Accounting changes to ASC Topic 842, Leases share many of the characteristics that made the revenue recognition updates in Topic 606 so challenging. Like revenue recognition, the Topic 842 leasing standard is another principles-based approach. It includes changes to definitions that will require case-by-case analysis. It could—and is more likely to than revenue recognition—have a financial impact on not-for-profit organizations because Topic 842 changes require all lessees to recognize lease assets and liabilities on their balance sheet. Recognizing these lease assets and liabilities will affect financial ratios and the processes that rely on them, such as loan covenants.
But because the leasing standard shares so much in common with the revenue recognition standard, not-for-profit organizations may be taking the same “wait and see” approach that many private organizations have been taking with revenue recognition. A survey from the fourth quarter of 2018 found that 63% of non-public organizations had not completed the initial assessment of the new leasing standard (28% hadn’t even started the assessment).
Waiting too long to begin implementation comes with a host of problems. The leasing standard will require significant time to apply and likely take more resources to monitor and track leases over the course of their term. Not-for-profit organizations can avoid some of these problems by incorporating the most important lesson we have taken from the Topic 606 revenue recognition changes: sticking to a project timeline for adoption.
Where You Should Be in the Leasing Adoption Process
Not-for-profit organizations that are not public bond obligors and that have calendar year ends will need to have the Topic 842 standard in place for Dec. 31, 2020 financial statements. Fiscal year-end entities must adopt for financial statements with fiscal years ending in 2021. While there is still ample time for not-for-profit organizations, that long “on ramp” before the leasing standard’s effective date will be needed as your organization prepares for its various adjustments. That’s where a project timeline will be essential, because it can break up adoption into manageable pieces.
It may be helpful to think of your leasing standard adoption in terms of two stages. The first phase focuses on the considerations around the impact assessment, including:
- Training employees involved with financial statement reporting on the core changes to Topic 842, including its new definitions
- Inventorying leases and review existing contracts to ensure all assets are listed on either the fixed asset listing or leases schedule
- Performing an initial impact assessment and sharing findings with board members
- Modifying loan covenants that may be adversely affected by the impending accounting change
Ideally, not-for-profit organizations will already be through the first stage by this time, and will be onto Phase Two, which focuses more on the processes that will be needed to actually implement the changes.
Phase Two: Process & Control Updates
The changes to Topic 842 require extensive updates to processes and controls for existing leases, new or modified leases, disclosures, and key “decision points” in the new standard. Spreadsheets may not be sufficient to handle all of these considerations for every lease your organization has. Instead, it may be time to evaluate potential leasing software solutions. Phase two projects include:
- Creating policies and controls
- Determining practical expedients and transition adjustments
- Gathering disclosure information
Policies and Controls
As with revenue recognition, there are some more qualitative elements to the new leasing standard. Your organization will also want to be sure it has processes and controls around these decision points, which include:
- Does the contract contain a lease?
- What are the components of the contract?
- What is the lease classification?
- What is the accounting treatment?
- What reassessments or modifications may be needed?
Organizations should ensure they have processes and controls for tracking new leases (which will require that decision-making process), modified leases, and reassessments. More information will need to be gathered and disclosed, and chances are, Excel spreadsheets are not going to be enough.
Preparing for Practical Expedients
Lessees have several practical expedients available to make the transition to the new leasing standard simpler. These include:
- A package of practical expedients for expired or existing contracts, that include not reassessing: whether contracts contain a lease, lease classification, and initial direct costs
- Use of hindsight for lease term and impairment of the right-of-use asset
- Not reassessing existing or expired land easements not accounted for under previous lease guidance
Not-for-profit organizations should be taking the time now to evaluate which practical expedients to adopt (if any). Once selected, the practical expedient will need to be applied to all similar leases.
Set Your Topic 842 Transition
Entities have two options when it comes to their leasing standard transition. They can take a modified retrospective approach where they apply the new leasing standard to all financial periods presented in their adoption year financial statement (which may require retrospective application to up to two years’ worth of financial statements). Or, they can take a cumulative-effect adjustment to the opening balance of retained earnings at their adoption date.
It is recommended that not-for-profit organizations be prepared for the transition method long before the effective date. No matter which method is selected, it will be time-consuming and complicated to transition to the new standard. If your organization finishes its transition adjustments in advance of the effective date, it could have time to submit its transition adjustments to an auditor for a compliance review.
Gather Disclosure Information
Not-for-profit organizations will also want to leave ample time for their new disclosure requirements. As with the revenue recognition standard, there will be a lot more disclosures in the new leasing standard than in current U.S. Generally Accepted Accounting Principles (GAAP). New processes will also need to be implemented to gather, track, and record leasing disclosures.
Seek Help If Needed
Making a project timeline and sticking to it can make the transition to the new leasing standard easier. If your not-for-profit organization encounters complications with its leasing standard adoption or is unsure of where to start, you may want to consult with an accounting provider who is experienced with the nuances and complexities of Topic 842. For more information about the leasing standard, please contact us.
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