Observations on the Implementation of the New Lease Standard in Q1 2019
By Giancarlo Garipoli, Senior Manager, Assurance Services
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842, ASC 842), which superseded the guidance for lease accounting, Leases (Topic 840). ASU 2016-02 required entities to recognize right-of-use assets and lease liabilities for leases with terms of more than 12 months on their balance sheets and to provide enhanced lease disclosures. In 2018, the FASB issued additional ASUs related to ASC 842 that clarified various aspects of the new lease guidance, including how to record certain transition adjustments, and recommended other improvements and practical expedients. The new standard went into effect on January 1, 2019, for substantially all public entities.
The biggest difference between the former leasing model under generally accepted accounting standards (“U.S. GAAP”) (ASC 840) and the new leasing model is the recognition of lease assets and liabilities by lessees for leases deemed operating leases under the old model. The new standard retains the classification between finance leases (previously called “capital leases”) and operating leases; however, all leases now result in recognized balance sheet liabilities. Operating leases previously did not result in the recognition of lease obligations in the balance sheet.
The biggest change under the new U.S. GAAP model is that a lessee’s balance sheet should show the assets and liabilities arising from all leases, regardless of whether they are classified as operating or finance leases. The model presumes that all leases create an asset and a liability for the lessee.
In addition, enhanced disclosure requirements for all leases now include, but are not limited to:
- Information about the nature of an entity’s leases (including subleases) including: general description of leases, basis and terms and conditions on which variable lease payments are determined, terms and conditions of options to extend or terminate leases, residual value guarantees, and restrictions or covenants imposed by leases;
- Leases that have not yet commenced;
- Significant assumptions and judgments including: whether a contract contains a lease, allocation of consideration in a contract, determination of the appropriate discount rate;
- Amounts recognized in the financial statements including: finance lease cost, operating lease cost, short-term lease cost, variable lease cost, sublease income, net gain or loss from sale-and-leaseback transactions, cash paid for amounts included in measurement of lease liabilities, supplemental noncash information, weighted-average remaining lease term, weighted-average discount rate;
- Maturity analysis of liabilities; and
- Lease transactions with related parties.
FIRM CLIENT EXPERIENCES
Marcum LLP is a PCAOB annually inspected firm, issuing over 100 audit reports, and the 7th largest issuer public accounting firm in the United States. In the reporting period from April 1, 2018, through March 31, 2019, Marcum issued audit reports for approximately 185 SEC registrant clients, the majority of which, unless qualifying for an exemption, were subject to the implementation of ASC 842 as of January 1, 2019. We made the following observations taken from the review of a selection of the March 31, 2019, 1st quarter 10-Q filings made by Marcum LLP issuer clients:
- While early implementation of ASC 842 was allowed, the majority of Marcum LLP clients did not opt for early implementation.
- Companies that evaluated their operating leases and found no lease terms extending beyond 12 months elected to apply the short-term lease measurement and recognition exemption in which the right-of-use assets and lease liabilities were not recognized for short-term leases.
- In the period of adoption, many issuer clients elected the practical expedient and applied the transition provisions as of the effective date. Reporting periods beginning on or after January 1, 2019, were presented under Topic 842, while prior period amounts, as reported under previous U.S. GAAP, were not adjusted.
- Many issuers had leases that did not have explicitly stated interest rates and, as a result, were required to estimate the incremental borrowing rate they would expect to pay to borrow on a similar collateralized basis over a similar term, in order to determine the present value of their lease payments.
- Period lease expense disclosures regarding finance lease cost, operating lease cost, interest expense, sublease incomes, etc., were disclosed in either narrative or tabular formats, in accordance with the preference of the issuer’s management.
It is too early to assess how much attention the SEC will focus on the adoption of ASC 842. In performing a basic, non-exhaustive and non-scientific search of the SEC’s EDGAR database, for the period January 1, 2019, through August 31, 2019, we noted five (5) SEC comment letters relating to ASC 842. Comments from the SEC included requests that registrants clarify disclosures around the following, among others: (a) criteria for lease classification between operating and financing; (b) amounts of finance lease costs and operating lease costs recognized; (c) adjustments made in arriving at non-GAAP measures included in “Results of Operations”; and (d) lease liability roll-forward. (https://www.sec.gov/edgar/searchedgar/companysearch.html). These comments are consistent with our observations above and may indicate that, in general, registrants faced challenges in the preparation of footnote disclosures in the initial period following the implementation of ASC 842.
In addition, PCAOB-registered firms should note that lease accounting under ASC 842 will be one of the “Key Areas of Focus” in 2019 inspections. From the PCAOB website, published March 14, 2019: “Audit procedures on new accounting standards, including…lease accounting (ASC 842 and IFRS 16), current expected credit losses (ASC 326), and financial instrument accounting (ASC 815 and IFRS 9)” (https://pcaobus.org/Inspections/Documents/2019-Staff-Inspections-Outlook-Audit-Committees.pdf).
The good news so far is that although the full impact of PCAOB inspection comments won’t be apparent until the 2019 inspection cycle, in preliminary observations the PCAOB noted, in relation to 2018 inspections, “…we observed that audit firms have revised their audit methodologies and conducted specific trainings. Firms continue to have regular interaction with management on the implementation of the new accounting standards.” See “Staff Preview of 2018 Inspection Observations,” published in May 2019, on the PCAOB website (https://pcaobus.org/Inspections/Documents/Staff-Preview-2018-Inspection-Observations.pdf).