For companies with high potential exposure to the new leasing standard, here are four steps worth considering now to enhance preparedness for the upcoming change:
Reviewing lease classifications. Under current rules, capital leases are recognized on the balance sheet, while operating leases are not. That will change under Topic 842, when all leases exceeding 12 months must be reported on the balance sheet. This change raises the stakes on the accuracy of lease classification.
Generally, a lease is a contract between two or more parties, in which the lessor conveys a right to control the use of a specific asset, in exchange for agreed-upon payments (or other consideration) from the lessee over a specific time frame. The “right to control” issue is an important change under Topic 842, since the new standard requires that a lessee has the right to direct the use of a leased asset, and to obtain the economic benefits from using that asset. If such “right to control” does not exist in the agreement, it will not be considered a lease, meaning that it does not need to be shown on the balance sheet.
Reassessing lease terms. As previously noted, leases with a duration of 12 months or less will not require balance sheet treatment under Topic 842. That’s why it makes sense for lessors to reassess several key elements of existing agreements, such as contractual factors (such as lease payments, terms, renewal options and costs), asset-related factors (location, leasehold improvements, costs of lost production), entity-specific factors (financial and tax consequences of changes to lease agreements), and market factors (local regulations, laws, and pricing of comparable rentals). Based on a review of one or more of those factors, a change in lease duration or option structuring may be warranted, and allow for continued “off balance sheet” treatment.
Similarly, it’s a good idea for lessees to reassess contract terms if the lessor unexpectedly exercises an option to extend or terminate a lease agreement, or when any significant changes or circumstances in the relationship make “reasonably certain” assumptions regarding the exercise of options a much harder scenario to predict.
Properly allocating initial direct costs. When negotiating or arranging lease agreements, there are certain expenses – such as fixed salaries, tax services and legal advice – that would exist even if no lease agreement was obtained. On the other hand, commissions (such as those paid to real estate agents) and incentive payments to help encourage a tenant or terminate a lease are considered initial direct costs. Under Topic 842, such initial direct costs must be included as part of any measure of the “right to use” lease, and capitalized over the term of the lease agreement.
Ensuring accounting systems can handle new disclosure requirements. Clearly, Topic 842 will generate a higher level of required financial disclosures for lessors and lessees. Given the extended time frame still remaining before the December 2018 implementation for public companies, it’s wise for business leaders to assess their accounting systems and determine what adjustments may be required to accommodate this new financial reporting requirement.
Please contact us for more information about the accounting treatment of lease transactions or other business accounting issues.
July 28, 2017