every entity who prepares their financial statements in accordance with GAAP will be impacted by the new standard. The standard will most significantly affect entities who only have leases that are currently classified as operating leases.

What is Changing?

Under the new standard, the entity’s lease, which represents a right to control the use of identified property, plant or equipment for a period of time, will be reflected as an asset on the entity’s balance sheet. A corresponding liability, equal to the present value of the lease payments, is also reflected on the balance sheet.

When Should Planning Start?

Although the standard is not effective for most companies until 2020, it is important to identify the entity’s population of leasing arrangements, including leases embedded in other agreements, as early as possible. Whether a lease contains renewal or extension options will impact the application of the standard on the entity’s books.  Additionally, an early review of the entity’s leases will provide the entity with time to negotiate practical changes to their leases before implementation of the new standard. Because the lease liability may affect an entity’s debt covenants, the entity should discuss the impact of the standard with its lenders.

What Should I Do Now?

The first step is to identify all the leases to which the entity is a party and review the provisions of the agreements in light of the new requirements. The next step would be to compute the amount of the lease asset and liability in accordance with the transition guidance within the standard. Finally, determine the effect of the standard’s requirements on other arrangements, especially debt agreements with financial institutions.

Revenue Recognition

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, which was subsequently amended throughout 2015 and 2016. The original ASU along with the subsequent amendments is collectively referred to as the Revenue Recognition standards and has been codified in the Accounting Standards Codification (ASC) Topic 606. The overall effect of Topic 606 is to move revenue recognition away from a transaction-based, industry-specific revenue recognition model and toward a principals-based approach to recognizing revenue.

Effective Date

For public entities, Topic 606 was effective for reporting periods which began after December 15, 2017. Public entities include:

• A public business entity;
• A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed or quoted on an exchange or an over-the counter market; and
• An employee benefit plan that files financial statements with the U.S. Securities and Exchange Commission.

For all other entities, Topic 606 will be effective for reporting periods beginning after December 15, 2018. Early application is permitted

Who Will Be Impacted?

Any entity that enters into contracts with customers to sell goods or services or transfer non-financial assets unless the contract is within the scope of another standard (i.e., leases or insurance contracts) is subject to Topic 606. Virtually every type of entity from manufacturers to construction contractors to broker-dealers, etc. will be impacted by Topic 606. The degree of the impact will be determined by the terms of the contracts each company enters into with its customers.

What is Changing?

Revenue has historically been recorded on a transactional basis – invoice a customer, record revenue. Allowances – for chargebacks, bad debts, discounts, etc. — are subsequently used to reduce the receivable to net realizable value. Under Topic 606, the entity recognizes revenue in an amount to which the entity expects to be entitled in exchange for the goods or services being transferred. A significant amount of judgement is applied in the recognition of revenue under Topic 606.  The entity follows a 5-step process to determine the amount of revenue to be recognized for each contract. If it is determined that a contract with the customer, as defined by Topic 606, does not exist, then the entity recognizes revenue on a cash basis only after full performance by both parties. In addition to the actual recognition of revenue, the financial statement disclosures, both quantitative and qualitative, regarding revenue recognition are greatly expanded under Topic 606.

Other Considerations

Topic 606 requires an entity to use either a retrospective or modified retrospective approach to transition to the new revenue recognition standard.

None of the off-the-shelf accounting software products have the ability to implement the requirements of Topic 606. Therefore each entity will need to develop its own systems and financial reporting controls for recognizing revenue.

Topic 606 only applies to financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Some entities might be able to switch to a special purpose financial reporting framework – cash, tax or the financial reporting framework for small- and medium-sized entities promulgated by the AICPA. Any change in financial reporting framework should be discussed with the entity’s lender in advance.