Get Ready for the New Lease Accounting RulesBy Richard Stern | February 26, 2019
The largest expense for a media company is salary. The second major expense would be rent – and all the leases that come with it. The accounting world – under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) –is changing the way that leases are going to be accounted for, beginning in 2019. The new rules will affect all companies that lease office space, equipment and other assets. The new guidance is intended to increase transparency and streamline financial reporting across these organisations. We will focus on US GAAP rules in this article, but will also touch on some differences under IFRS rules.
A new way to account for leases
Most of the changes in the new standard were made to the way lessees account for lease-related assets and liabilities on their balance sheets. Generally speaking, all leases with a term of more than 12 months will need to be recognised on a lessee’s balance sheet. This differs from current GAAP guidance, which requires only capital leases to be reported.
The new standard defines the lease term as ‘the non-cancellable period of the lease adjusted for options to renew the lease, terminate the lease or purchase the leased asset’. The renewal period must be included in the term if the lease can be renewed at the option of the lessee and the lessee is reasonably certain to exercise that option. If the lease can be renewed at the option of the lessor, the renewal period is included in the term, regardless of lessee intent.
Once a lease is identified as subject to the new standard, an entity needs to consider whether the contract includes more than one lease component or non-lease components. When the lease includes non-lease components, such as cleaning services, gym access, concierge services or building security, the fixed payments to be paid during the lease term need to be allocated based on the relative standalone prices of those components. A lessee is permitted, however, to elect to account for each lease component and its related non-lease components as a single lease asset.
Lease recognition and measurement
Some of the most significant updates to the US standard affect the way lessees and lessors recognise and measure leases on their balance sheets. Lessees must now record a lease liability and a related right-of-use (ROU) asset on their balance sheets on the commencement date of the lease. The lease liability figure is determined by the present value of future lease payments. A ROU asset is based on the cost of the asset, including the lease liability, pre-payments and initial direct costs (i.e. incremental costs that an entity would not have incurred had the lease not been obtained). The ROU asset will be amortised over the life of the lease period, and the corresponding adjustment will be to the rent expense account. The amortisation will be based on the total future lease payments, not just the present value. The lease liability figure will be adjusted over the life of the lease to reflect the present value at each reporting date, and the corresponding debit or credit will be an adjustment to the ROU.
Therefore, under GAAP, the impact to the income statement will be nominal. However, under the IFRS method, ROU will be amortised or depreciated as an expense based on the initial present value of the lease liability (plus costs of the lease and initial payments). The lease liability will be amortised as debt with the lease payments allocated between principal and interest expense. Consequently, under IFRS, there will be a greater amount of expense in the early portion of the lease and less towards the end. Also, under IFRS, a significant portion of the expense will be explicitly interest expense on the statement of profit and loss.
The IFRS statement of cash flows will show the portion of lease payment allocated to principal as a financing cash flow. The interest portion would be treated in accordance with the entity’s policy for interest payments in the statement of cash flows. Under GAAP, all lease payments are operating cash flows.
Under the new standard, a lessee can elect to exclude short-term leases from the ROU asset and lease liability. Short-term leases have a term of 12 months or less and do not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
Lessees and lessors will be required to provide additional disclosures to help financial statement users assess the amount, timing and uncertainty of cash flows from leases. The disclosures include both qualitative and quantitative items. This will also need to be discussed with bankers as loan covenants may need to be modified due to changes in the liabilities of a company.
Preparing for the new lease accounting standard
While some leases are straightforward with relatively standard terms and conditions, many are complex agreements tailored to the specific needs of the lessee or requirements of the lessor. The more complex the transaction, the more complex the accounting.
Developing a transition plan should be an immediate priority for both public and private companies. Financial reporting personnel need to be educated regarding the application of the new standard, but individuals from departments other than accounting and reporting should also be involved in planning activities, such as:
• Identifying all leases
• Evaluating leases individually to determine applicable accounting model for each
• Subsequently accounting for each lease, including disclosures
• Assessing the impact on contractual agreements, such as bank loan covenants
• Evaluating the efficiency and effectiveness of existing processes and controls over leasing activities
• Ensuring that vendor products used to handle lease administration (i.e. classification, measurement and recognition) will be compliant under ASC 842 or IFRS 16, as applicable.
After initial implementation, the new standards will require ongoing evaluation of a company’s leases to ensure compliance when any changes are made to a lease’s terms, components, disclosures, and so on. With the help of your independent accountant, early planning and action are critical to ensure timely preparation and continual compliance.
This article was originally published in the February 2019 edition of Your Global Advisors: Media and Entertainment.
About Richard Stern
Richard Stern, CPA, is a Partner in the Theater, Media and Entertainment Group at Marks Paneth LLP. While he serves clients in a broad range of industries, he concentrates heavily on theater, media and entertainment with a particular focus on serving the commercial, film and television industry including film equipment rental companies, directors, editors and music producers, as well as creative services. Mr. Stern also deals with production tax credits available for the film, television and... READ MORE +