Pictured, left to right: Prabhakar Kalavacherla, Mark LaMonte, Marc Siegel, Scott Taub, and Amie Thuener
Photos by E. Lee White
The panel began with Siegel outlining FASB’s development of the long-gestating lease accounting standard. “The idea was to try to take operating leases, which traditionally … have been added back to the balance sheet using the disclosures, and try to make that a little bit easier by actually presenting them on the balance sheet through recognition and measurement.” The standard was also part of the convergence effort with the IASB, though the final classification of leases as operating or finaning does deviate from the IFRS’s approach of classifying all leases as finance leases. “We went with a different approach based on feedback that we got from many constituents, including most of the preparers,” he admitted. “We’re hopeful that the actual outcomes in profit and loss statements wouldn’t be all that different in terms of trends,” he said.
LaMonte added that getting leases back on the balance sheet has been a desire of financial statement users for some time. At Moody’s, he said, “we’ve used some very complex calculations that try to simulate a whole-asset approach.” Because of this, Moody’s analysis will not change much, but LaMonte was quick to point out that Moody’s is unique in its ability to do such a deep analysis. “FASB has moved financial reporting for everyone closer to what the sophisticated users of financial reports were doing, and that’s a good thing,” he said.
Identifying Leases
Strauss then asked Thuener to explain how to determine what is and is not a lease under the new standard. Thuener outlined Google’s two-pronged, top-down and bottom-up approach to the question. The top-down approach started with the company’s 10-K commitment disclosure note, then led to training for business controllers regarding the inclusion of service contracts in the definition of a lease. “The controllers are really helping us identify the population [of leases], now that they understand the new rules,” she said. The bottom-up approach, Thuener said, involved searching purchase orders and general ledgers for key terms, such as “rent,” “truck,” and “storage,” that would indicate the existence of a contract that qualifies as a lease. Google has also added steps to its purchase order process to flag new contracts as leases for future recognition.
Taub mentioned two issues that have arisen in his practice. The first entails evaluating whether a contract not explicitly labeled as a lease meets the standard’s new definition. The second is that many of his clients say that they will have to go through all of their filing cabinets across the world to find all the documents marked “lease.” According to Taub, many smaller leases were not considered material and thus not previously covered in note disclosures.
Taub and Thuener both said that software solutions for identifying leases are not yet up to filers’ expectations. “Some companies are hoping that there will be a software package that will literally be able to read the contract with some artificial intelligence and identify whether there is a lease, pull out the payment information, and drop it in the calculation,” Taub said. Thuener stated that there is no such “endto-end” package on the market yet, although some programs can read contracts and pull out the relevant information, which companies can then feed into their record-keeping systems. “Until that system is fully built out,” she said, “we will have to do some off-line, top-level stuff to meet the disclosure requirements.”
Accounting for Lessees
Strauss then turned to Kalavacherla to detail the process for accounting for leases on the lessee side of the transaction. The biggest change, Kalavacherla said, is the placement of all operating leases on the balance sheet. “You probably cannot, in all likelihood, at big and small companies, take the note that you had in your previous financial statements and put that on the balance sheet. I don’t think that works.” Leases for a term of 12 months or less that have no reasonable certainty of being extended can, however, be omitted for the sake of practicality. He stressed, however, that “this is a class-of-asset-by-class-of-asset decision,” rather than asset-by-asset.
The definition of “reasonably certain” is also not clear, Kalavacherla said. LaMonte agreed, saying this could become the new “pain point” for companies. “In the past, there was a lot of structuring done to keep leases off balance sheet, at that threshold between what was a capital lease and what was an operating lease. It will be interesting now to see if that kind of structuring pressure moves to ways to minimize the amount going on the balance sheet, through things like renewals and this threshold of what is or is not reasonably certain.” LaMonte believes that companies will be doing what economically makes sense for them and not subjecting themselves to the risk that comes along with renewals.
Next, Taub took up the issue of amortizing the right-of-use asset. He disagreed with earlier comments by SEC Chief Accountant Wesley Bricker, saying that this provision of the standard will diverge U.S. reporting from IFRS, but to the benefit of both. “They used to be the same, and the accounting was really bad; now they will be different, but both will be better,” he said. Asset numbers will differ because of the different handling of amortization for operating leases under the U.S. standard.
LaMonte then detailed the specific difference between amortizing the two types of leases under U.S. GAAP. Finance lease accounting will be similar to capital lease accounting under the old standard for lessees, he said, with assets amortized on the interest method, front-loading the expense. LaMonte again said that the change in company behavior will be interesting to watch, as companies that are sensitive to earnings before income, taxes, depreciation, and amortization (EBITDA) measures may prefer classifying as many leases as possible as finance leases.
Thuener and Kalavacherla detailed the accounting for operating leases. Thuener noted that, while balances will look the same on profit and loss statements, the method of calculation will be very different. In short, the liability of the lease obligation is recognized, along with the corresponding right-of-use asset. The charge to income will, effectively, be the same as the rent expense. Kalavacherla then dove into the details of how these amounts balance: as the asset is amortized each year using the straight-line method, a “plug” must be used.
Kalavacherla then walked through how to arrive at the plug amount through a hypothetical example. “You cannot plug the interest expense, so you have to plug the asset,” he noted. “This is the only method suggested in FASB’s basis of conclusion, but the accounting firms have come out with another solution, which is equally correct if you accept the plug as the right thing to do.” Kalavacherla noted, however, that this alternative is difficult in practice and requires reversing entries and rebooking the liability and corresponding asset each period.
Other Accounting Issues
At Strauss’s urging, Taub talked more about the criteria used to separate finance and operating leases. The wording, he noted, is very similar to the old, principles-based International Accounting Standard (IAS) 17, Leases, and considers whether the payments represent “most of the fair value and whether the term represents a substantial portion of the useful life of the asset.” Listing of bright lines is not covered, although he noted that the implementation section does allow for a bright-line method of application. While there is room for other methods, Taub said, “I wouldn’t recommend anybody try it.”
Siegel then covered variable lease payments, which he said FASB spent a good deal of time on. Ultimately, the board decided that only those variable payments based on an index or rate, and not those based on sales or usage, would be included in the lease liability.
“For lessees, on the expense side, the variable lease payments would be recognized in the period when the obligation for those payments is incurred,” Siegel said. “On the lessor side, the income from the contingent rent or variable lease is recognized when you receive the payment or if there is a change in facts and circumstances that make you reconsider it.” Probability is not a factor, which LaMonte said could lead to more structuring of agreements to minimize recognized liability, which could in turn impair comparability between companies.
Thuener talked about the components of a contract and how to account for them. “Just like revenue recognition, you now have to look at a lease and see what all the components are, because you might have lease and nonlease components in a lease. You may also have multiple leases in a lease, and you need to account for them all separately,” Thuener said. “Look at what’s a separate deliverable and what’s really part of the lease,” she advised, using the example of a real estate lease where maintenance and utilities would be considered nonlease components. Grouping components by asset class is also an option, she said, which goes a long way to simplifying the process.
Kalavacherla then covered issues surrounding modifying leases, which is similar to a provision in the new revenue recognition standard. He praised FASB’s work in this area, saying, “The new guidance is very intuitive and makes a lot of sense.” New assets are accounted for as a new, separate lease, while modifications of existing terms trigger a reassessment of the lease’s classification and, if necessary, application of a discount rate to adjust the amount of the asset or liability. “The standard takes you down ‘how do you do that,’” he said, noting that many accounting firms have developed simple flowcharts explaining the process.
Siegel quickly covered the issue of initial direct costs, which have been narrowed to include only incremental costs that would not have incurred had the lease not been obtained, such as commissions paid to obtain the lease. “From the lessor perspective,” he said, “you may get more expenses now up front, and that may not be good,” as lease margins could become greater throughout the rest of the lease term.
Finally, Taub briefly discussed the lessor accounting under the new standard, which will, for the most part, remain the same. Accounting for variable payments has been simplified, allowing sales-type leases with such arrangements to retain that classification. In addition, there is currently no practical expedient to separate nonlease components for lessors, although Siegel clarified that FASB has voted to create one and should issue it soon. Siegel also listed other implementation issues that lessors have shared with FASB, which include insurance, sales, and property taxes, all of which the board is working to address.
Disclosures and Presentation
Regarding how the accounting is presented within the financial statements, Strauss turned to LaMonte to discuss disclosures. LaMonte said that this area “is something important for preparers of financial statements to start thinking about sooner rather than later, because you’re going to have more work to do here.” Quantitative and qualitative disclosures will be necessary, he said, and their net effect will be to enhance comparability. “Our analysts may be poking around in these disclosures where they have concerns about those particular issues,” he said.
Thuener then shared some of Google’s approach to disclosures, saying, “You have to capture way more information and be ready to disclose it. We’re looking at what we’re going to have to start capturing, and figuring out how we’re going to pull it out of those leases so that we’re ready.” Companies will have to consider the implications of the standard on all of their metrics, she said, and educate investors on what to expect. She also noted that preparers are happy about lease liabilities being separated from debt. “That’s going to help with some of the covenant calculations,” she said.
Final Touches
Strauss then shared a list of other areas of interest, such as subleases, sale and lease-back arrangements, residual value guarantees, and foreign exchange issues, for comment by the panelists. Siegel noted that subleases are treated as new leases, and that changes in terms in the sublease can complicate the accounting. Kavalacherla described the new accounting for sale and leasebacks as “watered down,” although he did say that there will still be challenges. “You need to look at the terms, whether you have a substantial call option or a put option, or whether the lessee will account for it as a finance lease,” he said.
Thuener covered the effective dates of the standard—2019 for public companies and 2020 for nonpublic companies—and discussed how Google is handling the approaching deadline. “It’s a lot of work,” she said. “If you haven’t started, you’ve got to get on it now.” The heavy workload of transition means that few companies have elected to adopt early; most that have did so to converge it with their adoption of the revenue recognition standard. Siegel noted, however, that there have been few requests for delayed adoption.
Taub then spoke about the transition process itself. The restatement of financials from 2017 and 2018 is allowed but not mandatory, per a March 2018 decision by FASB, with capital leases handled the same as before and operating leases handled under the new rules. “They tried to make it as painless as possible,” he said; preexisting leases will not need to be reclassified, nor will they need to be examined for service contracts that would qualify as leases under the new definition. Kavalacherla added that a modified retrospective method is the only option for the transition, and he expects most issuers to choose not to restate financials from 2017 and 2018. LaMonte agreed, saying that the difference would be minimal enough that Moody’s does not plan to reanalyze those old numbers, although he acknowledged that less sophisticated users would have to adjust how they read the statements. Kavalacherla also noted that any practical expedients taken must be used consistently; they cannot be elected on a lease-by-lease basis.
Siegel picked up on the thread of comparability, noting that users less sophisticated than Moody’s would have more difficulty comparing the 2019 numbers with those from previous years. “I’m assuming companies will try to make it as easy as possible for them to understand the year-over-year differences, if they’re significant,” he said. He also talked about the ongoing implementation process at FASB, which has been the source of many of the practical expedients mentioned during the panel. He urged the audience to refer regularly to the implementation section of FASB’s website for any updates.
Thuener discussed the costs of implementation, both financial and less tangible. “The cost has not been insignificant in terms of time and effort that this has taken,” she said. Google has set up a task force that draws from many different functional areas, including technical accounting, operational accounting, and business controllers. Education has been “critical” throughout the process, especially as the company itself has evolved. “We have new processes and controls because we’re implementing new systems, and we have to think about how we do leases differently than we did before and build in all those controls along the way,” she said. She also noted that the new standard and guidance have not affected Google’s decisions on whether to buy or lease things it needs.
Taub touched on disclosures under SEC Staff Accounting Bulletin (SAB) 74, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period, which specifically covers the impact of newly adopted accounting standards, noting that many companies try to get by saying they don’t yet know the effects. He questioned the accuracy of this, noting that they will probably have note disclosures on leases they can draw on to at least say something. “And if you really don’t know,” he added, “I’m worried about you.”
Finally, Siegel talked about the dual classification for leases, which was a major controversy in the development of the standard. The decision was based on the desires of issuers: “People told us this is what they wanted. They wanted an approach that would display the operating leases on the balance sheet but not change the P&L.” He did acknowledge that a single-classification route, such as in IFRS, may have been both easier and less costly, but that FASB ultimately focused on listening to the feedback it received from its constituents.
