6 Steps to Implementing Late-Stage Lease Accounting Compliance

“If you haven’t completed your 842 transition, you’ve moved from the 411 category of intel gathering to the 911 category of urgency.”

If you’re a private equity (PE) backed CFO, you have spent the last few years thinking (perhaps obsessing) about real estate. After the pandemic ushered in a new era of remote work, all of the money organizations spent on real estate and offices became questionable.

Over two years into the pandemic, the questions about real estate still linger. Do you stay remote and make office space less essential; go hybrid and enable a smaller, less costly footprint; or use the looming recession as a way to shift the power dynamic and have employees return to offices more permanently?

But if the “what” and “where” of real estate is giving PE-backed and other private company CFOs a headache, then the “how to” of accounting for real estate and other leasable assets is what’s causing the migraine.

As all stakeholders are aware, the Financial Accounting Standards Board (FASB) adopted the new lease accounting standard ASC Topic 842. The prior accounting standard (ASC 840) only required capital leases to be included on the balance sheet. The new rule requires most off-balance-sheet leases to be recorded. That nuance has tremendous implications for the CFO in terms of changing the way accounting is done for operating leases. The new approach may significantly alter the balance sheet structure and leverage (liability-to-equity) ratio as well as negatively impact net working capital.

Is this new? No, FASB adopted the rule in 2016, but delayed the effective date for private companies due to implementation challenges and the pandemic. However, it is now effective for annual periods as of January 1, 2022. The problem is too many private companies have been addressing their other real estate issues (see above) and haven’t yet had the time to ensure compliance with the near-term deadline. As a result, any company using outdated accounting entries for interim reporting (be it monthly or quarterly) will now have to convert the entire fiscal year 2022 period — no small undertaking.

What does that mean to a CFO not already well along in that process, particularly in industries such as consumer products, retail, distribution/wholesale, transportation, hospitality, and business services? They need to address it now.

Of course, the early bird doesn’t always get the worm. If there’s a silver lining for the late starters, it’s that they can apply some of the lessons learned from the companies that were early to comply with the new rule.

6 Commonly Overlooked Compliance Pitfalls

1. Hybrid causes headaches. Many companies have revisited their vision of real estate, turning from large office locations to remote or hybrid options. Similarly, retailers may have moved from brick and mortar to a more online presence. Either scenario may trigger complicated asset impairment testing and loss recognition accounting-related issues.
2. Treat terms tactfully. Favorable or unfavorable lease terms previously recognized under prior regulatory guidance may no longer be recognized, such as deferred and accrued rents, unamortized initial direct costs, or tenant allowances. In such cases, amounts recognized under ASC 840 should be zeroed out upon the transition to ASC 842, either by being subsumed into the right-of-use assets or equity.
3. Careful with construction. ASC 842 significantly changes how lessees evaluate their involvement in asset construction and built-to-suit transactions. CFOs trying to account for such situations must take care in determining who controls the underlying asset.
4. Query what qualifies. Many contracts do not bear the name of “lease contracts” in their title or were previously thought of as “service contracts,” such as the use of copiers, warehouse space, or coffee machines. But those contracts may now actually qualify as leases under the new guidance and require a corresponding recognition of the lease liability. It’s critical for CFOs to carefully review recurring monthly and/or quarterly payments in order to identify and account for these new lease contract assets.
5. Examine expedients and exemptions. The new lease guidance contains optional “expedients and exemptions” created to lessen the burden of adoption and provide some measure of accounting relief. These tend to be related to the transition and subsequent ongoing accounting, lease duration, public-vs-private status of the company, etc. While their proper use can be beneficial, they need to be disclosed in the financial statements, which means any incorrect use could prove problematic. It will take some expertise to guarantee these exemptions are more beneficial than burdensome in the long run.
6. Complicating Clauses. Added to all the potential pitfalls above are the other areas of complicated analysis that can’t be overlooked when transitioning to new lease guidance. Some of the more nuanced issues relate to sale-leasebacks, renewal options, leases acquired in the course of a business combination, variable lease payments, foreign leases, non-lease components, lease modifications, and month-to-month leases.

Now that the late-bird has stolen the worm, or is at least aware of the lessons learned, it’s ready to embark on the actual compliance implementation, using this six-step cheat sheet.

6 Steps to ASC 842 Implementation

1. Kick-off. An ASC 842 implementation project should start with a kick-off meeting with all relevant finance and non-finance stakeholders to define and discuss the project scope, milestones, timeline, and definition of success.
2. Analysis. Identify the lease population to ensure thoroughness of the project scope and then conduct current information and lease accounting process analyses. Identify technical accounting gaps and fill out an issues log. Then perform disclosure gap analysis, as ASC 842 has extensive new disclosure requirements.
3. Data gathering. We know from practical experience that data gathering may be a significant challenge, given the requirements of this step. You must review lease contracts, extract all the information necessary for calculations, and select the proper discount rate — either a risk-free rate as permitted for private companies or an incremental borrowing rate if the company is considering going public in the future. Begin calculation of amortization schedules and journal entries.
4. Tech transition. It is critical that companies undertaking this initial adoption transition away from Excel, which is prone to human error, especially given the number of manual inputs, in favor of specialized lease accounting applications or modules. Many of these modules only require the entry of inputs in the pre-determined fields after the transition methodology and lease classification are determined, enabling the rest to be automatically executed — computations, journal entries at transition and recurring monthly, and lease footnote disclosure. It is important to select the most appropriate technology platform and specific software package given company size, demand for scalability and future growth, implementation/maintenance costs, and the application’s interface friendliness and ease of use.
5. Implementation and project management. The private company CFO must create robust lease implementation project management, whether that’s an internal resource or an external expert, that takes into account the perspective and informational needs of all stakeholders: sponsors, the board and management, creditors/lenders, business units, and reporting and budgeting.
6. Create end-state deliverables. Typical end-state deliverables should include the ASC 842 transition accounting memorandum, a new formalized lease accounting policy, a new lease checklist, and a lease workbook containing the amortization schedules and monthly journal entries for each operating and finance lease.

We’re not going to lie; if you haven’t completed your 842 transition, you’ve moved from the 411 category of intel gathering to the 911 category of urgency. The good news is others who have already walked this path have provided a roadmap of some of the more common pitfalls. Experts can also provide step-by-step checklists to help CFOs undertake this initiative more programmatically on their own or with the help of such experts given the now accelerated timeline of compliance and the nuances of the new rules.