Prepare for three new FASB standards for revenues, leases, and loan impairments.
For many public companies, 2018 to 2020 may be the three most disruptive years in history for financial statements, while private companies have a one-year reprieve. Three new accounting standards with wide-ranging consequences are taking effect: revenue from contracts with customers, lease accounting, and current expected credit losses.
These three new standards issued by the Financial Accounting Standards Board may require substantial implementation efforts from corporate accounting and finance departments. Companies also shouldn’t underestimate the new standards’ impact on their broader business.
Revenue Recognition
The first standard that went into effect is ASC 606, Revenue from Contracts with Customers, which was effective for most public companies in 2018 and took effect this year for private companies. The new revenue standard provides a comprehensive framework for most types of revenue accounting, with certain exceptions including leasing income; interest income from loans and other financial instruments; and insurance premiums – all of which are governed by other accounting rules.
For most companies, adoption of the new revenue standard includes a significant effort to assess its provisions and how they apply to the company’s contracts. In many cases, however, the new guidance does not significantly change the timing and pattern of recognition. The new standard aims to provide a one-size-fits-all framework that can be applied by any company.
But one size rarely fits all, and many companies have struggled with applying the new concepts. For example, land and real estate developers historically have accounted for their projects using the percentage of completion method, which allows them to recognize revenues in proportion to their costs during a project. While the new revenue standard retains the PoC method (now called overtime recognition), it introduces new required criteria. Some developers are finding that their contracts don’t meet those standards. As a result, they must defer revenue recognition until the project is completed and delivered to the customer.
For many companies, the new standard’s biggest impact is the addition of lengthy new disclosures. Specifically, the standard requires new footnote disclosures that describe in detail the nature and timing of revenue streams, including whether revenues are generated under long- or short-term contracts; whether the revenues are earned 1) over time as services or goods are provided or manufactured or 2) at the point in time when services or goods are delivered; and how the timing of recognition of revenue differs from the timing of cash receipts.
Lease Accounting
The second new standard to go into effect is ASC 842, Leases, which is effective for most public companies this year and in 2020 for private companies. Under prior guidance, all leases were classified by the lessee as either operating or capital. Operating leases enjoyed off-balance sheet treatment, meaning that no liability was recognized for future lease payments, while capital leases were treated as if the asset had been purchased with a loan, with recognition of an asset and a liability.
With the new lease standard, FASB requires lessees to recognize almost all leases on the balance sheet, profoundly impacting many lessees. Under the new rules, lessees recognize a right-of-use asset representing the benefit they receive from the ability to use the leased asset, plus a lease liability representing the present value of the future lease payments they are obligated to make. While the impact from applying the new guidance to shorter-term leases may be minor, the result of recognizing future lease payments related to longer-term commercial leases, even on a discounted basis, is likely to create large new assets and liabilities.
While the most impacted industries are those that rely heavily on leasing, such as restaurants and retailers, very few companies are immune. The new standard applies to all lease arrangements, not just those of commercial real estate. For example, leases of equipment are also in scope, as well as those of vehicles and most other physical assets. Even leased copy machines and corporate cars fall under the new standard.
In fact, an agreement doesn’t have to be called a lease to be in the scope of the new standard. The rules also apply to embedded leases, or arrangements to use equipment or other assets as part of a larger agreement, usually a service arrangement. For example, if your contract with a security service provider includes cameras and other monitoring equipment, it might be considered an embedded lease under the new standard that you must recognize on your balance sheet.
Adopting the new standard requires an orchestrated effort across the organization to identify and gather information about all contracts. This exercise can be difficult if contracts are not managed centrally, and it may require polling your operations teams to understand what agreements are in place.
Once a company has identified all its leases, the next challenge is calculating the amounts to be recognized on the balance sheet and then accounting for their impact on expenses and net income. While companies with a few relatively simple leases may manage this process on their own, many will require a lease accounting system to ensure accurate and complete financials. This is especially true of public companies required to comply with the internal control provisions of Section 404 of the Sarbanes-Oxley Act. A new system not only increases cost and complexity, it lengthens the implementation timeline.
The new standard also may have implications beyond the balance sheet. For example, many debt covenants treat lease liabilities as additional debt. Companies should revisit their loan agreements and be proactive in explaining the new standard’s impact to lenders to minimize disruption to treasury operations.
This is also the time for companies to review their leasing strategies. Shorter-term leases with multiple renewal options may be more attractive under the new standard, because the impact to the balance sheet may be reduced. On the flip side, for companies that have historically entered longer-term leases, the adoption of the new standard is an opportunity to lock in the use of the asset for even longer to achieve preferential expense treatment. Although all leases will go on a balance sheet under the new standard, it does retain the operating versus capital (now called financing) lease classifications to determine income statement and cash flow statement presentation. Operating lease payments will continue to be reported as operating expenses and cash flows from operations. Payments associated with a financing lease will be reported outside of earnings before interest, tax, depreciation, and amortization – known as EBITDA. Extending already longer-term leases to result in financing lease classification won’t significantly change the impact to the balance sheet, but it could reduce operating expenses and increase reported EBITDA.
The new standard aims to provide a one-size-fits-all framework that can be applied by any company. But one size rarely fits all.
Lessors are impacted as well. In addition to changing priorities and strategies from lessees, lessors must consider relatively minor changes to their accounting model, which aims to align lessor accounting with revenue accounting under ASC 606. A more significant change for lessors is that they are now subject to sale-leaseback and build-to-suit guidance. In the past, lessees had to consider very detailed and punitive accounting rules on recognition of an asset on their books in a build-to-suit arrangement and when they could derecognize an asset sold in a sale-leaseback transaction, but lessors were exempt
from those rules. The new leasing standard eliminates much of the complexity of those rules, but they now apply to both lessee and lessor. Going forward, lessors could end up accounting for an asset acquired in a sale-leaseback as a receivable, as if they were a bank providing a mortgage to the seller-lessee.
New disclosures are required, too, including footnote disclosure of the nature and types of leasing arrangements, as well as the type, timing, and impact of lease payments. Additionally, specific information such as weighted-average discount rates and weighted-average remaining lease terms are required, as well as qualitative information about significant estimates and judgments. Lessees must also disclose information about leases that have been executed but have not yet become effective if material; lessors are required to disclose information about how they mitigate risk associated with the residual value of their leased assets.
Credit Impairments
The final new standard to be adopted is ASC 326, Measurement of Credit Losses on Financial Instruments, which is scheduled to take effect for most public companies in 2020 and in 2021 for private companies.
Lenders have been accounting for loan losses under an incurred loss model – it must be probable that a loss has happened to be recognized. The shortcomings of this model were apparent in the 2008 financial crises, because reporting of losses lagged behind the business cycle. To address this perceived weakness, FASB introduced a new model for recognizing loan losses, called the current expected credit losses model. CECL requires a lender to estimate losses over the life of a loan, incorporating both historical loss trends and current conditions, as well as reasonable forecasts of future conditions. This approach allows those losses to be recognized earlier.
Although banks and other lenders will feel the largest impact of the new CECL model, the new standard is not limited to financial institutions or long-term loans. It technically applies to all customer receivables. While operating lease receivables recognized under ASC 842 are outside its scope, the net investment in a sales-type or direct financing lease is not. Lessors who enter into long-term leases, such as equipment leases or some single-tenant commercial leases, that result in sales-type lease treatment will have to apply this new guidance. Like the other two new standards, the new credit losses standard requires significant new disclosures.
The new regulations and their impacts can seem overwhelming; the key is not to delay. Each standard can be implemented with a focused and determined approach, but it takes time.
By: Angela Newell (CCIM Institute)
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